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

**WASHINGTON, D.C. 20549**

 

**FORM 10-K**

 

| **x**                                                | ** ** | **ANNUAL  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934**     |
|------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------|
| ** **                                           | ** ** | ** **                                                                                               |
| **For the fiscal year ended December 31, 2008** |
| ** **                                           | ** ** | ** **                                                                                               |
| **OR**                                               |
| ** **                                           | ** ** | ** **                                                                                               |
| **o**                                                | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |

 

**For the transition period from             to             **

 

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

 

**VitalImages, Inc.**

(Exact name of registrant as specified in its charter)

 

| **Minnesota**                            | ** ** | **42-1321776**                       |
|------------------------------------------|------------|--------------------------------------|
| (State or other jurisdiction of          |       | (I.R.S. Employer Identification No.) |
| incorporation or organization)           | ** ** | ** **                           |
|                                     |       |                                 |
| **5850 Opus Parkway, Suite 300**    | ** ** | ** **                           |
| **Minnetonka, MN 55343-4414**            | ** ** | **55343-4414**                       |
| (Address of principal executive offices) |       | (Zip Code)                           |

 

**(952) 487-9500**

(Registrant’s telephone number, including area code)

 

Securities registered pursuant to Section 12(b) of the Act:

 

| **Title of Each Class** | ** ** | **Name of Each Exchange on Which Registered** |
|----------------------------------------|------------|-----------------------------------------------------------------------------|
| Common Stock, $.01 par value           |       | NASDAQ Global Select Market                                                 |

 

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

 

**Not applicable.**

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

 

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

Yeso         No x

 

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

Yeso         No x

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days.       Yes x          No o

 

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

 

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

 

| Large  accelerated filer o                |   | Accelerated  filer x    |
|------------------------------------------------|--------|------------------------------|
|                                           |   |                         |
| Non-accelerated  filer o                  |   | Smaller  reporting company o |
| (Do  not check if a smaller reporting company) |

 

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

 

As of June 30, 2008, the last day of theregistrant’s most recently completed second fiscal quarter, the aggregatemarket value of the registrant’s common stock held by non-affiliates of theregistrant was $213,381,914. The common stock is the registrant’s onlyclass of voting stock.

 

Thenumber of shares outstanding of the issuer’s class of common stock as of March 9,2009 was 14,552,991 shares.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of registrant’s definitive ProxyStatement in connection with the Annual Meeting of Stockholders to be held May 14,2009 (“2009 Proxy Statement”) are incorporated by reference into Part IIIof this Form 10-K, as indicated in Items 10 through 14 of Part III.

 

 

 

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Vital Images, Inc.

Form 10-K

 

Table of Contents

 
| Part I   |                                                                                                                |
|---------------|---------------------------------------------------------------------------------------------------------------------|
|          |                                                                                                                |   |
| Item 1.       | Business                                                                                                            | 2 |
| Item 1A.      | Risk Factors                                                                                                        | 10 |
| Item 1B.      | Unresolved  Staff Comments                                                                                          | 19 |
| Item 2.       | Properties                                                                                                          | 19 |
| Item 3.       | Legal Proceedings                                                                                                   | 20 |
| Item 4.       | Submission  of Matters to a Vote of Security Holders                                                                | 20 |
|          |                                                                                                                |   |
| Part II  |                                                                                                                |
|          |                                                                                                                |   |
| Item 5.       | Market for  Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases  of Equity Securities | 21 |
| Item 6.       | Selected  Financial Data                                                                                            | 23 |
| Item 7.       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                         | 24 |
| Item 7A.      | Quantitative  and Qualitative Disclosures About Market Risk                                                         | 36 |
| Item 8.       | Financial  Statements and Supplementary Data                                                                        | 36 |
| Item 9.       | Changes in  and Disagreements with Accountants on Accounting and Financial Disclosure                               | 36 |
| Item 9A.      | Controls and  Procedures                                                                                            | 36 |
| Item 9B.      | Other Information                                                                                                   | 37 |
|          |                                                                                                                |   |
| Part III |                                                                                                                |
|          |                                                                                                                |   |
| Item 10.      | Directors,  Executive Officers and Corporate Governance                                                             | 38 |
| Item 11.      | Executive  Compensation                                                                                             | 38 |
| Item 12.      | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters                    | 38 |
| Item 13.      | Certain  Relationships and Related Transactions, and Director Independence                                          | 38 |
| Item 14.      | Principal  Accountant Fees and Services                                                                             | 38 |
|          |                                                                                                                |   |
| Part IV  |                                                                                                                |
|          |                                                                                                                |   |
| Item 15.      | Exhibits and  Financial Statement Schedules                                                                         | 39 |
|          |                                                                                                                |   |
| Signatures    |                                                                                                                | 40 |

 

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**Part I**

 

**Cautionary Statement Regarding Forward-LookingInformation**

 

*Vital Images desires to takeadvantage of the “safe harbor” provisions of the Private Securities LitigationReform Act of 1995 (the “Reform Act”) and is filing this cautionarystatement in connection with the Reform Act. This Annual Report on Form 10-Kand any other written or oral statements made by us or on our behalf may includeforward-looking statements that reflect our current views with respect tofuture events and future financial performance. Certain statements in this Annual Report on Form 10-K are “forward-lookingstatements” withinthe meaning of Section 27(a) of the Securities Act of 1933 and Section 21Eof the Securities Exchange Act of 1934. You can identify these forward-lookingstatements by our use of the words “believes,” “anticipates,” “forecasts,” “projects,”“could,” “plans,” “expects,” “may,” “will,” “would,” “intends,” “estimates” andsimilar expressions, whether in the negative or affirmative. We wish tocaution you that any forward-looking statements made by us or on our behalf aresubject to uncertainties and other factors that could cause such statements tobe wrong.**We cannot guaranteethat we actually will achieve these plans, intentions or expectations. Actualresults or events could differ materially from the plans, intentions andexpectations disclosed in the forward-looking statements that we make.These statements are only predictions and speak only ofour views as of the date the statements were made. Although we believe that theexpectations reflected in the forward-looking statements are reasonable, wecannot guarantee future results, levels of activity, and/or performance ofachievements. We do not assume any obligation to update or revise anyforward-looking statements that we make, whether as a result of newinformation, future events or otherwise.*

 

*Factors that may impact forward-looking statementsinclude, among others,**our abilities to maintain the technological competitiveness of ourcurrent products, develop new products, successfully market our products,respond to competitive developments, develop and maintain partnerships with providersof complementary technologies, manage our costs and the challenges thatmay come with growth of our business, and attract and retain qualifiedsales, technical and management employees. We are also affected by the growthand regulation of the medical technology industry, including the acceptance ofadvanced visualization by hospitals, clinics, and universities, productclearances and approvals by the United States Food and Drug Administration andsimilar regulatory bodies outside the United States, and reimbursement andregulatory practices by Medicare, Medicaid, and private third-party payerorganizations. We are also affected by other factors identified in our filingswith the Securities and Exchange Commission, some of which are set forth in thesection entitled “Item 1A. Risk Factors” in this Annual Report on Form 10-K(and many of which we have discussed in prior filings).**Although we have attempted to list comprehensively these importantfactors, we also wish to caution investors that other factors may prove tobe important in the future in affecting our operating results. New factorsemerge from time to time, and it is not possible for us to predict all of thesefactors, nor can we assess the impact each factor or combination of factors may haveon our business.*

 

**Item 1. Business**

 

**Our Business**

 

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

 

We were founded andincorporated in Iowa in September 1988, and we re-incorporated inMinnesota in March 1997. Our principal executive offices are located at5850 Opus Parkway, Suite 300, Minnetonka, MN 55343 (telephone (952)487-9500, facsimile (952) 487-9510, e-mail – info@vitalimages.com ). From May 24,1994 

 

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through May 11,1997, we were a wholly-owned subsidiary of Bio-Vascular, Inc., which isnow known as Synovis Life Technologies, Inc.

 

Our corporate websiteaddress is www.vitalimages.com. To access our Annual Reports on Form 10-K,Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, otherreports and documents filed with or furnished to the United States Securitiesand Exchange Commission (the “SEC”) and amendments to these reports free ofcharge, go to the “Investors” section of our website, then to the “FinancialInfo & Filings” category, and then to the “SEC Filings” subcategory,where we make such filings available as soon as reasonably practicable afterthey are filed with or furnished to the SEC. The “Corporate Governance”category of the Investors section of our website also contains free copiesof the Charters for the Audit Committee, Compensation Committee, and GovernanceCommittee of our Board of Directors, as well as our Code of Business Conductand Ethics, which is our written code of ethics under Section 406 of theSarbanes-Oxley Act of 2002. Each of the above referenced documents can also beobtained free of charge (other than a reasonable charge for copying exhibits toour reports on Forms 10-K, 10-Q or 8-K) in print by any shareowner who requeststhem from our investor relations department. The investor relations department’semail address is investorrelations@vitalimages.com and its mail address is:Investor Relations, Vital Images, Inc., 5850 Opus Parkway, Suite 300,Minnetonka, MN 55343. Information available on our websiteis not incorporated by reference into this Annual Report on Form 10-K.

 

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

 

*ViTAL Enterprise*,introduced in May 2008, enables unlimited enterprise access to thecomplete ViTAL solution offering, including *Vitrea*, *Vitrea Web*, *ViTALConnect*and our specialized clinical options. *ViTAL Enterprise*provides customers with full access to our best-in-class clinical solutions andcomprehensive services, including education, consulting and maintenance. *ViTAL Enterprise* has the flexibility to scale to the size ofthe customer’s enterprise by providing access to the complete ViTAL solutionbased on unlimited users or concurrent users. Additionally, *ViTAL Enterprise* offers customers the ability to license thesolution through capital or subscription pricing, and it is available to ourworldwide installed base of existing customers. Going forward, we anticipate anincreasing percentage of license fee revenue will be from sales of *ViTAL Enterprise*.

 

*Vitrea® software*,our flagship software product, is an easy-to-use, intuitive, high-speed volumerendering technology that creates interactive two-dimensional, or 2D,three-dimensional, or 3D, and four-dimensional, or 4D, images from informationgenerated by standard CT scanners. *Vitrea* iscommonly deployed on standalone workstations, as well as on PACS, usingstandard computer hardware, and provides advanced visualization forradiological, cardiac, oncological and surgical applications. *Vitrea* renders vibrant, clear, color images at high speedsand enables users to interactively navigate within these images to visualize,measure and understand internal structures and disease conditions. We believeour user interfaces are intuitive, and they are specifically configured toassist physicians in optimizing their clinical workflow.

 

*Vitrea Web*provides users with everywhere access to Vital Images’ powerful advancedclinical applications via the Web. With *Vitrea Web*,customers have the same capabilities of a standalone workstation to review,analyze, and communicate findings, all from any PC. *Vitrea Web*enables advanced best of breed clinical applications access throughout thehealthcare enterprise.

 

*ViTALConnect® software*allows multiple physicians to collaboratively use advanced visualization intheir medical practices. It provides radiologists and referring physiciansanywhere, anytime access to interactive 2D, 3D and 4D medical images and theability to measure, rotate, analyze and segment those images. Our latestrelease includes features previously available only on multimodalityworkstations, such as a variety of multi-planar reformat, or MPR, modes, thickslab rendering in MPR, 3D volumetric visualization with simple point ofinterest navigation, 4D dataset visualization, CT/positron emission tomography,or PET, fusion and advanced analysis tools.

 

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Advanced visualization options expand the relevance of our products beyondthe radiology department to referring physicians and surgical specialists,particularly in the areas of cardiology, cardiovascular, oncology, neurologyand gastroenterology. Our advanced visualization options allow physicians tocustomize their software according to their unique requirements. Most optionsare proprietary; however, *ViTAL Enterprise*and*Vitrea* alsoserve as an integration platform for applications offered by our visualizationtechnology partners. Our options include:

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

 

Our software solutionsare used with medical diagnostic equipment, primarily in clinical analysis andtherapy planning. Our software applies proprietary technologies to a variety ofdata supplied by CT scanners to allow medical clinicians to create 2D, 3D and4D views of human anatomy and to non-invasively navigate within these images tobetter visualize and understand internal structures and pathologies. Our maincustomers are hospitals and clinics, university medical schools and diagnosticimaging centers. We market our products and services to these customers bothdirectly through our own sales force and indirectly through digital imagingequipment manufacturers and PACS companies, who sell our products with otherproducts they either manufacture or acquire from third parties.

 

Our products work withequipment from all major manufacturers of diagnostic imaging systems, includingToshiba Medical Systems Corporation (“Toshiba”), GE Healthcare (“GE”), SiemensMedical Systems, Inc. (“Siemens”) and Philips Medical Systems (“Philips”).Our products may also be integrated into PACS, such as those marketed byMcKesson Corporation (“McKesson”) and Sectra AB (“Sectra”), and run onoff-the-shelf third-party computer hardware.

 

**Maintenanceand Services**

 

In addition to softwareproducts, we provide maintenance and support services, as well as certain otherservices, such as installation and customer education. We offer maintenance andsupport services for our software solutions pursuant to which we provide errorcorrection, software enhancements, updates and upgrades, telephone support andother general support services.

 

**MarketOpportunity**

 

We believe thenumber and complexity of advanced medical imaging examinations creates asubstantial opportunity for us in the medical imaging market. Diagnostic CTscanning equipment today is capable of quickly generating thousands of discreteimages in a single imaging exam, which is many times more than were generallyattained in such exams as few as five years ago. This substantial data outputcannot be analyzed in a timely or cost-effective manner without the use ofdigital solutions capable of handling these large data sets efficiently andaccurately. Physicians require advanced visualization solutions that canquickly render 2D, 3D and 4D images to improve their 

 

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clinicalefficiency and efficacy as healthcare organizations search for ways to increasethroughput and gain operational efficiencies in their day-to-day practices.

 

While advancedvisualization applications are commonly used by radiologists, usage is becomingmore widespread among non-radiology specialties. In general, we expect tobenefit as advanced visualization software is used increasingly throughout thehealthcare enterprise by non-radiology clinicians and physicians. Non-radiologyclinical specialties are using advanced visualization and analysis tools toimprove productivity and facilitate less invasive patient care.  Expanding usage of our products in otherclinical specialties, including cardiology, neurology, women’s health,respiratory pulmonary medicine, gastroenterology and surgery, will serve toexpand our user base across the healthcare enterprise. In addition, images arenow being used by referring physicians to educate patients, plan treatment andmonitor patient progress.

 

This shift has createddemand for advanced visualization solutions that can be accessed throughout theenterprise. We facilitate enterprise-wide advanced visualization bydistributing images and certain analysis tools directly using *VitreaWeb*and *ViTALConnect* which allow remote access to *Vitrea’s* toolset, as well as through ourability to integrate with PACS and other healthcare information technologysystems.

 

In general, we believethat several macro market trends will drive long-term demand for our products:

 

·                  increasing number of imaging examsperformed due to the expanded use of CT imaging procedures by physicians and anaging U.S. population;

·                  technological advancements enablingCT scanners to generate thousands of images per exam;

·                  demand from radiologists,non-radiologists and other referring physicians for advanced visualizationsolutions that can improve productivity, optimize clinical workflow and enhancetreatment planning;

·                  international markets are still inthe early phases of adopting advanced healthcare technology and will continueto purchase increasingly more advanced healthcare technology as healthcareinfrastructure and demand for advanced services increase;

·                  increasing use of imaging technologythroughout the healthcare enterprise, in part due to the integration ofadvanced visualization with healthcare information technology systems; and

·                  growing importance of integratingadvanced visualization and analysis tools into the clinical enterprise tofacilitate collaboration among clinicians and physicians, increase access toinformation and improve workflow productivity.

 

In 2008, as was the casein 2007, market demand for advanced visualization solutions decreased. Webelieve the decrease in market demand in 2008 was caused primarily by the followingfactors:

 

·                   a general slowdown in hospitalpurchasing as a result of the global credit crisis and other macroeconomicfactors;

·                   a reduction in purchases of CTscanners and other imaging related healthcare information technology, as aresult of the broader economic slowdown and its related effect on imagingspending;

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

·                   reductions in purchases by medical imagingfacilities due to reduced profitability for that industry resulting fromincreased regulatory requirements and reductions in reimbursement; and

·                   a maturing of the PACS market, asmost large hospitals have previously installed PACS, resulting in the PACSmarket being a replacement market instead of a new installation market.

 

We expect many of thefactors affecting the market in 2008 to continue into 2009. Based on currentand anticipated 2009 hospital spending patterns and the condition of the overalleconomy in the U.S., we expect a decrease in the imaging equipment market andadvanced visualization market in 2009. These factors will affect not only ourcore customer base of radiologists but all potential users of advancedvisualization. At this time, it is difficult to predict market growth ratesbeyond 2009. However, until there are improvements in the credit markets andgeneral availability of debt instruments to help hospitals fund healthcaretechnology purchases, we expect that the environment will remain challenging.

 

**Strengths**

 

One of our key competitive differentiators from other advancedvisualization providers is our focus on, and investment in, developingintuitive, user-friendly software. Our software is designed to automate commonelements 

 

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of physician visualization workflow, which makes our software simple touse and facilitates user adoption across a broad range of constituents in thehealthcare enterprise. We believe that workflow automation and generalease-of-use are important factors that customers consider when choosing oursolutions. In addition, we believe that the following additional competitivestrengths also contribute to our success:

 

·                  ourcompatibility with all major diagnostic imaging scanners and with manydifferent healthcare information technologies, including PACS and ElectronicMedical Records (EMRs);

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

·                  our largeinstalled base of customers and our related commitment to service excellence,which contributes to our strong recurring revenue stream in the form of ongoingmaintenance and support revenue;

·                  our relationshipwith Toshiba, through which our products are distributed globally;

·                  our modularproducts for digital equipment manufacturers, PACS vendors and end-usercustomers that can easily be segmented or integrated into the healthcareinformation technology environment; and

·                  our ability todistribute our applications throughout a healthcare enterprise through ourWeb-based solutions and extensible infrastructure platform.

 

**Strategy**

 

Our goal is to be aleading provider of advanced visualization and image analysis solutions that webelieve can improve clinical outcomes and reduce the overall cost of healthcarefor our customers by improving both physician productivity and patientoutcomes. To achieve this goal, we intend to continue advancing via thefollowing key strategies:

 

·                  develop and maintain leading-edge,advanced visualization technology;

·                  increase penetration of our existingcustomer base and provide excellent customer service;

·                  expand our software functionality toappeal to a broader base of users;

·                  expand our presence in the advancedvisualization market by continuing to make our products easy to integrate withother healthcare information technologies;

·                  build on and grow our relationshipwith Toshiba and McKesson;

·                  grow our business internationally;

·                  grow our collaborative partnershipswith leading medical technology companies; and

·                  selectively pursue strategicacquisitions.

 

**Marketingand Distribution**

 

We market our products both as standalonesoftware packages and as part of integrated software and hardware systemsto radiologists, surgeons, primary care physicians and medical researchers. Wemarket our products directly to end-user customers and through businesspartners, including diagnostic imaging equipment manufacturers, PACS companies,and software developers, all of whom sell our products with products theyeither manufacture or acquire from third parties.

 

Our marketingpartners include Toshiba, which markets our software to**its customers through its subsidiariesand distributors in more than 50 countries throughout the world. Our agreementwith Toshiba commenced in 2001, and it has been extended four times, mostrecently through December 31, 2013. Sales through Toshiba are a materialportion of our revenues, comprising approximately 52% of our 2008 revenues, 47%of our 2007 revenues, and 41% of our 2006 revenues. See “Item 1A. Risk Factors- Dependence on Major Customers.”

 

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We also havemarketing and reseller agreements with several other companies, such asMcKesson, Sectra and Cerner Corp., under which these companies may resell ourproducts to their customers as add-on components to their products.

 

As of December 31,2008, we had 24 salespeople in the U.S., four salespeople in Europe, onesalesperson supporting national accounts, and two salespeople supporting ourinternational resellers outside of Europe.

 

**CollaborativeRelationships**

 

From time to time,we work with leading physicians in our industry to develop advanced clinicalapplications.  These physicians, as wellas information technology professionals who work for our customers, also giveus advice and guidance about how we can develop our products to mosteffectively operate with other technologies within their enterprises.  Further, we typically obtain significantinput from our leading customers about the clinical value of our clinicalsolutions for given applications.

 

**Competition**

 

The advancedvisualization market is highly competitive, subject to rapid change and issignificantly affected by new product introductions and other market activitiesof industry participants. Our products compete based on a multitude of factors,including quality, performance, functionality, clinical features, quality ofsupport and service, reputation, brand and price. Our primary competitors arediagnostic imaging system suppliers, which are typically large, multinationalcompanies with far greater financial and technical resources. They also havewell-established sales and distribution networks for their products. Thesecompanies, including GE, Siemens, and Philips, develop and market medicalimaging systems, such as CT and MR equipment, which may be purchased with integratedmedical imaging capabilities. Our software works on the products offered byeach of these companies. To win business against equipment manufacturers, wemust convince customers to buy our solution separately from their purchase ofimaging equipment instead of buying integrated systems from our competitors. Webelieve that we have the largest organization in the world dedicated todeveloping advanced visualization solutions, as the groups working oncompetitive technologies at the equipment manufacturers mentioned above aresmaller in relation to our company’s operations.

 

We also facecompetition from PACS vendors and other suppliers of medical imaging systemsand software. PACS companies sometimes provide medical imaging capability inaddition to their image archiving and networking products. Some of thediagnostic equipment manufacturers, including GE and Philips, also offer PACS.Vendors of hospital, clinical and radiology information systems have alsodiversified into the PACS and medical imaging product lines, either throughinternal development or business development and partnership channels. Thesecompanies, which may be large or small, attempt to offer an integratedsystem covering a full range of administrative, clinical and radiology informationmanagement capabilities to healthcare providers. Other suppliers of medicalimaging systems and software, such as TeraRecon, Inc., compete on thebasis of volume rendering or other visualization technologies, specificapplications or market niches. We are seeing additional competitors enter ourmarket, but have yet to see these competitors attain a meaningful share of themarket.

 

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

 

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

·                  provide clinical quality, integrated2D, 3D and 4D images at a high speed with interactive navigation;

·                  provide solutions that run oncommercial, off-the-shelf computer hardware;

·                  build user interfaces that are easyfor physicians and clinicians to use so that they can easily derive value fromour products;

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

·                  leverage our visualization andanalysis technology across multiple clinical disciplines;

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

·                  offer our market-leading clinicalapplications into the broadening clinical enterprise through a Web-basedarchitecture.

 

We believe thatproduct quality, performance, functionality and features, quality of supportand service, reputation, brand and price are also important competitivefactors. We believe that customers will prefer our solutions because they arethe best-in-class productivity tools for doctors. Although price has beenless significant than other factors, increasing competition in the marketmay result in price reductions and reduced gross margins. In particular,if one or more of the diagnostic imaging system suppliers or PACS vendors, manyof which have greater scale and 

 

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resources than wedo, provides or distributes more competitive medical imaging products thanours, our business, financial condition and results of operations could bematerially adversely affected.

 

**Customers and Customer Support**

 

Through December 31,2008, we had a customer install base of approximately 3,600, principallyconsisting of hospitals and teaching hospitals, clinics and imaging centers inmajor cities and smaller population areas.

 

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

 

**Intellectual Property**

 

We rely primarily on acombination of trade secret and copyright law, employee and third-partynondisclosure agreements and other protective measures to protect intellectualproperty rights pertaining to our products and technologies. Because of therapid pace of technological change in the medical software industry, we believethat the knowledge, ability and experience of our personnel; new productdevelopments and enhancements; and ongoing, reliable product maintenance andsupport will enhance our competitive position.

 

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

 

**Manufacturing and Service**

 

Our manufacturing effortsare limited to the production, quality assurance and distribution of oursoftware, which is distributed on CD-ROM and through password-protecteddownloads. After we send software to our customers, it is loaded into hardware,either by our personnel, personnel from one of our authorized resellers, or ourcustomers’ personnel. If our personnel load the software, it is as part ofour installation services. In addition to loading software into the hardware,our installation services generally include implementation of our software intocustomers’ computer networks, configuring the network requirements andverifying software operability on site.

 

We providecustomer education services for our customers, both in connection with theiracquisition of our software and as independent purchases. We conduct customereducation programs for our software at our headquarters in Minnetonka,Minnesota, at customers’ locations and at various designated locations throughthe United States.

 

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

 

We have alsosigned reseller distribution agreements that allow us to distribute productsfrom certain third parties. These third-party products include MeVis MedicalSolutions Inc.’s ImageChecker® CT software applications for the detection oflung nodules; Mirada Solutions Ltd.’s Fusion 7DTM software application for theanatomical alignment of two different image data sets from two different typesof diagnostic equipment, such as combining images from CT and PET scanners;Confirma Inc.’s CADstreamTM breast MRI software; and Medis Inc.’s QMass® MRsoftware.

 

**Governmental Regulation**

 

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

 

Class IIIdevices generally require more stringent clinical investigation and pre-marketclearance requirements. In such cases, the FDA will require that themanufacturer submit a pre-market approval (“PMA”) application that must

 

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be reviewed andapproved by the FDA prior to the sale and marketing of the device in the UnitedStates. The process of obtaining a PMA can be expensive, uncertain and lengthy,frequently requiring anywhere from one to several years from the date of FDAsubmission, if approval is obtained at all. Moreover, a PMA, if granted,may include significant limitations on the indicated uses for which aproduct may be marketed.

 

Our software isclassified as a Class II medical device and has received marketingclearances from the FDA as the result of 510(k) pre-market notifications.Specifically, our software in general release has been cleared to be marketedfor use with CT, MR and PET scanners. Future products, add-on options toexisting software, and expanded claims of efficacy will likely requireadditional 510(k) pre-market notifications.

 

There can be noassurance that future FDA review processes will not involve delays or thatclearances will be granted on a timely basis. In recent years, the FDA hasincreased its level of scrutiny of medical devices involving software, whichrequires us to produce additional documentation about the safety andeffectiveness of our devices in order to obtain regulatory clearance, and whichcan lengthen the time required to obtain such clearance.  Further, if any of our current or futureproducts become classified as Class III devices, they could be subject toan even more expensive, uncertain and lengthy approval process, and approval,if granted, could include significant limitations on the indicated uses forwhich a product may be marketed.

 

We are alsosubject to regulation in foreign countries in which we sell our products. Manyof the regulations applicable to our products in such countries are similar tothose of the FDA, but the regulations in several countries, particularly inAsia, may be more particular than those of the FDA, and significantly greatertime and resources may be required to obtain approval in those countries. Ourability to successfully market and sell our products in foreign markets dependsin large part on our ability to comply with such foreign regulatoryrequirements. Our products have been Conformitee Europeene (“CE”) marked,indicating conformance with applicable sections of the Medical Device Directive93/42/EEC, which allows the products to be marketed in the member countries ofthe European Communities.

 

We are alsosubject to periodic inspections by the FDA and similar foreign regulatoryagencies, whose primary purpose is to audit our compliance with quality systemregulations established by the FDA and other applicable government standards.Regulatory action may be initiated in response to audit deficiencies orproduct performance problems. We believe that our manufacturing and qualitycontrol procedures comply with all applicable requirements of the FDA andforeign regulatory agencies in countries in which we sell our products. We havereceived and maintain ISO 13485: 2007 Certification.

 

Medicare andMedicaid laws and regulations may impact the financial arrangementsthrough which we market, sell and distribute our products and services topatients who are Medicare or Medicaid beneficiaries. Violations of these lawsand regulations may result in civil and criminal penalties, includingsubstantial fines and imprisonment. In a number of states, the scope of theselaws and regulations has been extended to include the provision of services orproducts to all patients, regardless of the source of payment, although thereis variation from state to state as to the exact provisions of such laws orregulations. In other states, and on a national level, several health carereform initiatives have been proposed which would have a similar impact.We believe that our operations and our marketing, sales and distributionpractices currently comply with all current applicable fraud and abuse andphysician anti-referral laws and regulations.

