**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C.  20549**

 

**FORM 10-K**

 
| **ý**                                                                               | **ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934**     |
|------------------------------------------------------------------------------------------|-----------------------------------------------------------------------------------------------|
| **For  the fiscal year ended December 31, 2002**                                         |
|                                                                                     |
| **o**                                                                                    | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934** |
| **For  the transition period from       to    ** |

 

**CommissionFile Number 0-22229**

 

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**VITAL IMAGES, INC.**

(Exact name of Registrantas specified in its charter)

 

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

 

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Indicate by check mark whether the registrant (1) has filed all reportsrequired to be 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 to suchfiling requirements for the past 90 days. Yes  ý  No  o

 

Indicate by check mark if disclosure of delinquent filers pursuant toItem 405 of Regulation S-K is not contained herein, and will not be contained,to the best of registrant’s knowledge, in definitive proxy or informationstatements incorporated by reference in Part III of this Form 10-K or anyamendment to the Form 10-K.  o

 

Indicate by check mark whether the registrant is an accelerated filer(as defined in Rule 12b-2 of the act). Yes  o  No  ý

 

The aggregate market value of the common stock held by non-affiliatesof the registrant computed by reference to the price at which the common stockwas last sold as of June 28, 2002, the last business day of the registrant’smost recently completed second fiscal quarter, was $49,012,000.  The common stock is the registrant’s onlyclass of voting stock.

 

The number of shares outstanding of the issuer’s classes of commonstock as of February 28, 2003: Common stock, $.01 Par Value – 9,039,714.

 

DOCUMENTS INCORPORATED BYREFERENCE

 

Portions of registrant’s definitive Proxy Statement in connection withthe Annual Meeting of Shareholders to be held May 7, 2003 (“2003 ProxyStatement”) are incorporated by reference into Part III.

 

 

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VITAL IMAGES, INC.

FORM 10-K

 

TABLE OF CONTENTS

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

 

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Item 1.                                     BUSINESS

 

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

 

The Company files annual reports, quarterly reports,proxy statements, and other documents with the Securities and ExchangeCommission (SEC) under the Securities Exchange Act of 1934 (Exchange Act).  The public may read and copy any materialsthat the company files with the SEC at the SEC’s Public Reference Room at 450Fifth Street N.W., Washington, D.C. 20549. The public may obtain information on the operation of the PublicReference Room by calling the SEC at 1-800-SEC-0330.  Also, the SEC maintains an Internet website that containsreports, proxy and information statements, and other information regardingissuers, including the company, that file electronically with the SEC.  The public can obtain any documents that thecompany files with the SEC at http://www.sec.gov.

 

The Company also makes available free of chargethrough its Internet website (http://www.vitalimages.com) the Company’s AnnualReport on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form8-K, and, if applicable, amendments to those reports filed or furnishedpursuant to the Exchange Act as soon as reasonably practicable after theCompany electronically files such material with, or furnishes it to, the SEC.

 

Business Description

 

Vital Images develops, markets and supports 3D medicalimaging software for use primarily in disease screening, clinical diagnosis andtherapy planning.  The Company’ssoftware applies proprietary computer graphics and image processingtechnologies to a wide variety of data supplied by computed tomography (“CT”)scanners and magnetic resonance (“MR”) imaging devices.  Vital Images’ products allow clinicians tocreate both two- and three-dimensional views of human anatomy and tonon-invasively navigate within these images to better visualize and understandinternal structures and pathologies. The Company believes that its high-speed visualization technology andcustomized protocols cost-effectively bring 3D visualization and analysis intothe routine, day-to-day practice of medicine. The Company, which operates in a single business segment, markets itsproducts to healthcare providers and to manufacturers of diagnostic imagingsystems through a direct sales force in the United States and independentdistributors in international markets.

 

*Vitrea®*, Vital Images’ advanced 3D medicalimaging product for radiological and surgical applications, received FDAclearance in November 1996 and was released for sale in October 1997.  Due to its speed and ease-of-use, managementbelieves that *Vitrea*wasthe first 3D medical imaging product with the ability to appeal primarily tothe clinical market.  Historically, 3Dmedical imaging software was slow, difficult to use, and operated only onexpensive workstations.  Consequently,the functionality of such software was appealing only for researchapplications.  The Company’s *Vitrea*softwarecombined speed with ease-of-use to enable a physician to access, manipulate andanalyze 3D images, typically in less than five to ten minutes.  The Company has released several updates to *Vitrea*each year, and in February 2003released *Vitrea2 Version 3.2*, which has improved quality, reliability and usabilityfeatures to meet the diagnostic and treatment planning needs of busy radiologydepartments. The Company offers *Vitrea 2* both as an integrated softwareand hardware system, consisting of *Vitrea 2* software installed on a computerworkstation, and as a stand-alone software package.  To date, the Company has licensed over 850 copies of *Vitrea*and*Vitrea 2* to hospitals,clinics, imaging centers and other sites, including 14 of the nation’s top 17hospitals.

 

The Company believes that growing acceptance of 3Dmedical imaging offers Vital Images numerous market expansionopportunities.  Research and developmentefforts are currently focused on using the Company’s base of visualization technologyto expand to other imaging modalities, such as x-ray angiography, as well as

 

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expanding the features and functions in the currentmodalities.  Vital Images is alsodeveloping 3D medical imaging software tools for less-invasive screeningapplications, such as CT colonography for colon cancer screening, surgicalplanning, intra-operative visualization and real-time interventional 3Dvisualization.

 

The Company has a marketing and distribution agreement with ToshibaCorporation, Medical Systems Company ("Toshiba"), which names *Vitrea 2*as Toshiba's primary 3D softwarefor use with their CT scanners in the United States and in more than 50countries in North and South America, Europe, the Middle East, Africa,Australia and Asia, except Japan. The agreement runs through September 30,2003. Sales by the Company to Toshiba accounted for approximately 34%, 27% and27% of the Company's total revenue for the years ended December 31, 2002, 2001and 2000, respectively. See "Business —Marketing and Distribution"and " — Dependence on Major Customers."

 

The diagnostic medical imaging market continues to expand both itsgeographic boundaries and its definitive boundaries.  Long defined as the market for CT, MR, ultrasound and otherimaging modalities, the diagnostic imaging market has grown to include bothpicture archive and communications systems (“PACS”) and 3D imaging systems,which have become integral technologies for many radiology practices around theworld.

 

According to Frost & Sullivan, the estimated U.S. market for 3Ddiagnostic imaging was $398 million in 2002 and will grow to over $1 billion by2008, a compound annual growth rate of approximately 20%.  Today, only a minority of hospitals, clinicsand imaging centers use 3D medical imaging products in diagnostic imaging.  Recent technological advances in bothcomputer hardware and software development have dramatically improved thecost-to-performance ratio, bringing the prices for 3D medical imaging productsinto the reach of most healthcare providers. In addition, increasing clinical awareness, improving utility ofapplications and an exponential increase in CT slice volumes are driving demandfor 3D medical imaging products.

 

Based on an increasing number of 3D procedures being performed as aresult of the growing use of imaging technology, new 3D screening proceduresand broader acceptance of 3D applications, Vital Images estimates that thepotential worldwide market for 3D medical imaging software and workstations,including the U.S. market, will grow to $2 billion in less than five years.

 

Technology

 

The two core technologies underlying the Company’s products are“customized protocols,” which make*Vitrea 2* simple to use, and avisualization technique known as “volume rendering.”  A feature critical to *Vitrea 2’s* speed and ease-of-use are itscustomized protocols, which provide automated 2D and 3D renderings of scannerdata, optimized for individual clinical applications.  Vital Images’ engineers and clinical collaborators have selectedspecific views for each type of exam *Vitrea 2* supports in order to provideimmediate, useful 2D and 3D views for the user.  After the selected patient data has been retrieved, *Vitrea 2*provides the clinician with up to six views with all visualization parameterspre-set for the specific type of clinical exam.  The visualization settings for these views are stored in *Vitrea 2’s*software and are automatically and adaptively applied to each patient study,optimizing the views displayed.  Byapplying this proprietary protocol technique, the system anticipates theclinician’s needs and provides immediately useful views of the patientdata.  The use of customized protocolsautomates the complex and time-consuming approaches inherent in many competing3D medical imaging products and eliminates the need for the user to beproficient in operating complex graphics programs.  The Company has been issued Patent No. 5,986,662 from the U.S.Patent and Trademark Office for its mechanism for automated protocol selection,Patent No. 6,130,671 for the mechanism to calculate simulated lighting in 3Dimages and Patent No. 6,219,059 for the user interface and mechanism used tocontrol the relative transparency of 3D data in volume renderings of medicalimages.

 

Volume rendering is an advanced technique for displayingthree-dimensional views on a computer monitor that the Company believes hassignificant advantages over the alternative technique, known as “surfacerendering.”  Volume rendering permitsthe direct display of all of the imaging data without mathematical modeling andallows interactive control of the level of “transparency” of the data.  By comparison, surface rendering requiresthe creation of artificial surfaces based on selected imaging data, and theusefulness of the resulting visual image is largely dependent on where thesesurfaces are “set” by the clinical technician. Volume rendering is not dependent on the creation of artificial surfacesand allows visualization of varying components that might otherwise beeliminated from a surface rendered image due to surface approximation.  Because volume rendering uses all of thedata and information collected by the imaging equipment, the Company believesvisualization processes that use volume rendering provide clinicians with betterimages to define and display pathology and anatomy in a more useful manner.

 

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Until the last several years, most medical imaging companies largelyoverlooked volume rendering because the computer power necessary to performvolume rendering was significantly more expensive and intensive than therequirements for surface rendering.  TheCompany’s experience with volume rendering has its basis in the efforts of VincentJ. Argiro, Ph.D., the founder of the Company, who developed three-dimensionalvisualization software using volume rendering as an aid in his research indevelopmental neuroscience.  Dr. Argirofocused on accelerating the performance of volume rendering on standardcomputer platforms.  As a result of hiswork, he developed expertise in accelerated volume rendering, which forms thecore of the Company’s volume rendering technology.  Because the performance of standard computer platforms hasincreased while the relative cost of such performance has decreased, theCompany believes that volume rendering has become a more accessible imagingsolution for routine clinical applications.

 

The Company believes the combination of customized protocols andaccelerated volume rendering offered by *Vitrea 2,* together with improved computerperformance, allows it to deliver a simple, fast and affordable 3D medicalimaging product.

 

Industry Background

 

Medical practices in the areas of diagnostic imaging, surgery andcancer treatment have changed dramatically over the past 20 years, due in partto the introduction of a variety of new imaging, visualization, analysis,computer, networking, catheter and navigation technologies.  The result has been the rapid adoption and increaseduse of CT and MR scanners and the incorporation of new physician-care practicesbased on the imaging information provided by these devices.

 

Both of these imaging technologies capture data that provide aphysician with a graphical representation of the inside of the human body.  These images have traditionally been viewedas a series of two-dimensional, cross-sectional slices on x-ray-type film.  As computer processing speed increased,software performance improved and networking technologies developed,manufacturers of scanning equipment began offering integrated systems thatallowed clinicians to view, analyze and manipulate these medical images in adigital environment.  These systemsfirst visualized individual slices, or pictures, on a computer monitor andlater provided views of multiple slices. More recently, medical imaging systems began to permit viewing andmanipulation of large, multiple slice data sets as a single, three-dimensionalimage on a computer workstation.  Today,the 3D medical imaging industry involves the creation, visualization,manipulation, analysis and communication of medical images in two, three andfour dimensions.

 

Initially, the 3D medical imaging industry and the markets for 3Dmedical imaging products lagged the market for imaging devices due to the lackof industry standards for the generation, transmission and storage of medicalimaging data and due to computer costs and performance considerations.  After a time, many of the technical and costbarriers to growth in the 3D medical imaging industry and the PACS industrybegan to erode.  In particular, themedical industry embraced an image transmission and archiving standard calledDICOM, promulgated by the American College of Radiology and the NationalElectronic Manufacturer’s Association. This standard permits imaging, visualization, networking and archivingsystems from different vendors to work cooperatively within a singlenetwork.  In addition, thecost-to-performance ratio of computer products used in visualization and PACShas improved dramatically, bringing the prices for 3D medical imagingcapabilities and PACS within the grasp of most healthcare providers.  The Company believes that the acceptance ofindustry standards such as DICOM and the improvements in thecost-to-performance ratio for clinical workstations will support continuedmarket growth in the 3D medical imaging and PACS industries.

 

Vital Images also expects that a number of other advantages of 3Dmedical imaging products will support growth in the 3D medical imagingindustry:

 

•                        Recenttechnology improvements in CT and MR scanners enable them to generate anincreasing number of slices per exam, resulting in over 2,000 images, which ismore than 15 times as many

 

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images as the same studyless than five years ago.  This makesthe viewing of printed images on x-ray film, rather than in a medical imagingsystem, logistically impractical and expensive.

 

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

 

•                        Driven bya shortage of radiologists, hospital radiology departments are under pressureto perform as efficiently as possible. Thus an increased workload must be completed with the same or fewerpeople.  Speed in interpreting images isessential for increasing workflow productivity.  Thus, there is a clear need for a fast and efficient integrated2D, 3D and 4D visualization tool.  4D isdefined as 3D images showing changes over time such as images of a beatingheart.

 

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

 

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

 

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

 

Markets

 

The Company participates in the rapidly growing 3D medical imagingmarket.  The 3D medical imaging marketalso interrelates with a number of other markets such as the diagnostic imagingequipment market, the PACS market and the hospital and clinical informationsystems markets.  3D medical imagingsoftware and systems have application and/or potential in diagnostic screeningand radiology, remote diagnosis and consultation (e.g., telemedicine), surgicalassessment, planning, navigation and follow-up, and radiation and chemotherapytreatment planning and medical education. The customers for these applications include radiology, surgery andoncology departments, as well as other clinical specialists, of hospitals andresearch centers, diagnostic imaging and screening centers, outpatient surgerycenters, clinics and physician groups.

 

The diagnostic medical imaging market continues to expand itsboundaries.  Long defined as the marketfor CT, MR, ultrasound and other imaging modalities, the diagnostic imagingmarket has grown to include both PACS and 3D imaging systems, which have becomeintegral technologies for many radiology practices around the world.

 

According to Frost & Sullivan, the estimated U.S. market for 3Ddiagnostic imaging was $398 million in 2002 and will grow to over $1 billion by2008, a compound annual growth rate of approximately 20%.  Today, only a minority of hospitals, clinicsand imaging centers use 3D medical imaging products in diagnostic imaging.  Recent technological advances in bothcomputer hardware and software development

 

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have dramatically improved the cost-to-performance ratio, bringing theprices for 3D medical imaging products into the reach of most healthcareproviders.  In addition, increasingclinical awareness, improving utility of applications and an exponentialincrease in CT slice volumes are driving demand for 3D medical imagingproducts.

 

Based on an increasing number of 3D procedures being performed as aresult of the growing use of imaging technology, new 3D screening proceduresand broader acceptance of 3D applications, Vital Images estimates that thepotential worldwide market for 3D medical imaging software and workstations,including the U.S. market, will grow to $2 billion in less than five years.

 

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

 

Strategy

 

The Company’s goal is to be a leading provider of 3D medical imagingsoftware that improves clinical outcomes and reduces costs.  To achieve this goal, Vital Images intendsto implement the following key strategies:

 

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

 

•                        Furtherdevelop applications for the Company’s 3D medical imaging technology.  The Company intends to leverage its corecompetencies in volume rendering, computer graphics and clinical applications.  The Company plans to develop and offer afull range of 3D medical imaging software tools for disease screening,radiological diagnosis, therapy planning and intra-operative visualization.  The Company believes that significant newopportunities exist for the application of its innovative technologies for thediagnosis and treatment of cardiovascular disease, cancer and orthopedics.

 

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

 

•                        Continueto seek collaborative partnerships with leading medical institutions.  The Company has historically sought out anddeveloped collaborative relationships with several prestigious medicalinstitutions to develop and test the Company’s visualization tools.  The Company will

 

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continue to pursuecollaborations to focus on developing products that will improve clinicaloutcomes and reduce costs for the practices of medical imaging and surgery.

 

•                        Continueto seek collaborative partnerships with leading medical technology companies.  In addition to collaborations with medicalinstitutions, the Company intends to selectively pursue relationships withleading medical technology companies to expand the Company’s clinical,distribution, financial and/or technical capability for its 3D medical imagingsoftware products.  Examples of suchrelationships include the Company’s development, marketing and/or distributionagreements with Toshiba Corporation, Medical Systems Group (“Toshiba”); theSurgical Navigation Technologies division of Medtronic, Inc.; E-Z-EM, Inc.; andR2 Technology, Inc. (“R2”). See “Business-Marketing and Distribution," –"Intellectual Property" and – "Manufacturing and Services.” 

 

Products and Product Development

 

*Vitrea**.*  In December 1995, the Company assessed itsbusiness strategy and determined that to optimize its dedicated participationin the medical field, it needed to create a new product for direct clinicalapplication.  The objective for this newproduct effort was to produce an easy-to-use clinical software tool to allowradiologists and other clinicians to use two- and three-dimensionalvisualization in their routine clinical processes.  Unlike its predecessor software, *VoxelView®*, the Company setout to design this new software product for users with clinical knowledge ratherthan computer graphics expertise. Specifications for this new product, called *Vitrea,* were developed inearly 1996, with software development beginning in late spring of thatyear.  The Company submitted 510(k)documentation in September 1996 for *Vitrea* and was granted marketing clearanceby the U.S. Food and Drug Administration (the “FDA”) in November 1996 for useas a clinical diagnostic and surgical planning device when used with CT and MRmedical imaging data.  *Vitrea*was first released for sale to customers in October 1997.  In December 1999, the Company released *Vitrea 2*,a Microsoft® Windows NT compatible version of its *Vitrea* software for 2D/3Dvisualization and analysis of medical image data.  *Vitrea 2* was Vital Images’ first 3D-volume medical imagingsoftware product available for the Microsoft Windows operating system andprovides the speed and ease-of-use the medical community demands for diagnosisand treatment planning in a clinical environment.  In February 2003, the Company released *Vitrea 2 Version 3.2*, whichhas improved quality, reliability and usability features to meet the diagnosticand treatment planning needs of busy radiology departments and operates on theMicrosoft Windows XP operating system.

 

*Vitrea2* capitalizes on the Company’s experience in 3D medicalimaging and provides clinicians with an easy-to-use tool for disease screening,radiological diagnosis and therapy planning. It represents the Company’s most important step to date as a provider ofa range of clinical tools for broad distribution to the 3D medical imagingmarket.  *Vitrea 2’s* primary featuresare its high-speed rendering capability and the ability to provide two- andthree-dimensional viewing for routine diagnosis and therapy planning, withoutrequiring the user to be trained in computer graphics techniques.  The Company believes that both of thesefeatures - speed and ease-of-use - now make it possible to usethree-dimensional medical imaging in daily clinical routines.  A *Vitrea 2* user, following a built-in clinicalworkflow, can view the image data in two, three or four dimensions usingvisualization settings based on specific clinical applications stored withinthe system as dedicated visualization protocols.  The user may then interactively navigate around, or “flythrough,” the image to view clinically relevant anatomies and pathologies.  *Vitrea 2*software also allows the user tocapture views by taking “snapshots,” which can be integrated into customizedreports for electronic transmission and archiving through a DICOM network orsent to another location via the Internet.