 

**Third-Party Reimbursement and Cost Containment**

 

Our products arepurchased primarily by hospitals, clinics, imaging centers and other users thatbill various third-party payers for the services provided to the patients.These payers, which include Medicare, Medicaid, private insurance companies andmanaged care organizations, reimburse part or all of the costs and feesassociated with the diagnostic procedures utilizing our products. The medicalimaging services performed using our software, except for disease screeningprocedures, are covered by current CPT codes (Current Procedural Terminology,as defined by the Centers for Medicare & Medicaid Services). As such,hospitals providing services using our advanced visualization solutions canseek reimbursement for such services by using existing approved CPT codes.Medicare and Medicaid reimbursement for hospitals is based on a fixed amountfor treating a patient with a specific diagnosis. Because of this fixedreimbursement method, hospitals have incentives to use less costly methods intreating Medicare and Medicaid patients, and they will frequently make capitalexpenditures to take advantage of less costly treatment technologies. Often,reimbursement is reduced to reflect the availability of a new procedure or technique and, as aresult, hospitals are generally willing to implement new cost-savingtechnologies before these downward adjustments take effect. Likewise, becausethe rate of reimbursement for certain physicians who perform certainprocedures has been, and may in the future be, reduced in the event ofchanges in the resource-based relative value scale method of paymentcalculation, physicians may seek greater cost efficiency in treatment tominimize any 

 

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negative impact ofreduced reimbursement. Any amendments to existing reimbursement rules andregulations that restrict or terminate the reimbursement eligibility (or theextent or amount of coverage) of medical procedures using our products or theeligibility (or the extent or amount of coverage) of our products could have amaterial adverse impact on our business.

 

In response to thefocus of national attention on rising health care costs, a number of changes toreduce costs have been proposed or have begun to emerge. There have been, andmay continue to be, proposals by legislators and regulators andthird-party payers to reduce these costs. There has also been a significantincrease in the number of Americans enrolling in some form of managed careplan and, in addition, many hospitals participate in or have agreements withHMOs (health maintenance organizations). It has become a typical practice forhospitals to affiliate themselves with as many managed care plans as possible.Higher managed care penetration typically drives down the prices of healthcareprocedures, which in turn places pressure on medical supply prices. This causeshospitals to implement tighter vendor selection and certification processes byreducing the number of vendors used, purchasing more products from fewervendors and trading discounts on price for guaranteed higher volumes tovendors. Hospitals have also sought to control and reduce costs over the lastdecade by joining group purchasing organizations or purchasing alliances. Wecannot predict what continuing or future impact these practices, the existingor proposed legislation, or such third-party payer measures may have onour future business.

 

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

 

The HIPAA regulationsrequire our customers to observe several requirements for the privacy andsecurity of the protected health information (PHI) of their patients.  Although the products and services we providemay technically not be covered under the HIPAA regulations, we may have accessto PHI while working with our customers and they therefore routinely requestthat we sign “business associate” agreements with them. A “business associate”is a person or entity that performs certain functions or activities thatinvolve the use or disclosure of protected health information on behalf of, orprovides services to, a covered entity. By law, the HIPAA Privacy Rule appliesonly to covered entities — health plans, health care clearinghouses, andcertain health care providers. However, most health care providers do not carryout all of their health care activities and functions by themselves. Instead,they often use the services of a variety of other persons or businesses. ThePrivacy Rule allows covered providers and health plans to discloseprotected health information to these “business associates” if the providers orplans obtain satisfactory assurances that the business associate will use theinformation only for the purposes for which it was engaged by the coveredentity, will safeguard the information from misuse, and will help the coveredentity comply with some of the covered entity’s duties under the Privacy Rule.Covered entities may disclose protected health information to an entity inits role as a business associate onlyto help 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.

 

**Employees**

 

As of December 31,2008, we had 280 full-time employees, with 102 involved in research anddevelopment, 78 in sales and marketing, 53 in technical support functions and47 in administrative functions. We believe our relationship with our employeesis good.

 

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

 

The discussion ofour business and operations included in this annual report on Form 10-Kshould be read together with the risk factors set forth below. They describevarious risks and uncertainties to which we are or may become subject. Theserisks and uncertainties, together with other factors described elsewhere inthis report, have the potential to affect our business, financial condition,results of operations, cash flows, strategies or prospects in a material andadverse manner. New risks may emerge at any time, and we cannot predict thoserisks or estimate the extent to which they may affect financial performance.Each of the risks described below could adversely impact the value of oursecurities. These statements, like all statements in this report, speak only asof the date of this report (unless another date is indicated), and we undertakeno obligation to update or revise the statements in light of futuredevelopments.

 

*We offeronly one line of products, which is advanced visualization software, relatedservices and hardware, and if our products**do not continue to gain market acceptance, our financial results wouldbe adversely affected.*

 

Our success depends onour ability to successfully market advanced visualization software for clinicaluse, and on the ability and willingness of physicians to use enterprise-wideadvanced visualization medical imaging software in clinical analysis andtherapy planning. Our enterprise-wide advanced visualization software productsare alternatives to the conventional methods traditionally used for viewingmedical images in the clinical setting. Often, a purchase 

 

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by a customer of ourproducts means that it has chosen not to utilize software that was provided inconnection with the customer’s purchase of a scanner, which means that thecustomer may pay additional amounts to obtain our products.  The acceptance of our products by physiciansand other clinicians will depend on our ability to educate those users as tothe speed, ease-of-use and other benefits offered by our products and systems,as well as our timely introduction of new features and functions. There can beno assurance that users will prefer advanced visualization and analysissoftware solutions over less expensive 2D medical imaging software or that wewill succeed in our efforts to further develop, commercialize and achievemarket acceptance for our products or for any other product in the clinicalsetting. Further, most of our business in markets outside the United States isprovided through third parties with whom we have marketing agreements. Therecan be no assurance that these third parties will wish to continue ourrelationships on an indefinite basis or under the same terms as the business iscurrently conducted. Further, although we have undertaken efforts to developdirect relationships with customers in markets outside the United States, wemay not be successful in doing so at a sufficient level. The loss of or adversechanges in our relationships with our third-party business partners, and ourfailure to establish sufficient direct relationships with customers outside theUnited States, would have a material adverse impact on our business, financialcondition and results of operations.

 

*A substantial portion of our revenue is derivedfrom sales of our software in connection with customer purchases of CTscanners, and any decline in the purchase of CT scanners or any difficulty wehave in growing sales separately from sales of CT scanners could have amaterial adverse effect on our results of operations and financial condition.*

 

Our businesshistorically was tied to sales of our *Vitrea* advancedvisualization software and related software options (which includes software,hardware and maintenance and services), which were typically purchasedconcurrently with a customer’s purchase of CT imaging equipment. Forecasts for2009 suggest that the market for CT imaging equipment will be downsignificantly.  In order to improve themarketability of our products separately from sales of CT imaging equipment,during 2008, we evolved our business model into sales throughout a customer’senterprise when we launched *ViTAL Enterprise*inMay. *ViTAL Enterprise*includes *Vitrea*and *ViTALConnect*software,as well as all options that we manufacture for such products.  *ViTAL Enterprise*makesall of our clinical functionality available throughout a hospital enterprise tobetter enable specialists to take advantage of our tools. We intend for *ViTAL Enterprise*to be sold both with purchases of CTequipment as well as in the absence of such purchases. There can be no assurancethat *ViTAL Enterprise* will meet withacceptance by a wide range of hospitals or that specialists throughouthospitals will wish to use our tools. If *ViTAL Enterprise*does not meet with market acceptance, it would have a material adverse impacton our business, financial condition and results of operations.

 

*We presently depend on Toshiba for a significantportion of our total revenues. A reduction in the business from Toshiba couldadversely affect our revenues and could seriously harm our business.*

 

A limited numberof large customers may continue to account for a significant portion ofour revenue during any given period for the foreseeable future. One of ourprincipal distribution channels is to sell our medical imaging software inconnection with medical imaging equipment sold by Toshiba. Sales to Toshibaaccounted for 52% of our total revenue for the year ended December 31,2008, 47% of our total revenue for the year ended December 31, 2007 and41% of our total revenue for the year ended December 31, 2006. Toshiba’saccounts receivable represented 42% of our accounts receivable at December 31,2008 and 34% at December 31, 2007.Except for our agreement with Toshiba, we have no significant purchasecommitments from any of our customers or business partners, and we generallymake sales pursuant to individual transactions. Our joint distributionagreement with Toshiba commenced in 2001 and has been extended five times, mostrecently through December 31, 2013. A reduction, delay, or cancellation oforders from Toshiba, or our inability to collect accounts receivable fromToshiba, likely would have a material adverse effect on our financial conditionand operating results.

 

In February 2009,Toshiba announced that via its wholly-owned subsidiary, Toshiba MedicalVisualization Systems Europe, Ltd., it had completed its acquisition of theAdvanced Visualization Imaging System Division (AVIS) of Barco nv, Edinburgh,Scotland. This acquisition enables Toshiba to conduct in-house development of3D volume rendering and advanced visualization capabilities for all Toshibamodalities. For the past 10 years, Toshiba has used Voxar 3D visualization coresoftware, a product of AVIS, in its medical imaging products and PACS. AVIS, aspart of Barco, provided advanced visualization solutions for the medicalimaging and PACS markets.

 

We believe thatdue to Toshiba’s renewal in November 2008 of its agreement with us toresell our products and its execution in January 2009 of an agreement tofund our development of advanced visualization software, the acquisition ofAVIS by Toshiba will not have a material negative impact on our sales toToshiba.  However, there can be noassurance that Toshiba will not use AVIS to develop technologies that arecompetitive to our products, particularly to work with lower-end CT imagingequipment.  If Toshiba does developtechnologies that are 

 

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competitive to ourproducts, it could choose to sell its own products in place of ours, whichlikely would have a material adverse effect on our business, financialcondition and results of operations.

 

*We operate in a single industry and are thereforedependent upon growth in the advanced visualization market. If that market doesnot grow as we expect, our business, results of operations and financialcondition will be adversely affected.*

 

The advancedvisualization industry in which we market our products is currently faced withregulatory, technical and market challenges. State and federal governmentalagencies and private payors are putting pressure on reimbursement rates foradvanced visualization examinations, which can negatively affect demand for ourproducts. Many of the major hospitals and medical research centers within theUnited States have already purchased scanners, PACS and advanced visualizationtechnologies, causing future sales to be upgrades or replacements instead ofnew installations, potentially lengthening the sales cycles as customers feelless urgency to purchase and implement new systems. We believe that the marketfor advanced visualization technologies is still developing, with growthopportunities outside the United States and among specialists beyond radiology.

 

However, given theuncertainties associated with the developing stage of many of these markets,there can be no assurance that they will develop in the manner we anticipate orthat they will not require a level of investment greater than we expect.Additionally, some of our customers finance their acquisitions throughthird-party lenders.  With the recenttightening in the lending market, some customers who would otherwise purchaseour products may not be able to obtain sufficient financing and therefore willnot complete their purchases. Accordingly, there can be no assurance that theadvanced visualization industry will provide growth opportunities for us andour software products or that our business strategies will be successful as theindustry continues to evolve. Ultimately, if the advanced visualizationindustry fails to develop as we expect, our business, results of operations andfinancial condition will be materially and adversely affected.

 

*We participate in a highly competitive industry. Ifwe fail to compete effectively, our results of operations and financialcondition would be adversely affected.*

 

We face intense competition in the advanced visualization industry. Weexpect technology to continue to develop rapidly, and our success will dependto a large extent on our ability to maintain a competitive position with ourproducts. Our competitors in the advanced visualization industry include large,established manufacturers of CT and MR imaging equipment. Companies such as GE,Siemens and Philips typically offer their own advanced visualization softwareand workstations as part of their integrated imaging and scanner systems. Oursoftware works on the products offered by each of these companies. To winbusiness against equipment manufacturers, we must convince customers to buy oursoftware solutions separately from their purchase of imaging equipment insteadof buying integrated systems from our competitors.

 

In addition tohaving a competitive advantage in marketing advanced visualization tools as anintegrated part of their imaging products, our competitors have significantlygreater capital and staffing resources for research and development that arecritical to success in the dynamic advanced visualization industry, morerecognizable brand names, and more well-established marketing and distributionnetworks. Although price has been less significant than other factors,increasing competition may result in price reductions and reduced grossmargins. Additionally, we face competition from other entities, such as PACSvendors and developers of competitive or ancillary software packages. We maynot be able to compete effectively with such manufacturers or competingentities on each or any particular factor, including price, features andservice.

 

*Our products may become obsolete ornon-competitive, or we may develop non-competitive products, which would resultin reduced revenue and profit margins.*

 

The advancedvisualization market is characterized by rapid innovation and technologicalchange. For example, as scanners become faster and generate increasingly moreslices, our software must maintain its capability to handle the increased datavolumes generated by the more powerful scanners. We may devote time andresources to develop products that do not obtain market acceptance or for whichthe market is much smaller than we expected when we planned the products, andwe may be otherwise unable to compete effectively in the marketplace. Productsdeveloped by our competitors may render our products obsolete ornon-competitive. Similarly, our competitors may succeed in developing ormarketing products that are viewed as providing superior clinical performanceor are less expensive than our current or future products.

 

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*As our products are accessed by additional medicalprofessionals throughout an enterprise, the satisfaction of our customers maydecrease.*

 

Historically, ourproducts were used by radiologists who received education on the use of imagingproducts in medical school and continuing education programs and to whom weprovided training in connection with their purchases. Further, use of medicalimaging products is a relatively routine activity for radiologists. As ourproducts are used by additional medical professionals throughout an enterprise,however, they will be used by persons with less training and familiarity withimaging technologies.  Occasional andless-trained users of imaging technology may find use of our products to bemore difficult than do radiologists, which could increase our time and expensessupporting these users, thus negatively affecting our gross margins for supportservices. Further, these users may realize less satisfaction than do ourhistorical customers, negatively affecting the adoption of our productselsewhere in the enterprise. Finally, occasional and less-trained users aremore likely to use our products incorrectly. Although our products are intendedto be secondary analytical devices, their incorrect use could result in errorsby medical professionals in their treatment of patients, lowering theirsatisfaction with our products and potentially exposing us to legal andregulatory liability, which could affect our results of operations and abilityto market our products.

 

*We may make future acquisitions, which may bedifficult to integrate, divert management resources, result in unanticipatedcosts or dilute our shareholders.*

 

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

 

·                  we may have difficulty integratingthe purchased operations, technologies or products;

·                  we may incur substantialunanticipated integration costs;

·                  assimilating the acquired businessesmay divert significant management attention and financial resources from ourother operations and could disrupt our ongoing business;

·                  acquisitions could result in the lossof key employees, particularly those of the acquired operations;

·                  we may have difficulty retaining ordeveloping the acquired businesses’ customers;

·                  acquisitions could adversely affectour existing business relationships with suppliers and customers;

·                  we may fail to realize the potentialcost savings or other financial benefits and/or the strategic benefits of theacquisitions; and

·                  we may incur liabilities from theacquired businesses for infringement of intellectual property rights or otherclaims, and we may not be successful in seeking indemnification for suchliabilities or claims.

 

Further, we maynot receive the returns from an acquisition that were expected at the time ofacquisition. In connection with any acquisition or investment, we could incurdebt, be required to amortize expenses related to intangible assets, incurlarge and immediate write-offs, experience volatility in future earningsresulting from contingent consideration, assume liabilities, or issue stockthat would dilute our current shareholders’ percentage of ownership. We may notbe able to complete acquisitions or integrate the operations, products orpersonnel gained through any such acquisition without a material adverse effecton our business, financial condition and results of operations.

 

*We sell our products internationally and aresubject to various risks relating to such international activities, which couldharm our international sales and profitability.*

 

During the years ended December 31, 2008, 2007 and 2006, 29%, 19%and 15% of our total revenues, respectively, were attributable to internationalsales. Toshiba has been the primary source of our international sales. We arealso developing direct international sales and marketing efforts. By doingbusiness in international markets, we are exposed to risks separate anddistinct from those we face in our domestic operations. Our internationalbusiness may be adversely affected by changing economic conditions in foreigncountries. Because most of our sales are currently denominated in U.S. dollars,if the value of the U.S. dollar increases relative to foreign currencies, ourproducts could become more costly to the international consumer and thereforeless competitive in international markets, which could adversely affect ourprofitability. Furthermore, the percentage of sales denominated in non-U.S.currencies may increase in the future, in which case fluctuations in exchangerates could affect demand for our products. Engaging in international businessinherently involves a number of other difficulties and risks, including:

 

·                  export restrictions and controlsrelating to technology;

 

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·                  the availability and level ofreimbursement within prevailing foreign healthcare payment systems;

·                  pricing pressure that we mayexperience internationally;

·                  required compliance with existing andnew foreign regulatory requirements and laws;

·                  business customs in other countriesthat violate U.S. laws, such as the Foreign Corrupt Practices Act;

·                  laws and business practices favoringlocal companies;

·                  longer payment cycles;

·                  difficulties in enforcing agreementsand collecting receivables through foreign legal systems;

·                  political and economic instability;

·                  potentially adverse tax consequences,tariffs and other trade barriers;

·                  international terrorism andanti-American sentiment;

·                  difficulties and costs of staffingand managing foreign operations;

·                  changes in currency exchange rates;and

·                  difficulties in enforcingintellectual property rights.

 

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

 

*If our internal control over financial reporting isfound to be inadequate, our financial results may not be accurate, raisingconcerns for investors and potentially adversely affecting our stock price.*

 

Under Section 404of the Sarbanes-Oxley Act of 2002, we are required to evaluate and determinethe effectiveness of our internal controls over financial reporting. We havededicated a significant amount of time and resources to ensure compliance withthis legislation for the years ended December 31, 2008, 2007 and 2006 andwill continue to do so for future periods. We may encounter problems ordelays in completing the review and evaluation, the implementation ofimprovements, and the receipt of a positive attestation, or any attestation atall, from our independent registered public accounting firm. In addition, ourassessment of our internal controls may identify deficiencies that need tobe addressed in our internal controls over financial reporting or other mattersthat may raise concerns for investors and therefore adversely affect ourstock price.

 

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

 

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

 

·                  a significant number of our existingand prospective clients’ decisions regarding whether to enter into licenseagreements with us are made within the last few weeks or days of each quarter;

·                  the size and number of licensetransactions can vary significantly;

·                  our dependence on Toshiba or anyother major customer for a significant portion of our revenues;

·                  a decrease in license fee revenuewhich may likely result in a decrease in services revenue in the same or subsequentquarters;

·                  clients unexpectedly postponing orcancelling projects due to changes in their strategic priorities, projectobjectives, budget or personnel;

·                  the uncertainty caused by potentialbusiness combinations in the software industry, causing clients and prospectiveclients to cancel, postpone or reduce capital spending projects on software;

·                  client evaluations and purchasingprocesses that vary significantly from company to company, and a client’sinternal approval and expenditure authorization process that is difficult andtime consuming to complete, even after selection of a vendor;

·                  the number, timing and significanceof software product enhancements and new software product announcements by usor our competitors;

·                  existing clients declining to renewsupport for our products, and market pressures that limit our ability toincrease support fees or require clients to upgrade from older versions of ourproducts; or

·                  prospective clients declining ordeferring the purchase of new products or releases if we do not have sufficientclient references for those products.

 

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*If wedo not achieve a substantial improvement in pretax results in 2009 over 2008,we may need to establish a valuation allowance for some or all of our deferredtax assets, which could materially impact our income tax provision, results ofoperations and financial condition.*

 

As of December 31,2008, we had $14.6 million of deferred tax assets. Considerations for determining the realizability of our deferred taxassets primarily involve cumulative pre-tax income for financial reportingpurposes, cumulative taxable income for the past three years, estimated futurepre-tax income for financial reporting purposes and estimated future taxableincome from our core business. We also consider the expiration dates andamounts of net operating loss carryforwards and other tax credits, andestimate the impact of future tax deductions from the exercise of stockoptions. If we do not achieve a substantial improvement in pretax results in2009 over 2008, it is reasonably possible that we may need to establishadditional valuation allowances for some or all of our deferred tax assets,which could materially impact our income tax provision, financial position andresults of operations.

 

*We are subject to government regulation, which canresult in additional costs or restrict our ability to market our products.*

 

Our products aresubject to regulation by the FDA and by comparable agencies in foreigncountries. In the United States, the FDA regulates the development,introduction, manufacturing, labeling and record keeping procedures for medicaldevices, including 3D medical imaging software and systems. Our medical devicesrequire clearance or approval by the FDA before they can be commerciallydistributed in the United States. Modifications and enhancements to a medicaldevice also require a new FDA clearance or approval if they could significantlyaffect its safety or effectiveness or would constitute a major change in itsintended use, design or manufacture. The FDA requires every manufacturer tomake this determination in the first instance, but the FDA may review anymanufacturer’s decision and may require a new clearance or approval for themodification if it disagrees with the manufacturer’s decision. If the FDArequires us to seek clearance or approval for the modification of a previouslycleared product for which we have concluded that new clearances or approvalsare unnecessary, we may be required to cease marketing or to recall themodified product until we obtain clearance or approval, and we may be subjectto significant regulatory fines or penalties, which could have a materialadverse effect on our financial results and competitive position. The processof obtaining marketing clearance from the FDA for new products and newapplications for existing products can be time-consuming and expensive. All ofour current products are marketed pursuant to 510(k) pre-market clearancefrom the FDA. Our products have been cleared to be marketed for use with CT, MRand PET scanners. The FDA may not grant clearance with respect to our futureproducts or enhancements, or future FDA review may involve delays that couldadversely affect our ability to market such future products or enhancements. Inaddition, our future products or enhancements may be subject to a more lengthyand expensive pre-market approval process with the FDA.

 

Even if we obtainregulatory clearances and approvals to market a product from the FDA, theseapprovals may entail limitations on the indicated uses of the product. Productclearances and approvals by the FDA can also be withdrawn due to failure tocomply with regulatory standards or the occurrence of unforeseen problemsfollowing initial approval. The FDA could also limit or prevent thedistribution of our products and has the power to require the recall of suchproducts. FDA regulations depend heavily on administrative interpretation, andfuture interpretations made by the FDA or other regulatory bodies may adverselyaffect us. The FDA may inspect our facilities and operations to determinewhether we are in compliance with various regulations relating tospecification, development, documentation, validation, testing, quality controland product labeling. If the FDA determines that we are in violation of suchregulations, it could impose civil penalties, including fines, recall or seizeproducts and, in extreme cases, impose criminal sanctions.

 

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

 

*The imposition of requirements under the HealthInsurance Portability and Accountability Act of 1996, or HIPAA, could adverselyaffect our business.*

 

The HIPAA regulations require our customers to observe severalrequirements for the privacy and security of the protected health information(PHI) of their patients. Although the products and services we provide maytechnically not be covered under the HIPAA regulations, we may have access toPHI while working with our customers and they therefore routinely request thatwe sign “business associate” agreements with them. A “business associate” is aperson or entity that performs certain functions or activities that involve theuse or disclosure of protected health 

 

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information on behalf of, or that provides services to, a coveredentity. By law, the HIPAA Privacy Rule applies only to covered entities—healthplans, healthcare clearinghouses, and certain healthcare providers. However,most healthcare providers do not carry out all of their healthcare activitiesand functions by themselves. Instead, they often use the services of a varietyof 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. Covered entities may disclose protected healthinformation to an entity in its role as a business associate only to help thecovered entity carry out its healthcare functions—not for the businessassociate’s independent use or purposes, except as needed for the propermanagement and administration of the business associate. These agreements arenecessary for us in the normal course of servicing and supporting our productsand may require us to incur liabilities if we disclose protected healthinformation in a manner not allowed under any respective agreement. Ourpotential liabilities may include indemnifying our customer against any damagesresulting from the disclosure. If we are not willing to or are unable to enterinto a business associate agreement with current and potential customers, suchcustomers may not purchase our products or services, which would have amaterial adverse effect on our business, financial condition, or results ofoperations.

 

*We are subject to various federal and state “fraudand abuse” laws, and if we are unable to fully comply with such laws, we couldface substantial penalties, which may adversely affect our business.*

 

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

 

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

·                  the federal False Claims Act, whichprohibits anyone from knowingly presenting or causing to be presented a falseor fraudulent claim for payment to the federal government;

·                  HIPAA, which prohibits executing ascheme to defraud any health care benefit program;

·                  the federal False Statements Statute,which prohibits knowingly and willfully falsifying, concealing or covering up amaterial fact or making any materially false statement in connection with thedelivery of or payment for health care benefits, items or services; and

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

 

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

 

*The protection of our intellectual property may beuncertain, and we may face possible claims of others.*

 

Although we havereceived patents and have filed patent applications with respect to certainaspects of our technology, we generally do not rely principally on patentprotection with respect to our products and technologies. Instead, we relyprimarily on a combination of trade secret and copyright law, employee andthird-party nondisclosure agreements and other protective measures to protectintellectual property rights pertaining to our products and technologies. Suchmeasures may not provide meaningful protection of our trade secrets, know-howor other intellectual property in the event of any unauthorized use,misappropriation or disclosure. Others may independently develop similartechnologies or duplicate our technologies. In addition, to the extent that weapply for any patents, such applications may not result in issued patents or,if issued, such patents may not be valid or of value. Third parties could, inthe future, assert infringement or misappropriation claims against us withrespect to our current or future products and technologies, or we may need toassert claims of infringement against third 

 

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parties. Anyinfringement or misappropriation claim by us or against us could placesignificant strain on our financial resources, divert management’s attentionfrom our business and harm our reputation. The costs of prosecuting ordefending an intellectual property claim could be substantial and couldadversely affect our business, even if we are ultimately successful inprosecuting or defending any such claims. If our products or technologies arefound to infringe the rights of a third party, we could be required to paysignificant damages or license fees or cease production, any of which couldhave a material adverse effect on our business.

 

*We face the risk of product liability claims, andour product liability and errors and omissions insurance coverage may not beadequate to pay products liability claims, which could have a material adverseeffect on our financial condition.*

 

Our businessexposes us to the risk of product liability claims that is inherent in themanufacturing and marketing of medical devices, including those which may arisefrom the misuse or malfunction of, or design flaws in, our products. We may besubject to product liability claims if our products cause, or merely appear tohave caused, an injury. Claims may be made by patients, healthcare providers orothers selling our products. Although we have product liability and errors andomissions insurance that we believe is appropriate, this insurance is subjectto deductibles and coverage limitations. Our current product liabilityinsurance may not continue to be available to us on acceptable terms, if atall, and, if available, the coverages may not be adequate to protect us againstany future product liability claims. Further, if additional products areapproved for marketing, we may seek additional insurance coverage. If we areunable to obtain insurance at an acceptable cost or on acceptable terms withadequate coverage or otherwise protect against potential product liabilityclaims, we will be exposed to significant liabilities, which may harm ourbusiness. A product liability claim, recall or other claim with respect touninsured liabilities or for amounts in excess of insured liabilities couldresult in significant costs and significant harm to our business.

 

*If we fail to attract and retain qualifiedpersonnel, our business would be harmed.*

 

Recruiting andretaining talented personnel in the future will be critical to our success.There is intense competition from other companies, research and academicinstitutions, government entities and other organizations for qualifiedpersonnel in the areas of our activities. If we fail to identify, attract,retain and motivate these highly skilled personnel, we may be unable tocontinue our marketing and development activities.

 

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

 

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

 

*We depend on third-party reimbursement. A reductionor other change in reimbursement from third parties could negatively affect ourbusiness.*

 

Our products arepurchased by hospitals, clinics, imaging centers and other users, which billvarious third-party payers, such as government health programs, private healthinsurance plans, managed care organizations and other similar programs, for thehealthcare goods and services provided to their patients. There are currentlyCurrent Procedural Terminology, or CPT, reimbursement codes that describe mostof the diagnostic procedures that use our products. However, the amount ofreimbursement from third-party payers varies by site of service and geographiclocation and is subject to change. Payers may deny reimbursement if theydetermine that a product used in a procedure was not used in accordance withestablished payer protocol regarding cost-effective treatment methods or wasused for an unapproved indication. Third-party payers are increasinglychallenging the prices charged for medical services and, in some instances,have put pressure on service providers to lower their prices or reduce theirservices. We are unable to predict what changes will be made in thereimbursement methods used by third-party healthcare payers. Third-party payersmay not consider as cost effective the procedures in which our products areused. Reimbursement for such procedures may not be available or, if available,payers’ low reimbursement levels may adversely affect our ability to sell ourproducts on a profitable basis. In addition, there have been and may continue tobe changes and proposals by legislators, regulators and third-party payers tocurb further these costs in the future. For example, the Deficit Reduction Actof 2005, or the DRA, which was signed into law on February 8, 2006,imposes caps on Medicare payment rates for certain imaging services, includingMR and PET, furnished in 

 

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physicians’offices and other non-hospital based settings. Under the caps, payments forspecified imaging services cannot exceed the hospital outpatient payment ratesfor these services. This change applies to services furnished on or after January 1,2007. The DRA also codifies a reduction in Medicare payments for certainmultiple images performed on contiguous body parts, which was previouslyestablished in the 2006 Physician Fee Schedule final rule. A failure byhospitals and other users of our products to obtain reimbursement from third-partypayers, changes in third-party payers’ policies toward reimbursement forprocedures using our products, or legislative action could have a materialadverse effect on our business, financial condition and results of operations.