 

*Vitrea2* software conforms to the latest medical imaging andcomputer industry standards, such as *OpenGL*TM computer graphics applicationprogramming interface (API) and DICOM.

 

The Company offers *Vitrea 2* primarily as an integratedsoftware and hardware system, consisting of *Vitrea 2*software installed on a personalcomputer (“PC”).  Pursuant to purchasingarrangements between the Company and computer resellers, the Company purchasespersonal computers at a nominal discount, installs its *Vitrea 2*

 

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software, and markets the package as an integrated 3D medical imagingsolution, thereby implementing the Company’s strategy to develop, market, selland support an integrated 3D medical imaging workstation.  Currently, *Vitrea 2* operates on PCworkstations from Omni Tech, Inc., Hewlett-Packard Company and Dell ComputerCorporation.  The Company also sellssoftware licenses without the related workstation hardware.  The list price for a base model integratedworkstation and software package is approximately $99,000, and the list pricefor the *Vitrea2* software without a workstation is approximately $81,000.

 

In addition to its immediate clinical applications, *Vitrea 2*softwareincorporates a number of additional technological advances, thereby making itadaptable to routine clinical use in surgical navigation and cancer treatmentplanning and for integration into diagnostic imaging equipment manufactured byother companies.  In particular, *Vitrea 2*software was written using advanced programming techniques, a modular,object-oriented design, C++ programming language, and a shared messagingstructure.  The Company believes thesecharacteristics make it practical to modify *Vitrea 2* software to suit the clinicalneeds of surgical navigation and oncology, as well as allowing diagnosticequipment manufacturers to integrate *Vitrea 2*software or its components intoimaging system consoles and off-line review stations, thereby providing theCompany with the opportunity to leverage the *Vitrea 2* softwaredevelopment investment into new commercial areas.

 

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

 

*VScoreTM*.  In August 1999, the Company introduced its *VScore*softwarefor coronary artery calcium scoring. The *VScore*software product was the Company’s first add-on option to the Company’s *Vitrea 2*3D medical imaging software product. The *VScore*option adds the functionality to non-invasively quantify calcium in the fourmajor coronary arteries using CT image data. In August 2000, the Company introduced *VScorewith EKG Gate**Ô*,which allows physicians and technologists to select the images with the leastamount of motion by matching the EKG signal with the images.  In February 2001, the Company introduced *VScore with AutoGate**Ô*, which allows users to create high qualitycardiac images using existing helical CT scanners without the use of EKGrecording devices.

 

CT Brain Perfusion.  In October 2001, the Company introduced itsCT Brain Perfusion software option to assist radiologists in analyzing bloodflow of stroke victims where the speed of diagnosis and treatment is often theprimary factor in determining the extent of recovery.

 

CT Colonography.  In October 2001, the Company introduced itsCT Colonography software option, which generates two- and three-dimensionalimages of the entire colon, increasing the speed and ease of locating andanalyzing polyps.  The option provides aless invasive, more comfortable diagnostic procedure than previously possible,improving patient compliance for screening

 

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

 

CT Cardiac.  In February 2003, the Company introduced itsCT Cardiac software option, which defines the coronary anatomy and the degreeof luminal obstruction of the coronary arteries.  It is commonly used to determine the extent of obstructivecoronary artery disease and to assess the feasibility and appropriateness ofvarious forms of therapy or surgical interventions.

 

Maintenance and Support.  In addition to its system and softwareproducts, the Company also offers maintenance and support services to itscustomers, as well as certain other services such as installation andtraining.  In connection with thelicensing of *Vitrea 2*software, the Company markets annual maintenance

 

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services for both *Vitrea 2* software and the integrated *Vitrea 2*system, pursuant to which the Company provides software updates, minor featureenhancements, error correction, telephone support and general maintenanceservices for an annual fee of approximately $7,000.  Outside of these maintenance services, the Company is required byFDA regulations to provide certain levels of support to end users as a resultof the use of its products as medical devices. Maintenance services currently marketed by the Company do not includeinstallation, training and other services, whether on- or off-site, as suchservices are charged separately by the Company.

 

License fees accounted for 67%, 66% and 66% of total revenue in each ofthe fiscal years ended December 31, 2002, 2001 and 2000, respectively.  Maintenance and services comprised 19%, 16%and 13% of total revenue for the years ended December 31, 2002, 2001 and 2000,respectively, while hardware sales accounted for 14%, 18% and 21% of totalrevenue for the years ended December 31, 2002, 2001 and 2000, respectively.

 

The Company expensed $4,263,000, $3,419,000 and $3,036,000 incurred inits research and development efforts in each of the fiscal years ended December31, 2002, 2001 and 2000, respectively.

 

CollaborativeRelationships

 

Vital Images has formed collaboration relationships with some of theleading universities and physicians in medicine and medical imaging to developwhat it believes to be the most innovative and clinically relevant medicalimaging solutions.  Vital Images hasentered into clinical collaboration agreements with universities and physiciansto:

 

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

 

•                        Developclinical routines that incorporate Vital Images’ 3D medical imaging software innormal diagnostic, screening and therapy planning practices;

 

•                        Developnew features that facilitate and improve diagnosis and therapy planning forVital Images’ future products;

 

•                        Assess theclinical value of Vital Images’ 3D medical imaging software for givenapplications; and

 

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

 

The following universities and institutions have entered intoagreements with Vital Images for the purpose of forming collaborativerelationships:

 

•                        UCLAMedical Center

 

•                        DukeUniversity Medical Center

 

•                        Universityof Iowa Hospital and Clinics

 

•                        MallinckrodtInstitute of Radiology at the Washington University School of Medicine

 

•                        Universityof Minnesota-Fairview University Medical Center

 

•                        NorthwesternUniversity Medical Center

 

•                        MassachusettsGeneral Hospital

 

•                        StanfordUniversity Medical Center

 

•                        YaleUniversity School of Medicine

 

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The Company’s agreements with its collaborative partners do not providesuch collaborators with any ownership of technology developed by the Company inconnection with the collaboration and, with one exception, do not provide forthe payment of any fees or royalties to such collaborators.  The Company was obligated to pay a royaltyto the Stanford University Medical Center equal to 0.5% of the Company’ssoftware license revenue from the sale of *Vitrea* and *Vitrea 2*through September 2000.

 

Competition

 

The 3D medical imaging market is developing andgrowing rapidly.  It is intenselycompetitive, subject to rapid change and significantly affected by new productintroductions and other market activities of industry participants.  The Company’s primary competitors are thevarious diagnostic imaging system suppliers, which are typically large,multinational companies, having far greater financial and technical resourcesthan the Company. They also have well-established sales and distributionnetworks for their products. These companies, including GE Medical Systems,Siemens Medical Systems, Inc. and Philips Medical Systems, are engaged in thebusiness of developing and marketing medical imaging systems, such as CT and MRequipment.  These competitors offer 3Dmedical imaging capabilities integrated with their products in addition to the2D medical imaging capabilities typically provided as a part of the operator’sconsole on the imaging equipment itself. This medical imaging capability may be internally developed by thesecompanies, or it may be licensed from independent vendors.  In order to compete effectively with thesecompanies, Vital Images must convince customers to separate their purchasingdecisions regarding the imaging equipment itself from the selection andpurchase of the 3D medical imaging workstations instead of purchasing an entireintegrated system manufactured by one entity. To a lesser extent, the Company also faces competition from othermedical imaging systems and software suppliers, PACS vendors, hospital,radiology and clinical system suppliers, and internal development projectssponsored by hospital radiology departments.

 

Other medical imaging systems and software suppliers compete on thebasis of volume rendering or other visualization technologies, specificapplications or market niches.  Most ofthese suppliers, including Voxar Ltd., Viatronix, Inc. and TeraRecon, Inc., aresmaller companies than Vital Images. PACS companies sometimes provide medical imaging capability in additionto their image archiving and networking products.  Vendors of hospital, clinical and radiology information systemshave also diversified into the PACS and medical imaging product lines, eitherthrough internal development or business development.  These companies, which may be large or small, attempt to offer anintegrated system covering a full range of administrative, clinical andradiology information management capabilities to healthcare providers.  Finally, some research and universityhealthcare institutions may attempt to develop their own 3D medical imagingsystems.  These institutions have in thepast, and may in the future, attempt to secure FDA clearance for such systemsand to license such systems or technology for general commercial sale.

 

The Company’s competitive strength is based on its ability to do thefollowing:

 

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

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

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

•                  Leverage itsvisualization technology across multiple clinical disciplines, includingdisease screening, clinical diagnosis and therapy planning.

•                  Offer a “DICOMclient” product, which can operate on any DICOM network, independent of theimaging system and network provider.

•                  Serve bothoriginal equipment manufacturers (“OEM”) and end-user customers through thedevelopment of a modular end-user product that can easily be segmented for OEMcustomers.

 

The Company believes that product quality, performance, functionalityand features, quality of support and service, reputation and price are alsoimportant competitive factors.  TheCompany believes that customers will

 

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prefer *Vitrea 2* because it is simple, fast and affordable.  While price has been less significant thanother factors, increasing competition in the 3D medical imaging market mayresult in price reductions and reduced gross margins.  In particular, should one or more of the diagnostic imagingsystem suppliers choose to provide or distribute more competitive medicalimaging products than those offered by the Company, the Company’s business, financialcondition and results of operations could be materially adversely affected.

 

Marketing and Distribution

 

The Company markets *Vitrea 2* both as a software package and aspart of an integrated software and hardware system to radiologists, surgeons, primarycare physicians and medical researchers. The Company markets its products directly to end-user customers, such ashospitals and clinics, as well as to select diagnostic imaging companies,digital imaging equipment manufacturers and PACS companies for resale as aVital Images branded product.  InNovember 2001, the Company signed a joint venture agreement to workcollaboratively on products and services in image-guided surgery and surgicalplanning with the Surgical Navigation Technologies (SNT) division of Medtronic,Inc. Under this agreement, the Company’s advanced visualization technology willbe integrated into Medtronic SNT’s image-guided surgery products, and the twocompanies will collaborate on new surgical planning software and service offerings.  In October 2001, the Company signed anexclusive agreement with E-Z-EM, Inc. to develop and distribute a dedicated CTcolonography product.  In September2000, the Company signed a marketing and distribution agreement with ToshibaAmerica Medical Systems (“TAMS”), which named *Vitrea2* as TAMS’ primary 3D software for use with their CT scanners in theUnited States.  In February 2002, theCompany announced that it had entered into a marketing and distributionagreement with Toshiba Corporation, Medical Systems Company to offer *Vitrea 2* to**its subsidiaries and distributors, including TAMS, in morethan 50 countries in North and South America, Europe, the Middle East, Africa,Australia and Asia, except Japan. The agreement ran through September 30, 2002. In January 2003, the Company announcedthat it had renewed the agreement through September 30, 2003.  See “Business – Dependence on MajorCustomers.”

 

In addition, the Company markets its products directly to select OEMson either a standard basis or, in the case of Medtronic SNT, a customizedbasis.  In connection with its OEMopportunities, the Company will either provide complete systems for resale bysuch OEMs or will provide elements of its technology for incorporation into theproducts and systems of such OEMs.

 

The Company markets its products both domestically andinternationally.  In the United States,the Company markets its products through its direct sales force as well asthrough OEMs and resellers. Internationally, the Company markets its products through OEMs andresellers.  See Note 8 to the FinancialStatements - “Major Customers and Geographic Data” for information regardingthe Company’s export sales.  As of December31, 2002, the Company had 20 direct salespeople in the U.S., one internationalreseller salesperson, one OEM customer and nine international resellers.

 

Customers and Customer Support

 

Through December 31, 2002, the Company has sold over 850 separatesoftware licenses for *Vitrea,**Vitrea 2* and *InnerviewGITM*for use in over 700 different sites, including hospitals, clinics,imaging centers and other sites.  TheCompany’s customers include America’s most renowned hospitals, including thefollowing 14 of the top 17 hospitals listed in *U.S. News and World Report’s*honor roll of top hospitals:

 

 

•                       JohnsHopkins Hospital

•                       Mayo Clinic

•                       ClevelandClinic 

•                       MassachusettsGeneral Hospital 

•                       UCLAMedical Center

•                       DukeUniversity Medical Center

•                       UCSFMedical Center

•                       Barnes-JewishHospital 

•                       Brigham& Women’s Hospital

•                       Universityof Washington Medical Center

•                       New YorkPresbyterian Hospital

•                       Hospital ofthe University of Pennsylvania

•                       StanfordUniversity Hospital

•                       Universityof Chicago Hospitals

 

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In addition, the advantages of *Vitrea 2* software — simple, fast andaffordable — have also appealed to hospitals and clinics in smaller populationareas.

 

The Company is committed to rapid response to customer servicerequests.  Customer support representativesare available during the Company’s business hours to answer questions about theoperation, maintenance and repair of the Company’s products.

 

Intellectual Property

 

Although the Company has filed patent applications with respect tocertain aspects of its technology, it generally does not rely on patentprotection with respect to its products and technologies.  Instead, the Company relies primarily on acombination of trade secret and copyright law, employee and third-partynondisclosure agreements and other protective measures to protect intellectualproperty rights pertaining to its products and technologies.  Because of the rapid pace of technologicalchange in the 3D medical imaging industry, the Company believes that patent,trade secret and copyright protection are less significant to its competitiveposition than factors such as the knowledge, ability and experience of itspersonnel; new product developments and enhancements; and ongoing, reliableproduct maintenance and support.

 

The Company has been issued Patent No. 5,986,662 from the U.S. Patentand Trademark Office for its mechanism for automated protocol selection.  The use of automated protocol selectionwithin *Vitrea2* allows the user to view image data in two or three dimensionsusing visualization settings based on specific clinical applications storedwithin the software.  This uniquetechnology adds significantly to the simplicity of use of the software — a keyadvantage over competing technologies. The Company has been issued Patent No. 6,130,671 for the mechanism tocalculate simulated lighting in 3D images. The mechanism for calculating simulated lighting in 3D images permits“two-sided lighting” in volume-rendered images, which is crucial for viewingimage data that represents edges of bright as well as dark regions.  These include producing simulated endoscopicimages of contrast-filled blood vessels, the gastrointestinal tract and theurinary system.  The Company has beenissued Patent No. 6,219,059 for the user interface and mechanism used tocontrol the relative transparency of 3D data in volume renderings of medicalimages.  Volume rendering is an advancedtechnique for displaying two- or three-dimensional views on a computer screen.  It permits the direct display of all of theimaging data without mathematical modeling and allows interactive control ofthe level of “transparency” of the data. All of the patents listed above are utilized in the *Vitrea 2* software.

 

The Company does not own all of the software and other technologiesused in its products, but it has the licenses from third parties that theCompany believes are necessary for using that technology in its currentproducts. It may be necessary to renegotiate with such third parties for anynew versions of current products or any new products. Such third party licensesmay not be available on reasonable terms, or at all.

 

Manufacturing and Service

 

The Company’s manufacturing efforts are limited to the production,quality assurance and distribution of its software, which is distributed onCD-ROM.  The software is sent to thecustomer site and loaded into a personal computer.  The software for *Vitrea 2* is loaded into the computer byCompany personnel, as part of the Company’s installation services, which arepriced and billed incrementally to the software license billing, or by anauthorized reseller’s personnel as part of their installation services.  In addition to the loading of software intothe computer, installation services generally include integrating *Vitrea 2*workstations into customers’ computer networks, configuring the networkrequirements and verifying software operability on site.

 

The Company relies primarily on its own software development as itscore competence.  The Company sourcescertain application and utility software from third parties, see “—IntellectualProperty” above, and the

 

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operating system for integrated computer workstations from otherparties.  In addition, the Companysources systems components, computers and computer peripherals from third partysuppliers.

 

The Company has also signed reseller distribution agreements that allowit to distribute products from certain third parties.  The Company currently has agreements with R2 Technology, Inc. forR2’s ImageChecker® CT software applications for the detection of lung nodulesand Mindways Software, Inc. for Mindways’ QCT PRO BMD software for measuringbone density.

 

Governmental Regulation

 

As medical devices, the Company’s 3D medical imaging software productsare subject to extensive and rigorous regulation by numerous governmentalauthorities, principally the FDA and corresponding foreign agencies.  In the United States, the FDA administersthe Federal Food, Drug and Cosmetic Act and its amendments.  These regulations classify medical devicesas either Class I, II or III devices, which are subject to general controls,special controls or pre-market approval requirements, respectively.  Most Class I and II devices, as well as someClass III devices, can be cleared for marketing pursuant to a 510(k) pre-marketnotification. The process of obtaining a 510(k) clearance typically can takeseveral months to a year or longer.

 

Class III devices generally require more stringent clinicalinvestigation and pre-market clearance requirements.  In such cases, the FDA will require that the manufacturer submita pre-market approval (“PMA”) application that must be reviewed and approved bythe FDA prior to the sale and marketing of the device in the United States.  The process of obtaining a PMA can beexpensive, uncertain and lengthy, frequently requiring anywhere from one toseveral years from the date of FDA submission, if approval is obtained at all.  Moreover, a PMA, if granted, may includesignificant limitations on the indicated uses for which a product may bemarketed.

 

*Vitrea2* is classified as a Class II medical device and has receivedmarketing clearance from the FDA as the result of a 510(k) submission.  Specifically, *Vitrea 2* has been cleared tobe marketed for use with CT and MR scanners, the Company’s *VScore* software options havebeen cleared for use in coronary artery calcium scoring and the Company’s CTBrain Perfusion option has been cleared for analyzing the blood flow of strokevictims.  Future products, add-onoptions to existing software, and expanded claims of efficacy will likelyrequire additional 510(k) applications.

 

In the early 1990s, the review time by the FDA to clear medical devicesfor commercial release lengthened and the number of clearances, both of 510(k)submissions and PMAs, decreased.  Inresponse to public and congressional concern, the FDA Modernization Act of 1997was adopted with the intent of bringing better definition to the clearanceprocess.  Although this Act has resultedin improved cycle times for product clearance, there can be no assurance thatthe FDA review process will not involve delays or that certain clearances willbe granted on a timely basis.

 

The Company is also increasingly becoming subject to regulation inthose foreign countries in which it sells its products.  Many of the regulations applicable to theCompany’s products in such countries are similar to those of the FDA.  The Company’s ability to successfully marketand sell its products internationally depends in large part on its ability tocomply with such foreign regulatory requirements. *Vitrea 2* software has beenConformitee Europeene (“CE”) marked, indicating conformance with applicablesections of the Medical Device Directive 93/42/EEC, which allows the product tobe marketed in the member countries of the European Communities.

 

The Company is also subject to periodic inspections by the FDA, whoseprimary purpose is to audit the Company’s compliance with quality systemregulations established by the FDA and other applicable governmentstandards.  Regulatory action may beinitiated in response to audit deficiencies or to product performanceproblems.  The Company believes that itsmanufacturing and quality control procedures are in essential compliance withthe requirements of the FDA regulations.

 

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In January 2001, the Company announced that it had received ISO 9001Certification and an upgraded Class I Measurement CE Mark for its medicalimaging software products.