 

*Healthcare reform may negatively impact ourbusiness.*

 

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 healthcarethrough various means. In the United States, there has been, and we expect thatthere will continue to be, a number of federal, state and private proposals tocontrol healthcare costs. These proposals include legislative, regulatory andother initiatives and may contain measures intended to control public andprivate spending on healthcare as well as to provide universal public access tothe healthcare system. If enacted, these proposals may result in a substantialrestructuring of the healthcare delivery system. For example, the CongressionalBudget Office has issued a report suggesting that radiology benefit managerscould require pre-authorization, which could decrease the demand for imagingservices. Significant changes in the nation’s healthcare system could have asubstantial impact on the manner in which we conduct business and could have amaterial adverse effect on our business, financial condition and results ofoperations.

 

*Consolidationin the healthcare industry could lead to demands for price concessions or limitor eliminate our ability to sell to certain of our significant market segments.*

 

The cost of healthcarehas risen significantly over the past decade, and numerous initiatives andreforms initiated by legislators, regulators and third-party payors to curbthese costs have resulted in a consolidation trend in the medical deviceindustry as well as among our customers, including healthcare providers. Thisin turn has resulted in greater pricing pressures and limitations on ourability to sell to important market segments, as group purchasingorganizations, independent delivery networks and large single accounts, such asthe Veterans Administration in the United States, continue to consolidatepurchasing decisions for some of our healthcare provider customers. We expectthat market demand, government regulation, third-party reimbursement policiesand societal pressures will continue to change the worldwide healthcareindustry, resulting in further business consolidations and alliances which mayexert further downward pressure on the prices of our products and adverselyimpact our business, financial condition and results of operations.

 

*We may incur goodwill impairment charges thatadversely affect our operating results.*

 

We review goodwillfor impairment annually and more frequently if events and circumstancesindicate that the asset may be impaired and that the carrying value may not berecoverable. We operate as one reporting unit and therefore compare our bookvalue to our market value (consisting of market capitalization plus a controlpremium of 25%). If the market value exceeds the book value, goodwill isgenerally considered not to be impaired. After December 31, 2008, declinesin our stock price have resulted in our book value at times exceeding our marketvalue. If such a condition continues for a sustained period, our goodwill maybe impaired. The balance of goodwill was $9.1 million as of December 31,2008, which if impaired would have an adverse affect on our financial positionand operating results.

 

*If we do not reach certainmilestones in the implementation of our enterprise resource planning (“ERP”)system, we may incur impairment charges for all or a portion of the amounts wehave capitalized, which could adversely affect our operating results.*

 

In 2007, we began the implementation of an ERP system. The ERP systemis intended to replace numerous disconnected business management softwareapplications and link the data contained within these disconnected systems toenable better management of our business and derive more useful data forvarious business functions, such as sales, marketing, finance and customersupport.

 

Phase 1 of the implementation, which related to the replacement of ourgeneral ledger, was completed in 2007. The related capitalized costs are beingdepreciated over seven years and, as of December 31, 2008, the net bookvalue of Phase 1 was $1.0 million. Phase 2 of the implementation, whichconsists of replacing our various customer relationship management and orderprocessing systems, has yet to be completed or placed in service. As of December 31,2008, Phase 2 capitalized costs were $2.9 million.  We will continue implementation of the ERPduring 2009, and upon

 

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completion of the implementation, the cost will be depreciated overseven years. If we do not reach certain milestones in the implementationschedule, we may be required to write-off all or a portion of the amountscapitalized, which could negatively affect our operating results.

 

*The disruption in the global financial markets and theeconomic downturn may adversely impact customer purchasing and paymentpatterns.*

 

During 2008, we wereaffected by the general decline in the U.S. economy, which resulted incontracted capital spending by U.S. hospitals and lower interest rates on ourcash and investments. Disruptions in the financial markets and the relatedeconomic downturn could also negatively impact customer purchasing and paymentpatterns and have a material adverse effect on our financial condition andresults of operations. There can be no assurances as to the length or severityof this period of disruption and the related economic downturn.

 

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

 

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

 

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

 

We are subject toanti-takeover provisions of the Minnesota Business Corporation Act. Theseprovisions may deter or discourage takeover attempts and other changes incontrol that are not approved by our Board of Directors, and they may have adepressive effect on any market for our stock. As a result, our shareholdersmay lose opportunities to dispose of their shares at the higher pricestypically available in takeover attempts or that may be available under amerger proposal. In addition, these provisions may have the effect ofpermitting our current directors to retain their positions and place them in abetter position to resist changes that our shareholders may wish to make ifthey are dissatisfied with the conduct of our business.

 

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

 

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

 

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

 

As permitted byMinnesota law, our Articles of Incorporation provide that members of our Boardof Directors shall not be personally liable to our company or our shareholdersfor monetary damages for breach of fiduciary duty as a director, with certainexceptions. These provisions may discourage shareholders from bringing suitagainst a director for breach of fiduciary duty and may reduce the likelihood ofderivative litigation brought by shareholders on behalf of our company againsta director. In addition, our Bylaws provide for mandatory indemnification ofdirectors and officers to the fullest extent permitted by Minnesota law.

 

**Item 1B. Unresolved Staff Comments**

 

None.

 

**Item 2. Properties**

 

Our principal office islocated in an office building in Minnetonka, Minnesota, where we currentlyoccupy approximately 72,000 square feet under a lease that expires January 31,2012. We also lease small offices in Den Haag, the Netherlands, and Beijing,China, for our operations in those countries. We consider our currentfacilities adequate for our current needs.

 

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**Item 3. Legal Proceedings**

 

We are involved invarious claims and legal actions in the normal course of business. We are ofthe opinion that the outcome of such legal actions will not have a significantadverse effect on our financial position, results of operations or cash flows.Notwithstanding our belief, an unfavorable resolution of some or all of thesematters could materially affect our future results of operations or cash flows.

 

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

 

There was no mattersubmitted to the vote of security holders during the fourth quarter of thefiscal year ended December 31, 2008.

 

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**Part II**

 

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

 

Vital Images, Inc.’scommon stock is quoted on The NASDAQ Global Select Market under the symbol “VTAL.”The table below reflects the high and low per share closing sale prices of ourcommon stock as reported by The NASDAQ Global Select Market for each of theperiods indicated. Such prices reflect inter-dealer prices, do not includeadjustments for retail mark-ups, markdowns or commissions, and may notnecessarily represent actual transactions.

 
| ** **     | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------|------------|----------|------------|---------|------------|
| 2008           |       |     |       |    |       |
| Fourth Quarter |       | $        | 15.02      |    | $          | 10.60 |   |
| Third Quarter  |       | $        | 16.33      |    | $          | 12.19 |   |
| Second Quarter |       | $        | 16.36      |    | $          | 12.44 |   |
| First Quarter  |       | $        | 18.00      |    | $          | 14.46 |   |
|           |       |     |       |    |       |
| 2007           |       |     |       |    |       |
| Fourth Quarter |       | $        | 23.05      |    | $          | 16.18 |   |
| Third Quarter  |       | $        | 27.74      |    | $          | 17.30 |   |
| Second Quarter |       | $        | 33.51      |    | $          | 25.44 |   |
| First Quarter  |       | $        | 36.48      |    | $          | 30.16 |   |

 

We have never paidor declared any cash dividends on our common stock and do not intend to paydividends on our common stock in the foreseeable future. We expect to retainour future anticipated earnings to finance development and expansion of ourbusiness. As of March 9, 2009, there were approximately 6,400 beneficialowners and approximately 600 registered holders of record of our common stock.

 

On May 8, 2008, weannounced a share repurchase program of up to $25.0 million of our commonstock. On August 7, 2008, we announced additional repurchases of upto $15.0 million of our common stock, allowing for total repurchases of up to$40.0 million of our common stock under the share repurchase program. We completed this share repurchase programon February 6, 2009 through only open market transactions. Between theinception of this share repurchase program and December 31, 2008, werepurchased 2.8 million shares of our common stock for $38.2 million. On March 4,2009, we announced a new share repurchase program, under which we willrepurchase up to 1.0 million shares of our common stock. The new sharerepurchase program expires on February 28, 2010.

 

The following table presents information with respectto purchases of our common stock made during the quarter ended December 31,2008 by us or our “affiliated purchaser,” as defined in Rule 10b-18(a)(3) underthe Securities Exchange Act of 1934.

 
| **Period**                | ** ** | **Total Number  of Shares  Purchased** | ** ** | **Average  Price Paid  per Share** | ** ** | **Total Number of  Shares Purchased as  Part of Publicly  Announced Plans or  Programs** | ** ** | **Approximate Dollar  Value of Shares that  May Yet Be Purchased  Under the Plans or  Programs (in millions)** | ** ** |
|---------------------------|------------|--------------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| October 1-31,  2008  |       | 353,549                                          |       | $                                            | 13.02      |                                                                                                                             | 4,601,722  |                                                                                                                                                                       | $          | 10.0 |   |
| November 1-30,  2008 |       | 363,425                                          |       | $                                            | 12.75      |                                                                                                                             | 4,632,602  |                                                                                                                                                                       | $          | 5.4 |   |
| December 1-31,  2008 |       | 295,712                                          |       | $                                            | 12.06      |                                                                                                                             | 3,566,782  |                                                                                                                                                                       | $          | 1.8 |   |
|                      |       | 1,012,686                                        |       | $                                            | 12.64      |                                                                                                                             | 12,801,106 |                                                                                                                                                                       | $          | 1.8 |   |

 

**PerformanceGraph**

 

Since April 24,2007, our common stock has been quoted on The NASDAQ Global Select Market. FromJune 9, 2003 through April 23, 2007, our stock was quoted on TheNASDAQ Global Market. From September 29, 2000 through June 6, 2003,our common stock was quoted on The NASDAQ SmallCap Market (now known as TheNASDAQ Capital Market). The following graph shows changes during the periodfrom December 31, 2003 to

 

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December 31,2008 in the value of $100 invested in: (1) Vital Images, Inc.’scommon stock; (2) the CRSP Total Return Index for The NASDAQ Composite;and (3) NASDAQ Non-Financial Stocks. The values of each investment as ofthe dates indicated are based on share prices plus any dividends paid in cash,with the dividends reinvested on the date they were paid. The calculationsexclude trading commissions and taxes.

 

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

 

**COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN***

Among Vital Images, Inc., The NASDAQ Composite Index

And The NASDAQ Non-Financial Index

 

 

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*$100 invested on12/31/03 in stock & index-including investment of dividends. Fiscal yearending December 31.

 
| ** **               | ** ** | **12/31/03** | ** ** | **12/31/04** | ** ** | **12/31/05** | ** ** | **12/31/06** | ** ** | **12/31/07** | ** ** | **12/31/08** | ** ** |
|--------------------------|------------|--------------|------------|--------------|------------|--------------|------------|--------------|------------|--------------|------------|--------------|------------|
| Vital  Images, Inc. |       | $            | 100.00     |         | $          | 93.78        |       | $            | 146.42     |         | $          | 194.85       |       | $ | 101.18 |   | $ | 77.88 |   |
| NASDAQ Composite         |       | $            | 100.00     |         | $          | 110.08       |       | $            | 112.88     |         | $          | 126.51       |       | $ | 138.13 |   | $ | 80.47 |   |
| NASDAQ  Non-Financial    |       | $            | 100.00     |         | $          | 108.59       |       | $            | 109.34     |         | $          | 120.07       |       | $ | 132.52 |   | $ | 77.34 |   |

 

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

 
| **Years ended December 31:** | ** ** | **2008****(1)** | ** ** | **2007****(1)** | ** ** | **2006****(1)** | ** ** | **2005****(1)** | ** ** | **2004****(1)** | ** ** |
|---------------------------------------------|------------|-----------------|------------|-----------------|------------|-----------------|------------|-----------------|------------|-----------------|------------|
| Revenue                                     |       | $               | 68,141     |            | $          | 70,176          |       | $               | 70,512     |            | $          | 51,717 |   | $ | 36,122 |   |
| Gross profit                                |       | 52,268          |       | 54,587          |       | 56,302          |       | 40,157          |       | 25,675          |       |
|                                        |       |            |       |            |       |            |       |            |       |            |       |
| Operating  expenses                         |       | 62,093          | (2)        | 61,755          | (3)        | 49,371          |       | 32,592          | (4)        | 25,161          | (5)        |
| Operating (loss)  income                    |       | (9,825          | )          | (7,168          | )          | 6,931           |       | 7,565           |       | 514             |       |
|                                        |       |            |       |            |       |            |       |            |       |            |       |
| Net (loss)  income                          |       | $               | (2,800     | )               | $          | 1,367           |       | $               | 6,583      |            | $          | 5,801 |   | $ | 296 |   |
|                                        |       |            |       |            |       |            |       |            |       |            |       |
| Net (loss)  income per share-basic          |       | $               | (0.17      | )               | $          | 0.08            |       | $               | 0.49       |            | $          | 0.47 |   | $ | 0.03 |   |
|                                        |       |            |       |            |       |            |       |            |       |            |       |
| Weighted average  common shares             |       | 16,155          |       | 16,972          |       | 13,463          |       | 12,379          |       | 11,632          |       |
|                                        |       |            |       |            |       |            |       |            |       |            |       |
| Net income per  share-diluted               |       | $               | (0.17      | )               | $          | 0.08            |       | $               | 0.46       |            | $          | 0.44 |   | $ | 0.02 |   |
|                                        |       |            |       |            |       |            |       |            |       |            |       |
| Weighted average  common shares             |       | 16,155          |       | 17,457          |       | 14,259          |       | 13,283          |       | 12,536          |       |
|                                        |       |            |       |            |       |            |       |            |       |            |       |
| **At  December 31:**                   |       |            |       |            |       |            |       |            |       |            |       |
| Working capital                             |       | $               | 135,417    |            | $          | 173,905         |       | $               | 162,202    |            | $          | 45,604 |   | $ | 30,996 |   |
| Total assets                                |       | $               | 198,193    |            | $          | 230,996         |       | $               | 219,730    |            | $          | 91,151 |   | $ | 69,284 |   |
| Long-term debt                              |       | $               | —     |            | $          | —          |       | $               | —     |            | $          | — |   | $ | — |   |
| Total  stockholders’ equity            |       | $               | 168,691    |            | $          | 202,216         |       | $               | 190,902    |            | $          | 68,789 |   | $ | 54,554 |   |

 

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| (1)    |   | Includes  equity-based compensation of $5,007, $5,987, $5,063, $335 and $12 for the  fiscal years 2008, 2007, 2006, 2005 and 2004, respectively.      |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                  |
| (2)    |   | Includes a $660  restructuring charge related to a reduction in workforce of approximately 11%  in November 2008.                                |
|   |   |                                                                                                                                                  |
| (3)    |   | Includes an $885  charge related to the separation of Jay D. Miller, our former Chief Executive  Officer, in the fourth quarter of 2007.              |
|   |   |                                                                                                                                                  |
| (4)    |   | Includes a loss  on operating lease of $493 related to the relocation of our corporate  headquarters in the first quarter of 2005.                    |
|   |   |                                                                                                                                                  |
| (5)    |   | Includes $1,000  of acquired in-process research and development charge relating to the  acquisition of HInnovation, Inc. in February 2004. |

 

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

 

**Executive summary**

 

Since the secondquarter of 2007, financial results for Vital Images, Inc. (also referredto as “we”, “us” and “our”) have been significantly affected by weakness in thecomputed tomography, or CT, and picture archiving and communication systems, orPACS, markets and by the broad impact of the Deficit Reduction Act.

 

Vital Images, Inc.summary 2008 results were as follows:

·                  Total revenue of $68.1 million,compared to $70.2 million for 2007.

·                  Gross margin of 77%, compared to 78%for 2007.

·                  Operating expenses of $62.1 million,compared to $61.8 million for 2007.

·                  Net loss of $(2.8) million, or$(0.17) loss per diluted share, compared to 2007 net income of $1.4 million, or$0.08 per diluted share.

 

Total cash, cashequivalents and marketable securities were $147.0 million as of December 31,2008, compared to $178.4 million as of December 31, 2007. Working capital(defined as current assets less current liabilities) was $135.4 million as of December 31,2008, compared to $173.9 million as of December 31, 2007. The decrease in cash and working capitalduring 2008 was primarily the result of repurchases of our common stocktotaling $38.2 million under a share repurchase program authorized by our Boardof Directors in 2008.

 

During 2008, wecontinued to experience the effects of the industry-wide slowdown in thehigh-end CT market and the Deficit Reduction Act that significantly impactedour 2007 results. Additionally, in 2008 we were impacted by the general declinein the U.S. economy, which resulted in contracted capital spending by U.S.hospitals and lower interest rates on our cash and investments. We generated$4.6 million of interest income in 2008, compared to $8.9 million in 2007. Adecline in interest rates resulted in a 2.9% return on investments in 2008compared to a 5.1% return on investments in 2007.

 

We partiallymitigated these negative factors by making progress on our transition to anenterprise company, as demonstrated by our introduction of *ViTALEnterprise* in the 2008 second quarter, and by implementingsignificant cost-control measures, including an 11% workforce reduction in the2008 fourth quarter. We also responded by implementing a $40.0 million sharerepurchase program, resulting in the repurchase of 2.8 million shares of ourcommon stock for $38.2 million during 2008.

 

We further strengthenedour strategic relationship with Toshiba in 2008, renewing our globaldistribution agreement through December 31, 2013 and, in January 2009,entering into an agreement under which we will jointly develop applications.Our revenue from international sales grew 45% in 2008, and Toshiba has been theprimary source of our international growth.

 

Although we expectthe negative market factors that affected our 2007 and 2008 results to continueinto 2009 and beyond, we remain committed to developing the best softwaresolutions for the enterprise and taking exceptional care of our customers.

 

**Overview**

 

We are a leadingprovider of advanced visualization and analysis solutions for use by medicalprofessionals in clinical analysis and therapy planning. We provide software,customer education, software maintenance and support, professional servicesand, on occasion, third-party hardware to our customers. Our technology rapidlytransforms complex data generated by diagnostic imaging equipment intofunctional digital images that can be manipulated and analyzed using ourspecialized applications to better understand internal anatomy and pathology.Our solutions are designed to improve physician workflow and productivity,enhance the ability to make clinical decisions, facilitate less invasivepatient care, and complement often significant capital investments indiagnostic imaging equipment made by our customers. Our software is compatiblewith equipment from all major manufacturers of diagnostic imaging equipment,such as CT scanners, and can be integrated into PACS. Many hospitals use PACSto acquire, distribute and archive medical images and diagnostic reports,reducing the need for film and increasing reliance on advanced visualizationsolutions such as ours. We also offer a Web-based solution that providesphysicians with anywhere, anytime access to medical images and visualizationtools through any Internet-enabled computer.

 

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We operate andmanage our business as a single business segment – the development andmarketing of software and related services for advanced visualization andanalysis solutions for use by medical professionals in clinical analysis andtherapy planning. We market our products and services through a direct salesforce, resellers and independent distributors in the United States and ininternational markets. Our common stock is currently traded on The NASDAQGlobal Select Market under the symbol “VTAL.”

 

**Criticalaccounting policies and estimates**

 

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

 

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

 

*Allowance for doubtful accounts*

 

We maintain an allowancefor doubtful accounts in an amount estimated to be sufficient to provideadequate protection against losses resulting from extending credit to ourcustomers. In judging the adequacy of the allowance for doubtful accounts, weconsider multiple factors, including historical bad debt experience, thegeneral economic environment, the need for specific client reserves and theaging of our outstanding receivables. A portion of this provision is includedin operating expenses as a general and administrative expense and a portion ofthis provision is included as a reduction of license revenue. A considerableamount of judgment is required in assessing these factors. If the factorsutilized in determining the allowance do not reflect future performance, then achange in the allowance for doubtful accounts would be necessary in the periodsuch determination has been made, which would impact future results ofoperations. As of December 31, 2008, the allowance for doubtful accountswas $638,000 for gross accounts receivable of $13.7 million.

 

*Deferred taxes*

 

Significant judgmentis required in determining the realizability of our deferred tax assets. Wemust assess the likelihood that our net deferred tax assets will be recoveredfrom future taxable income, and to the extent we believe that recovery is notlikely, we must establish a valuation allowance. To the extent that weestablish a valuation allowance, we must include an expense within the taxprovision in the statement of operations. As of December 31, 2008, theconsolidated balance sheet included net deferred tax assets of $14.6 million.

 

Considerations for determining the realizability of our deferred taxassets primarily involve cumulative pre-tax income for financial reportingpurposes, cumulative taxable income for the past three years, estimated futurepre-tax income for financial reporting purposes and estimated future taxableincome from our core business. We also consider the expiration dates andamounts of net operating loss carryforwards and other tax credits, andestimate the impact of future tax deductions from the exercise of stockoptions. These estimates are projected through the life of the related deferredtax assets based on assumptions which we believe to be reasonable andconsistent with current operating results.

 

As of December 31,2008, the significant components of our deferred tax assets were asfollows:  

 

·                Deferredtax assets for net operating loss carryforwards and other tax credits of $8.7million, which is net of a valuation allowance of $221,000 relating to taxcredits and certain state net operating loss carryforwards that expire prior to2013.  We will require approximately$18.0 million in cumulative future taxable income to be generated at varioustimes over the next 18 years to realize the related deferred tax assets priorto expiration.

·                Deferredtax asset related to equity based compensation of $3.7 million. Many of thestock options related to this deferred tax asset are currently significantlyout-of-the money and may expire unutilized during the next six years.  Our projections of future taxable income havetaken into consideration our expectations that a portion of these out-of-themoney options will not result in future tax deductions and will not reducefuture taxable income.

 

After givingconsideration to the above factors, we concluded that the net deferred taxassets of $14.6 million as of December 31, 2008 do not require anyadditional valuation allowance. However, if we do not achieve a substantialimprovement in pretax results in 2009 over 2008, it is reasonably possible thatwe may need to establish additional valuation allowances for some or allof our deferred tax assets, which could materially impact our income taxprovision, financial position and results of operations.

 

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*Long-lived assets*

 

We review long-lived assets for impairment wheneverevents or changes in circumstances indicate the carrying amount may not berecoverable, in accordance with Statement of Financial Accounting Standard (“SFAS”)No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.”Events or changes in circumstances that indicate the carrying amountmay not be recoverable include, but are not limited to, a significantdecrease in the market value of the business or asset acquired, a significantadverse change in the extent or manner in which the business or asset acquiredis used, or a significant adverse change in the business climate. If suchevents or changes in circumstances are present, the undiscounted cash flowsmethod is used to determine whether the asset is impaired. Cash flows wouldinclude the estimated terminal value of the asset and exclude any interestcharges. To the extent the carrying value of the asset exceeds the undiscountedcash flows over the estimated remaining life of the asset or asset groups, theimpairment is measured as the difference between the carrying value of theasset and its fair value, determined using the discounted cash flows. Thediscount rate utilized would be based on our best estimate of the related risksand return at the time the impairment assessment is made.

 

Our long-livedassets consist of property and equipment of $11.5 million and other intangibleassets subject to amortization of $808,000 as of December 31, 2008. Apatent acquired in the HInnovation, Inc. acquisition having a $594,000 netbook value as of December 31, 2008 is currently under review by the UnitedStates Patent and Trademark Office (“USPTO”).

 

*Goodwill*

 

We account forgoodwill in accordance with the provisions of SFAS No. 142, “Goodwill andOther Intangible Assets.” Under SFAS No. 142, goodwill and intangibleassets with indefinite lives are reviewed for impairment annually or more frequentlyif events or changes in circumstances indicate that the asset might beimpaired. The first step of the goodwill impairment test, used to identifypotential impairment, compares the fair value of a reporting unit with itscarrying amount, including goodwill. We operate as one reporting unit andtherefore compare the book value to the market value (consisting of marketcapitalization plus a control premium of 25%). As of December 31, 2008, wehad 14.7 million shares outstanding, a closing stock price of $13.91 per share,a market value of $255.1 million, and a book value of $168.7 million, whichwould indicate that our goodwill was not impaired. Furthermore, based on December 31,2008 data including 14.7 million shares outstanding, our book value of $168.7million, and a control premium of 25%, our stock price would need to tradebelow $9.20 per share for a sustained period of time to indicate that ourgoodwill may be impaired. If the market value exceeds the book value, goodwillis considered not impaired, and thus the second step of the impairment test isnot necessary. If our book value exceeds the market value, the second step ofthe goodwill impairment test is performed to measure the amount of impairmentloss, if any. The second step of the goodwill impairment test, used to measurethe amount of impairment loss, compares the implied fair value of the goodwillwith the book value of the goodwill. If the carrying value of the goodwillexceeds the implied fair value of the goodwill, an impairment loss would berecognized in an amount equal to the excess. We completed the annual goodwillimpairment assessment as of December 31, 2008, in which no impairment wasidentified. Goodwill was $9.1 million as of December 31, 2008. If marketconditions continue to fluctuate, we may incur goodwill impairment charges thatadversely affect our financial position and operating results.

 

*Revenue Recognition*

 

We follow specificand detailed guidelines in determining the proper amount of revenue to berecorded; however, certain judgments affect the application of our revenuerecognition policy.

 

We recognizerevenue in accordance with American Institute of Certified Public Accountants (“AICPA”)Statement of Position (“SOP”) 97-2, Software Revenue Recognition, as amended bySOP 98-4 and SOP 98-9, as well as Technical Practice Aids issued from time totime by the AICPA, and SEC Staff Accounting Bulletin (“SAB”)

 

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

 

Revenue resultsare difficult to predict, and any shortfall in revenue or delay in recognizingrevenue could cause our operating results to vary significantly from period toperiod. The significant judgments for revenue recognition typically involvewhether collectability can be considered probable and whether fees are fixed ordeterminable. Significant judgment is also required when evaluating andassessing revenue recognition relating to our distribution agreements withoriginal equipment manufacturers, value-added resellers and independentdistributors (collectively, “Resellers”). In addition, our transactions oftenconsist of multiple element arrangements, which must be analyzed to determinethe fair value of each element, the amount of revenue to be recognized uponshipment, if any, and the period and conditions under which deferred revenueshould be recognized. As a result, if facts and circumstances change thataffect our current judgments, our revenue could be materially different in thefuture.

 

*Equity-based compensation*

 

We recognizeequity-based compensation expense under the fair value recognition provisionsof SFAS No. 123(R), “Share-Based Payment.” We recognize equity-basedcompensation net of an estimated forfeiture rate and recognize compensationcost only for those shares expected to vest over the requisite service periodof the award.

 

The fair value ofeach option award is estimated as of the date of grant using the Black-Scholesoption valuation model. The Black-Scholes option valuation model requires thedevelopment of assumptions that are input into the model. These assumptions arethe expected stock volatility, the risk-free interest rate, the option’sexpected life and the dividend yield on the underlying stock. Expectedvolatility is calculated based on the historical volatility of our common stockover the expected option life and other appropriate factors. Risk-free interestrates are calculated based on continuously compounded U.S. Treasury risk-freerates for the appropriate term. Prior to March 9, 2006, the expected lifeof stock options was calculated by performing a detailed analysis of allhistorical stock option information available. On March 9, 2006, we beganto grant options with a five-year legal life instead of the eight-year legallife that had historically been used. As a result, we elected to use the “simplified”method, as described in SAB No. 107, to estimate the expected life ofoptions granted on and after March 9, 2006. We will utilize the simplifiedmethod until sufficient historical information becomes available on thefive-year legal life options. The dividend yield is assumed to be zero, as wehave never paid or declared any cash dividends on our common stock and do notintend to pay dividends on our common stock in the foreseeable future. Theexpected forfeiture rate is estimated based on historical experience.

 

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

 

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**Results of Operations**

 

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

 
| ** **                            | ** ** | **For the Year Ended December 31,** | ** ** |
|---------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                            | ** ** | **2008**                                                     | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                  |       |                                                         |       |   |   |   |   |
| Revenue:                              |       |                                                         |       |   |   |   |   |
| License fees                          |       | 50.3                                                         | %          | 56.5 | % | 65.7 | % |
| Maintenance and  services             |       | 47.6                                                         |       | 42.0 |   | 32.1 |   |
| Hardware                              |       | 2.1                                                          |       | 1.5 |   | 2.2 |   |
| Total revenue                         |       | 100.0                                                        |       | 100.0 |   | 100.0 |   |
|                                  |       |                                                         |       |   |   |   |   |
| Cost of revenue:                      |       |                                                         |       |   |   |   |   |
| License fees                          |       | 7.2                                                          |       | 6.7 |   | 7.1 |   |
| Maintenance and  services             |       | 14.8                                                         |       | 14.2 |   | 11.4 |   |
| Hardware                              |       | 1.3                                                          |       | 1.0 |   | 1.7 |   |
| Impairment of  patent                 |       | —                                                       |       | 0.3 |   | — |   |
| Total cost of  revenue                |       | 23.3                                                         |       | 22.2 |   | 20.2 |   |
|                                  |       |                                                         |       |   |   |   |   |
| Gross profit                          |       | 76.7                                                         |       | 77.8 |   | 79.8 |   |
|                                  |       |                                                         |       |   |   |   |   |
| Operating  expenses:                  |       |                                                         |       |   |   |   |   |
| Sales and  marketing                  |       | 44.4                                                         |       | 45.6 |   | 36.0 |   |
| Research and  development             |       | 25.1                                                         |       | 21.7 |   | 18.6 |   |
| General and  administrative           |       | 20.6                                                         |       | 20.7 |   | 15.4 |   |
| Restructuring  charge                 |       | 1.0                                                          |       | — |   | — |   |
| Total operating  expenses             |       | 91.1                                                         |       | 88.0 |   | 70.0 |   |
|                                  |       |                                                         |       |   |   |   |   |
| Operating (loss)  income              |       | (14.4                                                        | )          | (10.2 | ) | 9.8 |   |
|                                  |       |                                                         |       |   |   |   |   |
| Interest income                       |       | 6.8                                                          |       | 12.6 |   | 4.7 |   |
| (Loss) income  before income taxes    |       | (7.6                                                         | )          | 2.4 |   | 14.5 |   |
|                                  |       |                                                         |       |   |   |   |   |
| (Benefit)  provision for income taxes |       | (3.5                                                         | )          | 0.5 |   | 5.2 |   |
|                                  |       |                                                         |       |   |   |   |   |
| Net (loss)  income                    |       | (4.1                                                         | )%         | 1.9 | % | 9.3 | % |

 

**Revenue(dollars in thousands)**

** **
| ** **                | ** ** | **For the Year Ended December 31,** | ** ** | **Increase (Decrease)** | ** ** | **Percent Increase (Decrease)** | ** ** |
|---------------------------|------------|--------------------------------------------------------------|------------|------------------------------|------------|-------------------------------------------|------------|
| ** **                | ** ** | **2008**                                                     | ** ** | **2007**                     | ** ** | **2006**                                  | ** ** | **2007 to 2008** | ** ** | **2006 to 2007** | ** ** | **2007 to 2008** | ** ** | **2006 to 2007** | ** ** |
| Revenues:                 |       |                                                         |       |                         |       |                                      |       |   |   |   |   |   |   |   |   |
| License fees              |       | $                                                            | 34,290     |                         | $          | 39,673                                    |       | $ | 46,332 |   | $ | (5,383 | ) | $ | (6,659 | ) | (14 | )% | (14 | )% |
| Maintenance and  services |       | 32,436                                                       |       | 29,487                       |       | 22,615                                    |       | 2,949 |   | 6,872 |   | 10 | % | 30 | % |
| Hardware                  |       | 1,415                                                        |       | 1,016                        |       | 1,565                                     |       | 399 |   | (549 | ) | 39 | % | (35 | )% |
| Total revenue             |       | $                                                            | 68,141     |                         | $          | 70,176                                    |       | $ | 70,512 |   | $ | (2,035 | ) | $ | (336 | ) | (3 | )% | (0 | )% |

 

For 2009, weexpect revenue of $61.0 million to $66.0 million, or a 3% to 10% decrease from2008 revenue.

 

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

 
| ** **                               | ** ** | **For the Year Ended December 31,** | ** ** | **Increase (Decrease)** | ** ** | **Percent Increase (Decrease)** | ** ** |
|------------------------------------------|------------|--------------------------------------------------------------|------------|------------------------------|------------|-------------------------------------------|------------|
| ** **                               | ** ** | **2008**                                                     | ** ** | **2007**                     | ** ** | **2006**                                  | ** ** | **2007 to 2008** | ** ** | **2006 to 2007** | ** ** | **2007 to 2008** | ** ** | **2006 to 2007** | ** ** |
| License fee  revenue:                    |       |                                                         |       |                         |       |                                      |       |   |   |   |   |   |   |   |   |
| Vitrea licenses                          |       | $                                                            | 9,242      |                         | $          | 12,853                                    |       | $ | 18,585 |   | $ | (3,611 | ) | $ | (5,732 | ) | (28 | )% | (31 | )% |
| Vitrea options  and third party software |       | 20,559                                                       |       | 24,967                       |       | 26,486                                    |       | (4,408 | ) | (1,519 | ) | (18 | )% | (6 | )% |
| ViTAL Enterprise                         |       | 3,303                                                        |       | —                       |       | —                                    |       | 3,303 |   | — |   | 100 | % | — | % |
| Other                                    |       | 1,186                                                        |       | 1,853                        |       | 1,261                                     |       | (667 | ) | 592 |   | (36 | )% | 47 | % |
| Total license  fee revenue               |       | $                                                            | 34,290     |                         | $          | 39,673                                    |       | $ | 46,332 |   | $ | (5,383 | ) | $ | (6,659 | ) | (14 | )% | (14 | )% |

 

*ViTALEnterprise*, introduced in May 2008, enables unlimitedenterprise access to the complete ViTAL solution offering, including *Vitrea*, *Vitrea Web*, *ViTALConnect* and our specialized clinical features. Weexpect that revenue from *Vitrea*licenses, *Vitrea* options and third party softwarewill continue to decrease in significance as compared to overall license feerevenue as sales of *ViTAL Enterprise*increase. The decrease in license fee revenue during 2008, as compared to 2007,was driven primarily by a decrease in the number of *Vitrea*licenses sold by our direct sales force, offset in part by new sales of *ViTAL Enterprise*, and by a greater percentage of license feerevenue from Toshiba, which has lower revenue per license. Sales of *ViTAL Enterprise*also impact overall revenue mix, as a larger percentage of each *ViTAL Enterprise* sale is allocated to maintenance andservices revenue than has historically been allocated for sales of *Vitrea.* The decrease in 2007 license fee revenueresulted from a 16% decrease in the number of Vitrea licenses sold in 2007compared to 2006.

 

The followingtable sets forth information on license fee revenue by source:

 
| ** **                       | ** ** | **For the Year Ended December 31,** | ** ** |
|----------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                       | ** ** | **2008**                                                     | ** ** | **2007** | ** ** | **2006** | ** ** |
| License fee  revenue:            |       |                                                         |       |   |   |   |   |
| Direct                           |       | $                                                            | 9,750      |   | $ | 14,202 |   | $ | 20,273 |   |
| Toshiba                          |       | 23,276                                                       |       | 22,141 |   | 20,414 |   |
| McKesson                         |       | 1,264                                                        |       | 3,330 |   | 5,645 |   |
| Total license  fees              |       | $                                                            | 34,290     |   | $ | 39,673 |   | $ | 46,332 |   |
|                             |       |                                                         |       |   |   |   |   |
| Percent of  license fee revenue: |       |                                                         |       |   |   |   |   |
| Direct                           |       | 28                                                           | %          | 36 | % | 44 | % |
| Toshiba                          |       | 68                                                           |       | 56 |   | 44 |   |
| McKesson                         |       | 4                                                            |       | 8 |   | 12 |   |
| Total license fee  revenue       |       | 100                                                          | %          | 100 | % | 100 | % |

 

**Maintenance and services revenue(dollars in thousands)**

 
| ** **                         | ** ** | **For the Year Ended December 31,** | ** ** | **Increase (Decrease)** | ** ** | **Percent Increase  (Decrease)** | ** ** |
|------------------------------------|------------|--------------------------------------------------------------|------------|------------------------------|------------|---------------------------------------|------------|
| ** **                         | ** ** | **2008**                                                     | ** ** | **2007**                     | ** ** | **2006**                              | ** ** | **2007 to  2008** | ** ** | **2006 to  2007** | ** ** | **2007 to  2008** | ** ** | **2006 to  2007** | ** ** |
| Maintenance and  services revenue: |       |                                                         |       |                         |       |                                  |       |   |   |   |   |   |   |   |   |
| Maintenance and  support           |       | $                                                            | 26,656     |                         | $          | 22,811                                |       | $ | 16,379 |   | $ | 3,845 |   | $ | 6,432 |   | 17 | % | 39 | % |
| Customer  education                |       | 4,478                                                        |       | 5,590                        |       | 5,178                                 |       | (1,112 | ) | 412 |   | (20 | )% | 8 | % |
| Professional  services             |       | 1,302                                                        |       | 1,086                        |       | 1,058                                 |       | 216 |   | 28 |   | 20 | % | 3 | % |
| Total  maintenance and services    |       | $                                                            | 32,436     |                         | $          | 29,487                                |       | $ | 22,615 |   | $ | 2,949 |   | $ | 6,872 |   | 10 | % | 30 | % |

 

In 2008, maintenance and services revenue was positively impacted bysales of *ViTAL Enterprise*, as a larger percentageof each *ViTAL Enterprise* sale is allocated tomaintenance and services revenue than has historically been allocated for salesof *Vitrea*. As in 2008, we expect that infuture periods, although sales of *ViTAL Enterprise*will result in proportionately lower license revenue upon sale, we will benefitfrom a recurring revenue stream from maintenance and services contracts.

 

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The increase in maintenance and support revenue in 2008 was primarilydriven by an increase in the number of customers on maintenance contracts,resulting from both new license sales and improvement in the percentage of ourexisting customers who went on maintenance contracts. The increase in maintenance and supportrevenue in 2007 was primarily driven by an increase in the number of customerson maintenance contracts, as well as by increased pricing on maintenance andsupport.

 

Decreased license sales in 2008, compared to 2007, and a generaldeferral of education sessions contributed to lower customer education revenuein 2008. Professional services revenue, which includes installation and otherimplementation-related services, increased due to an increase in servicesrelated to sales of *ViTAL Enterprise*.The increase in customer education revenue and professional services revenue in2007 was due in part to customer education revenue recognized in 2007 relatedto strong *Vitrea* license sales near the end of2006.

 

**Hardware revenue**

 

Hardware revenueincreased 39% to $1.4 million, compared to $1.0 million in 2007, which was a35% decrease from $1.6 million in 2006. We sell hardware as a convenience to our customers, and fluctuationsare driven by individual customer purchasing preferences. Sales of hardwaresystems are not core to our strategy and will fluctuate from period to perioddepending upon the needs of our customers.

 

**Cost of revenue and gross profit**

 

Gross profitdecreased 4% to $52.3 million in 2008, compared to $54.6 million in 2007, whichwas a 3% decrease from $56.3 million in 2006. Gross margin percentage decreasedslightly to 77% in 2008 from 78% in 2007. Gross margin was 80% in 2006.

 

A comparison ofgross profit and gross margin by revenue category is as follows (dollars inthousands):

 
| ** **                | ** ** | **For the Year Ended December 31,** | ** ** |
|---------------------------|------------|--------------------------------------------------------------|------------|
| ** **                | ** ** | **2008**                                                     | ** ** | **2007** | ** ** | **2006** | ** ** |
| Gross profit:             |       |                                                         |       |   |   |   |   |
| License fees              |       | $                                                            | 29,368     |   | $ | 34,948 |   | $ | 41,341 |   |
| Maintenance and  services |       | 22,347                                                       |       | 19,559 |   | 14,592 |   |
| Hardware                  |       | 553                                                          |       | 322 |   | 369 |   |
| Impairment of  patent     |       | —                                                       |       | (242 | ) | — |   |
| Total gross  profit       |       | $                                                            | 52,268     |   | $ | 54,587 |   | $ | 56,302 |   |
|                      |       |                                                         |       |   |   |   |   |
| Gross margin:             |       |                                                         |       |   |   |   |   |
| License fees              |       | 86                                                           | %          | 88 | % | 89 | % |
| Maintenance and  services |       | 69                                                           | %          | 66 | % | 65 | % |
| Hardware                  |       | 39                                                           | %          | 32 | % | 24 | % |
| Total gross  margin       |       | 77                                                           | %          | 78 | % | 80 | % |

 

Fluctuations inlicense fee gross margin are generally a result of average sales prices,changes in the product mix, and the mix between direct sales and sales todistribution partners, which tend to carry lower margins.

 

Maintenance andservices gross margin increased during 2008, compared to 2007, as a larger percentage of each *ViTAL Enterprise* sale being allocated to maintenance andservices revenue than has historically been allocated for sales of *Vitrea*, without a corresponding increase in costs.  In addition, in the fourth quarter of 2008,we recognized a $391,000 benefit to maintenance and support revenue arisingfrom Toshiba billing adjustments relating to historic periods. We will continue to invest in our customereducation, installation, professional services and customer support areas inthe future to adequately support our growing installed base of customers. Grossmargin for 2007 was relatively consistent with 2006.

 

Gross margin forhardware increased in 2008, compared to 2007 and increased in 2007, compared to2006. Variances in gross margin for hardware are expected, as hardware salesare not a substantial part of the sales strategy. Low volume can affect marginssubstantially.

 

During the thirdquarter 2007, we recognized a $242,000 patent impairment charge related to apatent application acquired in the HInnovation, Inc. acquisition in February 2004.This patent application was rejected by the USPTO

 

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on August 23,2007, and we decided not to pursue this application further. The impairment wasrecorded as a separate item in cost of revenue, and it is included in the totalgross margin percentage above.

 

For 2009, weexpect total gross margin to be approximately 76% to 77%.

 

**Operating expenses**

 

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

 
| ** **                  | ** ** | **Percent of Revenue for the  Year Ended December 31,** | ** ** | **Percent Increase (Decrease)** | ** ** |
|-----------------------------|------------|--------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                  | ** ** | **2008**                                                                                   | ** ** | **2007**                             | ** ** | **2006** | ** ** | **2007 to 2008** | ** ** | **2006 to 2007** | ** ** |
| Operating  expenses:        |       |                                                                                       |       |                                 |       |   |   |   |   |   |   |
| Sales and  marketing        |       | 44.4                                                                                       | %          | 45.6                                 | %          | 36.0 | % | (5 | )% | 26 | % |
| Research and  development   |       | 25.1                                                                                       |       | 21.7                                 |       | 18.6 |   | 13 | % | 16 | % |
| General and  administrative |       | 20.6                                                                                       |       | 20.7                                 |       | 15.4 |   | (4 | )% | 34 | % |
| Restructuring  charge       |       | 1.0                                                                                        |       | —                               |       | — |   | 100 | % | — | % |
| Total operating  expenses   |       | 91.1                                                                                       | %          | 88.0                                 | %          | 70.0 | % | (1 | )% | 25 | % |

 

**Sales andmarketing**

 

Sales and marketing expenses decreased $1.7 million, or 5%, to $30.3million in 2008, compared to $32.0 million in 2007, which was a $6.6 million,or 26%, increase from $25.4 million in 2006. The change in sales and marketingexpense is as follows (dollars in thousands):

 
| ** **                       | ** ** | **For the Year Ended  December 31,** | ** ** | **Increase (Decrease)** | ** ** | **Percent Increase  (Decrease)** | ** ** |
|----------------------------------|------------|----------------------------------------------------------|------------|------------------------------|------------|---------------------------------------|------------|
| ** **                       | ** ** | **2008**                                                 | ** ** | **2007**                     | ** ** | **2006**                              | ** ** | **2007 to  2008** | ** ** | **2006 to  2007** | ** ** | **2007 to  2008** | ** ** | **2006 to  2007** | ** ** |
| Salaries,  benefits and bonus    |       | $                                                        | 12,173     |                         | $          | 11,652                                |       | $ | 8,588 |   | $ | 521 |   | $ | 3,064 |   | 4 | % | 36 | % |
| Overhead and  other expenses     |       | 4,532                                                    |       | 4,634                        |       | 3,349                                 |       | (102 | ) | 1,285 |   | (2 | )% | 38 | % |
| Commissions                      |       | 3,592                                                    |       | 4,634                        |       | 5,266                                 |       | (1,042 | ) | (632 | ) | (22 | )% | (12 | )% |
| Travel, meals  and entertainment |       | 3,467                                                    |       | 3,676                        |       | 2,521                                 |       | (209 | ) | 1,155 |   | (6 | )% | 46 | % |
| Trade shows and  advertising     |       | 3,454                                                    |       | 3,623                        |       | 2,849                                 |       | (169 | ) | 774 |   | (5 | )% | 27 | % |
| Depreciation                     |       | 1,668                                                    |       | 1,380                        |       | 806                                   |       | 288 |   | 574 |   | 21 | % | 71 | % |
| Equity-based  compensation       |       | 1,408                                                    |       | 2,392                        |       | 1,995                                 |       | (984 | ) | 397 |   | (41 | )% | 20 | % |
| Total                            |       | $                                                        | 30,294     |                         | $          | 31,991                                |       | $ | 25,374 |   | $ | (1,697 | ) | $ | 6,617 |   | (5 | )% | 26 | % |

 

The decrease inexpenses in 2008 was due primarily to a decrease in commission expense relatedto the decrease in revenue and a decrease in equity-based compensationresulting from issuing equity awards at a lower exercise price, as well assignificant cancellations of equity awards resulting from organizationalchanges. The increase in expenses during 2007 was due to an increase incompensation costs as a result of additional personnel, higher travel andentertainment costs, and higher costs for attending U.S. and European industrytradeshows. Commission expense for both 2008 and 2007 decreased due to lowerdirect revenue compared to the respective prior year expense. We had 78, 103and 75 sales and marketing personnel as of December 31, 2008, 2007 and2006, respectively. The decrease in headcount as of December 31, 2008 wasdue primarily to the reduction in force described in “Restructuring charge.”

 

We expect salesand marketing expenses to be between 43% and 44% of total revenue for the yearending December 31, 2009.

 

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**Researchand development**

 

Research and development expenses increased $1.9 million, or 13%, to$17.1 million in 2008, compared to $15.2 million in 2007, which was an increaseof $2.1 million, or 16%, from $13.1 million in 2006. The change in research anddevelopment expense is as follows (dollars in thousands):

 
| ** **                    | ** ** | **For the Year Ended  December 31,** | ** ** | **Increase (Decrease)** | ** ** | **Percent Increase  (Decrease)** | ** ** |
|-------------------------------|------------|----------------------------------------------------------|------------|------------------------------|------------|---------------------------------------|------------|
| ** **                    | ** ** | **2008**                                                 | ** ** | **2007**                     | ** ** | **2006**                              | ** ** | **2007 to  2008** | ** ** | **2006 to  2007** | ** ** | **2007 to  2008** | ** ** | **2006 to  2007** | ** ** |
| Salaries,  benefits and bonus |       | $                                                        | 10,924     |                         | $          | 10,310                                |       | $ | 8,294 |   | $ | 614 |   | $ | 2,016 |   | 6 | % | 24 | % |
| Overhead and  other expenses  |       | 2,860                                                    |       | 2,680                        |       | 2,423                                 |       | 180 |   | 257 |   | 7 | % | 11 | % |
| Consulting                    |       | 1,394                                                    |       | 481                          |       | 804                                   |       | 913 |   | (323 | ) | 190 | % | (40 | )% |
| Equity-based  compensation    |       | 1,017                                                    |       | 729                          |       | 840                                   |       | 288 |   | (111 | ) | 40 | % | (13 | )% |
| Depreciation                  |       | 936                                                      |       | 1,004                        |       | 731                                   |       | (68 | ) | 273 |   | (7 | )% | 37 | % |
| Total                         |       | $                                                        | 17,131     |                         | $          | 15,204                                |       | $ | 13,092 |   | $ | 1,927 |   | $ | 2,112 |   | 13 | % | 16 | % |

 

The major driverof higher research and development expenses in 2008 was new productinitiatives, resulting in increased consulting expense and increasedcompensation expense due to higher average headcount in 2008 compared to 2007.The increase in expenses for 2007 was due primarily to increases incompensation costs as a result of additional personnel focused on productinnovation and development. We had 102, 118 and 100 research and developmentpersonnel as of December 31, 2008, 2007 and 2006, respectively. Thedecrease in headcount as of December 31, 2008 was due primarily to thereduction in force described in “Restructuring charge.”

 

During 2006, werequired a significant amount of temporary consulting services to completecertain research and development activities, specifically in the area ofsoftware testing and validation. We reduced these external expenses during 2007by hiring additional research and development personnel.

 

In January 2009,we entered into a co-development and collaboration agreement with Toshiba, inwhich we will enter into a mutual license of intellectual property and willjointly invest to develop and deliver innovative technology advancements forToshiba’s modalities and Vital Images’ advanced visualization software solutions.We do not expect the agreement will have a material impact on our 2009 researchand development expense.

 

We expect researchand development expenses to be between 23% and 25% of total revenue for theyear ending December 31, 2009.

 

**General andadministrative**

 

General and administrative expenses decreased $552,000, or 4%, to $14.0million in 2008, compared to $14.6 million in 2007, which was a 34% increasefrom $10.9 million in 2006. The change in general and administrative expense isas follows (dollars in thousands):

 
| ** **                            | ** ** | **For the Year Ended  December 31,** | ** ** | **Increase (Decrease)** | ** ** | **Percent Increase  (Decrease)** | ** ** |
|---------------------------------------|------------|----------------------------------------------------------|------------|------------------------------|------------|---------------------------------------|------------|
| ** **                            | ** ** | **2008**                                                 | ** ** | **2007**                     | ** ** | **2006**                              | ** ** | **2007 to  2008** | ** ** | **2006 to  2007** | ** ** | **2007 to  2008** | ** ** | **2006 to  2007** | ** ** |
| Salaries,  benefits and bonus         |       | $                                                        | 5,101      |                         | $          | 5,716                                 |       | $ | 4,869 |   | $ | (615 | ) | $ | 847 |   | (11 | )% | 17 | % |
| Overhead and  other expenses          |       | 3,516                                                    |       | 3,170                        |       | 2,429                                 |       | 346 |   | 741 |   | 11 | % | 31 | % |
| Professional and  consulting services |       | 3,142                                                    |       | 3,197                        |       | 1,751                                 |       | (55 | ) | 1,446 |   | (2 | )% | 83 | % |
| Equity-based  compensation            |       | 2,249                                                    |       | 2,477                        |       | 1,856                                 |       | (228 | ) | 621 |   | (9 | )% | 33 | % |
| Total                                 |       | $                                                        | 14,008     |                         | $          | 14,560                                |       | $ | 10,905 |   | $ | (552 | ) | $ | 3,655 |   | (4 | )% | 34 | % |

 

Salaries, benefitsand bonus and equity-based compensation decreased for 2008, compared to 2007,as 2007 included an $885,000 pre-tax charge related to the separation of ourformer Chief Executive Officer. Of this charge, $580,000 is included insalaries, benefits and bonus and $305,000 is included in equity-basedcompensation for 2007. Professional and consulting services for 2007 increaseddue to international expansion and higher accounting, audit and legal expenses.Overhead expenses increased both years due to the increase in infrastructure.We had 47, 52 and 50 general and administrative personnel as of December 31,2008, 2007 and 2006, respectively. The decrease in headcount as of December 31,2008 was due primarily to the reduction in force described in “Restructuringcharge.”

 

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We expect generaland administrative expenses to be approximately 18% to 19% of total revenue forthe year ending December 31, 2009.

 

**Restructuringcharge**

 

During 2008, wecontinued to experience the effects of the industry-wide slowdown in thehigh-end CT market and the Deficit Reduction Act that significantly impactedour 2007 results. Additionally, in 2008, we were impacted by the generaldecline in the U.S. economy, which resulted in contracted capital spending byU.S. hospitals and lower interest rates on our cash and investments. We reducedour workforce by approximately 11% under a plan announced in November 2008in order to align our operations with the current market conditions and improveprofitability in 2009 and beyond. We expect that the effect of the restructuringactivities will reduce employee costs by approximately $4.0 million to $5.0million in 2009, compared to 2008.

 

In connection withthe reduction in workforce, we incurred certain charges in 2008 totaling$660,000, which were primarily comprised of employee severance and othertermination costs. The following table summarizes 2008 restructuringtransactions and related liability balances (in thousands):

 
| ** **                         | ** ** | **Severance and  Other  Termination  Costs** | ** ** |
|------------------------------------|------------|---------------------------------------------------|------------|
| Balance at  January 1, 2008   |       | $                                                 | —     |   |
| Restructuring  charges             |       | 660                                               |       |
| Payments                           |       | (519                                              | )          |
| Balance at  December 31, 2008 |       | $                                                 | 141        |   |

 

Actions withrespect to the above activities were completed in the fourth quarter of 2008,and we do not anticipate any additional charges related to the restructuringplan announced in November 2008.

 

**Interestincome**

 

We generated $4.6million of interest income in 2008, compared to $8.9 million in 2007 and $3.3million in 2006. A decline in interest rates resulted in a 2.9% return oninvestments in 2008 compared to a 5.1% and 4.5% return on investments in 2007and 2006, respectively. During the fourth quarter of 2006, we completed apublic offering of 3.4 million shares of common stock, resulting in netproceeds of $97.7 million, which contributed to increased interest incomebeginning in the first quarter of 2007.

 

Interest income issignificantly impacted by changes in interest rates. We anticipatesignificantly lower interest rates in 2009 compared to 2008 due to generalmarket conditions; interest rate changes would have a significant impact onresults.

 

**Income taxes**

 

Our effectiveincome tax rates were 46%, 20% and 36% in 2008, 2007 and 2006, respectively.The fluctuations in our effective tax rates for 2008, 2007 and 2006 were dueprimarily to the relative impact of research and development credits on lowerpretax income in 2007.

 

Our effectiveincome tax rate may fluctuate significantly from quarter to quarter due to therelative proximity to breakeven of our results before taxes. For 2009, weexpect an effective tax rate of approximately 40% to 60%. Due to theutilization of deferred tax assets relating to net operating losses and taxdeductions from the exercise of stock options, we do not anticipate paying anysignificant cash for federal income taxes for the next three to four years.Actual results could accelerate or defer the utilization of our deferred taxassets. Additional information regarding income taxes and deferred tax assetsis included in “Deferred taxes” of “Item 7. Management’s Discussion andAnalysis of Financial Condition and Results of Operations — Critical accountingpolicies and estimates.”

 

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**Liquidity and capital resources**

 

The following table sets forth certain relevant measures of ourliquidity and capital resources (in thousands):

 
| ** **                                        | ** ** | **As of December 31,** | ** ** |
|---------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                        | ** ** | **2008**                              | ** ** | **2007** | ** ** |
| Cash and cash  equivalents                        |       | $                                     | 109,706    |   | $ | 146,685 |   |
| Marketable  securities                            |       | 37,287                                |       |   | 31,709 |   |
| Cash, cash  equivalents and marketable securities |       | $                                     | 146,993    |   | $ | 178,394 |   |
|                                              |       |                                  |       |   |   |
| Working capital                                   |       | $                                     | 135,417    |   | $ | 173,905 |   |
|                                              |       |                                  |       |   |   |
| Debt                                              |       | $                                     | —     |   | $ | — |   |

 

The decrease inour net cash position as of December 31, 2008, compared to December 31,2007, is primarily due to $38.2 million of share repurchases in 2008 under our$40.0 million share repurchase program implemented in 2008 and completed in February 2009.On March 3, 2009, we announced an additional share repurchase program,authorizing up to an additional 1.0 million shares to be repurchased on theopen market.