 

The financial arrangements through which the Company markets, sells anddistributes its products may be subject to certain federal and state laws andregulations in the United States with respect to the provision of services orproducts to patients who are Medicare or Medicaid beneficiaries.  Violations of these laws and regulations mayresult in civil and criminal penalties, including substantial fines andimprisonment.  In a number of states,the scope of these laws and regulations have been extended to include theprovision of services or products to all patients, regardless of the source ofpayment, although there is variation from state to state as to the exactprovisions of such laws or regulations. In other states and, on a national level, several health care reforminitiatives have been proposed which would have a similar impact.  The Company believes that its operations andits marketing, sales and distribution practices currently comply with allcurrent fraud and abuse and physician anti-referral laws and regulations, tothe extent they are applicable.

 

Third Party Reimbursement and Cost Containment

 

The Company’s products are purchased primarily by hospitals, clinics,imaging centers and other users that bill various third party payers for theservices provided to the patients. These payers, which include Medicare, Medicaid, private insurancecompanies and managed care organizations, reimburse part or all of the costsand fees associated with the procedures utilizing the Company’s products.  The medical imaging services performed usingthe Company’s software are covered by current CPT codes (Current ProceduralTerminology, as defined by the Centers for Medicare & Medicaid Services).  As such, hospitals providing services on theCompany’s 3D medical imaging workstations can seek reimbursement by usingexisting, approved CPT codes.  Medicareand Medicaid reimbursement for hospitals is based on a fixed amount foradmitting a patient with a specific diagnosis. Because of this fixed reimbursement method, hospitals have incentives touse less costly methods in treating Medicare and Medicaid patients, and willfrequently make capital expenditures to take advantage of less costly treatmenttechnologies.  Frequently, reimbursementis reduced to reflect the availability of a new procedure or technique and, asa result, hospitals are generally willing to implement new cost-savingtechnologies before these downward adjustments take effect.  Likewise, because the rate of reimbursementfor certain physicians who perform certain procedures has been, and may in thefuture, be reduced in the event of changes in the resource-based relative valuescale method of payment calculation, physicians may seek greater costefficiency in treatment to minimize any negative impact of reducedreimbursement.  Any amendments toexisting reimbursement rules and regulations which restrict or terminate thereimbursement eligibility (or the extent or amount of coverage) of medical proceduresusing the Company’s products or the eligibility (or the extent or amount ofcoverage) of the Company’s products could have a material adverse impact onbusiness.

 

In response to the focus of national attention on rising health carecosts, a number of changes to reduce costs have been proposed or have begun toemerge.  There have been, and maycontinue to be, proposals by legislators and regulators and third party payersto reduce these costs.  There has alsobeen a significant increase in the number of Americans enrolling in some formof managed care plan and, in addition, many hospitals participate in or haveagreements with HMOs.  It has become atypical practice for hospitals to affiliate themselves with as many managedcare plans as possible.  Higher managedcare penetration typically drives down the prices of healthcare procedures,which in turn places pressure on medical supply prices.  This causes hospitals to implement tightervendor selection and certification processes by reducing the number of vendorsused, purchasing more products from fewer vendors and trading discounts onprice for guaranteed higher volumes to vendors.  Hospitals have also sought to control and reduce costs over thelast decade by joining group purchasing organizations or purchasingalliances.  The Company cannot predictwhat continuing or future impact these practices, the existing or proposedlegislation, or such third party payer measures may have on its futurebusiness.

 

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Health Insurance Portability and Accountability Act of1996 (“HIPAA”)

 

The HIPAA regulations are causing customers of the Company to requestthat the Company sign “business associate” agreements with them.  A “business associate” is a person or entitythat performs certain functions or activities that involve the use ordisclosure of protected health information on behalf of, or provides servicesto, a covered entity.  By law, the HIPAAPrivacy Rule applies only to covered entities – health plans, health careclearinghouses, and certain health care providers.  However, most health care providers do not carry out all of theirhealth care activities and functions by themselves.  Instead, they often use the services of a variety of otherpersons or businesses.  The Privacy Ruleallows covered providers and health plans to disclose protected healthinformation to these “business associates” if the providers or plans obtainsatisfactory assurances that the business associate will use the informationonly for the purposes for which it was engaged by the covered entity, willsafeguard the information from misuse, and will help the covered entity complywith some of the covered entity’s duties under the Privacy Rule.  Covered entities may disclose protectedhealth information to an entity in its role as a business associate *only* to help the covered entity carry outits health care functions – not for the business associate’s independent use orpurposes, except as needed for the proper management and administration of thebusiness associate.

 

Employees

 

As of February 28, 2003, the Company had 105 full-time employees, with35 involved in research and development, 31 in sales and marketing, 20 intechnical support functions and 19 in administrative functions.  The Company is not a party to any collectivebargaining agreement involving its employees and believes its relationship withits employees is good.

 

Important Factors

 

The following factors are important and should be considered carefullyin connection with any evaluation of the Company’s business, financialcondition, results of operations and prospects.  Additionally, the following factors could cause the Company’sactual results to materially differ from those reflected in any forward-lookingstatements of the Company.

 

Historical Operating Losses

 

For the year ended December 31, 2002 the Company had operating incomeof $677,000.  The Company had operatinglosses of $1,055,000 and $2,787,000 for the years ended December 31, 2001 and2000, respectively, and, with the exceptions of the fiscal years ended December31, 2002 and October 31, 1995, has incurred operating losses each year since1990.  As of December 31, 2002, theCompany’s accumulated deficit was $20,088,000. The Company’s ability to maintain annual profitability will depend on,among other things, its ability to successfully market its products, make newproduct offerings, respond to competitive developments and attract and retainqualified sales, technical and management employees.  There can be no assurance that the Company will continue toachieve profitable operations on an annual basis.  See “Item 7. Management’s Discussion and Analysis of FinancialCondition and Results of Operations.”

 

New Product Acceptance

 

The Company’s success depends on its ability to successfully market its*Vitrea 2*software for clinical use, and the ability and willingness of physicians to usetwo- and three-dimensional medical imaging software in disease screening,clinical diagnosis and therapy planning and other diagnosis, surgical, andtreatment protocols.  Thethree-dimensional medical imaging software offered by *Vitrea 2* represents a newalternative to the conventional methods traditionally used for viewing medicalimages in the clinical setting.  Theacceptance of *Vitrea 2* by physicians and other clinicians will depend onthe Company’s ability to educate those users as to the speed, ease-of-use andother benefits offered by the *Vitrea 2* system, as well as the timelyintroduction of new features and functions by the Company.  There can be no assurance that users willprefer three-

 

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dimensional medical imaging software over less expensivetwo-dimensional medical imaging software, or that the Company will succeed inits efforts to further develop, commercialize, and achieve market acceptancefor its *Vitrea2* product or for any other product in the clinical setting.  See “Business—Technology,” “—IndustryBackground,” “—Markets” and “—Competition.”

 

Substantial Reliance on a Single Product

 

Revenue from sales of the *Vitrea 2* system constituted 98% of theCompany’s total revenue for the year ended December 31, 2002, 96% of theCompany’s total revenue for the year ended December 31, 2001 and 96% of theCompany’s total revenue for the year ended December 31, 2000.  Further, the Company anticipates thatrevenue from the sale of *Vitrea 2* will continue to account for asubstantial portion of the Company’s revenue for the foreseeable future.  As such, the failure of physicians to accept*Vitrea 2*would have a material adverse impact on the Company’s results of operations andfinancial condition.

 

Dependence on Market Growth 

 

The 3D medical imaging industry in which the Company markets itsproducts is still developing due to the fairly recent availability of highperformance computers at reduced prices, the recent adoption of industrystandards for the generation, transmission and storage of medical imaging data,and changing medical practices. Historically, there has been a perception thatthree-dimensional imaging was too slow or difficult for clinical use.  This perception was due largely to therelatively slower processing speed of workstations available in the past.  Although the Company believes that therecent advances in the affordability of high performance computers and in thedevelopment of industry standards for the generation, transmission, and storageof imaging data will provide opportunities for growth in the 3D medical imagingindustry, given the uncertainties associated with the developing stage of thisindustry, there can be no assurance that it will continue to develop in themanner anticipated by the Company. Accordingly, there can be no assurance that the 3D medical imagingindustry will provide growth opportunities for the Company and its softwareproducts or that the Company’s business strategies will be successful as the 3Dmedical imaging industry continues to evolve. Ultimately, if the 3D medical imaging industry fails to develop as theCompany expects, the Company’s business, results of operations and financialcondition will be materially and adversely affected.

 

Need for Additional Capital

 

If the Company’s operations progress as anticipated, of which there canbe no assurance, the Company believes that its existing cash balances, togetherwith cash flows from operations, should be sufficient to satisfy its cashrequirements for at least the next 12 months.

 

The timing of the Company’s future capital requirements will depend ona number of factors, including, but not limited to, the ability of Vital Imagesto successfully market its products; the ability and willingness of physiciansto use two- and three-dimensional medical imaging software in diseasescreening, clinical diagnosis and therapy planning and other diagnosis,surgical, and treatment protocols; the impact of competition in the 3D medicalimaging business; the ability of the Company to differentiate its products fromcompeting products; the capital equipment budget constraints of some potentialpurchasers; the ability of the Company to build an effective sales anddistribution force; and the ability to enhance existing products and developnew products on a timely basis.  To theextent that the Company’s operations do not progress as anticipated, additionalcapital may be required.  There can beno assurance that any required additional capital will be available onacceptable terms, or at all, and the failure to obtain any such requiredcapital would have a material adverse effect on Vital Images’ business.  The issuance of additional equity securitiesmay result in dilution of current shareholder voting and ownershipinterests.  See “Item 7. Management’sDiscussion and Analysis of Financial Condition and Results of Operations.”

 

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Highly Competitive Industry

 

The Company faces intense competition in the 3D medical imagingindustry.  The Company expectstechnology to continue to develop rapidly, and the Company’s success willdepend to a large extent on its ability to maintain a competitive position withits products.  Companies competing withthe Company in the 3D medical imaging industry include large, establishedmanufacturers of CT and MR imaging equipment. Companies such as GE Medical Systems, Siemens Medical Systems, Inc. andPhilips Medical Systems typically offer their own medical imaging software andworkstations as part of their integrated imaging and scanner systems.  The Company’s ability to successfully marketand sell its current 3D medical imaging products to prospective customersdepends, in part, on its ability to persuade such customers to separate thepurchase of CT or MR equipment from the selection and purchase of 3D medicalimaging workstations.  In addition tohaving significantly greater capital and staffing resources for research anddevelopment that are critical to success in the rapidly changing 3D medicalimaging industry, such companies also have well-established marketing anddistribution networks and have a competitive advantage in marketing 3D medicalimaging tools as an integrated part of their imaging products.  While price has been less significant thanother factors, increasing competition may result in price reductions andreduced gross margins.  Additionally,the Company faces competition from other entities, such as other softwaresuppliers, information storage and retrieval vendors, hospital, radiology andclinical systems suppliers and internal development projects sponsored byhospital radiology departments.  Therecan be no assurance that the Company will be able to compete effectively withsuch manufacturers or competing entities. See “Business—Technology,” “—Industry Background” and “—Competition.”

 

Risk of Technological Obsolescence

 

The 3D medical imaging market is characterized by rapid innovation and technologicalchange.  There can be no assurance thatthe Company will be able to compete effectively in the marketplace or thatproducts developed by its competitors will not render its products obsolete ornon-competitive.  Similarly, there canbe no assurance that the Company’s competitors will not succeed in developingor marketing products that are viewed as providing superior clinicalperformance or are less expensive than the Company’s products currentlymarketed or to be developed.

 

Dependence on Major Customers

 

One of the Company’s principal distribution channels is to sell its *Vitrea 2*medical imaging software for inclusion with the delivery of medical imagingequipment being sold by Toshiba Corporation, Medical Systems Company(“Toshiba”).  Sales by the Company toToshiba accounted for approximately 34%, 27% and 27% of the Company’s totalrevenue for the years ended December 31, 2002, 2001 and 2000, respectively.Management believes a limited number of large customers may continue to accountfor a significant portion of the Company’s revenue during any given period forthe foreseeable future.  Except for itsmarketing and distribution agreements with Toshiba, Medtronic SNT and E-Z-EM,Inc., the Company currently has no long-term purchase or other agreements withany of its customers and sales are generally made pursuant to purchaseorders.  A reduction, delay, orcancellation of orders from one or more of its significant customers likelywould have a material adverse effect on the Company’s operating results.  See “Business-Marketing and Distribution.”

 

Impact of Purchase Commitments

 

In November 2002, the Company entered into an agreement with R2Technology, Inc. (“R2”) to distribute R2’s lung nodule CAD software product(“lung CAD Product”) in conjunction with the Company’s products.  Upon the later of either the date on whichR2 is able to meet CE certification requirements and produce a “Declaration ofConformance” for the lung CAD product or the completion of the milestones inthe development plan with respect to the lung CAD product that will bedistributed in Europe, the Company is required to begin purchasing the lung CADproduct over the next three years.  Thetotal purchase commitment

 

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will be to a maximum of $5.6 million worth of product over thethree-year commitment period.  Thepurchase commitment price the Company has to pay will be reduced if the sellingprice of the lung CAD product when sold directly to end-users by R2 falls belowa specified price.

 

Fluctuations in Operating Results

 

The Company may experience significant fluctuations in future annualand quarterly operating results.  Ifthese fluctuations occur, they may result in volatility in the price of theCompany’s common stock.  Quarterlyrevenue and operating results may fluctuate as a result of a variety of factorsincluding, but not limited to, the timing of significant orders, the timing ofproduct enhancements and new product introductions by the Company, itscompetitors and its customers, the pricing of the Company’s products, changesin customers’ budgets, and competitive conditions, many of which are beyond thecontrol of the Company.

 

Government Regulation

 

The Company’s products are subject to regulation by the FDA and bycomparable agencies in foreign countries. In the United States, the FDA regulates the development, introduction,manufacturing, labeling and record keeping procedures for medical devices,including 3D medical imaging software and systems.  The process of obtaining marketing clearance from the FDA for newproducts and new applications for existing products can be time-consuming andexpensive.  All of the current productsactively marketed by the Company have received marketing clearance from the FDApursuant to 510(k) pre-market notifications. *Vitrea2* has been approved to be marketed for use with CT and MR scanners,the Company’s *VScore*options havebeen approved for use in coronary artery calcium scoring and theCompany’s CT Brain Perfusion option has been cleared for analyzing the bloodflow of stroke victims.  There can be noassurance, however, that clearance will be granted with respect to futureproducts or enhancements, or that FDA review will not involve delays that wouldadversely affect the Company’s ability to market such future products orenhancements.  In addition, there can beno assurance that future products or enhancements will not be subject to themore lengthy and expensive pre-market approval process with the FDA.

 

Even if regulatory approvals to market a product are obtained from theFDA, these approvals may entail limitations on the indicated uses of theproduct.  Product approvals by the FDAcan also be withdrawn due to failure to comply with regulatory standards or theoccurrence of unforeseen problems following initial approval.  The FDA could also limit or prevent thedistribution of the Company’s products and has the power to require the recallof such products.  FDA regulationsdepend heavily on administrative interpretation, and there can be no assurancethat future interpretations made by the FDA or other regulatory bodies will notadversely affect the Company.  The FDAmay inspect the Company and its facilities from time to time to determinewhether the Company is in compliance with various regulations relating tospecification, development, documentation, validation, testing, quality controland product labeling.  A determinationthat the Company is in violation of such regulations could lead to impositionof civil penalties, including fines, product recalls or product seizures and,in extreme cases, criminal sanctions.

 

The Company markets its products both domestically andinternationally.  Internationalregulatory bodies have established varying regulations governing productstandards, packaging requirements, labeling requirements, import restrictions,tariff regulations, duties and tax requirements.  The inability or failure of the Company to comply with thevarying regulations or the imposition of new regulations could restrict itsability to sell its products internationally and could thereby adversely affectthe Company’s business.  See“Business—Governmental Regulation.”

 

Health Insurance Portability and Accountability Act of1996 (“HIPAA”)

 

The HIPAA regulations are causing customers of the Company to requestthat the Company sign “business associate” agreements with them.  A “business associate” is a person or entitythat performs certain functions or activities that involve the use ordisclosure of protected health information on behalf of, or provides services

 

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to, a covered entity.  By law,the HIPAA Privacy Rule applies only to covered entities – health plans, healthcare clearinghouses, and certain health care providers.  However, most health care providers do notcarry out all of their health care activities and functions by themselves.  Instead, they often use the services of avariety of other persons or businesses. The Privacy Rule allows covered providers and health plans 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 PrivacyRule.  Covered entities may discloseprotected health information to an entity in its role as a business associate *only* to help the covered entity carry outits health care functions – not for the business associate’s independent use orpurposes, except as needed for the proper management and administration of thebusiness associate.  If the Company isnot willing to or is unable to enter into a “business associate” agreement withcurrent and potential customers, the customer may not purchase products andservices from the Company and this would have a material adverse impact on theCompany’s results of operations and financial condition.

 

Uncertain Protection for Intellectual Property;Possible Claims of Others

 

Although the Company has filed patent applications with respect tocertain aspects of its technology, it generally does not rely on patentprotection with respect to its products and technologies.  Instead, the Company relies primarily on acombination of trade secret and copyright law, employee and third-partynondisclosure agreements and other protective measures to protect intellectualproperty rights pertaining to its products and technologies.  There can be no assurance that thesemeasures will provide meaningful protection of the Company’s trade secrets,know-how or other intellectual property in the event of any unauthorized use,misappropriation or disclosure or that others will not independently developsimilar technologies or duplicate any technology developed by the Company.  In addition, to the extent that any patentsare applied for, there can be no assurance that such applications will resultin issued patents or, if issued, that such patents will be held to be valid orwill otherwise be of value.  While theCompany does not believe that its products and technologies infringe anyexisting patents or intellectual property rights of third parties, there can beno assurance that such infringement does not exist.  The costs of prosecuting or defending an intellectual propertyclaim could be substantial and could adversely affect the Company, even if it wasultimately successful in prosecuting or defending any such claims.  If the Company’s products or technologieswere found to infringe the rights of a third party, the Company could berequired to pay significant damages or license fees or cease production, any ofwhich could have a material adverse effect on the Company’s business.  See “Business—Intellectual Property.”

 

Product Liability Risk; Limited Insurance Coverage

 

The manufacture and sale of products used in the practice of medicineentail significant risk of product liability claims.  While the Company currently maintains product liability insurancein the amount of $11,000,000 per occurrence and $12,000,000 in total and alsomaintains errors and omissions coverage in the amount of $11,000,000 peroccurrence and in total, there can be no assurance that its coverage limitswill be adequate to protect the Company from any liabilities it might incur inconnection with the sale of its products, or that the Company will be able tomaintain this level of coverage in the future. The Company also may require increased product liability coverage asadditional products and updates are released. Such insurance is expensive and in the future may not be available onacceptable terms, if at all.  Asuccessful product liability claim or series of such claims against the Companyin excess of the Company’s insurance coverage could have a material adverseeffect on its business.

 

Dependence on Key Employee; Need to Hire AdditionalPersonnel

 

The Company depends upon the continued active participation of Dr.Vincent J. Argiro, its Chief Technology Officer and Founder.  Loss of the services of Dr. Argiro couldhave a material adverse effect on the Company’s future business.  Dr. Argiro does not have an employmentagreement with the Company, but he

 

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does have a confidentiality and non-competition agreement with theCompany.** **The Company maintains key personlife insurance coverage on Dr. Argiro’s life in the amount of $500,000.

 

The Company’s ability to enhance and develop markets for its currentproducts as well as to introduce new products to the marketplace also dependson its ability to attract and retain qualified scientific and managementpersonnel.  The Company competes forsuch personnel with other companies, academic institutions, government entitiesand organizations, many of which have substantially greater capital resources,name recognition, and research and development capabilities than theCompany.  There can be no assurance thatthe Company will be successful in recruiting or retaining such personnel.  The inability of the Company to recruit andretain such personnel would have a material adverse effect on the Company’sbusiness.

 

Management of Growth

 

The execution of the Company’s business plan will place increasingdemands on the Company’s existing management and resources.  There can be no assurance that the Companywill be able to effectively manage any expansion of its business, which couldhave a material adverse effect on the Company’s business, financial conditionand results of operations.

 

Dependence on Third-Party Reimbursement

 

The Company’s products are purchased by hospitals, clinics, imagingcenters and other users, which bill various third party payers, such asgovernment health programs, private health insurance plans, managed careorganizations and other similar programs, for the health care goods andservices provided to their patients. There is currently a Current Procedural Terminology (CPT) reimbursementcode for procedures that utilize the Company’s products.  However, the amount of such reimbursementvaries by location and is subject to change. Payers may deny reimbursement if they determine that a product used in aprocedure was not used in accordance with established payer protocol regardingcost-effective treatment methods or was used for an unapproved indication.  Third party payers are increasinglychallenging the prices charged for medical services and, in some instances,have put pressure on service providers to lower their prices or reduce theirservices.  The Company is unable topredict what changes will be made in the reimbursement methods used by thirdparty healthcare payers.  There can beno assurance that procedures in which the Company’s products are used will beconsidered cost effective by third party payers, that reimbursement for suchprocedures will be available or, if available, that payers’ reimbursementlevels will not adversely affect the Company’s ability to sell its products ona profitable basis.  In addition, therehave been and may continue to be proposals by legislators, regulators and thirdparty payers to curb further these costs in the future.  Failure by hospitals and other users of theCompany’s products to obtain reimbursement from third party payers, changes inthird party payers’ policies toward reimbursement for procedures using theCompany’s products or legislative action could have a material adverse effecton the Company’s business.  See “Business—ThirdParty Reimbursement and Cost Containment.”

 

Uncertainty of Health Care Reform

 

The levels of revenue and profitability of medical technology companiesmay be affected by the efforts of government and third party payers to containor reduce the costs of health care through various means.  In the United States there have been, andthe Company expects that there will continue to be, a number of federal, state,and private proposals to control health care costs.  These proposals may contain measures intended to control publicand private spending on health care as well as to provide universal publicaccess to the health care system.  Ifenacted, these proposals may result in a substantial restructuring of thehealth care delivery system. Significant changes in the nation’s health care system could have asubstantial impact on the manner in which the Company conducts its business andcould have a material adverse effect on the Company’s business, financialcondition and results of operations.

 

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Possible Issuances of Preferred Stock; CertainAnti-Takeover Considerations

 

The Company’s Articles of Incorporation authorize the Company’s Boardof Directors, without any action by its shareholders, to establish the rightsand preferences of up to 5,000,000 shares of currently undesignated preferredstock.  Such shares of preferred stock could possess voting and conversion rights,which could adversely affect the voting power of the holders of the commonstock and may have the effect of delaying, deferring or preventing a change incontrol of the Company.  Noshares of preferred stock or other senior equity securities are currentlydesignated and currently there is no plan to designate or to issue any suchsecurities.  The Company is also subjectto certain “anti-takeover” provisions of the Minnesota Business CorporationAct.  In addition, the Company hasadopted a Shareholder Rights Plan (the “Rights Agreement”) designed to protectthe Company and its shareholders from unsolicited attempts to acquire the Company.  These measures may, in certaincircumstances, deter or discourage takeover attempts and other changes incontrol of the Company not approved by its Board of Directors and may have adepressive effect on any market for the Company’s stock.  As a result, the Company’s shareholders maylose opportunities to dispose of their shares at the higher prices typicallyavailable in takeover attempts or that may be available under a mergerproposal.  In addition, these measuresmay have the effect of permitting the Company’s current directors to retaintheir positions and place them in a better position to resist changes that theCompany’s shareholders may wish to make if they are dissatisfied with theconduct of the Company’s business.

 

No Dividends

 

The Company has not paid cash dividends on itscommon stock in the past and does not intend to do so in the foreseeablefuture.

 

Limitations on Director Liability

 

As permitted by Minnesota law, the Company’s Articles of Incorporationprovide that a director of the Company shall not be personally liable to theCompany or its shareholders for monetary damages for breach of fiduciary dutyas a director, with certain exceptions. These provisions may discourage shareholders from bringing suit againsta director for breach of fiduciary duty and may reduce the likelihood ofderivative litigation brought by shareholders on behalf of the Company againsta director.  In addition, the Company’sBylaws provide for mandatory indemnification of directors and officers to thefullest extent permitted by Minnesota law.

 

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Item 2.                                     PROPERTIES

 

The Company’s principal office is located in Plymouth, Minnesota, wherethe Company currently occupies approximately 27,000 square feet under a leasethat expires July 31, 2005. Under certain conditions contained in the lease,the Company has the option to expand its facilities.

 

The Company considers its current facilities adequate for its currentneeds and believes that suitable additional space will be available as and ifneeded.

 

Item 3.                                     LEGALPROCEEDINGS

 

The Company is not engaged in any legal proceedings at this time.

 

Item 4.                                     SUBMISSION OFMATTERS TO A VOTE OF SECURITY HOLDERS

 

There was no matter submitted to the vote of security holders duringthe fourth quarter of 2002.

 

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PART II

 

Item 5.                                     MARKET FORREGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

 

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

 

|           |   | **High** |   | **Low** |   |
|----------------|--------|----------|--------|---------|--------|
| 2002           |   |     |   |    |   |
| Fourth Quarter |   | $        | 9.80   |    | $      | 4.69 |   |
| Third Quarter  |   | 6.95     |   | 5.15    |   |
| Second Quarter |   | 9.40     |   | 6.23    |   |
| First Quarter  |   | 11.25    |   | 6.75    |   |
|           |   |     |   |    |   |
| 2001           |   |     |   |    |   |
| Fourth Quarter |   | $        | 10.32  |    | $      | 5.00 |   |
| Third Quarter  |   | 7.35     |   | 4.40    |   |
| Second Quarter |   | 6.95     |   | 3.63    |   |
| First Quarter  |   | 5.25     |   | 3.25    |   |

 

The Company has never paid or declared any cash dividends on its commonstock and does not intend to pay dividends on its common stock in the nearfuture.  To date, the Company hasincurred cumulative operating losses and presently expects to retain its futureanticipated earnings to finance development and expansion of its business.  As of February 28, 2003, there wereapproximately 4,900 beneficial owners and approximately 900 registered holdersof record of the Company’s common stock.

 

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Item 6.                                     SELECTEDFINANCIAL DATA

 

The following selected financial data for each of the fiscal years inthe five-year period ended December 31, 2002 is derived from the auditedfinancial statements of the Company and the notes thereto.  The information set forth below should beread in conjunction with the Company’s financial statements, including thenotes thereto, and “Item 7. Management’s Discussion and Analysis of FinancialCondition and Results of Operations,” which are included elsewhere in thisAnnual Report on Form 10-K.

 

**(Inthousands, except per share data)**

 
|                                                  |   | **For the  Years Ended  or As of  December 31,** |   |
|-------------------------------------------------------|--------|--------------------------------------------------|--------|
|                                                  |   | **2002**                                         |   | **2001** |   | **2000** |   | **1999** |   | **1998** |   |
|                                                  |   |                                             |   |   |   |   |   |   |   |   |   |
| **Statement of Operations Data:**                     |   |                                             |   |   |   |   |   |   |   |   |   |
| Revenue                                               |   | $                                                | 21,116 |   | $ | 15,196 |   | $ | 10,628 |   | $ | 6,623 |   | $ | 4,527 |   |
| Gross margin                                          |   | 16,664                                           |   | 11,886 |   | 8,110 |   | 5,080 |   | 3,302 |   |
|                                                  |   |                                             |   |   |   |   |   |   |   |   |   |
| Operating  expenses:                                  |   |                                             |   |   |   |   |   |   |   |   |   |
| Selling, general  and administrative                  |   | 11,724                                           |   | 9,523 |   | 7,861 |   | 5,858 |   | 4,954 |   |
| Research and  development                             |   | 4,263                                            |   | 3,418 |   | 3,036 |   | 2,525 |   | 1,815 |   |
| Operating income  (loss)                              |   | 677                                              |   | (1,055 | ) | (2,787 | ) | (3,303 | ) | (3,467 | ) |
|                                                  |   |                                             |   |   |   |   |   |   |   |   |   |
| Net income  (loss)                                    |   | $                                                | 790    |   | $ | (1,012 | ) | $ | (2,637 | ) | $ | (3,218 | ) | $ | (3,209 | ) |
|                                                  |   |                                             |   |   |   |   |   |   |   |   |   |
| Net income  (loss) per share-basic                    |   | $                                                | 0.09   |   | $ | (0.14 | ) | $ | (0.39 | ) | $ | (0.64 | ) | $ | (0.66 | ) |
|                                                  |   |                                             |   |   |   |   |   |   |   |   |   |
| Weighted average  common shares outstanding - basic   |   | 8,861                                            |   | 7,075 |   | 6,760 |   | 5,046 |   | 4,841 |   |
|                                                  |   |                                             |   |   |   |   |   |   |   |   |   |
| Net income  (loss) per share-diluted                  |   | $                                                | 0.08   |   | $ | (0.14 | ) | $ | (0.39 | ) | $ | (0.64 | ) | $ | (0.66 | ) |
|                                                  |   |                                             |   |   |   |   |   |   |   |   |   |
| Weighted average  common shares outstanding - diluted |   | 9,822                                            |   | 7,075 |   | 6,760 |   | 5,046 |   | 4,841 |   |
|                                                  |   |                                             |   |   |   |   |   |   |   |   |   |
| **Balance Sheet Data:**                               |   |                                             |   |   |   |   |   |   |   |   |   |
| Working capital                                       |   | $                                                | 9,219  |   | $ | 6,094 |   | $ | 2,344 |   | $ | 5,409 |   | $ | 3,360 |   |
| Total assets                                          |   | 18,827                                           |   | 13,269 |   | 7,287 |   | 8,666 |   | 5,938 |   |
| Long-term debt                                        |   | —                                           |   | — |   | — |   | — |   | — |   |
| Total  shareholders’ equity                      |   | 11,721                                           |   | 8,051 |   | 3,765 |   | 6,098 |   | 4,134 |   |

 

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Item 7.                                     MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

**Overview**

 

Vital Images develops, markets and supports 3D medical imaging softwarefor use primarily in disease screening, clinical diagnosis and therapyplanning.  The Company’s softwareapplies proprietary computer graphics and image processing technologies to awide variety of data supplied by computed tomography (“CT”) scanners andmagnetic resonance (“MR”) imaging devices. Vital Images’ products allow clinicians to create both two- andthree-dimensional views of human anatomy and to non-invasively navigate withinthese images to better visualize and understand internal structures andpathologies.  The Company believes thatits high-speed visualization technology and customized protocolscost-effectively bring 3D visualization and analysis into the routine,day-to-day practice of medicine.  TheCompany, which operates in a single business segment, markets its products tohealthcare providers and to manufacturers of diagnostic imaging systems througha direct sales force in the United States and independent distributors ininternational markets.

 

On October 28, 1996, the Board of Directors of Bio-Vascular, Inc.(“Bio-Vascular”), now known as Synovis Life Technologies, Inc., the formerparent company of Vital Images, approved a plan to spin off and establish VitalImages as an independent, publicly-owned company.  On May 12, 1997, Bio-Vascular distributed all of the shares ofVital Images to the shareholders of Bio-Vascular, and on that date Vital Imagesbegan operating as an independent public company.  All Bio-Vascular shareholders of record as of May 5, 1997 receivedone share of Vital Images common stock for each two shares of Bio-Vascularstock held on that date, and cash in lieu of fractional shares.  Vital Images’ common stock is currentlytraded on The Nasdaq SmallCap Market under the symbol VTAL.

 

**CriticalAccounting Policies and Estimates**

 

Management’s discussion and analysis of its financial position andresults of operations are based upon the Company’s consolidated financialstatements, which have been prepared in accordance with accounting principlesgenerally accepted in the United States of America. The preparation of thesefinancial statements requires management to make estimates and assumptions thataffect the reported amounts of assets and liabilities and disclosure ofcontingent assets and liabilities as of the date of the financial statementsand the reported amounts of revenue and expenses during the reportingperiods.  Actual results could differfrom those estimates.  The followingrepresents those critical accounting policies and estimates where materiallydifferent amounts could be reported under different conditions or usingdifferent assumptions.

 

*Allowancefor doubtful accounts.* The Company maintains anallowance for doubtful accounts that reflects the Company’s estimate of lossesthat may result from the uncollectibility of accounts receivable.  The allowance for doubtful accounts is basedprimarily on an analysis of individual accounts for which the Company hasinformation indicating the customer may not be able to pay amounts owed to the Company.  In these cases, based on the available factsand circumstances, the Company estimates the amount that will be collected fromsuch customers.  The Company alsoevaluates the collectibility of our accounts receivable in the aggregate basedon factors such as the aging of receivable amounts, customer concentrations,historical experience, and current economic trends and conditions.  The allowance for doubtful accounts isadjusted when additional information is received that impacts the amountreserved. If circumstances change, the Company’s estimates of therecoverability of accounts receivable could be reduced or increased by amaterial amount.  Such a change inestimated recoverability would be accounted for in the period in which thefacts that give rise to the change become known.  As of December 31, 2002, the Company had an allowance fordoubtful accounts of $240,000.

 

*Deferredtax asset.* TheCompany records a valuation allowance to reduce its deferred tax asset to theamount that is more likely than not to be realized.  Presently the Company maintains a valuation allowance to offsetall of its net deferred tax asset. While the Company has considered future taxable income in assessing theneed for the valuation allowance, in the event the Company were to determinethat it would be able to realize its deferred tax asset in the future in excessof its

 

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net recordedamount, an adjustment to the deferred tax asset would increase income in theperiod such a determination was made and such a determination will become morelikely if the Company continues to generate income.  Likewise, should the Company determine that it would not be ableto realize all or part of its net deferred tax asset in the future, anadjustment to the deferred tax asset would be charged to income in the periodsuch a determination was made.  As ofDecember 31, 2002, the Company has recorded a valuation allowance against thedeferred tax assets of $8,598,000. Despite the full valuation allowance, theincome tax benefits related to these deferred tax assets will remain availableto offset future taxable income. 

 

*Long-LivedAssets.*The Company periodically reviews the carrying amountsof property and equipment and intangible assets purchased in the normal courseof business to determine whether current events or circumstances, as defined inStatement of Financial Accounting Standard No 144, “Accounting for theImpairment or Disposal of Long-Lived Assets,” warrant adjustments to such carryingamounts.  In reviewing the carryingvalues of property and equipment and intangible assets purchased in the normalcourse of business the Company considers, among other things, the future cashflows expected from the use of the asset. To the extent these estimated cash flows significantly change, animpairment would be identified.

 

*RevenueRecognition. *TheCompany recognizes revenue in accordance with AICPA Statement of Position(“SOP”) 97-2, “Software Revenue Recognition,” as amended by SOP 98-4 and SOP98-9, as well as Technical Practice Aids issued from time to time by theAmerican Institute of Certified Public Accountants.  License fees revenue is derived from the licensing of computersoftware.  Hardware revenue is derivedfrom the sale of system hardware, including peripheral equipment.  Maintenance and service revenue is derivedfrom hardware and software maintenance and from services consisting ofinstallation, training and engineering services.

 

In software arrangements that include the rights to multiple softwareproducts, system hardware, specified upgrades, maintenance or services, theCompany allocates the total arrangement fee among each deliverable based on therelative fair value of each of the deliverables determined based on vendor-specificobjective evidence. In software arrangements in which the Company does not havevendor-specific objective evidence, revenue is deferred until the earlier ofwhen vendor-specific objective evidence is determined for the undeliveredelements (residual method) or when all elements have been delivered.

 

Revenue from license fees is recognized when persuasive evidence of anarrangement exists, shipment of the product has occurred, no significantCompany obligations with regard to implementation remain, the fee is fixed anddeterminable and collection is probable. Revenue allocable to maintenance is recognized on a straight-line basisover the periods in which it is provided. The Company evaluates arrangements that include services to determinewhether those services are essential to the functionality of other elements ofthe arrangement.  Generally, theCompany’s services are not considered essential to the functionality of otherelements, and accordingly, revenue allocable to services is recognized as theservices are performed.  In arrangementswhere the Company is performing significant customization or modification ofsoftware, revenue from the arrangements is recognized using contractaccounting, generally on a percentage-of-completion basis. Hardware revenue isrecognized upon shipment when all other revenue recognition criteria in thearrangement have been met.

 

**Revenue**

 

Total revenue increased 39% to $21,116,000 in 2002 from total revenueof $15,196,000 in 2001.  Total revenueincreased 43% to $15,196,000 in 2001 compared with $10,628,000 in 2000.  The revenue growth was driven by theincrease in the Company’s core revenue components of software license fees andmaintenance and service revenue. License fee revenue increased 41% to $14,212,000 in 2002 from$10,083,000 in 2001.  The increase insoftware license fee revenue was driven primarily by an increase in the numberof Vitrea*â 2*licenses sold and an increase in thenumber of *Vitrea* add-on optionssold.  License fee revenue increased 43%to $10,083,000 in 2001 from $7,037,000 in 2000.  The increase in software license fee revenue was driven by anincrease in the number of Vitrea*â 2*licenses sold as well as an increasein the number of *Vitrea* add-onoptions sold.

 

Maintenance and services revenue increased 64% to $4,019,000 in 2002from $2,450,000 in 2001 and increased 74% to $2,450,000 in 2001 from $1,412,000in 2000.  The increases were primarilydue to increases

 

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in maintenance revenue as the Company added new customers to theinstalled base and increases in training revenue due to an increase in thenumber of training sessions sold with customer purchases of software and add-onoptions.  The Company recorded anadditional $400,000 in service revenue in 2002 to integrate certain Companytechnology into image-guided surgery products for Surgical NavigationTechnologies, Inc., a division of Medtronic, Inc. and $60,000 from ToshibaCorporation, Medical Systems Group (“Toshiba”) for the development of a 3DAngiography option.  The Companyrecorded an additional $348,000 in service revenue in 2001 for the developmentof a CT colonography product, InnerviewGITM, for E-Z-EM, Inc.