 

We believe ourexisting cash and investments will satisfy our foreseeable working capital requirementsfor at least the next 12 months. Additionally, we believe our liquidity andstrong balance sheet enable us to execute our repurchases of common stock whilestill investing in our enterprise solution and marketing strategy and remainingwell positioned to pursue strategic acquisitions if and when they emerge.

 

We haveinvestments in marketable securities that are classified and accounted for asavailable-for-sale. Market conditions during 2008 and 2009 indicate significantuncertainty on the part of investors on the economic outlook for the U.S. andfor financial institutions that have potential exposure to the sub-primehousing market. Our corporate debt included $257,000 and $3.0 million ofasset-backed securities as of December 31, 2008 and 2007, respectively.The net unrealized gains (losses) on asset-backed securities were $(7,000) and$(19,000) as of December 31, 2008 and 2007, respectively. Our asset-backedsecurities are rated AAA and are current on scheduled pay downs, with expectedfull maturity within the next 12 months. For further information about therisks associated with our investments, see the “Market Risk” section and thesection entitled “Risk Factors.”

 

*Summaryof Cash Flows*

 

A summary of cashflows is as follows (in thousands):

 
| ** **                               | ** ** | **For the Year Ended December 31,** | ** ** |
|------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                               | ** ** | **2008**                                                     | ** ** | **2007** | ** ** | **2006** | ** ** |
| Cash provided by  (used in)              |       |                                                         |       |   |   |   |   |
| Operating  activities                    |       | $                                                            | 8,581      |   | $ | 13,902 |   | $ | 14,771 |   |
| Investing  activities                    |       | (10,246                                                      | )          | (15,870 | ) | 1,382 |   |
| Financing  activities                    |       | (35,314                                                      | )          | 4,271 |   | 107,384 |   |
| Net change in  cash and cash equivalents |       | $                                                            | (36,979    | ) | $ | 2,303 |   | $ | 123,537 |   |

 

*Operating activities*

 

Net cash provided by operating activities decreased $5.3 million in2008, compared to 2007, due to a $4.2 million decrease in net income and a $1.9million decrease in non-cash operating items, offset by a $791,000 increasedue  to the timing of other receipts andpayments in the ordinary course of business.

 

Net cash provided by operating activities decreased $869,000 in 2007,compared to 2006, primarily due to a $5.2 million decrease in net income,offset by a $1.4 million increase in non-cash operating items and a $2.9million increase due to the timing of other receipts and payments in theordinary course of business.

 

*Investing activities*

 

We used $10.2 millionfor cash and investing activities in 2008. Net cash used by investingactivities was $15.9 million in 2007. Net cash provided by investing activitieswas $1.4 million in 2006.

 

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We used $5.4million, $6.6 million and $6.4 million for purchases of property and equipment in 2008, 2007 and 2006, respectively. The purchases for all periodswere principally to expand our facilities and upgrade computer equipment and topurchase computer equipment for new personnel. Additionally, in 2007, we beganthe implementation of an enterprise resource planning (“ERP”) system. Wecontinued implementation of the ERP during 2008 and expect to continue to incurcosts in future periods as we complete subsequent phases of the implementation.We anticipate that we will continue to purchase property and equipment in thenormal course of business. The amount and timing of these purchases and therelated cash outflows in future periods are difficult to predict and depend ona number of factors, including the hiring of employees and the rate of changeof computer hardware.

 

We used $76.3 million, $60.0 million and $29.5 million to purchaseinvestments in marketable securities during 2008, 2007 and 2006, respectively. We realized $71.6 million,$50.7 million and $37.4 million of proceeds from maturities and sales ofmarketable securities during 2008, 2007 and 2006, respectively. The marketable securities consist of U.S. governmentobligations, U.S. government agency obligations, corporate commercialobligations and certificates of deposits.

 

*Financingactivities*

 

Cash used by financing activities totaled $35.3 million for 2008,compared to cash provided by financing activities of $4.3 million and $107.4million for 2007 and 2006,respectively. The primary use of cash in 2008 was for the repurchase of $38.2million of our common stock under our $40.0 million share repurchase programinitiated in 2008. The cash provided by financing activities in 2007 resultedprimarily from the exercise of stock options granted under our stock plans andupon the exercise of warrants. The cash provided by financing activities in2006 related primarily to the $97.7 million in net proceeds from our publicoffering of 3.4 million shares of common stock.

 

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

 

The following summarizes our contractual obligations at December 31,2008 and the effect such obligations are expected to have on our liquidity andcash flow in future periods (in thousands).

 
| ** **       | ** ** | **Total** | ** ** | **1 Year or Less** | ** ** | **1 to 3 Years** | ** ** | **3 to 5 Years** | ** ** | **More than 5  Years** | ** ** |
|------------------|------------|-----------|------------|-----------------------------------|------------|---------------------------------|------------|---------------------------------|------------|----------------------------------|------------|
|             |       |      |       |                              |       |                            |       |                            |       |                             |       |
| Operating leases |       | $         | 3,067      |                              | $          | 1,154                           |       | $                               | 1,837      |                             | $          | 76 |   | $ | — |   |
|                  |            |           |            |                                   |            |                                 |            |                                 |            |                                  |            |  |  |  |  |  |

 

Off-balance-sheet arrangements

 

We did not have any off-balance sheet arrangements as of December 31,2008 or 2007.

 

Purchase commitments

 

We had no significant outstanding purchase orders as of December 31,2008. We have entered into a number of technology licensing agreements thatprovide for the payment of royalties when we sell *Vitrea,ViTALConnect*and*ViTAL Enterprise*;we are not obligated for any minimum payments under such agreements.

 

**Foreigncurrency transactions**

 

Our export salesare primarily negotiated, invoiced and paid in U.S. dollars, with a portion ofsales transactions denominated in foreign currencies. As we expand our directbusiness internationally, we expect to enter into a higher percentage of salestransactions in foreign currencies and could be subject to greater gains orlosses based on exchange rate fluctuations.

 

**Inflation**

 

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

 

**Recent accounting pronouncement**

 

Informationregarding new accounting pronouncements is included in Note 2 to theConsolidated Financial Statements.

 

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

 

Market risk refersto the risk that a change in the level of one or more market prices, interestrates, indices, volatilities, correlations or other market factors such asliquidity will result in losses for a certain financial instrument or group offinancial instruments. We do not hold or issue financial instruments fortrading purposes, and we do not enter into forward financial instruments tomanage and reduce the impact of changes in foreign currency rates because, asdisclosed above, our export sales are primarily negotiated, invoiced and paidin U.S. dollars, with a small percentage of sales transactions denominated inforeign currencies. Based on the controls in place and the relative size of thefinancial instruments entered into, we believe the risks associated with notusing these instruments would not have a material adverse effect on ourconsolidated financial position or results of operations.

 

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

 

In the normalcourse of business, we are exposed to market risks, including changes ininterest rates and price changes, which could affect our operating results.

 

**Interest rate risk**

 

We place our cash,cash equivalents and marketable securities, which generally have a term of lessthan one year, with a high-quality financial institution and have investmentguidelines relative to diversification and maturities designed to maintainsafety and liquidity. As of December 31, 2008, we had cash, cash equivalentsand marketable securities totaling $147.0 million. If, during 2008, averageshort-term interest rates decreased by 1.0% from 2008 average rates, based onour quarterly average balance of cash, cash equivalents and marketablesecurities, our projected interest income from short-term investments wouldhave decreased by approximately $1.6 million.

 

**Foreign currency risk**

 

Our export salesare primarily negotiated, invoiced and paid in U.S. dollars, with a portion ofsales transactions denominated in foreign currencies. Therefore, fluctuationsin the value of the dollar as compared to other foreign currencies have not hada significant effect on our results of operations or financial condition. As weexpand our direct business internationally, we expect to enter into a higherpercentage of sales transactions in foreign currencies and could be subject togreater gains or losses based on exchange rate fluctuations.

 

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

 

Our financialstatements and Report of Independent Registered Public Accounting Firmthereon, 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 Accountants on Accounting and Financial Disclosure**

 

Not applicable.

 

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

 

**Evaluation of disclosure controls and procedures**

 

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

 

Our management, under the supervision of and with the participation ofour Chief Executive Officer and Chief Financial Officer, has evaluated theeffectiveness of our disclosure controls and procedures, as defined in Rules 13a-15(e) and15d-15(e) under the Exchange Act, as of the end of the period covered bythis report. Based on such evaluation, our Chief Executive Officer and ChiefFinancial Officer have concluded that, as of the end of the period covered bythis report, our disclosure controls and procedures were effective.

 

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

 

Our management is responsible for establishing and maintaining adequateinternal control over financial reporting. Our internal control over financialreporting is a process designed to provide reasonable assurance regarding thereliability of financial reporting and the preparation of financial statementsfor external purposes in accordance with generally accepted accountingprinciples. Because of its inherent limitations, internal control overfinancial reporting may not prevent or detect misstatements. Also, projectionsof any evaluation of effectiveness to future periods are subject to the riskthat controls may become inadequate because of changes in conditions or thatthe degree of compliance with established policies or procedures maydeteriorate.

 

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

 

The effectiveness of ourinternal control over financial reporting as of December 31, 2008 has beenaudited by PricewaterhouseCoopers LLP, an independent registered publicaccounting firm, as stated in their report which is included in Item 15(a)(1) ofthis Annual Report on Form 10-K.

 

**Changesin internal control over financial reporting**

 

There were nochanges in internal control over financial reporting during the quarter ended December 31,2008 that have materially affected, or are reasonably likely to materiallyaffect, our internal control over financial reporting.

 

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

 

None.

 

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**Part III**

 

Certain information required by Part III is omitted from thisAnnual Report on Form 10-K because we will file a definitive ProxyStatement relating to our 2009 Annual Meeting of Stockholders pursuant toSchedule 14A (the “Proxy Statement”) not later than 120 days afterthe end of the fiscal year covered by this Annual Report on Form 10-K, andcertain information included therein is incorporated herein by reference asindicated below.

 

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

 

The informationrequired by this Item 10 will be included under the captions “Election ofDirectors” and “Information Concerning Directors, Nominees and ExecutiveOfficers” in our Proxy Statement for our 2009 annual meeting of shareholders.Information concerning the compliance of our officers, directors and 10%shareholders with Section 16(a) of the Securities Exchange Act of1934 is incorporated by reference to the information to be contained in the2009 proxy statement under the caption “Information Concerning DirectorsNominees and Executive Officers — Section 16(a) Beneficial OwnershipReporting Compliance.” The information regarding Audit Committee members and “AuditCommittee Financial Experts” is incorporated by reference to the information tobe contained in the 2009 proxy statement under the caption “InformationConcerning Directors Nominees and Executive Officers — Board Committees.” Theinformation regarding our Code of Business Ethics is incorporated by referenceto the information to be contained in the 2009 proxy statement under theheading “Information Concerning Directors Nominees and Executive Officers —Code of Business Conduct and Ethics.”

 

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

 

The informationunder the captions “Information Concerning Directors Nominees and Executive Officers— Executive Compensation” and “Information Concerning Directors Nominees andExecutive Officers — Director Compensation” to be contained in the 2009 proxystatement is incorporated herein by reference.

 

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

 

The informationunder the captions “Beneficial Ownership of Common Stock” and “InformationConcerning Directors, Nominees and Executive Officers — Securities Authorizedfor Issuers Under Equity Compensation Plans” to be contained in the 2009 proxystatement is incorporated herein by reference.

 

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

 

The informationunder the caption “Information Concerning Directors, Nominees and ExecutiveOfficers” to be contained in the 2009 proxy statement is incorporated herein byreference.

 

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

 

The informationunder the caption “Ratification of Appointment of PricewaterhouseCoopers LLP asIndependent Registered Public Accounting Firm” to be contained in the 2009proxy statement is incorporated herein by reference.

 

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**Part IV**

 

**Item 15.****                           ****Exhibits and Financial StatementSchedules**

 
| (a)    | The following Consolidated Financial Statements of  Vital Images, Inc. and Report of Independent Registered Public  Accounting Firm thereon are included herein: |                                                                                                                                                                                                               |
|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                  |                                                                                                                                                                                                               |   |
|   | (1)                                                                                                                                                                   | Financial  Statements                                                                                                                                                                                              |   |
|   |                                                                                                                                                                  |                                                                                                                                                                                                               |   |
|   |                                                                                                                                                                  | Report of Independent  Registered Public Accounting Firm                                                                                                                                                           | 41 |
|   |                                                                                                                                                                  | Consolidated Balance Sheets as of  December 31, 2008 and 2007                                                                                                                                                 | 42 |
|   |                                                                                                                                                                  | Consolidated Statements of  Operations for the years ended December 31, 2008, 2007 and 2006                                                                                                                   | 43 |
|   |                                                                                                                                                                  | Consolidated  Statements of Stockholders’ Equity and Comprehensive Income (Loss) for the  years ended December 31, 2008, 2007 and 2006                                                                   | 44 |
|   |                                                                                                                                                                  | Consolidated  Statements of Cash Flows for the years ended December 31, 2008, 2007 and  2006                                                                                                                  | 45 |
|   |                                                                                                                                                                  | Notes to  Consolidated Financial Statements                                                                                                                                                                        | 46 |
|   |                                                                                                                                                                  |                                                                                                                                                                                                               |   |
|   | (2)                                                                                                                                                                   | All other  schedules to the Consolidated Financial Statements required by Article 12  of Regulation S-X are not required under the related instructions or are  inapplicable and therefore have been omitted. |   |
|   |                                                                                                                                                                  |                                                                                                                                                                                                               |   |
|   | (3)                                                                                                                                                                   | Listing of  Exhibits                                                                                                                                                                                               |   |
|   |                                                                                                                                                                  |                                                                                                                                                                                                               |   |
|   |                                                                                                                                                                  | The Exhibits  required to be a part of this Report are listed in the Index to  Exhibits.                                                                                                                      |   |
|   |                                                                                                                                                                  |                                                                                                                                                                                                               |   |
| (b)    | Exhibits                                                                                                                                                              |                                                                                                                                                                                                               |

 

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

 

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**Signatures**

 

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the Registrant has duly caused this Report to be signed on its behalf bythe undersigned, thereunto duly authorized, in Minneapolis, Minnesota, on the16th day of March, 2009.

 

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

 

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

 
| **Signature**                 | ** ** | **Title**                                                       | ** ** | **Date**             |
|-------------------------------|------------|-----------------------------------------------------------------|------------|----------------------|
| ** **                    | ** ** | ** **                                                      | ** ** | ** **           |
| /s/ Michael H.  Carrel        |       | President, Chief  Executive Officer and Director                |       | March 16,  2009 |
| Michael H.  Carrel            |       | (Principal Executive Officer)                                   |       |                 |
|                          |       |                                                            |       |                 |
| /s/Peter J.  Goepfrich        |       | Chief Financial  Officer and Treasurer                          |       | March 16,  2009 |
| Peter J.  Goepfrich           |       | (Principal Financial Officer and Principal  Accounting Officer) |       |                 |
|                          |       |                                                            |       |                 |
| /s/James B.  Hickey, Jr. |       | Chairman of the  Board and Director                             |       | March 16,  2009 |
| James B.  Hickey, Jr.    |       |                                                            |       |                 |
|                          |       |                                                            |       |                 |
| /s/Douglas M.  Pihl           |       | Director                                                        |       | March 16,  2009 |
| Douglas M. Pihl               |       |                                                            |       |                 |
|                          |       |                                                            |       |                 |
| /s/Richard W.  Perkins        |       | Director                                                        |       | March 16,  2009 |
| Richard W.  Perkins           |       |                                                            |       |                 |
|                          |       |                                                            |       |                 |
| /s/Michael W.  Vannier        |       | Director                                                        |       | March 16,  2009 |
| Michael W.  Vannier           |       |                                                            |       |                 |
|                          |       |                                                            |       |                 |
| /s/Sven A.  Wehrwein          |       | Director                                                        |       | March 16,  2009 |
| Sven A. Wehrwein              |       |                                                            |       |                 |
|                          |       |                                                            |       |                 |
|                          |       | Director                                                        |       |                 |
| Gregory J. Peet               |       |                                                            |       |                 |

 

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**Report of Independent Registered Public AccountingFirm**

 

To the Board ofDirectors and Stockholders of Vital Images, Inc.:

 

In our opinion,the accompanying consolidated balance sheets and the related consolidatedstatements of operations, of stockholders’ equity and comprehensive income(loss) and of cash flows present fairly, in all material respects, thefinancial position of Vital Images, Inc. and its subsidiaries at December 31,2008 and December 31, 2007, and the results of its operations and its cashflows for each of the three years in the period ended December 31, 2008,in conformity with accounting principles generally accepted in the UnitedStates of America.  Also in our opinion,the Company maintained, in all material respects, effective internal controlover financial reporting as of December 31, 2008, based on criteriaestablished in Internal Control - Integrated Framework issued by the Committeeof Sponsoring Organizations of the Treadway Commission (COSO).  The Company’s management is responsible forthese financial statements, for maintaining effective internal control overfinancial reporting and for its assessment of the effectiveness of internalcontrol over financial reporting, included in Management’s Report on InternalControl over Financial Reporting appearing under Item 9A. Our responsibility isto express opinions on these financial statements and on the Company’s internalcontrol over financial reporting based on our integrated audits.  We conducted our audits in accordance withthe standards of the Public Company Accounting Oversight Board (UnitedStates).  Those standards require that weplan and perform the audits to obtain reasonable assurance about whether thefinancial statements are free of material misstatement and whether effectiveinternal control over financial reporting was maintained in all materialrespects.  Our audits of the financialstatements included examining, on a test basis, evidence supporting the amountsand disclosures in the financial statements, assessing the accountingprinciples used and significant estimates made by management, and evaluatingthe overall financial statement presentation. Our audit of internal control over financial reporting includedobtaining an understanding of internal control over financial reporting,assessing the risk that a material weakness exists, and testing and evaluatingthe design and operating effectiveness of internal control based on theassessed risk.  Our audits also includedperforming such other procedures as we considered necessary in thecircumstances. We believe that our audits provide a reasonable basis for ouropinions.

 

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

 

Because of itsinherent limitations, internal control over financial reporting may not preventor detect misstatements.  Also,projections of any evaluation of effectiveness to future periods are subject tothe risk that controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures maydeteriorate.

 

/s/PricewaterhouseCoopers LLP

PricewaterhouseCoopersLLP

Minneapolis,Minnesota

March 16,2009

 

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

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

 
| ** **                                                                                                                                                                                    | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                    | ** ** | **2008**              | ** ** | **2007** | ** ** |
| **Assets**                                                                                                                                                                                    | ** ** | ** **            | ** ** | ** ** | ** ** |
| Current assets:                                                                                                                                                                               | ** ** | ** **            | ** ** | ** ** | ** ** |
| Cash and cash  equivalents                                                                                                                                                                    |       | $                     | 109,706    |   | $ | 146,685 |   |
| Marketable  securities                                                                                                                                                                        |       | 37,287                |       | 31,709 |   |
| Accounts  receivable, net                                                                                                                                                                     |       | 13,047                |       | 15,962 |   |
| Deferred income  taxes                                                                                                                                                                        |       | 654                   |       | 3,472 |   |
| Prepaid expenses  and other current assets                                                                                                                                                    |       | 2,179                 |       | 2,441 |   |
| Total current assets                                                                                                                                                                          |       | 162,873               |       | 200,269 |   |
| Property and  equipment, net                                                                                                                                                                  |       | 11,519                |       | 11,165 |   |
| Deferred income  taxes                                                                                                                                                                        |       | 13,904                |       | 8,621 |   |
| Other intangible  assets, net                                                                                                                                                                 |       | 808                   |       | 1,852 |   |
| Goodwill                                                                                                                                                                                      |       | 9,089                 |       | 9,089 |   |
| Total assets                                                                                                                                                                                  |       | $                     | 198,193    |   | $ | 230,996 |   |
|                                                                                                                                                                                          |       |                  |       |   |   |
| **Liabilities  and Stockholders’ Equity**                                                                                                                                                |       |                  |       |   |   |
| Current  liabilities:                                                                                                                                                                         |       |                  |       |   |   |
| Accounts payable                                                                                                                                                                              |       | $                     | 3,792      |   | $ | 3,330 |   |
| Accrued  compensation                                                                                                                                                                         |       | 2,936                 |       | 3,092 |   |
| Accrued  royalties                                                                                                                                                                            |       | 1,057                 |       | 1,113 |   |
| Other current  liabilities                                                                                                                                                                    |       | 1,947                 |       | 2,282 |   |
| Deferred revenue                                                                                                                                                                              |       | 17,724                |       | 16,547 |   |
| Total current  liabilities                                                                                                                                                                    |       | 27,456                |       | 26,364 |   |
| Deferred revenue                                                                                                                                                                              |       | 1,164                 |       | 1,140 |   |
| Deferred rent                                                                                                                                                                                 |       | 882                   |       | 1,276 |   |
| Total  liabilities                                                                                                                                                                            |       | 29,502                |       | 28,780 |   |
|                                                                                                                                                                                          |       |                  |       |   |   |
| Commitments and  contingencies (Note 4)                                                                                                                                                       |       |                  |       |   |   |
|                                                                                                                                                                                          |       |                  |       |   |   |
| Stockholders’  equity:                                                                                                                                                                   |       |                  |       |   |   |
| Preferred stock:  $0.01 par value; 5,000 shares authorized; none issued or outstanding                                                                                                        |       | —                |       | — |   |
| Common stock:  $0.01 par value; 40,000 shares authorized; 14,673 issued and outstanding as  of December 31, 2008; and 17,153 shares issued and outstanding as of  December 31, 2007 |       | 147                   |       | 172 |   |
| Additional  paid-in capital                                                                                                                                                                   |       | 168,738               |       | 199,625 |   |
| (Accumulated  deficit) retained earnings                                                                                                                                                      |       | (380                  | )          | 2,420 |   |
| Accumulated  other comprehensive income (loss)                                                                                                                                                |       | 186                   |       | (1 | ) |
| Total  stockholders’ equity                                                                                                                                                              |       | 168,691               |       | 202,216 |   |
| Total  liabilities and stockholders’ equity                                                                                                                                              |       | $                     | 198,193    |   | $ | 230,996 |   |

 

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

 

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**Vital Images, Inc.**

**Consolidated Statements of Operations**

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

 
| ** **                                            | ** ** | **For the Year Ended December 31,** | ** ** |
|-------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                            | ** ** | **2008**                                                     | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                                  |       |                                                         |       |   |   |   |   |
| Revenue:                                              |       |                                                         |       |   |   |   |   |
| License fees                                          |       | $                                                            | 34,290     |   | $ | 39,673 |   | $ | 46,332 |   |
| Maintenance and  services                             |       | 32,436                                                       |       | 29,487 |   | 22,615 |   |
| Hardware                                              |       | 1,415                                                        |       | 1,016 |   | 1,565 |   |
| Total revenue                                         |       | 68,141                                                       |       | 70,176 |   | 70,512 |   |
|                                                  |       |                                                         |       |   |   |   |   |
| Cost of revenue:                                      |       |                                                         |       |   |   |   |   |
| License fees                                          |       | 4,922                                                        |       | 4,725 |   | 4,991 |   |
| Maintenance and  services                             |       | 10,089                                                       |       | 9,928 |   | 8,023 |   |
| Hardware                                              |       | 862                                                          |       | 694 |   | 1,196 |   |
| Impairment of  patent                                 |       | —                                                       |       | 242 |   | — |   |
| Total cost of  revenue                                |       | 15,873                                                       |       | 15,589 |   | 14,210 |   |
|                                                  |       |                                                         |       |   |   |   |   |
| Gross profit                                          |       | 52,268                                                       |       | 54,587 |   | 56,302 |   |
|                                                  |       |                                                         |       |   |   |   |   |
| Operating  expenses:                                  |       |                                                         |       |   |   |   |   |
| Sales and  marketing                                  |       | 30,294                                                       |       | 31,991 |   | 25,374 |   |
| Research and  development                             |       | 17,131                                                       |       | 15,204 |   | 13,092 |   |
| General and  administrative                           |       | 14,008                                                       |       | 14,560 |   | 10,905 |   |
| Restructuring  charge                                 |       | 660                                                          |       | — |   | — |   |
| Total operating  expenses                             |       | 62,093                                                       |       | 61,755 |   | 49,371 |   |
|                                                  |       |                                                         |       |   |   |   |   |
| Operating (loss)  income                              |       | (9,825                                                       | )          | (7,168 | ) | 6,931 |   |
|                                                  |       |                                                         |       |   |   |   |   |
| Interest income                                       |       | 4,643                                                        |       | 8,886 |   | 3,342 |   |
| (Loss) income  before income taxes                    |       | (5,182                                                       | )          | 1,718 |   | 10,273 |   |
|                                                  |       |                                                         |       |   |   |   |   |
| (Benefit)  provision for income taxes                 |       | (2,382                                                       | )          | 351 |   | 3,690 |   |
|                                                  |       |                                                         |       |   |   |   |   |
| Net (loss)  income                                    |       | $                                                            | (2,800     | ) | $ | 1,367 |   | $ | 6,583 |   |
|                                                  |       |                                                         |       |   |   |   |   |
| Net (loss)  income per share – basic             |       | $                                                            | (0.17      | ) | $ | 0.08 |   | $ | 0.49 |   |
| Net (loss)  income per share – diluted           |       | $                                                            | (0.17      | ) | $ | 0.08 |   | $ | 0.46 |   |
|                                                  |       |                                                         |       |   |   |   |   |
| Weighted average  common shares outstanding - basic   |       | 16,155                                                       |       | 16,972 |   | 13,463 |   |
| Weighted average  common shares outstanding - diluted |       | 16,155                                                       |       | 17,457 |   | 14,259 |   |

 

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

 