 

Hardware revenue increased 8% to $2,885,000 in 2002 from $2,663,000 in2001 and increased 22% to $2,663,000 in 2001 from $2,179,000 in 2000.  The increase in hardware revenue was primarilydue to an increase in the number of hardware systems sold with the *Vitrea*software licenses.  The hardware revenue growth was lower in2002 than in 2001 due to a change in the sales model with Toshiba AmericaMedical Systems, Inc. (“TAMS”).  Priorto the third quarter of 2001, all of the Company’s sales to TAMS were completesystems sales.  Beginning in the thirdquarter of 2001, most of the revenue resulting from sales to TAMS was derivedfrom software-only sales, which generate higher margins than complete systemsales.

 

The Company had a license agreement with Paradigm GeophysicalCorporation (“Paradigm”), which expired in January 2001.  Revenue received under the license agreementwith Paradigm was $106,000 and $210,000 in 2001 and 2000, respectively.

 

**GrossMargin**

 

The Company’s gross margin percentage was 79% in 2002, up from 78% in2001. The gross margin percentage was 76% in 2000.  The increase in gross margin for 2002 and 2001 was primarilyattributable to a change in the sales model with TAMS as discussed above and anincrease in software only sales to international resellers including Toshiba.

 

The *Vitrea2* system, consisting of *Vitrea 2* software and third-party hardwareand peripherals, is designed to offer end users an integrated 3D medical imagingsystem.  The Company receives a nominaldiscount in purchasing the third-party hardware and peripheral components ofthe *Vitrea2*system, and the Company’s gross margin on the resale of thesesystem components approximates its discount. The Company anticipates that software license fee revenue as apercentage of the Company’s total revenue will increase modestly in futureperiods and, therefore, management believes the overall gross margin percentagewill increase modestly in future periods.

 

**Sales andMarketing**

 

Sales and marketing expenses were $8,531,000, or 40% of total revenue,$6,865,000, or 45% of total revenue and $5,651,000, or 53% of total revenue,for 2002, 2001 and 2000, respectively. The increases in sales and marketing expenses from 2001 to 2002 and 2000to 2001 were primarily due to increased compensation costs as a result ofadditional personnel and increased sales commissions as a result of increasedrevenue.  Tradeshow and marketing costsincreased from 2001 to 2002, primarily due to the Company purchasing more spaceat tradeshows and attending additional tradeshows.  Depreciation expense increased in 2001 as compared with 2000,primarily due to equipment purchases used for the additional personnel,upgrades of computer equipment and equipment for tradeshows.  During these periods, sales and marketingexpenses as a percentage of revenue declined primarily due to the Company’sability to generate revenue growth without proportionately increasing sales andmarketing costs.  The Company expectssales and marketing costs to increase in future periods primarily as a resultof the cost of additional sales and customer support personnel.  However, management expects sales andmarketing expenses to decline as a percentage of total revenue in 2003.

 

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**Researchand Development**

 

Research and development expenses were up 25% to $4,263,000 or 20% oftotal revenue in 2002 from $3,419,000, or 22% of total revenue, in 2001.  In addition, $211,000 of expenses wereclassified in cost of revenue during 2002 in connection with engineeringservices provided to others under various product development agreements.  The increase in expenses from 2001 to 2002was primarily due to increased compensation costs resulting from additionalpersonnel supporting the development of *Vitrea2* and the amortization of licensed technology.  Research and development expenses were up13% to $3,419,000 or 22% of total revenue in 2001 from $3,036,000, or 29% oftotal revenue, in 2000.  The increasewas primarily due to increased compensation costs resulting from additionalpersonnel supporting the development of *Vitrea2*, the amortization of licensed technology and increases in expensesto support clinical collaboration sites. There were also consecutive increases in annual depreciation expensebetween 2000 and 2002, primarily as the result of equipment purchases tosupport the additional personnel and to upgrade computer equipment.  The decreases in research and developmentexpenses as a percentage of revenue during these periods reflect the Company’sability to generate increased revenue more rapidly than it increases itsproduct development costs.  The Companyanticipates that research and development costs will increase in future periodsas the Company develops software tools for applications with large potentialmarkets, such as cardiovascular disease, disease screening applications such ascolon cancer, and surgical and therapy planning.  However, management expects research and development costs todecline as a percentage of total revenue in 2003.

 

**Generaland Administrative**

 

General and administrative expenses were $3,193,000, or 15% of totalrevenue, $2,658,000, or 17% of total revenue and $2,210,000, or 21% of totalrevenue, in 2002, 2001 and 2000, respectively. The increase from 2001 to 2002was primarily due to severance costs of $230,000 for the Company’s former chiefexecutive officer, higher insurance costs due to the growth of the Company aswell as premium rate increases, an increase in consulting fees and increasedtravel costs related to investor relations and business development.  The increase from 2000 to 2001 was primarilydue to compensation costs increasing due to additional personnel and increasesin professional fees incurred in establishing partnering agreements.  The decreases in general and administrativeexpenses as a percentage of revenue during these periods reflect the Company’sability to limit operating costs while increasing revenue. The Company believesthat general and administrative expenses will increase in future periods due toincreased infrastructure costs as the business grows, but that they willcontinue to decrease as a percentage of total revenue in 2003.

 

**OperatingIncome (Loss)**

 

The increasing revenue from *Vitrea 2* and add-on software options andrelated service revenues, net of the increased expenses attributable to thedevelopment of the Company’s infrastructure and the development and promotionof the *Vitrea2*product, resulted in an operating income of $677,000 for 2002compared with an operating loss of $1,055,000 for 2001 and an operating loss of$2,787,000 for 2000.

 

**InterestIncome**

 

There was $135,000 of interest income for 2002, compared with $55,000in 2001 and $162,000 in 2000.  Theincrease in interest income from 2001 to 2002 was primarily due to an increasein cash, cash equivalents and marketable securities.  The increase in cash, cash equivalents and marketable securitieswas primarily due to the exercise of warrants for the purchase of common stock,which generated approximately $1,725,000 and $4,490,000 in proceeds for theyears of ended December 31, 2002 and 2001, respectively.  The decrease in interest income from 2000 to2001 was primarily due to a lower balance of cash and cash equivalentsthroughout the year as a result of the use of cash to fund the Company’soperations.

 

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**IncomeTaxes**

 

The income tax provisions for 2002, 2001 and 2000 consist solely ofcertain state minimum fees.  As a resultof the Company’s history of generating net operating losses, the Company hasestablished a valuation allowance to completely reserve for the deferred taxasset of the Company.  The Companycontinues to monitor realizability of this benefit related to its net deferredtax asset.  To the extent managementestimates that realization of this benefit is more likely than not based uponexpected future taxable income, part or all of the valuation will bereversed.  Such a reversal would resultin an income tax benefit in the period of reversal.

 

**Liquidity and Capital Resources**

 

As of December 31, 2002, the Company had $8,123,000 in cash and cashequivalents, working capital of $9,219,000 and no borrowings.

 

Cash provided by operations was $2,437,000 for 2002 compared with cashprovided by operations of $771,000 for 2001 and cash used in operations of$1,961,000 for 2000.  The primarysources of cash from operations for 2002 were net income, an increase indeferred revenue and non-cash expenses for depreciation and amortization.  The primary sources of cash from operationsfor 2001 was an increase in deferred revenue and accrued payroll and otherliabilities and non-cash expenses for depreciation and amortization, which waspartially offset by cash flow usages to fund operating losses. Cash flow usagesfor 2000 were primarily to fund operating losses, which were partially offsetby non-cash expenses for depreciation and amortization.  Increases in accounts receivable reducedcash flows in each of the years 2002, 2001 and 2000.  Increases in deferred revenue and accrued expenses and otherliabilities resulted in increased cash flows in 2002, 2001 and 2000.

 

The increases in deferred revenue for 2002, 2001 and 2000 wereprimarily due to volume increases in *Vitrea2*sales and renewals of annual maintenance.  The increases in accounts receivable for2002, 2001 and 2000 were due primarily to volume increases in *Vitrea 2*sales.  The increases in accrued payrolland other liabilities in 2002 and 2001 were primarily due to increases inincentive bonuses and sales commissions directly related to increased revenueand profitability.  The increases inaccrued payroll and other liabilities in 2000 were primarily due to increasesin accrued vacation due to increases in headcount and in sales commissions as aresult of increased revenue.

 

The Company used $4,008,000 of cash in investing activities in 2002, ofwhich $1,500,000 was used for purchases of property and equipment, primarilyfor new computer equipment.  Thepurchases were primarily to upgrade computer equipment and to purchase computerequipment for new personnel. Capital expenditures in 2002 also includedleasehold improvements for a new training facility.  The Company spent $8,047,000 to purchase investments inmarketable securities and received $5,539,000 of proceeds from maturities ofmarketable securities during 2002.  Themarketable securities are invested in U.S. government obligations, U.S.government agency obligations, corporate commercial obligations andcertificates of deposits.  The Companyused $1,519,000 of cash in investing activities in 2001, of which $769,000 wasused for purchases of property and equipment, primarily for new computerequipment.  In addition, the Companyentered into an agreement during 2001 to license technology from a third partyand paid $750,000 to the licensor.  TheCompany used $1,384,000 of cash in investing activities in 2000 to purchaseproperty and equipment primarily related to the move to new office facilities in2000 and equipment for additional personnel.

 

Cash provided by financing activities totaled $2,862,000, $5,288,000and $303,000 in 2002, 2001 and 2000, respectively.  In December 2001, the Company called the outstanding warrantsissued as part of a private placement of common stock in December 1999.  All of the warrant holders elected toexercise the warrants rather than allowing the Company to redeem them.  Purchases of common stock resulting from theexercise of these stock warrants generated approximately $1,725,000 and$4,491,000 in 2002 and 2001, respectively. During October 2001, the Company sold 82,332 shares of newly issuedcommon stock of Vital Images, Inc. to

 

30

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E-Z-EM, Inc. for approximately $552,000.  During 2002, 2001 and 2000, net cash of $1,137,000, $245,000 and$303,000, respectively, was provided by proceeds from the exercise of stockoptions.

 

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

 

The following summarizes our contractual obligations, includingpurchase commitments at December 31, 2002, and the effect such obligations areexpected to have on our liquidity and cash flow in future periods.

 
|                   |   | **2003** |    | **2004** |   | **2005**  |   | **2006** |      |
|------------------------|--------|----------|---------|----------|--------|-----------|--------|----------|-----------|
| Operating leases       |   | $        | 385,000 |     | $      | 388,000   |   | $        | 227,000   |   | $ | — |   |
|                   |   |     |    |     |   |      |   |     |      |
| Purchase commitment(1) |   | $        | 840,000 |     | $      | 1,750,000 |   | $        | 1,960,000 |   | $ | 1,050,000 |   |

 

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(1)  Assumes the R2 Technologies, Inc.’s lung nodule CADsoftware product will be available for sale beginning in the third quarter of2003.

 

Management believes that its cash and cash equivalents should besufficient to satisfy the Company’s cash requirements for at least the next 12months.

 

**ForeignCurrency Transactions**

 

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

 

**Inflation**

 

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

 

**RecentAccounting Pronouncements**

 

In June 2001, the Financial Accounting Standards Board approvedStatements of Financial Accounting Standards (“SFAS”) No. 141, “BusinessCombinations,” and No. 142, “Goodwill and Other Intangible Assets.” Thestatements eliminate the pooling-of-interests method of accounting for businesscombinations and require that goodwill and certain intangible assets not beamortized.  Instead, these assets willbe reviewed for impairment at least annually with any related losses recognizedwhen incurred.  SFAS No. 141 was generallyeffective for business combinations completed after June 30, 2001.  SFAS No. 142 was adopted by the Company onJanuary 1, 2002.  The adoption of SFASNo. 141 and No. 142 had no impact on the Company’s financial position orresults of operations.

 

In October 2001, the Financial Accounting Standards Board issued SFASNo. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.”  This statement addresses financialaccounting and reporting for the impairment of long-lived assets and for long-livedassets to be disposed of and supersedes SFAS No. 121 and APB Opinion No.30.  SFAS No. 144 was effective for theCompany beginning January 1, 2002.  Theadoption of SFAS No. 144 had no impact on the Company’s financial position orresults of operations.

 

 

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In June 2002, the FASB issued SFAS No. 146, “Accounting for CostsAssociated with Exit or Disposal Activities,” which replaces Emerging IssuesTask Force (EITF) Issue No. 94-3, “Liability Recognition for Certain EmployeeTermination Benefits and Other Costs to Exit an Activity (including CertainCosts Incurred in a Restructuring).” SFAS No. 146 requires companies torecognize costs associated with exit or disposal activities when they areincurred rather than at the date of a commitment to an exit or disposal plan.SFAS No. 146 is effective for exit or disposal activities that are initiatedafter December 31, 2002.  The Companywill apply this standard to exit and disposal activities initiated afterDecember 31, 2002.

 

In December 2002, the FASB issued SFAS No. 148, “Accounting forStock-Based Compensation – Transition Disclosure – an amendment of SFAS No.123.”  This Statement amends SFAS 123,“Accounting for Stock-Based Compensation”, to provide alternative methods oftransition for a voluntary change to the fair value based method of accountingfor stock-based compensation.  Inaddition, SFAS 148 amends the disclosure requirements of SFAS 123 to requireprominent disclosures in both annual and interim financial statements about themethod of accounting for stock-based compensation and the effect of the methodused on reported results.  SFAS 148 iseffective for fiscal years ending after December 15, 2002, and disclosurerequirements are effective for interim periods beginning after December 15,2002.  Disclosures required by SFAS 148are included in the financial statements for the year ended December 31,2002.  The Company will begin making theadditional disclosures required by SFAS 148 in the first quarter of 2003.  The Company intends to continue to accountfor stock-based compensation using the intrinsic value method prescribed by APBOpinion No. 25 and related interpretations. Accordingly, the adoption of SFAS 148 will not impact the Company’s financialposition or results of operations.

 

In November 2002, the FASB issuedInterpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements forGuarantees, Including Indirect Guarantees of Indebtedness of Others.”  This interpretation elaborates on thedisclosures required in financial statements concerning obligations undercertain guarantees.  It also clarifiesthe requirements related to the recognition of liabilities by a guarantor atthe inception of certain guarantees. The disclosure requirements of this interpretation were effective forthe Company on December 31, 2002 and, accordingly, are reflected in theCompany’s financial statements.  Therecognition provisions of the interpretation are effective for the Company in2003 and are applicable only to guarantees issued or modified after December31, 2002.  The Company does not expectthe adoption of this interpretation to have a material impact on its financialposition or results of operations.

 

In January 2003, the Financial Accounting Standards Board issued FASBInterpretation No. 46, “Consolidation of Variable Interest Entities.” This interpretation addresses the requirements for business enterprisesto consolidate related entities in which they are determined to be the primaryeconomic beneficiary as a result of their variable economic interests. The interpretation is intended to provide guidance in judging multipleeconomic interests in an entity and in determining the primary beneficiary. The interpretation outlines disclosure requirements for VIEs in existenceprior to January 31, 2003, and outlines consolidation requirements for VIEscreated after January 31, 2003.  The Company does not expect the adoption ofthis interpretation to have a material impact on its financial position orresults of operations.

 

**Forward-LookingStatements**

 

This Annual Report on Form 10-K contains certain forward-lookingstatements within the meaning of the Private Securities Litigation Reform Actof 1995 and information that is based on management’s beliefs as well as onassumptions made by, and upon information currently available to,management.  When used in this AnnualReport on Form 10-K, the words “expect,” “anticipate,” “intend,” “plan,”“believe,” “seek,” and “estimate,” or similar expressions are intended toidentify such forward-looking statements. However, this Annual Report on Form 10-K also contains otherforward-looking statements. Forward-looking statements are

 

32

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not guarantees of future performance and are subject to certain risks,uncertainties and assumptions, including, but not limited to, the followingfactors, which could cause the Company’s future results and shareholder valuesto differ materially from those expressed in any forward-looking statementsmade by or on behalf of the Company: the dependence on market growth of theindustry in which the Company operates; the extent to which the Company’sproducts gain market acceptance; the need for and availability of additionalcapital; the potential for litigation regarding patent and other intellectualproperty rights; the introduction of competitive products by others; dependenceon major customers; fluctuations in quarterly results; the progress of productdevelopment; the availability of third party reimbursement; and the receipt andtiming of regulatory approvals and other factors detailed from time to time inthe Company’s filings with the Securities and Exchange Commission, includingthose set forth under the heading “Important Factors” included in Item 1 ofthis Annual Report on Form 10-K.

 

Item 7A.                           QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK

 

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

 

In addition, the Company does not engage in speculative transactionsand does not use derivative instruments or engage in hedging activities.  See the Notes to Financial Statements for adescription of the Company’s accounting policies and other information relatedto these financial instruments.

 

In the normal course of business, the Company is exposed to marketrisks, including changes in interest rates and price changes that could affectthe Company’s operating results.  As ofDecember 31, 2002, fluctuations in interest rates, exchange rates and pricechanges would not have a material effect on the Company’s financial position oroperating results.

 

**Interest Rate Risk**

 

The Company places its cash and cash equivalents, which generally havea term of less than 90 days, with a high-quality financial institution and hasinvestment guidelines relative to diversification and maturities designed tomaintain safety and liquidity.  As ofDecember 31, 2002, the Company had cash and cash equivalents totalingapproximately $8,123,000.  Due to theshort-term nature of these instruments, the carrying value approximates marketvalue.  If, during 2003, averageshort-term interest rates decreased by 1.0% over 2002 average rates, theCompany’s projected interest income from short-term investments would decreaseby approximately $80,000, assuming a similar level of investments in 2003.

 

**Price Risk**

 

As of December 31, 2002, the Company held marketable securities with anaggregate fair market value of $2,508,000.  All of the Company’s marketable securities are classified asavailable-for-sale and all, except $500,000, mature in one year or less.  The remaining $500,000 of marketable securitieshad a contractual maturity date in September 2004 but was called in March of2003.  Available-for-sale investmentsare recorded at market value, which is based on quoted market prices, withunrealized holding gains and losses included as a separate component ofshareholders’ equity.  The Company usesa specific identification cost method to determine the gross realized gains andlosses on the sale of its securities. Had market prices of such

 

33

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securities declined 10% as of December 31, 2002, the values of theseinstruments would have decreased by $250,000.

 

**Foreign Currency Risk**

 

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

 

Item 8.                                     FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA

 

The Company’s financial statements, supplementalschedule and Report of Independent Accountants thereon, all of which areincluded in this Annual Report on Form 10-K, are listed in Item 15 (a) (1) ofthis Form 10-K.

 

Item 9.                                     CHANGESIN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIALDISCLOSURE

 

Not applicable.

 

34

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PART III

 

Item 10.                               DIRECTORS AND EXECUTIVEOFFICERS OF REGISTRANT

 

(a)          Directors of theRegistrant.

 

The information under thecaptions “Election of Directors” and “Information Concerning Directors,Nominees and Executive Officers” in the Company’s 2003 Proxy Statement isincorporated herein by reference.

 

(b)         Executive Officers of theRegistrant.

 

The information under thecaptions “Election of Directors” and “Information Concerning Directors,Nominees and Executive Officers" in the Company’s 2003 Proxy Statement isincorporated herein by reference.

 

(c)          Compliance with 16(a) ofthe Securities Exchange Act of 1934.

 

The information under thecaption “Compliance with Section 16(a)” in the Company’s 2003 Proxy Statementis incorporated herein by reference.

 

Item 11.                               EXECUTIVE COMPENSATION

 

The information under the captions “ExecutiveCompensation” and “Director Compensation” in the Company’s 2003 Proxy Statementis incorporated herein by reference.

 

Item 12.                               SECURITY OWNERSHIP OFCERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

 

The information under the captions “BeneficialOwnership of Common Stock” and "Equity Compensation Plan Information"in the Company’s 2003 Proxy Statement are incorporated herein by reference.

 

35

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Item 13.                               CERTAIN RELATIONSHIPSAND RELATED TRANSACTIONS

 

There are no reportable transactions.

 

Item 14.                               CONTROLS AND PROCEDURES

 

(a)          Evaluation of disclosurecontrols and procedures. Based on their evaluation as of a date within 90 daysof the filing date of this report, the Company’s principal executive officerand principal financial officer have concluded that the Company’s disclosurecontrols and procedures (as defined in Rules 13a-14(c) and 15d-14(c) under theSecurities Exchange Act of 1934 (the ”Exchange Act”) are effective toensure that information required to be disclosed by the Company in reports thatit files or submits under the Exchange Act is recorded, processed, summarizedand reported within the time periods specified in Securities and ExchangeCommission rules and forms.

 

(b)       Changes in internalcontrols. There were no significant changes in the Company’s internal controlsor in other factors that could significantly affect these controls subsequentto the date of their evaluation. There were no significant deficiencies ormaterial weaknesses, and therefore there were no corrective actions taken.

 

36

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PART IV

 

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

 

(a) (1)                 The followingfinancial statements and supplemental schedule of Vital Images, Inc. and Reportof Independent Accountants thereon are included herein:

 
| Report of Independent  Accountants                                                            |
|-----------------------------------------------------------------------------------------------|
| Balance Sheets as of December 31, 2002  and 2001                                              |
| Statements of Operations for  the years ended December 31, 2002, 2001 and 2000                |
| Statements of  Shareholders’ Equity for the years ended December 31, 2002, 2001 and 2000 |
| Statements  of Cash Flows for the years ended December 31, 2002, 2001 and 2000                |
| Notes to Financial  Statements                                                                |
|                                                                                          |
| Schedule II. Valuation and Qualifying  Accounts                                               |

 

(a) (2) Included in Item 15 (a) (1) above

 

All other schedules to the financial statementsrequired by Article 12 of Regulation S-X are not required under the relatedinstructions or are inapplicable and therefore have been omitted.

 

(a) (3)                 LISTING OFEXHIBITS

 

The Exhibits required to be a part of this Report arelisted in the Index to Exhibits, which follows the Financial Statement Scheduleon page 61.

 

(b)                                 REPORTSON FORM 8-K

 

The Company had no Current Reports on Form 8-K duringthe year ended December 31, 2002 or during the period from December 31, 2002 tothe date of this Annual Report on Form 10-K.

 

(c)                                  EXHIBITS

 

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

 

37

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SIGNATURES

 

Pursuant to the requirements of Section 13 or 15(d) of the SecuritiesExchange Act of 1934, the Registrant has duly caused this Report to be signedon its behalf by the undersigned, thereunto duly authorized, in Minneapolis,Minnesota, on the 28th day of March 2003.

 

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

 

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

 
| **Signature**            |   | **Title**                                                                                               |   | **Date**       |
|--------------------------|--------|---------------------------------------------------------------------------------------------------------|--------|----------------|
|                     |   |                                                                                                    |   |           |
| /s/ Jay D. Miller        |   | President, Chief  Executive Officer  and Director  (Principal Executive Officer)                        |   | March 28, 2003 |
| Jay D. Miller            |   |                                                                                                    |   |
|                     |   |                                                                                                    |   |
|                     |   |                                                                                                    |   |           |
| /s/ Gregory S. Furness   |   | Chief Financial  Officer,  Vice President-Finance, Treasurer  and Secretary  (Chief Accounting Officer) |   | March 28, 2003 |
| Gregory S. Furness       |   |                                                                                                    |   |
|                     |   |                                                                                                    |   |
|                     |   |                                                                                                    |   |
|                     |   |                                                                                                    |   |           |
| /s/ Douglas M. Pihl      |   | Chairman of the Board and Director                                                                      |   | March 28, 2003 |
| Douglas M. Pihl          |   |                                                                                                    |   |           |
|                     |   |                                                                                                    |   |           |
| /s/ Vincent J. Argiro    |   | Chief Technology  Officer, Founder  and Director                                                        |   | March 28, 2003 |
| Vincent J. Argiro        |   |                                                                                                    |   |
|                     |   |                                                                                                    |   |           |
| /s/ James B. Hickey, Jr. |   | Director                                                                                                |   | March 28, 2003 |
| James B. Hickey, Jr.     |   |                                                                                                    |   |           |
|                     |   |                                                                                                    |   |           |
| /s/ Richard W. Perkins   |   | Director                                                                                                |   | March 28, 2003 |
| Richard W. Perkins       |   |                                                                                                    |   |           |
|                     |   |                                                                                                    |   |           |
| /s/ Michael W. Vannier   |   | Director                                                                                                |   | March 28, 2003 |
| Michael W. Vannier       |   |                                                                                                    |   |           |
|                     |   |                                                                                                    |   |           |
| /s/ Sven A. Wehrwein     |   | Director                                                                                                |   | March 28, 2003 |
| Sven A. Wehrwein         |   |                                                                                                    |   |           |

 

38

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CERTIFICATIONS

 

I, Jay D. Miller, certify that:

 

1.               I have reviewedthis annual report on Form 10-K of Vital Images, Inc.;

 

2.               Based on myknowledge, this annual report does not contain any untrue statement of amaterial fact or omit to state a material fact necessary to make the statementsmade, in light of the circumstances under which such statements were made, notmisleading with respect to the period covered by this annual report;

 

3.               Based on myknowledge, the financial statements, and other financial information includedin this annual report, fairly present in all material respects the financialcondition, results of operations and cash flows of the registrant as of, andfor, the periods presented in this annual report;

 

4.               The registrant’sother certifying officer and I are responsible for establishing and maintainingdisclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and15d-14) for the registrant and we have:

 

a)            designed suchdisclosure controls and procedures to ensure that material information relatingto the registrant, including its consolidated subsidiaries, is made known to usby others within those entities, particularly during the period in which thisannual report is being prepared;

 

b)           evaluated theeffectiveness of the registrant’s disclosure controls and procedures as of adate within 90 days prior to the filing date of this annual report (the“Evaluation Date”); and

 

c)            presented in thisannual report our conclusions about the effectiveness of the disclosurecontrols and procedures based on our evaluation as of the Evaluation Date;

 

5.               The registrant’sother certifying officer and I have disclosed, based on our most recentevaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors (or persons performing the equivalentfunction):

 

a)            all significantdeficiencies in the design or operation of internal controls which couldadversely affect the registrant’s ability to record, process, summarize andreport financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and

 

b)           any fraud, whether ornot material, that involves management or other employees who have asignificant role in the registrant’s internal controls; and

 

6.               The registrant’sother certifying officer and I have indicated in this annual report whether ornot there were significant changes in internal controls or in other factorsthat could significantly affect internal controls subsequent to the date of ourmost recent evaluation, including any corrective actions with regard tosignificant deficiencies and material weaknesses.

 

Date:  March28, 2003

 
|   |   | /s/ Jay D. Miller                     |   |
|--------|--------|---------------------------------------|--------|
|   |   | Jay D. Miller                         |
|   |   | President and Chief Executive Officer |
|        |        |                                       |        |  |

 

39

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I, Gregory S. Furness, certify that:

 

1.               I have reviewedthis annual report on Form 10-K of Vital Images, Inc.;

 

2.               Based on myknowledge, this annual report does not contain any untrue statement of amaterial fact or omit to state a material fact necessary to make the statementsmade, in light of the circumstances under which such statements were made, notmisleading with respect to the period covered by this annual report;

 

3.               Based on myknowledge, the financial statements, and other financial information includedin this annual report, fairly present in all material respects the financialcondition, results of operations and cash flows of the registrant as of, andfor, the periods presented in this annual report;

 

4.               The registrant’sother certifying officer and I are responsible for establishing and maintainingdisclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and15d-14) for the registrant and we have:

 

a)            designed suchdisclosure controls and procedures to ensure that material information relatingto the registrant, including its consolidated subsidiaries, is made known to usby others within those entities, particularly during the period in which thisannual report is being prepared;

 

b)           evaluated theeffectiveness of the registrant’s disclosure controls and procedures as of adate within 90 days prior to the filing date of this annual report (the“Evaluation Date”); and

 

c)            presented in thisannual report our conclusions about the effectiveness of the disclosurecontrols and procedures based on our evaluation as of the Evaluation Date;

 

5.               The registrant’sother certifying officer and I have disclosed, based on our most recentevaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors (or persons performing the equivalentfunction):

 

a)            all significantdeficiencies in the design or operation of internal controls which couldadversely affect the registrant’s ability to record, process, summarize andreport financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and

 

b)           any fraud, whether ornot material, that involves management or other employees who have asignificant role in the registrant’s internal controls; and

 

6.               The registrant’sother certifying officer and I have indicated in this annual report whether ornot there were significant changes in internal controls or in other factorsthat could significantly affect internal controls subsequent to the date of ourmost recent evaluation, including any corrective actions with regard tosignificant deficiencies and material weaknesses.

 

Date:  March28, 2003

 
|   |   | /s/ Gregory S. Furness                                     |   |
|--------|--------|------------------------------------------------------------|--------|
|   |   | Gregory S. Furness                                         |
|   |   | Chief Financial Officer and  Senior Vice President-Finance |

 

40

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**REPORTOF INDEPENDENT ACCOUNTANTS**

 

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

 

In our opinion, the financial statements listed in the index appearingunder Item 15(a)(1) present fairly, in all material respects, the financialposition of Vital Images, Inc. (the Company) at December 31, 2002 and 2001, andthe results of its operations and its cash flows for each of the three years inthe period ended December 31, 2002 in conformity with accounting principlesgenerally accepted in the United States of America.  In addition, in our opinion, the financial statement schedulelisted in the index appearing under Item 15(a)(1) presents fairly, in allmaterial respects, the information set forth therein when read in conjunctionwith the related financial statements. These financial statements and financial statement schedule are theresponsibility of the Company’s management; our responsibility is to express anopinion on these financial statements and financial statement schedule based onour audits. We conducted our audits of these statements in accordance withauditing standards generally accepted in the United States of America, whichrequire that we plan and perform the audit to obtain reasonable assurance aboutwhether the financial statements are free of material misstatement.  An audit includes examining, on a test basis,evidence supporting the amounts and disclosures in the financial statements,assessing the accounting principles used and significant estimates made bymanagement, and evaluating the overall financial statement presentation.  We believe that our audits provide areasonable basis for our opinion.

 

 

PricewaterhouseCoopers LLP

Minneapolis, Minnesota

February 6, 2003

 

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**VITAL IMAGES, INC.BALANCE SHEETS**

 
|                                                                                                                                                               |   | **As of  December 31,** |       |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|------------|
|                                                                                                                                                               |   | **2002**                |       | **2001** | ** ** |
|                                                                                                                                                               |   |                    |       |   |   |
| **ASSETS**                                                                                                                                                         |   |                    |       |   |   |
| Current assets:                                                                                                                                                    |   |                    |       |   |   |
| Cash and cash  equivalents                                                                                                                                         |   | $                       | 8,122,547  |   | $ | 6,830,906 |   |
| Marketable  securities                                                                                                                                             |   | 2,508,113               |       | — |   |
| Accounts  receivable, net of allowance for doubtful accounts of$240,000 and $185,000 as  of December 31, 2002 and 2001, respectively                               |   | 4,971,079               |       | 3,637,954 |   |
| Prepaid expenses  and other current assets                                                                                                                         |   | 498,692                 |       | 557,833 |   |
| Total current  assets                                                                                                                                              |   | 16,100,431              |       | 11,026,693 |   |
| Property and  equipment, net                                                                                                                                       |   | 2,156,835               |       | 1,552,116 |   |
| Licensed  technology, net                                                                                                                                          |   | 570,000                 |       | 690,000 |   |
|                                                                                                                                                               |   |                    |       |   |   |
| TOTAL ASSETS                                                                                                                                                       |   | $                       | 18,827,266 |   | $ | 13,268,809 |   |
|                                                                                                                                                               |   |                    |       |   |   |
| **LIABILITIES AND SHAREHOLDERS’  EQUITY**                                                                                                                     |   |                    |       |   |   |
| Current  liabilities:                                                                                                                                              |   |                    |       |   |   |
| Accounts payable                                                                                                                                                   |   | $                       | 757,715    |   | $ | 864,385 |   |
| Accrued payroll                                                                                                                                                    |   | 1,486,654               |       | 1,326,214 |   |
| Deferred revenue                                                                                                                                                   |   | 3,870,958               |       | 2,199,465 |   |
| Accrued  royalties                                                                                                                                                 |   | 546,593                 |       | 362,637 |   |
| Other current  liabilities                                                                                                                                         |   | 219,036                 |       | 179,610 |   |
| Total current  liabilities                                                                                                                                         |   | 6,880,956               |       | 4,932,311 |   |
| Deferred revenue                                                                                                                                                   |   | 225,539                 |       | 285,709 |   |
| Total  liabilities                                                                                                                                                 |   | 7,106,495               |       | 5,218,020 |   |
|                                                                                                                                                               |   |                    |       |   |   |
| Commitments  (Notes 5 and 12)                                                                                                                                      |   |                    |       |   |   |
|                                                                                                                                                               |   |                    |       |   |   |
| Shareholders’  equity:                                                                                                                                        |   |                    |       |   |   |
| Preferred stock:  $0.01 par value; 5,000,000 shares authorized; none issued oroutstanding as of  December 31, 2002 and 2001                                        |   | —                  |       | — |   |
| Common stock:  $0.01 par value; 20,000,000 shares authorized; 8,987,009 and 8,186,092 shares  issued and outstanding as of December 31, 2002 and 2001,respectively |   | 89,870                  |       | 81,861 |   |
| Additional  paid-in capital                                                                                                                                        |   | 31,719,371              |       | 28,846,906 |   |
| Accumulated  deficit                                                                                                                                               |   | (20,088,470             | )          | (20,877,978 | ) |
| Total  shareholders’ equity                                                                                                                                   |   | 11,720,771              |       | 8,050,789 |   |
|                                                                                                                                                               |   |                    |       |   |   |
| TOTAL  LIABILITIES AND SHAREHOLDERS’ EQUITY                                                                                                                   |   | $                       | 18,827,266 |   | $ | 13,268,809 |   |

 

(The accompanying notesare an integral part of the financial statements.)

 

42

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**VITAL IMAGES, INC.**

**STATEMENTSOF OPERATIONS**

 
|                                                       |   | **For the  Years Ended December 31,** |       |
|------------------------------------------------------------|--------|---------------------------------------|------------|
|                                                       |   | **2002**                              |       | **2001** |   | **2000** |   |
|                                                       |   |                                  |       |   |   |   |   |
| Revenue:                                                   |   |                                  |       |   |   |   |   |
| License fees                                               |   | $                                     | 14,211,640 |   | $ | 10,082,897 |   | $ | 7,037,227 |   |
| Maintenance and  services                                  |   | 4,019,639                             |       | 2,450,037 |   | 1,411,583 |   |
| Hardware                                                   |   | 2,884,795                             |       | 2,662,702 |   | 2,179,381 |   |
| Total revenue                                              |   | 21,116,074                            |       | 15,195,636 |   | 10,628,191 |   |
|                                                       |   |                                  |       |   |   |   |   |
| Cost of revenue:                                           |   |                                  |       |   |   |   |   |
| License fees                                               |   | 1,130,426                             |       | 643,593 |   | 238,775 |   |
| Maintenance and  services                                  |   | 1,126,273                             |       | 552,861 |   | 385,950 |   |
| Hardware                                                   |   | 2,195,182                             |       | 2,112,982 |   | 1,893,075 |   |
| Total cost of  revenue                                     |   | 4,451,881                             |       | 3,309,436 |   | 2,517,800 |   |
|                                                       |   |                                  |       |   |   |   |   |
| Gross margin                                               |   | 16,664,193                            |       | 11,886,200 |   | 8,110,391 |   |
|                                                       |   |                                  |       |   |   |   |   |
| Operating  expenses:                                       |   |                                  |       |   |   |   |   |
| Sales and  marketing                                       |   | 8,531,563                             |       | 6,864,762 |   | 5,651,333 |   |
| Research and development                                   |   | 4,263,257                             |       | 3,418,506 |   | 3,036,016 |   |
| General and  administrative                                |   | 3,192,735                             |       | 2,657,998 |   | 2,209,999 |   |
| Total operating  expenses                                  |   | 15,987,555                            |       | 12,941,266 |   | 10,897,348 |   |
|                                                       |   |                                  |       |   |   |   |   |
| Operating income  (loss)                                   |   | 676,638                               |       | (1,055,066 | ) | (2,786,957 | ) |
|                                                       |   |                                  |       |   |   |   |   |
| Interest income,  net                                      |   | 134,870                               |       | 55,089 |   | 161,726 |   |
| Income (loss)  before income taxes                         |   | 811,508                               |       | (999,977 | ) | (2,625,231 | ) |
|                                                       |   |                                  |       |   |   |   |   |
| Income taxes                                               |   | 22,000                                |       | 12,000 |   | 12,000 |   |
|                                                       |   |                                  |       |   |   |   |   |
| Net income  (loss)                                         |   | $                                     | 789,508    |   | $ | (1,011,977 | ) | $ | (2,637,231 | ) |
|                                                       |   |                                  |       |   |   |   |   |
| Net income  (loss) per share – basic                  |   | $                                     | 0.09       |   | $ | (0.14 | ) | $ | (0.39 | ) |
|                                                       |   |                                  |       |   |   |   |   |
| Weighted average  common shares outstanding – basic   |   | 8,861,132                             |       | 7,074,906 |   | 6,760,233 |   |
|                                                       |   |                                  |       |   |   |   |   |
| Net income  (loss) per share – diluted                |   | $                                     | 0.08       |   | $ | (0.14 | ) | $ | (0.39 | ) |
|                                                       |   |                                  |       |   |   |   |   |
| Weighted average  common shares outstanding – diluted |   | 9,821,798                             |       | 7,074,906 |   | 6,760,233 |   |

 

(The accompanying notesare an integral part of the financial statements.)