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**VitalImages, Inc.**

**Consolidated Statements of Stockholders’ Equity and ComprehensiveIncome (Loss)**

**(In thousands)**

 
| ** **                                                                                                     | ** ** | ** **        | ** ** | ** **  | ** ** | ** **     | ** ** | ** **       | ** ** | **Retained**      | ** ** | **Accumulated**        | ** ** | ** **        | ** ** | ** **         | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-------------|------------|----------------|------------|------------------|------------|-------------------|------------|------------------------|------------|-------------------|------------|--------------------|------------|
| ** **                                                                                                     | ** ** | ** **        | ** ** | ** **  | ** ** | **Additional** | ** ** | ** **       | ** ** | **Earnings  /**   | ** ** | **Other**              | ** ** | **Total**         | ** ** | ** **         | ** ** |
| ** **                                                                                                     | ** ** | **Common  Stock** | ** ** | **Paid-In** | ** ** | **Deferred**   | ** ** | **(Accumulated** | ** ** | **Comprehensive** | ** ** | **Stockholders’** | ** ** | **Comprehensive** | ** ** |
| ** **                                                                                                     | ** ** | **Shares**        | ** ** | **Amount**  | ** ** | **Capital**    | ** ** | **Compensation** | ** ** | **Deficit)**      | ** ** | **Income /  (Loss)**   | ** ** | **Equity**        | ** ** | **Income  (Loss)** | ** ** |
|                                                                                                           |       |              |       |        |       |           |       | ** **       |       |              |       | ** **             | ** ** |              |       |               |       |
| Balances as of December 31, 2005                                                                          |       | 12,848            |       | 128         |       | 75,918         |       | (1,707           | )          | (5,530            | )          | (20                    | )          | 68,789            |       |               |       |
|                                                                                                           |       |              |       |        |       |           |       | ** **       |       |              |       | ** **             | ** ** |              |       |               |       |
| Issuance of  common stock upon exercise of stock options                                                       |       | 564               |       | 6           |       | 5,168          |       |             |       |              |       | ** **             | ** ** | 5,174             |       |               |       |
| Tax benefit  related to exercise of stock options and release of restricted stock                              |       |              |       |        |       | 4,403          |       |             |       |              |       | ** **             | ** ** | 4,403             |       |               |       |
| Issuance of  common stock under employee stock purchase plan                                                   |       | 16                |       | —      |       | 364            |       |             |       |              |       | ** **             | ** ** | 364               |       |               |       |
| Grant of restricted stock to employees                                                                         |       | 34                |       | —      |       | —         |       |             |       |              |       | ** **             | ** ** | —            |       |               |       |
| Forfeiture or  cancellation of restricted stock                                                                |       | (4                | )          | —      |       | —         |       |             |       |              |       | ** **             | ** ** | —            |       |               |       |
| Common stock  surrendered for payment of payroll tax liability resulting from the vesting  of restricted stock |       | (10               | )          | —      |       | (292           | )          |             |       |              |       | ** **             | ** ** | (292              | )          |               |       |
| Issuance of  common stock as contingent consideration related to the acquisition of  Hinnovation (See note 3)  |       | 106               |       | 1           |       | 3,083          |       |             |       |              |       | ** **             | ** ** | 3,084             |       |               |       |
| Issuance of  common stock in connection with public offering, net of offering costs of  $6,271                 |       | 3,354             |       | 34          |       | 97,669         |       |             |       |              |       | ** **             | ** ** | 97,703            |       |               |       |
| Stock-based compensation                                                                                       |       |              |       |        |       | 5,063          |       |             |       |              |       | ** **             | ** ** | 5,063             |       |               |       |
| Reclassification  of deferred compensation pursuant to FAS123R                                                 |       |              |       |        |       | (1,707         | )          | 1,707            |       |              |       | ** **             | ** ** | —            |       |               |       |
| Change in  unrealized gain or loss on investments, net of tax                                                  |       |              |       |        |       |           |       |             |       |              |       | 27                     |       | 27                |       | $                  | 27         |   |
| Cumulative translation adjustment                                                                              |       |              |       |        |       |           |       |             |       |              |       | 4                      |       | 4                 |       | 4                  |       |
| Net income                                                                                                     |       |              |       |        |       |           |       |             |       | 6,583             |       | ** **             | ** ** | 6,583             |       | 6,583              |       |
| Balances as of December 31, 2006                                                                          |       | 16,908            |       | 169         |       | 189,669        |       | —           |       | 1,053             |       | 11                     |       | 190,902           |       | $                  | 6,614      |   |
|                                                                                                           |       |              |       |        |       |           |       | ** **       |       |              |       | ** **             | ** ** |              |       |               |       |
| Issuance of  common stock upon exercise of stock options                                                       |       | 221               |       | 3           |       | 2,352          |       |             |       |              |       | ** **             | ** ** | 2,355             |       |               |       |
| Tax benefit  related to exercise of stock options and release of restricted stock                              |       |              |       |        |       | 1,443          |       |             |       |              |       | ** **             | ** ** | 1,443             |       |               |       |
| Issuance of  common stock under employee stock purchase plan                                                   |       | 27                |       | —      |       | 521            |       |             |       |              |       | ** **             | ** ** | 521               |       |               |       |
| Grant of restricted stock to employees                                                                         |       | 14                |       | —      |       | —         |       |             |       |              |       | ** **             | ** ** | —            |       |               |       |
| Forfeiture or  cancellation of restricted stock                                                                |       | (5                | )          | —      |       | —         |       |             |       |              |       | ** **             | ** ** | —            |       |               |       |
| Common stock  surrendered for payment of payroll tax liability resulting from the vesting  of restricted stock |       | (12               | )          | —      |       | (347           | )          |             |       |              |       | ** **             | ** ** | (347              | )          |               |       |
| Stock-based compensation                                                                                       |       |              |       |        |       | 5,987          |       |             |       |              |       | ** **             | ** ** | 5,987             |       |               |       |
| Change in  unrealized gain or loss on investments, net of tax                                                  |       |              |       |        |       |           |       |             |       |              |       | (8                     | )          | (8                | )          | $                  | (8         | ) |
| Cumulative translation adjustment                                                                              |       |              |       |        |       |           |       |             |       |              |       | (4                     | )          | (4                | )          | (4                 | )          |
| Net income                                                                                                     |       |              |       |        |       |           |       |             |       | 1,367             |       | ** **             | ** ** | 1,367             |       | 1,367              |       |
| Balances as of December 31, 2007                                                                          |       | 17,153            |       | 172         |       | 199,625        |       | —           |       | 2,420             |       | (1                     | )          | 202,216           |       | $                  | 1,355      |   |
|                                                                                                           |       |              |       |        |       |           |       | ** **       |       |              |       | ** **             | ** ** |              |       |               |       |
| Issuance of  common stock upon exercise of stock options                                                       |       | 243               |       | 2           |       | 1,927          |       |             |       |              |       | ** **             | ** ** | 1,929             |       |               |       |
| Tax benefit  related to exercise of stock options and release of restricted stock                              |       |              |       |        |       | 50             |       |             |       |              |       | ** **             | ** ** | 50                |       |               |       |
| Issuance of  common stock under employee stock purchase plan                                                   |       | 43                |       | —      |       | 490            |       |             |       |              |       | ** **             | ** ** | 490               |       |               |       |
| Grant of restricted stock to employees                                                                         |       | 30                |       | —      |       | —         |       |             |       |              |       | ** **             | ** ** | —            |       |               |       |
| Forfeiture or  cancellation of restricted stock                                                                |       | (27               | )          | —      |       | —         |       |             |       |              |       | ** **             | ** ** | —            |       |               |       |
| Common stock  surrendered for payment of payroll tax liability resulting from the vesting  of restricted stock |       | (12               | )          | —      |       | (174           | )          |             |       |              |       | ** **             | ** ** | (174              | )          |               |       |
| Stock-based compensation                                                                                       |       |              |       |        |       | 5,007          |       |             |       |              |       | ** **             | ** ** | 5,007             |       |               |       |
| Repurchases of common stock                                                                                    |       | (2,757            | )          | (27         | )          | (38,187        | )          |             |       |              |       | ** **             | ** ** | (38,214           | )          |               |       |
| Change in  unrealized gain or loss on investments, net of tax                                                  |       |              |       |        |       |           |       |             |       |              |       | 187                    | ** ** | 187               |       | $                  | 187        |   |
| Net loss                                                                                                       |       |              |       |        |       |           |       |             |       | (2,800            | )          | ** **             | ** ** | (2,800            | )          | (2,800             | )          |
| Balances as of December 31, 2008                                                                          |       | 14,673            |       | $           | 147        |           | $          | 168,738          |       | $                 | —     |                   | $          | (380              | )          | $                  | 186        |   | $ | 168,691 |   | $ | (2,613 | ) |
|                                                                                                                |            |                   |            |             |            |                |            |                  |            |                   |            |                        |            |                   |            |                    |            |  |  |  |  |  |  |  |

 

The accompanying notesare an integral part of the Consolidated Financial Statements.

 

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**Vital Images, Inc.**

**ConsolidatedStatements of Cash Flows**

**(In thousands)**

 
| ** **                                                                          | ** ** | **For the Year Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                                                          | ** ** | **2008**                                                     | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                                                                |       |                                                         |       |   |   |   |   |
| Cash flows from  operating activities:                                              |       |                                                         |       |   |   |   |   |
| Net (loss)  income                                                                  |       | $                                                            | (2,800     | ) | $ | 1,367 |   | $ | 6,583 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities:  |       |                                                         |       |   |   |   |   |
| Depreciation and  amortization of property and equipment                            |       | 4,919                                                        |       | 4,517 |   | 2,910 |   |
| Amortization of  identified intangible assets                                       |       | 1,044                                                        |       | 1,205 |   | 1,404 |   |
| Impairment of  patent                                                               |       | —                                                       |       | 242 |   | — |   |
| Provision for  doubtful accounts                                                    |       | 519                                                          |       | 239 |   | 25 |   |
| Deferred income  taxes                                                              |       | (2,521                                                       | )          | (16 | ) | 3,472 |   |
| Excess tax  benefit from stock transactions                                         |       | (481                                                         | )          | (1,395 | ) | (4,143 | ) |
| Amortization of  discount and accretion of premium on marketable securities         |       | (473                                                         | )          | (857 | ) | (382 | ) |
| Employee  stock-based compensation                                                  |       | 5,007                                                        |       | 5,987 |   | 5,045 |   |
| Non-employee  stock-based compensation                                              |       | —                                                       |       | — |   | 18 |   |
| Amortization of  deferred rent                                                      |       | (375                                                         | )          | (338 | ) | (195 | ) |
| Changes in  operating assets and liabilities:                                       |       |                                                         |       |   |   |   |   |
| Accounts  receivable                                                                |       | 2,396                                                        |       | 3,388 |   | (5,284 | ) |
| Prepaid expenses  and other assets                                                  |       | 262                                                          |       | (513 | ) | (701 | ) |
| Accounts payable                                                                    |       | 623                                                          |       | (363 | ) | 836 |   |
| Accrued expenses  and other liabilities                                             |       | (740                                                         | )          | (1,142 | ) | 193 |   |
| Deferred revenue                                                                    |       | 1,201                                                        |       | 1,382 |   | 4,429 |   |
| Deferred rent                                                                       |       | —                                                       |       | 199 |   | 561 |   |
| Net cash  provided by operating activities                                          |       | 8,581                                                        |       | 13,902 |   | 14,771 |   |
|                                                                                |       |                                                         |       |   |   |   |   |
| Cash flows from  investing activities:                                              |       |                                                         |       |   |   |   |   |
| Purchases of  property and equipment                                                |       | (5,434                                                       | )          | (6,577 | ) | (6,436 | ) |
| Purchases of  marketable securities                                                 |       | (76,395                                                      | )          | (59,974 | ) | (29,545 | ) |
| Proceeds from  maturities of marketable securities                                  |       | 70,002                                                       |       | 49,931 |   | 35,987 |   |
| Proceeds from  sales of marketable securities                                       |       | 1,581                                                        |       | 750 |   | 1,376 |   |
| Net cash (used  in) provided by investing activities                                |       | (10,246                                                      | )          | (15,870 | ) | 1,382 |   |
|                                                                                |       |                                                         |       |   |   |   |   |
| Cash flows from  financing activities:                                              |       |                                                         |       |   |   |   |   |
| Repurchases of  common stock                                                        |       | (38,214                                                      | )          | — |   | — |   |
| Proceeds from  sale of common stock under stock plans                               |       | 2,419                                                        |       | 2,876 |   | 5,538 |   |
| Proceeds from  sale of common stock, net of offering costs                          |       | —                                                       |       | — |   | 97,703 |   |
| Excess tax  benefit from stock transactions                                         |       | 481                                                          |       | 1,395 |   | 4,143 |   |
| Net cash (used  in) provided by financing activities                                |       | (35,314                                                      | )          | 4,271 |   | 107,384 |   |
|                                                                                |       |                                                         |       |   |   |   |   |
| Net (decrease)  increase in cash and cash equivalents                               |       | (36,979                                                      | )          | 2,303 |   | 123,537 |   |
|                                                                                |       |                                                         |       |   |   |   |   |
| Cash and cash  equivalents, beginning of year                                       |       | 146,685                                                      |       | 144,382 |   | 20,845 |   |
|                                                                                |       |                                                         |       |   |   |   |   |
| Cash and cash  equivalents, end of year                                             |       | $                                                            | 109,706    |   | $ | 146,685 |   | $ | 144,382 |   |
|                                                                                |       |                                                         |       |   |   |   |   |
| Supplemental  cash flow information:                                                |       |                                                         |       |   |   |   |   |
| Purchases of  property and equipment with accounts payable                          |       | $                                                            | 366        |   | $ | 525 |   | $ | 662 |   |
| Non-cash  investing and financing activities:                                       |       |                                                         |       |   |   |   |   |
| Common stock  issued relating to acquisition of HInnovation, Inc. (see Note 3) |       | $                                                            | —     |   | $ | — |   | $ | 3,084 |   |

 

The accompanying notesare an integral part of the Consolidated Financial Statements.

 

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**VitalImages, Inc.**

**Notes to Consolidated Financial Statements**

 

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

 

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

 

The Company views its operations and manages its business as onereportable segment — the development and marketing of software and relatedservices for advanced visualization and analysis solutions for use by medicalprofessionals in clinical analysis and therapy planning. Factors used toidentify the Company’s single operating segment include the financialinformation available for evaluation by the chief operating decision maker inmaking decisions about how to allocate resources and assess performance. TheCompany markets its products and services through a direct sales force andindependent distributors in the United States and international markets.

 

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

 

**Basis of presentation**

 

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

 

**Use of estimates**

 

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

 

**Fair value of financial instruments**

 

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

 

**Cash and cash equivalents**

 

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

 

**Marketable securities**

 

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

 

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identification method. The cost of marketable securities is adjustedfor amortization of premiums and accretion of discounts to maturity. Suchamortization and accretion is included in interest income. Interest anddividends on securities classified as available-for-sale are included ininterest income. As of December 31, 2008, all investments mature withinone year.

 

As of December 31, 2008 and 2007, the Company’s marketablesecurities were as follows (in thousands):

 
| ** **      | ** ** | **December 31, 2008** | ** ** | **December 31, 2007** | ** ** |
|-----------------|------------|---------------------------------|------------|---------------------------------|------------|
| ** **      | ** ** | **Adjusted Cost  Basis**   | ** ** | **Aggregate Fair  Value**  | ** ** | **Net Unrealized  Gains / (Losses)** | ** ** | **Adjusted  Cost Basis** | ** ** | **Aggregate Fair  Value** | ** ** | **Net Unrealized  Gains / (Losses)** | ** ** |
| ** **      | ** ** | ** **                      | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Corporate debt  |       | $                               | 2,253      |                            | $          | 2,255 |   | $ | 2 |   | $ | 9,993 |   | $ | 9,975 |   | $ | (18 | ) |
| Government debt |       | 34,742                          |       | 35,032                          |       | 290 |   | 21,717 |   | 21,734 |   | 17 |   |
|            |       | $                               | 36,995     |                            | $          | 37,287 |   | $ | 292 |   | $ | 31,710 |   | $ | 31,709 |   | $ | (1 | ) |

 

As of December 31, 2008 and 2007, the Company’s gross unrealizedgains and losses were as follows (in thousands):

 
|            |   | **December 31, 2008** |       | **December 31, 2007** |       |
|-----------------|--------|---------------------------------|------------|---------------------------------|------------|
|            |   | **Gross  Unrealized  Gains**    | ** ** | **Gross  Unrealized  (Losses)** | ** ** | **Net Unrealized  Gains / (Losses)** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  (Losses)** | ** ** | **Net Unrealized  Gains / (Losses)** |   |
|            |   |                            |       |                            |       |   |   |   |   |   |   |   |   |
| Corporate debt  |   | $                               | 9          |                            | $          | (7 | ) | $ | 2 |   | $ | 2 |   | $ | (20 | ) | $ | (18 | ) |
| Government debt |   | 290                             |       | —                          |       | 290 |   | 17 |   | — |   | 17 |   |
|            |   | $                               | 299        |                            | $          | (7 | ) | $ | 292 |   | $ | 19 |   | $ | (20 | ) | $ | (1 | ) |

 

The carrying values of available-for-sale securities are at fair value.There were no material realized gains or losses on any investments for theyears ended December 31, 2008, 2007 or 2006.

 

Corporate debt included $257,000 and $3.0 million of asset-backedsecurities as of December 31, 2008 and 2007, respectively. The netunrealized losses on asset-backed securities were $(7,000) and $(19,000) as of December 31,2008 and 2007, respectively. The Company’s asset-backed securities are ratedAAA and are current on scheduled pay downs, with expected full maturity withinthe next 12 months. Given the current conditions of the credit markets, thereis some risk the unrealized losses as of December 31, 2008 could increaseif the credit markets continue to deteriorate.

 

The Company analyzes its investments for impairment on an ongoingbasis. Factors considered in determining whether an unrealized loss is atemporary loss or an other-than-temporary loss include the length of time andextent to which the securities have been in an unrealized loss position and theCompany’s ability and intent to hold the investment for a period of timesufficient to allow for any anticipated market recovery. The Company has theability and intent to hold these investments until anticipated recovery of fairvalue, which may be maturity, and therefore the Company does not consider theseinvestments to be impaired as of December 31, 2008.

 

**Accounts receivable and allowance for doubtfulaccounts**

 

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

 

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**Concentration of credit risk**

 

Financial instruments that potentially subject the Company toconcentrations of credit risk consist primarily of cash and cash equivalentsand trade accounts receivable. Deposits with the Company’s bank may exceedthe amount of insurance provided on such deposits. Financial instruments thatpotentially subject the Company to concentrations of credit risk consistprincipally of cash and cash equivalents and marketable securities. Marketablesecurities consist of corporate debt and government debt. The Company’sinvestment policy, approved by its Investment Committee, limits the amount theCompany may invest in any one type of investment, thereby reducing creditrisk concentrations. A significant portion of the Company’s accounts receivablerelates to Toshiba Medical Systems Corporation and McKesson Corporation,totaling 42% and 7% of accounts receivable, respectively. The Company reviewsthe creditworthiness of its customers prior to product shipment and generallydoes not require collateral.

 

**Property and equipment**

 

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

 

**Long-lived assets**

 

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

 

**Goodwill**

 

The Company accounts for goodwill in accordance with the provisions ofSFAS No. 142, “Goodwill and Other Intangible Assets.” Under SFAS No. 142,goodwill and intangible assets with indefinite lives are reviewed forimpairment annually or more frequently if events or changes in circumstancesindicate that the asset might be impaired. The first step of the goodwillimpairment test, used to identify potential impairment, compares the fair valueof a reporting unit with its carrying amount, including goodwill. The Companyoperates as one reporting unit and therefore compares the book value to themarket value (market capitalization plus a control premium). If the marketvalue exceeds the book value, goodwill is considered not impaired, and thus thesecond step of the impairment test is not necessary. If the Company’s bookvalue exceeds the market value, the second step of the goodwill impairment testis performed to measure the amount of impairment loss, if any. The second stepof the goodwill impairment test, used to measure the amount of impairment loss,compares the implied fair value of the goodwill with the book value of thegoodwill. If the carrying value of the goodwill exceeds the implied fair valueof the goodwill, an impairment loss would be recognized in an amount equal tothe excess. Any loss recognized cannot exceed the carrying amount of goodwill.The Company completed the annual goodwill impairment assessment as of December 31,2008, in which no impairment was recorded. If market conditions continue tofluctuate, the Company may incur goodwill impairment charges that adverselyaffect its financial position and operating results.

 

**Revenue recognition**

 

The Company recognizes revenue in accordance with American Institute ofCertified Public Accountants (“AICPA”) Statement of Position (“SOP”) 97-2, “SoftwareRevenue Recognition,” as amended by SOP 98-4 and SOP 98-9, as well as TechnicalPractice Aids issued from time to time by the AICPA and SEC Staff Accounting

 

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Bulletin (“SAB”) No. 104. The Company recognizes revenue when itis 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 collectability is probable.

 

License feerevenue is derived from the licensing of computer software. Hardware revenue isderived from the sale of system hardware, including peripheral equipment.Maintenance and service revenue is derived from software maintenance and fromtelephone support, installation, customer education and consulting services.The Company’s software licenses are generally sold as part of anarrangement that includes maintenance and support and often installation andcustomer education services.

 

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

 

·                  Software 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.

 

·                  Services – Revenue from maintenanceand support arrangements is deferred and recognized ratably over the term ofthe maintenance and support arrangements. Revenue from customer education,installation and consulting services is recognized as the services are providedto customers or upon contractual expiration of such services.

 

·                  Multiple-Element Arrangements – TheCompany enters into arrangements with customers that include a combination ofsoftware products, system hardware, maintenance and support (which includesunspecified upgrades), or installation and customer education services. Forsuch arrangements, the Company recognizes revenue using the residual method.The Company allocates the total arrangement fee among the various elements ofthe arrangement based on the fair value of each of the undelivered elementsdetermined by vendor-specific objective evidence. The fair value ofinstallation and customer education services and maintenance and supportservices is established based upon sold separately pricing for the services orstated renewal rate. In software arrangements for which the Company does nothave vendor-specific objective evidence of fair value for all elements, revenueis deferred until the earlier of when vendor-specific objective evidence isdetermined for the undelivered elements (residual method) or when all elementsfor which the Company does not have vendor-specific objective evidence of fairvalue have been delivered.

 

**Equity-based compensation**

 

The Company accounts for equity-basedcompensation in accordance with SFAS No. 123 (revised 2004), “Share-BasedPayment” (“SFAS No. 123(R)”), which requires the measurement andrecognition of compensation expense for all equity-based payment awards made toemployees and directors, including employee stock options, restricted stock andemployee stock purchases related to the Employee Stock Purchase Plan, based onestimated fair values.

 

Equity-based compensation expense recognized under SFAS No. 123(R) forthe years ended December 31, 2008, 2007 and 2006 was $5.0 million, $6.0million and $5.1 million, respectively.

 

SFAS No. 123(R) requires companies to estimate the fair valueof equity-based payment awards on the date of grant using an option-pricingmodel. The Company uses the Black-Scholes option-pricing model, which requiresthe input 

 

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of assumptions, including an estimate of the average period of timeemployees will retain vested stock options before exercising them, theestimated volatility of the Company’s common stock price over the expectedterm, and the number of options that will ultimately be forfeited beforecompleting vesting requirements. Changes in the assumptions can materiallyaffect the estimate of fair value of equity-based compensation and,consequently, the related expense recognized. The value of the portion of theaward that is ultimately expected to vest is recognized as expense over therequisite vesting period.

 

Equity-based compensation expense recognized for the years ended December 31,2008, 2007 and 2006 included compensation expense for equity-based paymentawards granted on or prior to December 31, 2005 but not yet vested as ofthat date. Because equity-based compensation expense recognized for the yearsended December 31, 2008, 2007 and 2006 is based on awards ultimatelyexpected to vest, it has been reduced for estimated forfeitures. SFAS No. 123(R) requiresforfeitures to be estimated at the time of grant and revised, if necessary, insubsequent periods if actual forfeitures differ from those estimates.

 

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

 
| ** **                                          | ** ** | **For the Year Ended December 31,** | ** ** |
|-----------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                          | ** ** | **2008**                                                     | ** ** | **2007** | ** ** | **2006** | ** ** |
| Cost of revenue                                     |       | $                                                            | 333        |   | $ | 389 |   | $ | 372 |   |
| Sales and  marketing                                |       | 1,408                                                        |       | 2,392 |   | 1,995 |   |
| Research and  development                           |       | 1,017                                                        |       | 729 |   | 840 |   |
| General and administrative                          |       | 2,249                                                        |       | 2,477 |   | 1,856 |   |
| Equity-based  compensation before income taxes      |       | 5,007                                                        |       | 5,987 |   | 5,063 |   |
| Income tax  benefit                                 |       | (1,771                                                       | )          | (1,964 | ) | (1,488 | ) |
| Total  equity-based compensation after income taxes |       | $                                                            | 3,236      |   | $ | 4,023 |   | $ | 3,575 |   |

 

For purposes ofcalculating the fair value of options under SFAS No. 123(R), the weightedaverage fair value of options granted during 2008, 2007 and 2006 were $5.50,$13.47 and $13.58, respectively. The weighted-average fair values for theoptions were based on the fair values on the dates of grant. The fair valuesfor the options were calculated using the Black-Scholes option-pricing model,with the following weighted-average assumptions and expense adjusted using thefollowing expected forfeiture rate assumptions:

 
| ** **                  | ** ** | **For the Year Ended December 31,** | ** ** |
|-----------------------------|------------|--------------------------------------------------------------|------------|
| ** **                  | ** ** | **2008**                                                     | ** ** | **2007** | ** ** | **2006** | ** ** |
| Expected option  life       |       | 3.75 years                                                   |       | 3.75 years |   | 3.78 years |   |
| Expected  volatility factor |       | 46                                                           | %          | 52 | % | 52 | % |
| Expected  dividend yield    |       | 0                                                            | %          | 0 | % | 0 | % |
| Risk-free  interest rate    |       | 2.33                                                         | %          | 4.46 | % | 4.65 | % |
| Expected forfeiture  rate   |       | 1                                                            | %          | 1 | % | 1 | % |

 

Prior to March 9,2006, the expected life of stock options was calculated by performing adetailed analysis of all historical stock option information available. On March 9,2006, the Company began to grant options with a five-year legal life instead ofthe eight-year legal life that it had previously used. As a result, the Companyhas elected to use the “simplified” method as described in SAB No. 107to estimate the expected life of options granted on and after March 9,2006. The Company will utilize the simplified method until sufficienthistorical information becomes available on the five-year legal life options.The expected volatility is calculated based on the historical volatility of theCompany’s common stock over the expected option life and other appropriatefactors. The expected dividend yield is based on the Company’s intent not toissue dividends for the foreseeable future. Risk-free interest rates arecalculated based on continuously compounded U.S. Treasury risk-free rates forthe appropriate term. The expected forfeiture rate is estimated based onhistorical experience.

 

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As of December 31,2008, there was $7.0 million of unrecognized compensation expense related tostock options that is expected to be recognized over a weighted-average periodof 3.0 years.

 

The Company hasgranted nonvested shares of common stock (“restricted stock”) to certainemployees under its 1997 Stock Option and Incentive Plan and 2006 Long-TermIncentive Plan. With the exception of shares of restricted stock subject toperformance vesting, as noted below, restricted stock generally vests 25%annually beginning one year after the grant date. The Company recordsequity-based compensation expense equal to the fair market value of the commonstock on the date of grant ratably over the vesting period. Equity-basedcompensation expense related to restricted stock was $491,000, $741,000 and$728,000 for the years ended December 31, 2008, 2007 and 2006,respectively.

 

In the firstquarter of 2007, the Company granted shares of restricted stock withperformance-based vesting to certain employees. The Company granted a total of13,500 restricted shares with a total grant-date fair value of $464,000. As of December 31,2008, after forfeitures, 6,700 restricted shares with a total grant-date fairvalue of $230,000 remained outstanding. The awards vest upon achievement ofcertain Company performance metrics for fiscal years 2007 through 2009.One-third of each award will vest on each of the Company’s Form 10-Kfiling dates for the years ending December 31, 2007, 2008 and 2009 if theperformance metrics are met for the respective fiscal year. If the performancemetrics are not met for a given year, the unvested portion will carry forwardto the next fiscal year and may vest if that year’s metric is met. As of theCompany’s Form 10-K filing date for the year ending December 31,2009, any unvested portion of the award will be forfeited. The performancemetrics were not achieved for the years ended December 31, 2008 and 2007.Therefore, no equity-based compensation expense for the awards was recognizedfor the years ended December 31, 2008 and 2007. The amount of the expenserelated to the awards not recognized as of December 31, 2008 but which maybe recognized in future periods if performance metrics are met was $139,000.The first quarter of 2007 was the only period in which the Company grantedrestricted stock awards with performance-based vesting.

 

As of December 31,2008, there was $612,000 of unrecognized compensation expense related torestricted stock awards that is expected to be recognized over aweighted-average period of 2.3 years. The aggregate fair value of restrictedstock that vested was $488,000 and $1.0 million for the years ended December 31,2008 and 2007, respectively.

 

Employee StockPurchase Plan (“ESPP”) compensation expense was $154,000 and $161,000 for theyears ended December 31, 2008 and 2007, respectively.

 

The fair value of stock compensation expense associated with theCompany’s ESPP was estimated on the date of grant using the Black-Scholesoption pricing model with the following weighted-average assumptions:

 
| ** **                     | ** ** | **For the Year Ended December 31,** | ** ** |
|--------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                     | ** ** | **2008**                                                     | ** ** | **2007** | ** ** | **2006** | ** ** |
| Expected life of  ESPP options |       | 3 months                                                     |       | 3 months |   | 3 months |   |
| Expected  volatility factor    |       | 46                                                           | %          | 51 | % | 50 | % |
| Expected  dividend yield       |       | 0                                                            | %          | 0 | % | 0 | % |
| Risk-free  interest rate       |       | 1.81                                                         | %          | 4.59 | % | 4.64 | % |

 

Prior to the adoption of SFAS No. 123(R), the Company presentedall tax benefits resulting from the exercise of stock options and settlement ofrestricted stock awards as operating cash inflows in the consolidatedstatements of cash flows in accordance with the provisions of the EmergingIssues Task Force (“EITF”) Issue No 00-15, “Classification in the Statement ofCash Flows of the Income Tax Benefit Received by a Company upon Exercise of aNonqualified Employee Stock Option.” SFAS No. 123(R) requires thebenefits of tax deductions in excess of the compensation cost recognized forthose options and stock awards to be classified as financing cash inflowsrather than operating cash inflows on a prospective basis. This amount is shownas “Excess tax benefit from stock transactions” on the Consolidated Statementof Cash Flows.

 

The Company’sadoption of SFAS No. 123(R) using the modified prospectiveapplication required the Company to determine the amount of eligible windfalltax benefits (the pool of windfall tax benefits) that are available on theadoption date to offset future shortfalls. The Company has elected to calculateits historical pool of windfall tax benefits (that is, the amount that wouldhave accumulated as of the adoption date of SFAS No. 123(R)) using thealternative (“short-cut”) method, as provided in FSP No. FAS 123(R)-3, andthe “tax law ordering approach” to 

 

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determine when thehistoric tax benefits are realized (tax benefits realized based on provisionsin the tax law that identify the sequence in which stock option deductions areutilized for tax purposes). The Company will continue to track the balance ofthe pool of windfall tax benefits based on windfalls or shortfalls incurredafter the adoption date.

 

**Research and development costs**

 

Costs related toresearch, design and development of products are charged to research anddevelopment expense as incurred. Software development costs are capitalizedbeginning when a product’s technological feasibility has been established andending when a product is available for general release to customers. TheCompany uses the working model approach to determine technological feasibility.Generally, the Company’s products are released soon after technologicalfeasibility has been established. As a result, the Company has not capitalizedany software development costs because such costs have not been significant.

 

**Income taxes**

 

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

 

**Computation of net income per share**

 

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

 

The computations for basic and diluted net income pershare are as follows (in thousands, except per share amounts):

 
| ** **                                                                                                               | ** ** | **For the Year Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                                                                                               | ** ** | **2008**                                                     | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                                                                                               | ** ** | ** **                                                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Numerator:                                                                                                               |       |                                                         |       |   |   |   |   |
| Net (loss)  income                                                                                                       |       | $                                                            | (2,800     | ) | $ | 1,367 |   | $ | 6,583 |   |
|                                                                                                                     |       |                                                         |       |   |   |   |   |
| Denominator:                                                                                                             |       |                                                         |       |   |   |   |   |
| Denominator for  weighted average common shares outstanding – basic                                                 |       | 16,155                                                       |       | 16,972 |   | 13,463 |   |
|                                                                                                                     |       |                                                         |       |   |   |   |   |
| Dilution  associated with the company’s stock based compensation plans                                              |       | —                                                       |       | 485 |   | 779 |   |
|                                                                                                                     |       |                                                         |       |   |   |   |   |
| Dilution  associated with contingent stock consideration relating to acquisition of HInnovation, Inc.  (see note 3) |       | —                                                       |       | — |   | 17 |   |
|                                                                                                                     |       |                                                         |       |   |   |   |   |
| Denominator:                                                                                                             |       |                                                         |       |   |   |   |   |
| Denominator for  weighted average common shares outstanding – diluted                                               |       | 16,155                                                       |       | 17,457 |   | 14,259 |   |
|                                                                                                                     |       |                                                         |       |   |   |   |   |
| Net (loss)  income per share – basic                                                                                |       | $                                                            | (0.17      | ) | $ | 0.08 |   | $ | 0.49 |   |
| Net (loss)  income per share – diluted                                                                              |       | $                                                            | (0.17      | ) | $ | 0.08 |   | $ | 0.46 |   |
|                                                                                                                     |       |                                                         |       |   |   |   |   |
| Antidilutive  stock options and restricted stock awards excluded from above calculation                                  |       | 2,515                                                        |       | 809 |   | 379 |   |

 

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**Comprehensive income (loss)**

 

Comprehensive income (loss) as defined by SFAS No. 130, “ReportingComprehensive Income,” includes net income and items defined as othercomprehensive income. SFAS No. 130 requires that items defined as othercomprehensive income, such as foreign currency translation adjustments andunrealized gains and losses on certain marketable securities, be separatelyclassified in the financial statements. Such items are reported in theconsolidated statements of stockholders’ equity as comprehensive income (loss).

 

**New accounting pronouncements**

 

FASB StaffPosition (“FSP”) FAS No. 157-2, “Effective Date of FASB Statement No. 157,”delayed the effective date of the application of SFAS No. 157, “Fair ValueMeasurements,” to fiscal years beginning after November 15, 2008 for allnonfinancial assets and nonfinancial liabilities that are recognized ordisclosed at fair value in the financial statements on a nonrecurring basis.Nonrecurring nonfinancial assets and nonfinancial liabilities for which we havenot applied the provisions of SFAS No. 157 include those measured at fairvalue during impairment testing for goodwill and other long-lived assets andthose initially measured at fair value in a business combination. The Companydoes not believe SFAS No. 157 will have a material impact on the Company’sconsolidated financial statements.

 

In December 2007, the FASB issued SFAS No. 141(R), “BusinessCombinations,” which changes accounting for business acquisitions. SFAS No. 141(R) willrequire the acquiring entity in a business combination to recognize all (andonly) the assets acquired and liabilities assumed in the transaction andestablish the acquisition-date fair value as the measurement objective for allassets acquired and liabilities assumed in a business combination. Certainprovisions of this standard will, among other things, impact the determinationof acquisition-date fair value of consideration paid in a business combination(including contingent consideration); exclude transaction costs fromacquisition accounting; and change accounting practices for acquiredcontingencies, acquisition-related restructuring costs, in-process research anddevelopment, indemnification assets and tax benefits. SFAS No. 141(R) willbe effective for the Company for business combinations occurring after December 31,2008. The impact on the Company’s consolidated financial statements ofadopting SFAS 141(R) will depend on the nature, terms and size ofbusiness combinations completed after December 31, 2008.

 

In June 2008,the FASB issued FSP Emerging Issues Task Force (“EITF”) 03-6-1, “Determining Whether Instruments Granted inShare-Based Payment Transactions Are Participating Securities” (“FSPEITF 03-6-1”). FSP EITF 03-6-1 is effective for the Company in the firstquarter of 2009. The Company does not expect that the adoption of FSP EITF03-6-1 will have a material impact on the Company’s consolidated financialstatements.

 

**3.****              Financial statementcomponents**

 

**Allowance for doubtful accounts**

 

The allowance for doubtful accounts activity was as follows (inthousands):

 
| ** **         | ** ** | **For the Year Ended December 31,** | ** ** |
|--------------------|------------|--------------------------------------------------------------|------------|
| ** **         | ** ** | **2008**                                                     | ** ** | **2007** | ** ** | **2006** | ** ** |
|               |       |                                                         |       |   |   |   |   |
| Beginning  balance |       | $                                                            | 505        |   | $ | 266 |   | $ | 320 |   |
| Provision          |       | 519                                                          |       | 239 |   | 25 |   |
| Write-offs         |       | (386                                                         | )          | — |   | (87 | ) |
| Recoveries         |       | —                                                       |       | — |   | 8 |   |
| Ending balance     |       | $                                                            | 638        |   | $ | 505 |   | $ | 266 |   |

 

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**Property and equipment, net**

 

The components ofproperty and equipment were as follows (in thousands):

 
| ** **                                      | ** ** | **December 31,** | ** ** |
|-------------------------------------------------|------------|-----------------------|------------|
| ** **                                      | ** ** | **2008**              | ** ** | **2007** | ** ** |
|                                            |       |                  |       |   |   |
| Equipment                                       |       | $                     | 13,551     |   | $ | 13,776 |   |
| Furniture and  fixtures                         |       | 3,993                 |       | 3,813 |   |
| Computer  software                              |       | 7,572                 |       | 4,543 |   |
| Leasehold  improvements                         |       | 2,521                 |       | 2,780 |   |
| Total property  and equipment                   |       | 27,637                |       | 24,912 |   |
| Less accumulated  depreciation and amortization |       | (16,118               | )          | (13,747 | ) |
| Property and  equipment, net                    |       | $                     | 11,519     |   | $ | 11,165 |   |

 

Depreciation andamortization expense was $4.9 million, $4.5 million and $2.9 million for theyears ended December 31, 2008, 2007 and 2006, respectively.

 

In2007, the Company began the implementation of an enterprise resource planning (“ERP”)system. Phase 1 of the implementation, which related to the replacement of theCompany’s general ledger, was completed in 2007. The related capitalized costsare being depreciated over seven years and, as of December 31, 2008, thenet book value of Phase 1 was $1.0 million. Phase 2 of the implementation,which consists of replacing the Company’s various customer relationshipmanagement and order processing systems, has yet to be completed or placed inservice. As of December 31, 2008, Phase 2 capitalized costs were $2.9million.  The Company will continueimplementation of the ERP during 2009, and upon completion of theimplementation, the cost will be depreciated over seven years. If the Companydoes not reach certain milestones in the implementation schedule, it may berequired to write-off all or a portion of the amounts capitalized, whichcould negatively affect its financial position and results of operations.

 

**Other intangible assets, net**

 

Acquired intangibleassets subject to amortization were as follows (in thousands):

 
| ** **                                       | ** ** | **December 31, 2008** | ** ** | **December 31, 2007** | ** ** |
|--------------------------------------------------|------------|---------------------------------|------------|---------------------------------|------------|
| ** **                                       | ** ** | **Gross  Carrying  Value**      | ** ** | **Accumulated  Amortization**   | ** ** | **Net Carrying  Value** | ** ** | **Gross Carrying  Value** | ** ** | **Accumulated  Amortization** | ** ** | **Net Carrying  Value** | ** ** |
| ** **                                       | ** ** | ** **                      | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Software  technology                             |       | $                               | 3,400      |                            | $          | (3,334 | ) | $ | 66 |   | $ | 3,400 |   | $ | (2,650 | ) | $ | 750 |   |
| Patents and  patent applications                 |       | 2,500                           |       | (1,758                          | )          | 742 |   | 2,500 |   | (1,398 | ) | 1,102 |   |
| Total intangible  assets subject to amortization |       | $                               | 5,900      |                            | $          | (5,092 | ) | $ | 808 |   | $ | 5,900 |   | $ | (4,048 | ) | $ | 1,852 |   |

 

During the third quarter2007, the Company recognized a $242,000 patent impairment charge related to apatent application acquired in the HInnovation, Inc. acquisition in February 2004.This patent application was rejected by the United States Patent and TrademarkOffice (“USPTO”) on August 23, 2007, and the Company decided not to pursuethis application further.

 

Intangible assets subjectto amortization are amortized on a straight-line basis over the estimatedperiod of benefit. Amortization expense was $1.0 million, $1.2 million and $1.3million for the years ended December 31, 2008, 2007 and 2006,respectively. The estimated future annual amortization expense for identifiedintangible assets is as follows (in thousands):

 
| 2009   |   | $   | 426    |   |
|--------|--------|-----|--------|--------|
| 2010   |   | 360 |   |
| 2011   |   | 22  |   |
|   |   | $   | 808    |   |

 

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The preceding expectedamortization expense is an estimate. Actual amortization expensemay differ from estimates due to additional intangible asset acquisitions,impairment of intangible assets, accelerated amortization of intangible assets,and other events. A patent acquired in the HInnovation, Inc. acquisitionhaving a $594,000 net book value as of December 31, 2008 is currently underreview by the USPTO.

 

**Goodwill**

 

There were no changes tothe carrying value of goodwill for the years ended December 31, 2008 and 2007.Goodwill increased during 2006 due to contingent consideration paid through theissuance of 106,000 shares of common stock valued at $3.1 million in connectionwith the acquisition of HInnovation, Inc. on February 18, 2004.

 

**Deferred revenue**

 

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

 
| ** **                             | ** ** | **December 31,** | ** ** |
|----------------------------------------|------------|-----------------------|------------|
| ** **                             | ** ** | **2008**              | ** ** | **2007** | ** ** |
|                                   |       |                  |       |   |   |
| Maintenance and  support               |       | $                     | 13,912     |   | $ | 12,376 |   |
| Customer  education                    |       | 3,034                 |       | 3,311 |   |
| Professional  services                 |       | 788                   |       | 762 |   |
| Software                               |       | 616                   |       | 755 |   |
| Hardware and  other                    |       | 538                   |       | 483 |   |
| Total deferred  revenue                |       | 18,888                |       | 17,687 |   |
| Less current  portion                  |       | (17,724               | )          | (16,547 | ) |
| Long-term  portion of deferred revenue |       | $                     | 1,164      |   | $ | 1,140 |   |

 

**4.****              Commitments andcontingencies**

 

**Operating lease commitments**

 

The Company rents officespace and certain office equipment under operating leases. In addition tominimum lease payments, the office leases require payment of a proportionateshare of real estate taxes and building operating expenses. Total rent expense,including an allocation of the lessor’s operating costs, was $1.8 million, $1.7million and $1.2 million for the years ended December 31, 2008, 2007 and 2006,respectively.

 

In March 2004, theCompany signed a non-cancelable operating lease for a new office facility inMinnetonka, Minnesota. The new lease term started in February 2005 andexpires in January 2012. The Company moved into the Minnetonka locationand moved out of its Plymouth, Minnesota location in February 2005.

 

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

 

During the years ended December 31,2007 and 2006, the Company expanded its Minnetonka headquarters and receivedleasehold improvements paid for by the Minnetonka lessor of $199,000 and$561,000, respectively. Such leasehold improvements were recorded as an assetby the Company and amortized over the shorter of their estimated useful livesor the remaining terms of the related leases, with a corresponding amountrecorded as deferred rent and amortized as a reduction of rent expense over theterm of the Minnetonka lease.

 

The deferred rent balancewas $1.3 million ($394,000 was classified as current) and $1.7 million($375,000 was classified as current) as of December 31, 2008 and 2007,respectively.

 

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

 
| 2009  | ** ** | $   | 1,154  | ** ** |
|-------|------------|-----|--------|------------|
| 2010  |       | 930 |   |
| 2011  |       | 907 |   |
| 2012  |       | 76  |   |
| Total |       | $   | 3,067  |       |

 

**Other items**

 

Under general contractterms, the Company sometimes includes an indemnification clause in its softwarelicensing agreement providing that the Company will indemnify the licenseeagainst liability and damages arising from any claims of patent, copyright,trademark or trade secret infringement by the Company’s software. The Companyhas incurred insignificant costs as a result of this type of indemnificationclause, and the Company does not maintain a product warranty liability relatedto such indemnification clauses.

 

The Company has enteredinto various employment agreements with certain executives of the Company,which include provisions for severance payments subject to certain conditionsand events.

 

The Company recorded an$885,000 charge in the fourth quarter of 2007 related to the resignation of JayD. Miller, the company’s former president and chief executive officer, of which$580,000 related to 2008 cash payments and $305,000 related to equity-basedcompensation.

 

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

 

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

 

**Background**

 

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

 

**ShareRepurchase Program**

 

During 2008, the Company’s Board of Directors approved a sharerepurchase program, which authorized open market transactions of up to $40.0million, including fees and expenses, of the Company’s common stock. Theprogram authorizes management to repurchase shares from time to time, dependingon market conditions. During 2008, the Company completed stock repurchases of2.8 million shares for $38.2 million, inclusive of fees and expenses. At timeof repurchase, shares are returned to the status of authorized and unissuedshares. The Company has accounted for the repurchases as constructively retiredand recorded such repurchases as a reduction of common stock and additionalpaid-in capital.

 

The Company completed the$40.0 million share repurchase program on February 6, 2009. Between January 1,2009 and February 6, 2009, the Company purchased 149,000 shares under theprogram for $1.8 million, inclusive of fees and expenses, bringing the totalaggregate shares repurchased to 2.9 million shares. On March 3, 2009, theCompany announced an additional share repurchase program, authorizing up to anadditional 1.0 million shares to be repurchased on the open market.

 

**Publicoffering of common stock**

 

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

 

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**Stockoption plans**

 

In May 1997,Bio-Vascular, Inc., which is now known as Synovis Life Technologies, Inc.,as the sole shareholder of the Company, approved and adopted the Vital Images, Inc.1997 Stock Option and Incentive Plan (the “1997 Plan”), which became effectiveon the Distribution Date. Under the terms of the 1997 Plan, the Board ofDirectors or a committee of the Board may grant options and otherequity-based awards to key employees to purchase shares of the Company’s commonstock at an option exercise price equal to or greater than 85% of the fairmarket value on the date of grant. The options are exercisable at such times,in installments or otherwise, as the Board of Directors or a committee of theBoard may determine. Generally, these options have a term of five or eightyears and are exercisable as to 28% of the total grant one year after the dateof grant and 2% per month thereafter. The total number of shares of common stockthat may be issued or awarded under the 1997 Plan was 4,100,000 shares.The 1997 Plan expired on March 19, 2007, and no more rights to purchaseshares will be granted from it.

 

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

 

On May 4, 2006, theshareholders of the Company approved the Vital Images, Inc. 2006 Long-TermIncentive Plan (the “2006 Plan”). The 2006 Plan provides that the total numberof shares of the Company’s common stock that may be subject to options,restricted stock awards and other equity awards granted under the 2006 Planshall not exceed 900,000 shares. On June 3, 2008, the shareholders of theCompany approved an amendment to the 2006 Plan to increase the shares reservedunder the plan by 1.6 million shares, resulting in total shares reserved forissuance under the 2006 Plan of 2.5 million shares. The 2006 Plan provides theBoard of Directors or a committee of the Board the authority to grant incentivestock options qualified as such under Section 422 of the Internal RevenueCode of 1986 and nonqualified stock options, awards of restricted stock, stockappreciation rights, other equity-based awards, cash-based awards or anycombination of such awards subject to the terms of the 2006 Plan. As of December 31,2008, 1,435,208 shares remained available for the grant of awards under the2006 Plan.

 

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The following tablesummarizes stock option activity for 2008, 2007 and 2006:

 
| ** **                                      | ** ** | **Shares Underlying  Options** | ** ** | **Weighted-Average  Exercise Price Per  Share** | ** ** | **Weighted-Average  Remaining  Contractual Term  (in years)** | ** ** | **Aggregate  Intrinsic  Value (in  thousands)** | ** ** |
|-------------------------------------------------|------------|-------------------------------------|------------|-----------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
|                                            |       |                                |       |                                                      |       |                                                                    |       |                                                 |       |
| Total  outstanding as of December 31, 2005 |       | 1,997,275                           |       | $                                                         | 11.45      |                                                                    |       |                                                 |       |   |
|                                            |       |                                |       |                                                      |       |                                                                    |       |                                                 |       |
| Options granted                                 |       | 383,300                             |       | $                                                         | 31.15      |                                                                    |       |                                                 |       |   |
| Options  exercised                              |       | (564,286                            | )          | $                                                         | 9.17       |                                                                    |       |                                                 |       |   |
| Options  cancelled                              |       | (19,110                             | )          | $                                                         | 23.33      |                                                                    |       |                                                 |       |   |
|                                            |       |                                |       |                                                      |       |                                                                    |       |                                                 |       |
| Total  outstanding as of December 31, 2006 |       | 1,797,179                           |       | $                                                         | 16.24      |                                                                    |       |                                                 |       |   |
|                                            |       |                                |       |                                                      |       |                                                                    |       |                                                 |       |
| Options granted                                 |       | 469,595                             |       | $                                                         | 30.99      |                                                                    |       |                                                 |       |   |
| Options  exercised                              |       | (220,604                            | )          | $                                                         | 10.68      |                                                                    |       |                                                 |       |   |
| Options  cancelled                              |       | (64,766                             | )          | $                                                         | 26.66      |                                                                    |       |                                                 |       |   |
|                                            |       |                                |       |                                                      |       |                                                                    |       |                                                 |       |
| Total  outstanding as of December 31, 2007 |       | 1,981,404                           |       | $                                                         | 20.03      |                                                                    |       |                                                 |       |   |
|                                            |       |                                |       |                                                      |       |                                                                    |       |                                                 |       |
| Options granted                                 |       | 1,081,070                           |       | $                                                         | 14.77      |                                                                    |       |                                                 |       |   |
| Options  exercised                              |       | (242,525                            | )          | $                                                         | 7.95       |                                                                    |       |                                                 |       |   |
| Options  cancelled                              |       | (367,090                            | )          | $                                                         | 23.93      |                                                                    |       |                                                 |       |   |
|                                            |       |                                |       |                                                      |       |                                                                    |       |                                                 |       |
| Total  outstanding as of December 31, 2008 |       | 2,452,859                           |       | $                                                         | 18.32      |                                                                    | 3.25       |                                                 | $          | 2,278 |   |
|                                            |       |                                |       |                                                      |       |                                                                    |       |                                                 |       |
| Options  exercisable as of:                     |       |                                |       |                                                      |       |                                                                    |       |                                                 |       |
| December 31,  2006                         |       | 1,064,923                           |       | $                                                         | 11.39      |                                                                    |       |                                                 |       |   |
| December 31,  2007                         |       | 1,206,104                           |       | $                                                         | 14.71      |                                                                    |       |                                                 |       |   |
| December 31,  2008                         |       | 1,259,018                           |       | $                                                         | 18.98      |                                                                    | 2.43       |                                                 | $          | 2,016 |   |

 

Various price ranges andweighted average information for options outstanding and exercisable as of December 31,2008 are as follows:

 
| ** **                                         | ** ** | **Options Outstanding** | ** ** | **Options Exercisable**                                                 | ** ** |
|----------------------------------------------------|------------|-------------------------|------------|-------------------------------------------------------------------------|------------|
| **Range of  Exercise Prices**            | ** ** | **Number  Outstanding** | ** ** | **Weighted Average  Remaining  Contractual Life  (in years)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number  Exercisable** | ** ** | **Weighted  Average  Exercise****Price** | ** ** |
| $   5.19  -  $ 12.23 |       | 472,057                 |       | 2.62                                                                    |       | $ | 9.42 |   | 318,057 |   | $ | 8.07 |   |
| $ 12.44  -  $ 15.11            |       | 488,817                 |       | 3.81                                                                    |       | $ | 14.47 |   | 121,537 |   | $ | 12.62 |   |
| $ 15.17  -  $ 15.40            |       | 444,502                 |       | 4.19                                                                    |       | $ | 15.27 |   | 50,280 |   | $ | 15.40 |   |
| $ 15.50  -  $ 19.64            |       | 442,001                 |       | 3.09                                                                    |       | $ | 17.55 |   | 366,282 |   | $ | 17.82 |   |
| $ 19.80  -  $ 32.14            |       | 461,020                 |       | 2.65                                                                    |       | $ | 30.49 |   | 308,473 |   | $ | 30.28 |   |
| $ 32.16  -  $ 35.70            |       | 144,462                 |       | 2.98                                                                    |       | $ | 33.34 |   | 94,389 |   | $ | 33.47 |   |
|                                               |       | 2,452,859               |       | 3.25                                                                    |       | $ | 18.32 |   | 1,259,018 |   | $ | 18.98 |   |

 

The aggregate intrinsicvalue of options (that is, the amount by which the market price of the stock onthe date of exercise exceeded the exercise price of the option) exercisedduring the years ended December 31, 2008, 2007 and 2006 was $1.5 million,$4.4 million and $12.8 million, respectively. Cash received from the exerciseof stock options for the years ended December 31, 2008, 2007 and 2006 was$1.9 million, $2.4 million and $5.2 million, respectively. The total taxbenefit realized for the tax deductions from options exercised for the yearsended December 31, 2008, 2007 and 2006 was $490,000, $1.5 million and $4.4million, respectively.

 

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**Restricted stock**

 

The Company grants nonvested shares of commonstock (“restricted stock”) to certain employees under the 1997 Plan and the2006 Plan. The restricted stock generally vests 25% annually beginning one yearafter the grant date. The following table summarizes the restricted stockactivity for the year ended December 31, 2008 and 2007:

 
| ** **                                      | ** ** | **Restricted  Shares** | ** ** | **Weighted-Average  Grant Date Fair  Value Per Share** | ** ** |
|-------------------------------------------------|------------|------------------------|------------|----------------------------------------------------------------------------|------------|
| Total  outstanding as of December 31, 2005 |       | 114,770                |       | $                                                                          | 17.61      |   |
| Shares granted                                  |       | 33,910                 |       | $                                                                          | 31.76      |   |
| Shares vested                                   |       | (29,226                | )          | $                                                                          | 17.51      |   |
| Shares  forfeited/cancelled                     |       | (3,777                 | )          | $                                                                          | 21.44      |   |
| Total  outstanding as of December 31, 2006 |       | 115,677                |       | $                                                                          | 21.65      |   |
| Shares granted                                  |       | 14,250                 |       | $                                                                          | 34.21      |   |
| Shares vested                                   |       | (35,677                | )          | $                                                                          | 20.88      |   |
| Shares  forfeited/cancelled                     |       | (4,647                 | )          | $                                                                          | 24.53      |   |
| Total  outstanding as of December 31, 2007 |       | 89,603                 |       | $                                                                          | 23.81      |   |
| Shares granted                                  |       | 30,000                 |       | $                                                                          | 13.74      |   |
| Shares vested                                   |       | (29,816                | )          | $                                                                          | 20.98      |   |
| Shares  forfeited/cancelled                     |       | (27,210                | )          | $                                                                          | 25.42      |   |
| Total  outstanding as of December 31, 2008 |       | 62,577                 |       | $                                                                          | 19.63      |   |

 

The total taxbenefit realized for the tax deductions from restricted stock vested during theyears ended December 31, 2008, 2007 and 2006 was $183,000, $368,000 and$315,000, respectively.

 

**Employeestock purchase plan**

 

The ESPP was approved and adopted by Bio-Vascular, as the soleshareholder of the Company, in May 1997. The ESPP, which became effectiveon July 1, 1997, enables eligible employees to purchase the Company’scommon stock at a price equal to 85% of the fair market value of the stock onthe date an offering period commences or on the date an offering periodterminates, whichever is lower. Shares of common stock are offered under theESPP during a series of offering periods, with each offering period running fora calendar quarter. On June 3, 2008, the shareholders of the Companyapproved an amendment to the ESPP to increase, from 250,000 shares of commonstock to 400,000 shares of common stock, the number of aggregate shares ofcommon stock that can be issued and sold to participating employees of theCompany under the ESPP. The ESPP covers substantially all employees, subject tocertain limitations. Each employee may elect to have up to 10% of his orher base pay withheld and applied toward the purchase of shares in each suchoffering period. As of December 31, 2008, 132,955 shares of common stockremained reserved for future purchases under the ESPP.

 

**6.****             ****Income taxes**

 

Effective January 1, 2007, the Company adoptedFASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN48”). FIN 48 prescribes a recognition threshold and measurement attribute forrecognition and measurement of a tax position taken or expected to be taken ina tax return. FIN 48 also provides guidance on de-recognition, classification,interest and penalties, accounting in interim periods, disclosure andtransition. The adoption of FIN 48 did not have a material impact on theCompany’s Consolidated Financial Statements. Additionally, the adoption of FIN48 had no impact on retained earnings or the gross liability for uncertain taxpositions. The Company had no uncertain tax positions as of December 31,2008 and 2007.

 

The Company didnot have any material unrecognized tax benefits as of December 31, 2008and 2007. The Company recognizes potential accrued interest and penaltiesrelated to unrecognized tax benefits as a component of income tax expense. Tothe extent interest and penalties are not assessed with respect to uncertaintax positions, amounts accrued will be reduced and reflected as a reduction ofthe overall income tax provision. The Company recorded no interest andpenalties during the year ended December 31, 2008 and had no accruedinterest and penalties as of December 31, 2008. The Company is no longersubject to U.S. federal tax examinations by tax authorities for tax yearsbefore 2005. The Company is open to state tax audits until the applicablestatute of limitations expires.