 

43

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**VITAL IMAGES, INC.**

**STATEMENTS OF SHAREHOLDERS’ EQUITY**

 
|                                                        |   |             |   | **Additional****Paid-In  Capital** |   | **Accumulated  Deficit** |   | **Total  Shareholders’  Equity** |   |
|-------------------------------------------------------------|--------|------------------|--------|------------------------------------|--------|--------------------------|--------|---------------------------------------|--------|
|                                                        |   | **Common Stock** |   |                               |   |                     |
|                                                        |   | **Shares**       |   | **Amount**                         |   |                     |   |                                  |
|                                                        |   |             |   |                               |   |                     |   |                                  |   |   |   |
| Balances as of December 31, 1999                            |   | 6,695,867        |   | $                                  | 66,959 |                     | $      | 23,260,227                            |   | $ | (17,228,770 | ) | $ | 6,098,416 |   |
|                                                        |   |             |   |                               |   |                     |   |                                  |   |   |   |
| Issuance of common stock upon exercise of stock options     |   | 105,650          |   | 1,056                              |   | 216,468                  |   |                                  |   | 217,524 |   |
| Issuance of common stock under Employee Stock Purchase Plan |   | 21,589           |   | 216                                |   | 85,749                   |   |                                  |   | 85,965 |   |
| Net and comprehensive loss                                  |   |             |   |                               |   |                     |   | (2,637,231                            | )      | (2,637,231 | ) |
| Balances as of December 31, 2000                            |   | 6,823,106        |   | 68,231                             |   | 23,562,444               |   | (19,866,001                           | )      | 3,764,674 |   |
|                                                        |   |             |   |                               |   |                     |   |                                  |   |   |   |
| Stock-based compensation                                    |   |             |   |                               |   | 10,447                   |   |                                  |   | 10,447 |   |
| Issuance of common stock upon exercise of stock options     |   | 49,520           |   | 495                                |   | 153,073                  |   |                                  |   | 153,568 |   |
| Issuance of common stock under Employee Stock Purchase Plan |   | 25,487           |   | 255                                |   | 91,397                   |   |                                  |   | 91,652 |   |
| Issuance of common stock upon exercise of stock warrants    |   | 1,205,647        |   | 12,057                             |   | 4,478,744                |   |                                  |   | 4,490,801 |   |
| Issuance of common stock (Note 11)                          |   | 82,332           |   | 823                                |   | 550,801                  |   |                                  |   | 551,624 |   |
| Net and comprehensive loss                                  |   |             |   |                               |   |                     |   | (1,011,977                            | )      | (1,011,977 | ) |
| Balances as of December 31, 2001                            |   | 8,186,092        |   | 81,861                             |   | 28,846,906               |   | (20,877,978                           | )      | 8,050,789 |   |
|                                                        |   |             |   |                               |   |                     |   |                                  |   |   |   |
| Stock-based compensation                                    |   |             |   |                               |   | 18,279                   |   |                                  |   | 18,279 |   |
| Issuance of common stock upon exercise of stock options     |   | 288,008          |   | 2,880                              |   | 1,003,321                |   |                                  |   | 1,006,201 |   |
| Issuance of common stock under Employee Stock Purchase Plan |   | 24,539           |   | 245                                |   | 130,363                  |   |                                  |   | 130,608 |   |
| Issuance of common stock upon exercise of stock warrants    |   | 488,370          |   | 4,884                              |   | 1,720,502                |   |                                  |   | 1,725,386 |   |
| Net and comprehensive income                                |   |             |   |                               |   |                     |   | 789,508                               |   | 789,508 |   |
| Balances as of December 31, 2002                            |   | 8,987,009        |   | $                                  | 89,870 |                     | $      | 31,719,371                            |   | $ | (20,088,470 | ) | $ | 11,720,771 |   |

 

(The accompanying notesare an integral part of the financial statements.)

 

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**VITAL IMAGES, INC.**

**STATEMENTSOF CASH FLOWS**

 
|                                                                                                 |   | **For the  Years Ended December 31,** |      |
|------------------------------------------------------------------------------------------------------|--------|---------------------------------------|-----------|
|                                                                                                 |   | **2002**                              |      | **2001** |   | **2000** |   |
|                                                                                                 |   |                                  |      |   |   |   |   |
| CASH FLOWS FROM  OPERATING ACTIVITIES:                                                               |   |                                  |      |   |   |   |   |
| Net income  (loss)                                                                                   |   | $                                     | 789,508   |   | $ | (1,011,977 | ) | $ | (2,637,231 | ) |
| Adjustments to  reconcile net income (loss) to net cash provided by (used in) operating  activities: |   |                                  |      |   |   |   |   |
| Depreciation                                                                                         |   | 894,814                               |      | 746,727 |   | 718,978 |   |
| Stock-based  compensation                                                                            |   | 18,279                                |      | 10,447 |   | — |   |
| Provision for  uncollectible accounts receivable                                                     |   | 64,000                                |      | 114,000 |   | 122,000 |   |
| Amortization of  licensed technology                                                                 |   | 120,000                               |      | 60,000 |   | — |   |
| Changes in  operating assets and liabilities:                                                        |   |                                  |      |   |   |   |   |
| Accounts  receivable                                                                                 |   | (1,397,125                            | )         | (727,655 | ) | (1,141,185 | ) |
| Prepaid expenses  and other current assets                                                           |   | 59,141                                |      | (116,333 | ) | 21,809 |   |
| Accounts payable                                                                                     |   | (106,670                              | )         | (155,513 | ) | 188,157 |   |
| Deferred revenue                                                                                     |   | 1,611,323                             |      | 1,137,477 |   | 414,227 |   |
| Accrued expenses  and other current liabilities                                                      |   | 383,822                               |      | 714,136 |   | 352,165 |   |
| Net cash  provided by (used in) operating activities                                                 |   | 2,437,092                             |      | 771,309 |   | (1,961,080 | ) |
|                                                                                                 |   |                                  |      |   |   |   |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                                               |   |                                  |      |   |   |   |   |
| Additions to  property and equipment                                                                 |   | (1,499,533                            | )         | (769,155 | ) | (1,384,187 | ) |
| Payment for  licensed technology                                                                     |   | —                                |      | (750,000 | ) | — |   |
| Purchases of  marketable securities                                                                  |   | (8,047,536                            | )         | — |   | — |   |
| Sale of  marketable securities                                                                       |   | 5,539,423                             |      | — |   | — |   |
| Net cash used in  investing activities                                                               |   | (4,007,646                            | )         | (1,519,155 | ) | (1,384,187 | ) |
|                                                                                                 |   |                                  |      |   |   |   |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                                               |   |                                  |      |   |   |   |   |
| Proceeds from  sale of common stock                                                                  |   | —                                |      | 551,624 |   | — |   |
| Proceeds from  sale of common stock under stock plans                                                |   | 1,136,809                             |      | 245,220 |   | 303,489 |   |
| Proceeds from  sale of common stock under stock warrants                                             |   | 1,725,386                             |      | 4,490,801 |   | — |   |
| Net cash  provided by financing activities                                                           |   | 2,862,195                             |      | 5,287,645 |   | 303,489 |   |
|                                                                                                 |   |                                  |      |   |   |   |   |
| NET INCREASE  (DECREASE) IN CASH AND CASH EQUIVALENTS                                                |   | 1,291,641                             |      | 4,539,799 |   | (3,041,778 | ) |
|                                                                                                 |   |                                  |      |   |   |   |   |
| CASH AND CASH  EQUIVALENTS, BEGINNING OF YEAR                                                        |   | 6,830,906                             |      | 2,291,107 |   | 5,332,885 |   |
|                                                                                                 |   |                                  |      |   |   |   |   |
| CASH AND CASH  EQUIVALENTS, END OF YEAR                                                              |   | $                                     | 8,122,547 |   | $ | 6,830,906 |   | $ | 2,291,107 |   |
|                                                                                                 |   |                                  |      |   |   |   |   |
| SUPPLEMENTAL  CASH FLOW INFORMATION:                                                                 |   |                                  |      |   |   |   |   |
| Cash paid during  the year for interest                                                              |   | $                                     | —    |   | $ | 17,730 |   | $ | 5,204 |   |

 

(The accompanying notesare an integral part of the financial statements.)

 

45

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**VITALIMAGES, INC.**

**NOTES TO FINANCIAL STATEMENTS**

 

**(1)Business Description and Background**

 

*Business Description*

 

Vital Images develops, markets and supports 3D medical imaging softwarefor use primarily in disease screening, clinical diagnosis and therapyplanning.  The Company’s softwareapplies proprietary computer graphics and image processing technologies to awide variety of data supplied by computed tomography (“CT”) scanners andmagnetic resonance (“MR”) imaging devices. Vital Images’ products allow clinicians to create both two- andthree-dimensional views of human anatomy and to non-invasively navigate withinthese images to better visualize and understand internal structures andpathologies.  The Company believes thatits high-speed visualization technology and customized protocols cost-effectivelybring 3D visualization and analysis into the routine, day-to-day practice ofmedicine.  The Company, which operatesin a single business segment, markets its products to healthcare providers andto manufacturers of diagnostic imaging systems through a direct sales force inthe United States and independent distributors in international markets.

 

*Background*

 

On October 28, 1996, the Board of Directors of Bio-Vascular, Inc.(“Bio-Vascular”), now known as Synovis Life Technologies, Inc., the formerparent company of Vital Images, approved a plan to spin off and establish VitalImages as an independent, publicly owned company.  On May 12, 1997 (the “Distribution Date”), Bio-Vasculardistributed all of the shares of Vital Images to the shareholders of Bio-Vascular(the “Distribution”), and on that date Vital Images began operating as anindependent public company.  AllBio-Vascular shareholders of record as of May 5, 1997 received one share ofVital Images common stock for each two shares of Bio-Vascular stock held onthat date, and cash in lieu of fractional shares.

 

**(2)Summary of Significant Accounting Policies**

 

*Use of Estimates*

 

The preparation of the Company’s financial statements in conformitywith accounting principles generally accepted in the United States of Americarequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities and disclosure of contingent assets andliabilities as of the date of the financial statements and the reported amountsof revenues and expenses during the reporting periods.  Actual results could differ from thoseestimates.

 

*Cash Equivalents and Marketable Securities*

 

Cash equivalents consist principally of money market funds as well ascorporate bonds and certificates of deposits with original maturities of threemonths or less at the date of purchase. Marketable securities consist of U.S.government agency securities and certificates of deposit.

 

Management determines the appropriate classification of marketablesecurities at the time of purchase and reevaluates such designation at eachbalance sheet date.  Marketablesecurities as of December 31, 2002 are classified as“available-for-sale.” Available-for-sale securities are carried at fair value, with theunrealized gains and losses reported in a separate component of stockholders’equity.  As of December 31, 2002, theCompany has recorded no unrealized gains and losses.  The cost of debt securities in this category is adjusted foramortization of premiums and accretion of discounts to maturity. Suchamortization and accretion is included in interest income.  Realized gains and losses and declines invalue judged to be other-than-temporary on available-for-sale securities areincluded in net income.  The cost ofsecurities sold is based on the specific identification method.  Interest and dividends on securitiesclassified as available-for-sale are included in interest income.

 

46

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*Concentration of Credit Risk*

 

Cash and cash equivalentsare primarily maintained with one financial institution. Deposits with the bankmay exceed the amount of insurance provided on such deposits. Generally, thesedeposits may be redeemed upon demand and, therefore, bear minimal risk.Financial instruments that potentially subject the Company to concentrations ofcredit risk consist principally of marketable securities. Marketable securitiesconsist of U.S. government agency notes and certificates of deposits. TheCompany’s investment policy, approved by the Board of Directors, limits the amountthe Company may invest in any one type of investment, thereby reducing creditrisk concentrations.  The Company’scustomer base is generally concentrated with a small base of customers.  The Company reviews the creditworthiness ofits customers prior to product shipment and generally does not requirecollateral.

 

*Trade Accounts Receivable*

* *

Trade accounts are initially recorded atfair value upon the sale of goods or services to customers.  They are stated net of allowances foruncollectible accounts, which represent estimated losses resulting from theinability of customers to make the required payments.  When determining the allowances for uncollectible accounts,management takes several factors into consideration including the overallcomposition of accounts receivable aging, prior historyof accounts receivablewrite-offs, the type of customer and day-to-day knowledge of specificcustomers.  Changes in the allowancesfor uncollectible accounts are recorded as bad debt expense and are included ingeneral and administrative expense in the statements of operations.

* *

*Property and Equipment*

 

Property and equipment are stated at cost.  Depreciation is computed using the straight-line method over therelated asset’s estimated useful life, generally three to seven years.  Depreciation expense was $895,000, $747,000and $719,000 for each of the years ended December 31, 2002, 2001, and 2000,respectively.  Leasehold improvementsare amortized over the shorter of their estimated useful lives or the remainingterms of the related leases.  The assetcost and related accumulated depreciation or amortization are adjusted forasset retirement or disposal with the resulting gain or loss, if any, creditedor charged to results of operations.

 

*Impairment of Long-Lived Assets*

 

The Companyperiodically reviews the carrying amounts of property and equipment andintangible assets purchased in the normal course of business, to determinewhether current events or circumstances, as defined in Statement of FinancialAccounting Standard No 144, “Accounting for the Impairment or Disposal ofLong-Lived Assets,” warrant adjustments to such carrying amounts.  In reviewing the carrying values of propertyand equipment and intangible assets, the Company considers, among other things,the future cash flows expected from the use of the asset.  The Company reviews its intangible assets purchased in the normalcourse of business and other long-lived assets for impairment whenever an eventor change in circumstances indicates that the carrying value of an asset maynot be recoverable.  If such an event orchange in circumstances occurs and potential impairment is indicated becausethe carrying values exceed the estimated future undiscounted cash flows, theCompany would measure the impairment loss as the amount by which the carryingvalue of the asset exceeds its fair value.

 

*Revenue Recognition*

 

The Company recognizes revenue in accordance with AICPA Statement ofPosition (“SOP”) 97-2, “Software Revenue Recognition,” as amended by SOP 98-4and SOP 98-9, as well as Technical Practice Aids issued from time to time bythe American Institute of Certified Public Accountants.  License fees revenue is derived from thelicensing of computer software. Hardware revenue is derived from the sale of system hardware, includingperipheral equipment.  Maintenance andservice revenue is derived from hardware and software maintenance and fromservices consisting of installation, training and engineering services.

 

In software arrangements that include the rights to multiple softwareproducts, system hardware, specified upgrades, maintenance or services, theCompany allocates the total arrangement fee among each deliverable based on therelative fair value of each of the deliverables determined based onvendor-specific objective evidence. In software arrangements in which theCompany does not have vendor-specific objective evidence, revenue is deferreduntil the earlier of when vendor-specific objective evidence is determined forthe undelivered elements (residual method) or when all elements have beendelivered.

 

Revenue from license fees is recognized when persuasive evidence of anarrangement exists, shipment of the product has occurred, no significantCompany obligations with regard to implementation remain, the fee is fixed anddeterminable and collection is probable. Revenue allocable to maintenance is recognized on a 

 

47

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straight-line basis over the periods in which it is provided.  The Company evaluates arrangements thatinclude services to determine whether those services are essential to thefunctionality of other elements of the arrangement.  Generally, the Company’s services are not considered essential tothe functionality of other elements, and accordingly, revenue allocable toservices is recognized as the services are performed.  In arrangements where the Company is performing significantcustomization or modification of software, service revenue from thearrangements is recognized using contract accounting, generally on apercentage-of-completion basis. Hardware revenue is recognized upon shipment when all other revenuerecognition criteria in the arrangement have been met.

 

*Research and Development Costs*

 

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

 

*Income Taxes*

 

The Company accounts for income taxes using the asset and liabilitymethod.  Deferred income tax assets andliabilities are determined based on differences between financial reporting andtax bases of assets and liabilities and are measured using the enacted taxrates and laws that will be in effect when the differences are expected toreverse.  Valuation allowances areestablished when necessary to reduce deferred tax assets to the amountsexpected to be realized.

 

*Computation of Net Income (Loss) Per Share*

 

Net income (loss) per share - basic is computed using the weightedaverage common shares outstanding during the period.  Net income (loss) per share – diluted is computed using theweighted average common shares outstanding and common share equivalents sharesoutstanding during the period.  Commonshare equivalents are not included in the net income (loss) per sharecalculations if they are anti-dilutive. Common share equivalents consist of warrants and options.

 

48

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

 
|                                                                        |   | **For the  Years Ended December 31,** |       |
|-----------------------------------------------------------------------------|--------|---------------------------------------|------------|
|                                                                        |   | **2002**                              |       | **2001** |   | **2000** |   |
|                                                                        |   |                                  | ** ** |   | ** ** |   | ** ** |
| Numerator:                                                                  |   |                                  |       |   |   |   |   |
| Net income  (loss)                                                          |   | $                                     | 789,508    |   | $ | (1,011,977 | ) | $ | (2,637,231 | ) |
|                                                                        |   |                                  |       |   |   |   |   |
| Denominator:                                                                |   |                                  |       |   |   |   |   |
| Denominator for  weighted average common shares outstanding – basic    |   | 8,861,132                             |       | 7,074,906 |   | 6,760,233 |   |
|                                                                        |   |                                  |       |   |   |   |   |
| Dilution  associated with common stock warrants                             |   | 59,984                                |       | — |   | — |   |
|                                                                        |   |                                  |       |   |   |   |   |
| Dilution  associated with the company’s stock based compensation plans |   | 900,682                               |       | — |   | — |   |
|                                                                        |   |                                  |       |   |   |   |   |
| Denominator:                                                                |   |                                  |       |   |   |   |   |
| Denominator for  weighted average common shares outstanding – diluted  |   | 9,821,798                             |       | 7,074,906 |   | 6,760,233 |   |
|                                                                        |   |                                  |       |   |   |   |   |
| Net income  (loss) per share – basic                                   |   | $                                     | 0.09       |   | $ | (0.14 | ) | $ | (0.39 | ) |
|                                                                        |   |                                  |       |   |   |   |   |
| Net income  (loss) per share – diluted                                 |   | $                                     | 0.08       |   | $ | (0.14 | ) | $ | (0.39 | ) |

 

Options to purchase 81,100 shares in 2002, options and warrants topurchase approximately 2,892,000 shares in 2001 and options and warrants topurchase approximately 3,890,000 shares in 2000 were not included in thecomputation of earnings per share assuming dilution because their effect onearnings per share would have been antidilutive.  The decrease in numberof shares excluded in 2002 is the result of all shares being antidilutive innet loss years, such as 2001 and 2000.

 

*Stock-Based Compensation*

 

The Company has stock-based employee and director compensation plans,which are described more fully in Note 6. The Company accounts for these plansunder the recognition and measurement principles of APB Opinion No. 25, *Accounting for Stock Issued to Employees,*and related Interpretations. No stock-based employee and director compensationcost is reflected in net income (loss), as all options granted under thoseplans had an exercise price equal to the market value of the underlying commonstock on the date of grant. The following table illustrates the effect on netincome (loss) and net income (loss) per share if the Company had applied thefair value recognition provisions of FASB Statement No. 123, *Accounting for Stock-Based Compensation,*to stock-based employee and director compensation.