 

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The components of income before income taxes were asfollows (in thousands):

 
| ** **                   | ** ** | **For the Year Ended December 31,** | ** ** |
|------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                   | ** ** | **2008**                                                     | ** ** | **2007** | ** ** | **2006** | ** ** |
| Income before  income taxes: |       |                                                         |       |   |   |   |   |
| U.S.                         |       | $                                                            | (5,710     | ) | $ | 1,313 |   | $ | 9,951 |   |
| International                |       | 528                                                          |       | 405 |   | 322 |   |
|                         |       | (5,182                                                       | )          | 1,718 |   | 10,273 |   |
|                              |            |                                                              |            |  |  |  |  |  |  |  |

 

The income taxprovision included the following components (in thousands):

 
| ** **                  | ** ** | **For the Year Ended December 31,** | ** ** |
|-----------------------------|------------|--------------------------------------------------------------|------------|
| ** **                  | ** ** | **2008**                                                     | ** ** | **2007** | ** ** | **2006** | ** ** |
| Current income  taxes:      |       |                                                         |       |   |   |   |   |
| Federal                     |       | $                                                            | —     |   | $ | 112 |   | $ | 91 |   |
| State                       |       | —                                                       |       | 140 |   | 48 |   |
| Foreign                     |       | 139                                                          |       | 115 |   | 79 |   |
|                        |       | 139                                                          |       | 367 |   | 218 |   |
| Deferred income  taxes:     |       |                                                         |       |   |   |   |   |
| Federal                     |       | (2,296                                                       | )          | 93 |   | 3,181 |   |
| State                       |       | (225                                                         | )          | (109 | ) | 218 |   |
| Foreign                     |       | —                                                       |       | — |   | 73 |   |
|                        |       | (2,521                                                       | )          | (16 | ) | 3,472 |   |
| Provision for  income taxes |       | $                                                            | (2,382     | ) | $ | 351 |   | $ | 3,690 |   |

 

A reconciliationof the Company’s income tax provision computed using the federal statutory rateto the tax provision reported in the Company’s statements of operations is asfollows (in thousands):

 
| ** **                                            | ** ** | **For the Year Ended December 31,** | ** ** |
|-------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                            | ** ** | **2008**                                                     | ** ** | **2007** | ** ** | **2006** | ** ** |
| Tax provision  computed at the federal statutory rate |       | $                                                            | (1,762     | ) | $ | 584 |   | $ | 3,493 |   |
| State taxes, net  of federal benefit                  |       | (132                                                         | )          | 96 |   | 378 |   |
| Increase  (decrease) in tax from:                     |       |                                                         |       |   |   |   |   |
| Stock-based  compensation                             |       | 52                                                           |       | 244 |   | 334 |   |
| Research and  development tax credits                 |       | (725                                                         | )          | (682 | ) | (562 | ) |
| Business meals  and entertainment                     |       | 119                                                          |       | 119 |   | 75 |   |
| Extraterritorial  income exclusion                    |       | —                                                       |       | — |   | (38 | ) |
| Foreign tax rate  differential                        |       | (39                                                          | )          | (23 | ) | (5 | ) |
| Change in  valuation allowance                        |       | 108                                                          |       | (4 | ) | (25 | ) |
| Other, net                                            |       | (3                                                           | )          | 17 |   | 40 |   |
| Provision for  income taxes                           |       | $                                                            | (2,382     | ) | $ | 351 |   | $ | 3,690 |   |

 

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The significant components of the Company’stax-effected net deferred tax assets were as follows (in thousands):

 
| ** **                                                      | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                      | ** ** | **2008**              | ** ** | **2007** | ** ** |
| Current:                                                        |       |                  |       |   |   |
| Accrued expenses  and allowances                                |       | $                     | 760        |   | $ | 829 |   |
| Equity-based  compensation                                      |       | —                |       | 2,643 |   |
| Unrealized gain  on investments                                 |       | (106                  | )          | — |   |
| Total current  deferred tax asset                               |       | 654                   |       | 3,472 |   |
| Noncurrent:                                                     |       |                  |       |   |   |
| Equity-based  compensation                                      |       | 3,736                 |       | — |   |
| Net operating  loss carryforwards                               |       | 4,418                 |       | 4,221 |   |
| Research and  development tax credit carryforwards              |       | 4,285                 |       | 3,579 |   |
| Depreciation and  amortization                                  |       | 1,286                 |       | 952 |   |
| Deferred revenue                                                |       | 425                   |       | 416 |   |
| Identifed  intangible assets                                    |       | (295                  | )          | (677 | ) |
| Other                                                           |       | 270                   |       | 269 |   |
| Total noncurrent  deferred tax asset before valuation allowance |       | 14,125                |       | 8,760 |   |
| Total deferred  tax asset before valuation allowance            |       | 14,779                |       | 12,232 |   |
| Less valuation  allowance                                       |       | (221                  | )          | (139 | ) |
| Total net  deferred tax asset                                   |       | $                     | 14,558     |   | $ | 12,093 |   |

 

Deferred tax assets related to equity-basedcompensation as of December 31, 2008 were reclassified to noncurrent, asthe Company does not anticipate tax deductions from the related stock optionsduring 2009. This is due to the fact that the majority of the stock optionshave exercise prices that are significantly higher than the market price pershare as of December 31, 2008.

 

**Netoperating loss carryforwards and other tax credit carryforwards**

 

The Company had federal tax loss carryforwards of approximately $12.6million, representing a $4.3 million deferred tax asset as of December 31,2008. The federal tax loss carryforwards will expire in 2019 through 2028 ifnot utilized. The Company estimates that it is more likely than not that thisdeferred tax asset will be realized prior to expiration.

 

The Company had state tax loss carryforwards of approximately $2.2million, representing a $125,000 deferred tax asset as of December 31,2008. The state tax loss carryforwards will expire at various dates through2024 if not utilized. The Company had an $18,000 valuation allowance related tothis deferred tax asset as of December 31, 2008 due to the uncertainty inrealization prior to expiration.

 

The Company had other federal and state tax credits and carryforwards ofapproximately $4.6 million, representing a $4.6 million deferred tax asset asof December 31, 2008. The federal and state credits and carryforwards willexpire in 2009 through 2028 if not utilized. The Company had a $203,000valuation allowance related to this deferred tax asset as of December 31,2008 due to the uncertainty in realization prior to expiration for creditsexpiring 2012 and earlier. During the year ended December 31, 2008, theCompany wrote off $26,000 to the valuation allowance related to research anddevelopment tax credits that had expired prior to realization.

 

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During the yearended December 31, 2007, the Company reversed $4,000 of the valuationallowance relating to state tax losscarryforwards as it was more likely than not that the deferred tax assetwould be realized prior to expiration.During the year ended December 31, 2007, the Company wrote off $42,000 tothe valuation allowance related to research and development tax credits thathad expired prior to realization.

 

During the yearended December 31, 2006, the Company reversed $25,000 of the valuationallowance relating to state tax losscarryforwards, as it was more likely than not that the deferred taxasset would be realized prior toexpiration. During the year ended December 31, 2006, the Company wrote-off$79,000 to the valuation allowance related to research and development taxcredits that had expired prior to realization.

 

**Realizabilityof Deferred Tax Assets**

 

Significantjudgment is required in determining the realizability of the Company’s deferredtax assets. The Company must assess the likelihood that the net deferred taxassets will be recovered from future taxable income, and to the extent that theCompany believes that recovery is not likely, the Company must establish avaluation allowance. To the extent that the Company establishes a valuationallowance, the Company must include an expense within the tax provision in thestatement of operations. As of December 31, 2008, the consolidated balancesheet included net deferred tax assets of $14.6 million.

 

Considerations for determining the realizability of the Company’sdeferred tax assets primarily involve cumulative pre-tax income for financialreporting purposes, cumulative taxable income for the past three years,estimated future pre-tax income for financial reporting purposes and estimatedfuture taxable income from the Company’s core business. The Company also considersthe expiration dates and amounts of net operating loss carryforwards and other tax credits, and estimates the impact offuture tax deductions from the exercise of stock options. These estimates areprojected through the life of the related deferred tax assets based onassumptions which the Company believes to be reasonable and consistent withcurrent operating results.

 

As of December 31,2008, the significant components of the Company’s deferred tax assets were asfollows:  

 

·                Deferred tax assets for net operatingloss carryforwards and other tax credits of $8.7 million, which is net of avaluation allowance of $221,000 relating to tax credits and certain state netoperating loss carryforwards that expire prior to 2013.  The Company requires approximately $18.0million in cumulative future taxable income to be generated at various timesover the next 18 years to realize the related deferred tax assets prior toexpiration.

·                Deferred tax asset related to equitybased compensation of $3.7 million. Many of the stock options related to thisdeferred tax asset are currently significantly out-of-the money and may expireunutilized during the next six years.  TheCompany’s projections of future taxable income have taken into considerationthe Company’s expectations that a portion of these out-of-the money optionswill not result in future tax deductions and will not reduce future taxableincome.

 

After givingconsideration to the above factors, the Company concluded that the net deferredtax assets of $14.6 million as of December 31, 2008 do not require anyadditional valuation allowance. However, if the Company does not achieve asubstantial improvement in pretax results in 2009 over 2008, it is reasonablypossible that the Company may need to establish additional valuationallowances for some or all of the Company’s deferred tax assets, which couldmaterially impact the Company’s income tax provision, financial position andresults of operations.

 

**Netoperating loss carryforward limitations**

 

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

 

**7.****             ****Employee benefit plan**

 

The Companymaintains the Vital Images, Inc. Salary Savings Plan (the “Plan”), whichis intended to qualify under Section 401(k) of the Internal RevenueCode of 1986, as amended. The Plan covers substantially all employees. Eachemployee may elect to contribute to the Plan through payroll deductions upto 100% of his or her salary, subject to certain limitations. At the discretionof the Board of Directors, the Company may make matching contributionsequal to a percentage of the salary reduction contributions or otherdiscretionary amounts. The Company paid matching contributions of $412,000,$410,000 and $214,000 in 2008, 2007 and 2006, respectively.

 

**8.****             ****Restructuring charge**

 

The Companyreduced its workforce by approximately 11% under a plan announced in November 2008in order to align the Company’s operations with the

 

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current marketconditions and improve profitability in 2009 and beyond. In connection with thereduction in workforce, the Company incurred certain charges in 2008 totaling$660,000, which were primarily comprised of employee severance and othertermination costs. The following table summarizes 2008 restructuringtransactions and related liability balances (in thousands):

 
| ** **                        | ** ** | **Severance and  Other  Termination  Costs** | ** ** |
|-----------------------------------|------------|---------------------------------------------------|------------|
| Balance at January 1, 2008   |       | $                                                 | —     |   |
| Restructuring charges             |       | 660                                               |       |
| Payments                          |       | (519                                              | )          |
| Balance at December 31, 2008 |       | $                                                 | 141        |   |

 

Actions withrespect to the above activities were completed in the fourth quarter of 2008. 

 

**9.****             ****Fair Value Measurements**

 

TheCompany adopted SFAS No. 157, “Fair Value Measurements,” as of January 1,2008, with the exception of the application of SFAS No. 157 tononrecurring nonfinancial assets and nonfinancial liabilities. Nonrecurringnonfinancial assets and nonfinancial liabilities to which we have not appliedthe provisions of SFAS No. 157 include those measured at fair value duringimpairment testing for goodwill and other long-lived assets and those initiallymeasured at fair value in a business combination.

 

SFAS No. 157establishes a valuation hierarchy for disclosure of the inputs to valuationused to measure fair value. This hierarchy prioritizes the inputs into threebroad levels. Level 1 inputs are quoted prices (unadjusted) in active marketsfor identical assets or liabilities. Level 2 inputs are quoted prices forsimilar assets and liabilities in active markets or inputs that are observablefor the asset or liability, either directly or indirectly through marketcorroboration, for substantially the full term of the financial instrument.Level 3 inputs are unobservable inputs based on our own assumptions used tomeasure assets and liabilities at fair value. A financial asset’s or liability’sclassification within the hierarchy is determined based on the lowest levelinput that is significant to the fair value measurement.

 

The following table provides the assets andliabilities carried at fair value measured on a recurring basis as of December 31,2008 (in thousands):

 
| ** **                                        | ** ** | ** **                                                            | ** ** | **Fair Value Measurements at December 31, 2008 Using** | ** ** |
|---------------------------------------------------|------------|-----------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------|------------|
| ** **                                        | ** ** | **Total Carrying  Value at****December 31, 2008** | ** ** | **Quoted price in  active markets  (Level 1)**                        | ** ** | **Significant other  observable inputs  (Level 2)** | ** ** | **Significant  unobservable inputs  (Level 3)** | ** ** |
| Cash  equivalents:                                |       |                                                                  |       |                                                                                      |       |   |   |   |   |
| Money market                                      |       | $                                                                     | 102,877    |                                                                                      | $          | 102,877 |   | $ | — |   | $ | — |   |
|                                              |       |                                                                  |       |                                                                                      |       |   |   |   |   |
| Marketable  securities:                           |       |                                                                  |       |                                                                                      |       |   |   |   |   |
| Corporate debt                                    |       | 2,255                                                                 |       | 1,998                                                                                     |       | 257 |   | — |   |
| Government debt                                   |       | 35,032                                                                |       | 35,032                                                                                    |       | — |   | — |   |
| Total marketable  securities                      |       | 37,287                                                                |       | 37,030                                                                                    |       | 257 |   | — |   |
| Total cash  equivalents and marketable securities |       | $                                                                     | 140,164    |                                                                                      | $          | 139,907 |   | $ | 257 |   | $ | — |   |

 

Cash equivalents andmarketable securities measured at fair value using quoted market prices areclassified within Level 1 of the valuation hierarchy. Marketable securitiesclassified within Level 2 of the valuation hierarchy consist

 

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ofasset-backed securities for which significant observable market data exists butthe Company’s nonstandard lot sizes prevent measurement using quoted market prices.The valuation of asset-backed securities is determined by reviewing quotedmarket prices for traded lots of the same or similar securities. Allasset-backed securities held by the Company are rated AAA and are current onscheduled pay downs with expected full maturity within the next 12 months.Given the current conditions of the credit markets, there is some risk theunrealized losses as of December 31, 2008 could increase if the creditmarkets continue to deteriorate.

 

The Companyanalyzes its investments for impairment on an ongoing basis. Factors consideredin determining whether an unrealized loss is a temporary loss or another-than-temporary loss include the length of time and extent to which thesecurities have been in an unrealized loss position and the Company’s abilityand intent to hold the investment for a period of time sufficient to allow forany anticipated market recovery. The Company has the ability and intent to holdthese investments until anticipated recovery of fair value, which may bematurity, and therefore the Company did not consider these investments to beother than temporarily impaired as of December 31, 2008.

 

In February 2007, the FASB issued SFAS No. 159, “TheFair Value Option for Financial Assets and Financial Liabilities,” whichpermits entities to choose to measure many financial instruments and certainother items at fair value that are not currently required to be measured atfair value. The Company adopted SFAS No. 159 on January 1, 2008and has elected not to measure any additional financial instruments and otheritems at fair value.

 

**10.****       Major customers andgeographic data**

 

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

 
| ** **                           | ** ** | **For the Year Ended December 31,** | ** ** |
|--------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                           | ** ** | **2008**                                                     | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                 |       |                                                         |       |   |   |   |   |
| Toshiba Medical  Systems Corporation |       | $                                                            | 35,275     |   | $ | 32,710 |   | $ | 28,879 |   |
| Percentage of  total revenue         |       | 52                                                           | %          | 47 | % | 41 | % |
|                                 |       |                                                         |       |   |   |   |   |
| McKesson  Corporation                |       | $                                                            | 4,516      |   | $ | 6,061 |   | $ | 7,314 |   |
| Percentage of  total revenue         |       | 7                                                            | %          | 9 | % | 10 | % |

 

As of December 31,2008 and 2007, Toshiba Medical Systems Corporation accounted for 42% and 34% ofaccounts receivable, respectively.

 

The majority ofthe Company’s long-lived assets are located in the United States.

 

Export revenueaccounted for 29%, 19% and 15% of total revenue for the years ended December 31,2008, 2007 and 2006, respectively. The Company’s export sales are primarilynegotiated, invoiced and paid in U.S. dollars, with a portion of salestransactions denominated in foreign currencies.

 

Sales to customerslocated in the following geographic areas are summarized as follows (inthousands):

 
| ** **               | ** ** | **For the Year Ended December 31,** | ** ** |
|--------------------------|------------|--------------------------------------------------------------|------------|
| ** **               | ** ** | **2008**                                                     | ** ** | **2007** | ** ** | **2006** | ** ** |
|                     |       |                                                         |       |   |   |   |   |
| United States            |       | $                                                            | 48,473     |   | $ | 56,630 |   | $ | 59,640 |   |
| Europe                   |       | 11,316                                                       |       | 8,378 |   | 5,713 |   |
| Asia and Pacific  Region |       | 3,643                                                        |       | 2,380 |   | 2,520 |   |
| Canada                   |       | 1,401                                                        |       | 349 |   | 441 |   |
| Other foreign  countries |       | 3,308                                                        |       | 2,439 |   | 2,198 |   |
|                     |       | $                                                            | 68,141     |   | $ | 70,176 |   | $ | 70,512 |   |

 

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

 

The following summarized unaudited quarterly financial data has beenprepared using the financial statements of the Company (in thousands, exceptper share data):

 
| ** **                                    | ** ** | **First Quarter** | ** ** | **Second Quarter** | ** ** | **Third Quarter** | ** ** | **Fourth Quarter** | ** ** |
|-----------------------------------------------|------------|------------------------|------------|-------------------------|------------|------------------------|------------|-------------------------|------------|
|                                          |       |                   |       |                    |       |                   |       |                    |       |
| **2008**                                      |       |                   |       |                    |       |                   |       |                    |       |
| Total revenue                                 |       | $                      | 17,317     |                    | $          | 15,707                 |       | $                       | 17,679     |   | $ | 17,438 |   |
| Gross profit                                  |       | $                      | 13,397     |                    | $          | 12,106                 |       | $                       | 13,619     |   | $ | 13,146 |   |
| Net loss                                      |       | $                      | (594       | )                       | $          | (1,577                 | )          | $                       | (243       | ) | $ | (386 | ) |
| Loss per share –  basic (1)              |       | $                      | (0.03      | )                       | $          | (0.09                  | )          | $                       | (0.02      | ) | $ | (0.03 | ) |
| Loss per share –  diluted (1)            |       | $                      | (0.03      | )                       | $          | (0.09                  | )          | $                       | (0.02      | ) | $ | (0.03 | ) |
|                                          |       |                   |       |                    |       |                   |       |                    |       |
| **2007**                                      |       |                   |       |                    |       |                   |       |                    |       |
| Total revenue                                 |       | $                      | 20,825     |                    | $          | 15,534                 |       | $                       | 17,115     |   | $ | 16,702 |   |
| Gross profit                                  |       | $                      | 16,480     |                    | $          | 11,842                 |       | $                       | 13,329     |   | $ | 12,936 |   |
| Net income  (loss)                            |       | $                      | 2,372      |                    | $          | (379                   | )          | $                       | 927        |   | $ | (1,553 | ) |
| Earnings (loss)  per share – basic (1)   |       | $                      | 0.14       |                    | $          | (0.02                  | )          | $                       | 0.05       |   | $ | (0.09 | ) |
| Earnings (loss)  per share – diluted (1) |       | $                      | 0.14       |                    | $          | (0.02                  | )          | $                       | 0.05       |   | $ | (0.09 | ) |

 

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(1)          The sum of the quarterly earnings (loss) per share may not equalthe annual earnings per share due to changes in average shares outstanding.

 

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

 

**Index to Exhibits**

 
| **Item  No.** | ** ** | **Description**                                                                                                                                                                                                                                                                                                   |
|---------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **    | ** ** | ** **                                                                                                                                                                                                                                                                                                        |
| 3.1           |       | Articles of Incorporation of the Company,  incorporated by reference to Exhibit 3.1 to the Company’s Registration  Statement on Form 10 dated March 13, 1997 (“Form 10”).                                                                                                      |
|          |       |                                                                                                                                                                                                                                                                                                              |
| 3.2           |       | By-laws of the Company, incorporated by reference to  Exhibit 3.2 to the Form 10.                                                                                                                                                                                                                       |
|          |       |                                                                                                                                                                                                                                                                                                              |
| 4.1           |       | Form of common stock certificate of the  Company, incorporated by reference to Exhibit 4.3 to the Form 10.                                                                                                                                                                                         |
|          |       |                                                                                                                                                                                                                                                                                                              |
| 10.1          |       | Employee Stock Purchase Plan, incorporated by  reference to Exhibit 10.10 to the Form 10.*                                                                                                                                                                                                              |
|          |       |                                                                                                                                                                                                                                                                                                              |
| 10.2          |       | 1997 Stock Option and Incentive Plan, as amended,  incorporated by reference to Exhibit 10.11 to the Form 10 and  Exhibit 99.9 to the Company’s Registration Statement on Form S-8  dated May 23, 2005.*                                                                            |
|          |       |                                                                                                                                                                                                                                                                                                              |
| 10.3          |       | 1997 Director Stock Option Plan, as amended,  incorporated by reference to Exhibit 10.12 to the Form 10 and  Exhibit 99.14 to the Company’s Registration Statement on Form S-8  dated May 23, 2005.*                                                                                |
|          |       |                                                                                                                                                                                                                                                                                                              |
| 10.4          |       | Form of Change in Control Agreement between  Vital Images, Inc. and Steven P. Canakes, incorporated by reference to  Exhibit 10.40 to the Company’s Annual Report on Form 10-K for the  year ended December 31, 2000.*                                                              |
|          |       |                                                                                                                                                                                                                                                                                                              |
| 10.5          |       | Employment Agreement dated September 8, 2005 by  and between Vital Images, Inc. and Dr. Susan A. Wood, incorporated  by reference to Exhibit 99.4 to the Company’s Current Report on  Form 8-K dated September 12, 2005.*                                                      |
|          |       |                                                                                                                                                                                                                                                                                                              |
| 10.6          |       | Change in Control Agreement dated September 8,  2005 by and between Vital Images, Inc. and Dr. Susan A. Wood,  incorporated by reference to Exhibit 99.5 to the Company’s Current  Report on Form 8-K dated September 12, 2005.*                                               |
|          |       |                                                                                                                                                                                                                                                                                                              |
| 10.7          |       | Employment Agreement dated September 8, 2005 by  and between Vital Images, Inc. and Philip I. Smith, incorporated by  reference to Exhibit 99.6 to the Company’s Current Report on  Form 8-K dated September 12, 2005.*                                                             |
|          |       |                                                                                                                                                                                                                                                                                                              |
| 10.8          |       | Employment Agreement dated September 8, 2005 by  and between Vital Images, Inc. and Steven P. Canakes, incorporated by  reference to Exhibit 99.7 to the Company’s Current Report on  Form 8-K dated September 12, 2005.*                                                           |
|          |       |                                                                                                                                                                                                                                                                                                              |
| 10.9          |       | Change in Control Agreement dated May 16, 2005,  by and between Vital Images, Inc. and Michael H. Carrel, incorporated by  reference to Exhibit 99.4 to the Company’s Current Report on  Form 8-K dated May 19, 2005.*                                                              |
|          |       |                                                                                                                                                                                                                                                                                                              |
| 10.10         |       | Form of Change in Control Agreement between  Vital Images, Inc. and Philip I. Smith, incorporated by reference to  Exhibit 10.22 to the Company’s Annual Report on Form 10-K for the  year ended December 31, 2005.                                                                 |
|          |       |                                                                                                                                                                                                                                                                                                              |
| 10.11         |       | 2006 Long Term Incentive Plan, as amended,  incorporated by reference to Exhibit 10.19 to the Company’s Annual  Report on Form 10-K for the year ended December 31, 2006 and  Exhibit 99.1to the Company’s Registration Statement on Form S-8  dated September 08, 2006.* |
|          |       |                                                                                                                                                                                                                                                                                                              |
| 10.12         |       | Employment Agreement dated January 12, 2008 by  and between Vital Images, Inc. and Michael H. Carrel, incorporated by  reference to Exhibit 10.13 to the Company’s Annual Report on Form 10-K  for the year ended December 31, 2007.*                                               |

 

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| **Item  No.** |   | **Description**                                                                                                                                                                                                                                                                                  |
|---------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **    |   | ** **                                                                                                                                                                                                                                                                                       |
| 10.13         |   | Employment Agreement  dated January 12, 2008 by and between Vital Images, Inc. and Peter  J. Goepfrich, incorporated by reference to Exhibit 10.14 to the  Company’s Annual Report on Form 10-K for the year ended December 31,  2007.*                            |
|          |   |                                                                                                                                                                                                                                                                                             |
| 10.14         |   | Separation and  Non-Compete Agreement dated January 16, 2008 by and between Vital Images, Inc.  and Jay D. Miller, incorporated by reference to Exhibit 10.19 to the  Company’s Annual Report on Form 10-K for the year ended December 31,  2007.*                 |
|          |   |                                                                                                                                                                                                                                                                                             |
| 10.15         |   | Separation and  Non-Compete Agreement dated June 30, 2008 by and between Vital Images, Inc.  and Philip I. Smith, incorporated by reference to Exhibit 10.1 to the  Company’s Quarterly Report on Form 10-Q for the quarter ended June 30,  2008.*                 |
|          |   |                                                                                                                                                                                                                                                                                             |
| 10.16         |   | Separation and  Non-Compete Agreement dated September 11, 2008 by and between Vital  Images, Inc. and Susan A. Wood, Ph. D., incorporated by reference to Exhibit 10.1  to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30,  2008.* |
|          |   |                                                                                                                                                                                                                                                                                             |
| 10.17         |   | Offer letter dated August 5,  2008 by and between Vital Images, Inc. and Vikram Simha, filed  herewith.* b                                                                                                                                                                             |
|          |   |                                                                                                                                                                                                                                                                                             |
| 10.18         |   | Employment  Agreement dated August 6, 2008 by and between Vital Images, Inc.  and Vikram Simha, filed herewith.*                                                                                                                                                                       |
|          |   |                                                                                                                                                                                                                                                                                             |
| 10.19         |   | Change in Control  Agreement dated August 6, 2008, by and between Vital Images, Inc.  and Vikram Simha, filed herewith.*                                                                                                                                                               |
|          |   |                                                                                                                                                                                                                                                                                             |
| 10.20         |   | Offer letter dated December 10,  2008 by and between Vital Images, Inc. and Reza A. Ghanbari, filed  herewith.*                                                                                                                                                                        |
|          |   |                                                                                                                                                                                                                                                                                             |
| 10.21         |   | Employment  Agreement dated December 10, 2008 by and between Vital Images, Inc.  and Reza A. Ghanbari, filed herewith.*                                                                                                                                                                |
|          |   |                                                                                                                                                                                                                                                                                             |
| 10.22         |   | Change in Control  Agreement dated December 10, 2008, by and between Vital Images, Inc.  and Reza A. Ghanbari, filed herewith.*                                                                                                                                                        |
|          |   |                                                                                                                                                                                                                                                                                             |
| 10.23         |   | Marketing and  Distribution Agreement between Vital Images, Inc. and Toshiba Medical  Systems Corporation dated November 21, 2008, filed herewith. b                                                                                                                                   |
|          |   |                                                                                                                                                                                                                                                                                             |
| 10.24         |   | Development Agreement  between Vital Images, Inc. and Toshiba Medical Systems Corporation dated  January 8, 2009, filed herewith. b                                                                                                                                                    |
|          |   |                                                                                                                                                                                                                                                                                             |
| 21.1          |   | Subsidiaries of  Registrant, filed herewith.                                                                                                                                                                                                                                                     |
|          |   |                                                                                                                                                                                                                                                                                             |
| 23.1          |   | Consent of  PricewaterhouseCoopers LLP, filed herewith.                                                                                                                                                                                                                                          |
|          |   |                                                                                                                                                                                                                                                                                             |
| 31.1          |   | Certification of Chief  Executive Officer Pursuant to Rules 13a-14(a)/15d-14(a) under the  Securities Exchange Act of 1934 and Section 302 of the Sarbanes-Oxley  Act of 2002, filed herewith.                                                                                    |
|          |   |                                                                                                                                                                                                                                                                                             |
| 31.2          |   | Certification of Chief  Financial Officer Pursuant to Rules 13a-14(a)/15d-14(a) under the  Securities Exchange Act of 1934 and Section 302 of the Sarbanes-Oxley  Act of 2002, filed herewith.                                                                                    |
|          |   |                                                                                                                                                                                                                                                                                             |
| 32.1          |   | Certification of Chief  Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted  Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, filed  herewith.                                                                                                                  |
|          |   |                                                                                                                                                                                                                                                                                             |
| 32.2          |   | Certification of Chief  Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted  Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, filed  herewith.                                                                                                                  |

 

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*                 Indicates a management contract orcompensatory plan or arrangement.

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

 

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