 

49

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|                                                                                                                                    |        | **For the  Years Ended December 31,** |       |
|-----------------------------------------------------------------------------------------------------------------------------------------|-------------|---------------------------------------|------------|
|                                                                                                                                    |        | **2002**                              |       | **2001** |   | **2000** |   |
|                                                                                                                                    |        |                                  | ** ** |   | ** ** |   | ** ** |
| Net income  (loss), as reported                                                                                                         |        | $                                     | 789,508    |   | $ | (1,011,977 | ) | $ | (2,637,231 | ) |
|                                                                                                                                    |        |                                  |       |   |   |   |   |
| Deduct: Total stock-based employee compensation  expense determined under fair value method for all awards, net of related tax  effects |        | (1,560,508                            | )          | (1,210,023 | ) | (932,769 | ) |
|                                                                                                                                    |        |                                  |       |   |   |   |   |
| Pro forma net  (loss)                                                                                                                   |        | $                                     | (771,000   | ) | $ | (2,222,000 | ) | $ | (3,570,000 | ) |
|                                                                                                                                    |        |                                  |       |   |   |   |   |
| Net income (loss) per share   – basic                                                                                              | As reported |                                  | $          | 0.09 |   | $ | (0.14 | ) | $ | (0.39 | ) |
|                                                                                                                                    | Pro forma   |                                  | $          | (0.09 | ) | $ | (0.31 | ) | $ | (0.53 | ) |
|                                                                                                                                    |        |                                  |       |   |   |   |   |
| Net income (loss) per share   – diluted                                                                                            | As reported |                                  | $          | 0.08 |   | $ | (0.14 |   | $ | (0.39 | ) |
|                                                                                                                                    | Pro forma   |                                  | $          | (0.09 | ) | $ | (0.31 | ) | $ | (0.53 | ) |

 

The proforma effects on the net income (loss) for 2002, 2001, and 2000are not necessarily representative of the pro forma effect that may occur onthe net income (loss) in future periods. 

 

*Recent Accounting Pronouncements*

 

In June 2001, the Financial Accounting Standards Board approvedStatements of Financial Accounting Standards (“SFAS”) No. 141, “BusinessCombinations,” and No. 142, “Goodwill and Other Intangible Assets.” Thestatements eliminate the pooling-of-interests method of accounting for businesscombinations and require that goodwill and certain intangible assets not beamortized.  Instead, these assets willbe reviewed for impairment at least annually with any related losses recognizedwhen incurred.  SFAS No. 141 wasgenerally effective for business combinations completed after June 30,2001.  SFAS No. 142 was adopted by theCompany on January 1, 2002.  Theadoption of SFAS No. 141 and No. 142 had no impact on the Company’s financialposition or results of operations.

 

In October 2001, the Financial Accounting Standards Board issued SFASNo. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.”  This statement addresses financialaccounting and reporting for the impairment of long-lived assets and forlong-lived assets to be disposed of and supersedes SFAS No. 121 and APB OpinionNo. 30.  SFAS No. 144 is effective forthe Company beginning January 1, 2002. The adoption of SFAS No. 144 had no impact on the Company’s financialposition or results of operations.

 

In June 2002, the FASB issued SFAS No. 146, “Accounting for CostsAssociated with Exit or Disposal Activities,” which replaces Emerging IssuesTask Force (EITF) Issue No. 94-3, “Liability Recognition for Certain EmployeeTermination Benefits and Other Costs to Exit an Activity (including CertainCosts Incurred 

 

50

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in a Restructuring).” SFAS No. 146 requires companies to recognizecosts associated with exit or disposal activities when they are incurred ratherthan at the date of a commitment to an exit or disposal plan. SFAS No. 146 iseffective for exit or disposal activities that are initiated after December 31,2002.  The Company will apply thisstandard to exit and disposal activities initiated after December 31, 2002.

 

In December 2002, the FASB issued SFAS No. 148, “Accounting forStock-Based Compensation – Transition Disclosure – an amendment of SFAS No.123.”  This Statement amends SFAS 123,“Accounting for Stock-Based Compensation”, to provide alternative methods oftransition for a voluntary change to the fair value based method of accountingfor stock-based compensation.  Inaddition, SFAS 148 amends the disclosure requirements of SFAS 123 to requireprominent disclosures in both annual and interim financial statements about themethod of accounting for stock-based compensation and the effect of the methodused on reported results.  SFAS 148 iseffective for fiscal years ending after December 15, 2002, and disclosurerequirements are effective for interim periods beginning after December 15,2002.  Disclosures required by SFAS 148are included in the financial statements for the year ended December 31,2002.  The Company will begin making theadditional disclosures required by SFAS 148 in the first quarter of 2003.  The Company intends to continue to accountfor stock-based compensation using the intrinsic value method prescribed by APBOpinion No. 25 and related interpretations. Accordingly, the adoption of SFAS 148 will not impact the Company’sfinancial position or results of operations.

 

In November 2002, the FASB issuedInterpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements forGuarantees, Including Indirect Guarantees of Indebtedness of Others.”  This interpretation elaborates on thedisclosures required in financial statements concerning obligations undercertain guarantees.  It also clarifiesthe requirements related to the recognition of liabilities by a guarantor atthe inception of certain guarantees. The disclosure requirements of this interpretation were effective forthe Company on December 31, 2002 and, accordingly, are reflected in theCompany’s financial statements.  Therecognition provisions of the interpretation are effective for the Company in2003 and are applicable only to guarantees issued or modified after December31, 2002.  The Company does not expectthe adoption of this interpretation to have a material impact on its financialposition or results of operations.

 

In January 2003, the Financial Accounting Standards Board issued FASBInterpretation No. 46, “Consolidation of Variable Interest Entities.” This interpretation addresses the requirements for business enterprisesto consolidate related entities in which they are determined to be the primaryeconomic beneficiary as a result of their variable economic interests. The interpretation is intended to provide guidance in judging multipleeconomic interests in an entity and in determining the primary beneficiary. The interpretation outlines disclosure requirements for VIEs in existenceprior to January 31, 2003, and outlines consolidation requirements for VIEscreated after January 31, 2003.  The Company does not expect the adoption ofthis interpretation to have a material impact on its financial position orresults of operations.

 

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

 

Property and Equipmentconsisted of the following at December 31:

** **
|                                            |   | **2002**   |      | **2001**   |   |
|-------------------------------------------------|--------|------------|-----------|------------|--------|
|                                            |   |       |      |       |   |
| Equipment                                       |   | $          | 4,361,806 |       | $      | 3,262,566 |   |
| Furniture and  fixtures                         |   | 1,034,641  |      | 869,920    |   |
| Computer  software                              |   | 680,190    |      | 540,910    |   |
| Leasehold  improvements                         |   | 172,323    |      | 79,861     |   |
| Total property  and equipment                   |   | 6,248,960  |      | 4,753,257  |   |
| Less accumulated  depreciation and amortization |   | (4,092,125 | )         | (3,201,141 | )      |
| Property and  equipment, net                    |   | $          | 2,156,835 |       | $      | 1,552,116 |   |

 

51

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**(4) Deferred Revenue**

 

Deferred revenue consistsprimarily of service revenue, which is recognized as the services areperformed, and maintenance revenue, which is recognized on a straight-linebasis over the term of the arrangement.

 

**(5) Operating Lease Commitments**

 

The Company leases itsoffice facilities in Plymouth, Minnesota pursuant to terms of a non-cancelableoperating lease, as amended, that expires on July 31, 2005.  Under the terms of the lease, the Company isrequired to pay a portion of the lessor’s operating costs.

 

Total rent expense, includingan allocation of the lessor’s operating costs, was $596,000, $554,000 and$476,000 for the years ended December 31, 2002, 2001 and 2000, respectively.

 

Scheduled minimum lease payments for the next five years areapproximately as follows:

 

| **Year Ending   December 31,** |   |    |      |
|--------------------------------|--------|---------|-----------|
|                           |   |    |      |
| 2003                           |   | $       | 385,000   |   |
| 2004                           |   | 388,000 |      |
| 2005                           |   | 227,000 |      |
| Total                          |   | $       | 1,000,000 |   |

 

**(6) Shareholders’ Equity**

 

*Stock Option Plans*

 

In connection with theDistribution, Bio-Vascular, as the sole shareholder of the Company, approvedand adopted several option plans and stand-alone option grants, which coveredemployees of both Vital Images and Bio-Vascular.  The adopted plans include the Incentive Stock Option AdjustmentPlan, the 1990 Management Incentive Stock Option Plan, the 1992 Director StockOption Adjustment Plan, the 1992 Stock Option Plan, and the 1995 StockIncentive Adjustment Plan (collectively, the “Mirror Plans”).  Each of these plans is intended to mirrorthe provisions of a corresponding Bio-Vascular plan that was in effect at thetime of the Distribution.  As eachBio-Vascular option plan generally provided for the termination of optionsfollowing termination of employment, each of the Mirror Plans, as well as eachof the stand-alone option grants (the “Mirror Grants”), were approved andadopted to provide that the Distribution would not cause a termination of anyVital Images employee for the purposes of such plans or option grant, and thatBio-Vascular options held by Vital Images employees following the Distributionwould remain exercisable following the Distribution, so long as such employeesremain employed by Vital Images or any subsidiary.  Similar provisions were also adopted with respect to Vital Imagesoptions held by Bio-Vascular employees. On the Distribution Date, 608,534 options were issued in connection withthe Mirror Plans and the Mirror Grants (collectively, the “MirrorOptions”).  These options had vestingperiods ranging from less than one year up to four years and terms ranging fromless than one year up to ten years.  Noadditional grants may be made pursuant to any of the Mirror Plans.

 

In May 1997, Bio-Vascular, as the sole shareholder of the Company,approved and adopted the Vital Images, Inc. 1997 Stock Option and IncentivePlan (the “Stock Option Plan”), which became effective on the DistributionDate.  Under the terms of the plan, theBoard of Directors may grant options and other stock-based awards to keyemployees to purchase shares of the Company’s common stock at an optionexercise price equal to or greater than 85% of the fair market value on thedate of grant.  The options areexercisable at such times, in installments or otherwise, as the Board ofDirectors may determine.  Generally,these options are incentive stock options with a term of eight years and areexercisable as to 28% of the total grant one year after 

 

52

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the date of grant and 2% per month thereafter.  In May 2002, the shareholders of the Companyapproved an increase of 500,000 common shares, bringing the total number ofshares of common stock that may be issued or awarded under the Stock OptionPlan to 3,000,000.  As of December 31,2002, there were 901,801 shares available for the grant of awards under theStock Option Plan.

 

Also in May 1997, Bio-Vascular, as the sole shareholder of the Company,approved and adopted the Vital Images, Inc. 1997 Director Stock Option Plan(the “Director Plan”) (together with the Stock Option Plan, the “1997 Plans”),which became effective on the Distribution Date.  The Director Plan provides non-employee directors with automaticgrants of stock options and allows the Board of Directors to make additionaldiscretionary option grants to any or all directors.  Options that are granted under the Director Plan are generallygranted with an option price equal to the fair market value on the date ofgrant, with a term of eight years, are non-qualified options and becomeexercisable in three equal annual installments beginning on the first occurringDecember 31 after the date of grant.  InMay 2002, the shareholders of the Company approved an increase of 90,000 commonshares, bringing the total number of shares of common stock that may be issuedor awarded under the Director Plan to 300,000. As of December 31, 2002, there were 115,000 shares available for thegrant of awards under the Director Plan.

 

Certain non-plan options were granted to certain officers of theCompany in 1998, 1999 and 2002.  InFebruary 1998, the Company reserved and granted 300,000 non-qualified, non-planoptions to an officer of the Company. These non-plan options have a term of eight years, vest over a two yearperiod and were granted at exercise prices at least equal to fair market valueof the Company’s common stock on the date of grant.  In December 1999, 100,000 of these non-plan options werecanceled.  As of December 31, 2002, theremaining 200,000 are still outstanding. In December 1999, the Company granted 175,000 non-qualified, non-planoptions to another officer of the Company. These non-plan options had a term of eight years, were exercisable as to28% of the total grant one year after the date of grant and 2% per monththereafter and were granted at exercise prices at least equal to fair marketvalue of the Company’s common stock on the date of grant.  In February 2002, 80,500 of these non-planoptions were canceled and the remaining 94,500 options were exercised in2002.  In March 2002, the Companygranted an additional 165,000 non-qualified, non-plan options to another officerof the Company.  These non-plan optionshave a term of eight years, are exercisable as to 28% of the total grant oneyear after the date of grant and 2% per month thereafter and were granted atexercise prices at least equal to fair market value of the Company’s commonstock on the date of grant.  As ofDecember 31, 2002, these options are still outstanding.

 

*Non-Employee Options*

 

In December 2000, the Company granted 10,000 options to a non-employeeconsultant.  Options to purchase 5,000shares vest over a four-year period and the remaining options will vestimmediately when a specified milestone is achieved.  In December 2001, the Company granted a total of 4,000 options totwo non-employee consultants and in December 2002, the Company granted another4,000 options to two non-employee consultants. These options vest over a four-year period.  All of the non-plan options have a term of eight years and weregranted at exercise prices at least equal to fair market value of the Company’scommon stock on the date of grant. The Company records compensation expenserelated to these arrangements based upon the fair values of the options duringthe periods the consultants provide services. Such fair values are measuredusing the Black-Scholes option-pricing model. The fair value of these optionswas approximately $98,000 at December 31, 2002. The Company recordedapproximately $18,000, $10,000 and $0 of compensation expense related to theseoptions for each of the years ended December 31, 2002, 2001 and 2000, respectively.

 

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The following table summarizes stock option activity for 2002, 2001 and2000:

 

|                                       |   | **Shares  Under  Option** |   | **Weighted  Average  Exercise Price  Per Share** |   |
|--------------------------------------------|--------|---------------------------|--------|--------------------------------------------------|--------|
|                                       |   |                      |   |                                             |   |
| Total  outstanding as of December 31, 1999 |   | 1,810,910                 |   | $                                                | 3.02   |   |
|                                       |   |                      |   |                                             |   |
| Options granted                            |   | 482,750                   |   | 6.83                                             |   |
| Options  exercised                         |   | (105,650                  | )      | 2.06                                             |   |
| Options canceled                           |   | (111,986                  | )      | 4.56                                             |   |
|                                       |   |                      |   |                                             |   |
| Total  outstanding as of December 31, 2000 |   | 2,076,024                 |   | 3.87                                             |   |
|                                       |   |                      |   |                                             |   |
| Options granted                            |   | 323,250                   |   | 5.43                                             |   |
| Options  exercised                         |   | (50,013                   | )      | 3.07                                             |   |
| Options canceled                           |   | (60,805                   | )      | 4.93                                             |   |
|                                       |   |                      |   |                                             |   |
| Total  outstanding as of December 31, 2001 |   | 2,288,456                 |   | 4.08                                             |   |
|                                       |   |                      |   |                                             |   |
| Options granted                            |   | 677,750                   |   | 7.21                                             |   |
| Options  exercised                         |   | (288,008                  | )      | 3.49                                             |   |
| Options canceled                           |   | (216,354                  | )      | 4.44                                             |   |
|                                       |   |                      |   |                                             |   |
| Total  outstanding as of December 31, 2002 |   | 2,461,844                 |   | $                                                | 4.98   |   |
|                                       |   |                      |   |                                             |   |
| Options  exercisable as of:                |   |                      |   |                                             |   |
|                                       |   |                      |   |                                             |   |
| December 31,  2000                         |   | 1,125,409                 |   | $                                                | 2.87   |   |
| December 31,  2001                         |   | 1,462,761                 |   | $                                                | 3.41   |   |
| December 31,  2002                         |   | 1,505,069                 |   | $                                                | 3.83   |   |

 

Various price ranges and weighted average information for optionsoutstanding and exercisable as of December 31, 2002 are as follows:

** **
|                          |             | **Options  Outstanding**                     |    | **Options  Exercisable**                            |       |
|-------------------------------|------------------|----------------------------------------------|---------|-----------------------------------------------------|------------|
| **Range of  Exercise Prices** |             | **Number   Outstanding as of  Dec 31, 2002** |    | **Weighted  Average   Remaining  Contractual Life** |       | **Weighted  Average Exercise   Price** |   | **Number   Exercisable as of   Dec 31, 2002** |   | **Weighted   Average   Exercise Price** |   |
|                          |             |                                         |    |                                                |       |   |   |   |   |   |   |
| $                             | 1.13 – 2.25 |                                         | 321,405 |                                                | 3.10 years |   | $ | 1.57 |   | 321,405 |   | $ | 1.57 |   |
|                          | 2.31 – 2.75 |                                         | 412,204 |                                                | 2.67 years |   | 2.41 |   | 412,204 |   | 2.41 |   |
|                          | 3.51 – 4.75 |                                         | 462,898 |                                                | 4.19 years |   | 4.60 |   | 412,578 |   | 4.61 |   |
|                          | 5.13 – 7.00 |                                         | 365,717 |                                                | 6.22 years |   | 5.50 |   | 155,717 |   | 5.45 |   |
|                          | 7.25 – 7.25 |                                         | 554,250 |                                                | 7.19 years |   | 7.25 |   | — |   | — |   |
|                          | 7.34 – 9.24 |                                         | 345,370 |                                                | 5.80 years |   | 7.56 |   | 203,165 |   | 7.43 |   |
|                          |             | 2,461,844                                    |    | 5.00 years                                          |       | $ | 4.98 |   | 1,505,069 |   | $ | 3.83 |   |

 

*Employee Stock Purchase Plan*

 

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

 

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substantially all employees, subject to certain limitations.  Each employee may elect to have up to 10% ofhis or her base pay withheld and applied toward the purchase of shares in eachsuch offering.  Purchases under the ESPPfor 2002 were 24,539 shares, generating proceeds to the Company of $130,608 atan average purchase price of $5.32; for 2001, there were 25,487 shares,generating proceeds to the Company of $91,652 at an average purchase price of$3.60; and for 2000, there were 21,589 shares, generating proceeds to theCompany of $85,965 at an average purchase price of $3.99.  As of December 31, 2002, there are 114,448shares of common stock reserved for purchases under the ESPP.

 

*Stock-Based Compensation*

 

For purposes of calculating the fair value recognition provisions ofFASB Statement No. 123, the weighted average fair values of options grantedwere:

 

|                          |   | **For the  Years Ended December 31,** |   |
|-------------------------------|--------|---------------------------------------|--------|
|                          |   | **2002**                              |   | **2001** |   | **2000** |   |
| Options under the 1997  Plans |   | $                                     | 5.03   |   | $ | 4.19 |   | $ | 5.43 |   |
| Options under ESPP            |   | $                                     | 0.94   |   | $ | 0.64 |   | $ | 0.70 |   |
| Non-plan options              |   | $                                     | 5.13   |   | $ | 6.02 |   | $ | 3.66 |   |
|                               |        |                                       |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The weighted average fair values for the 1997 Plans and the non-planoptions were based on the fair values on the dates of grant.  The fair values of options under the ESPPwere based on the 15 percent purchase discount.  The fair values for the 1997 Plans and the non-plan options werecalculated using the Black-Scholes option-pricing model with the followingassumptions:

 

|                        |   | **For the  Years Ended December 31,** |   |
|-----------------------------|--------|---------------------------------------|--------|
|                        |   | **2002**                              |   | **2001** |   | **2000** |   |
| Expected option  life       |   | 5.0                                   | years  | 6.0 | years | 6.0 | years |
| Expected  volatility factor |   | 85.9                                  | %      | 90.8 | % | 92.6 | % |
| Expected  dividend yield    |   | 0                                     | %      | 0 | % | 0 | % |
| Risk-free  interest rate    |   | 4.69                                  | %      | 4.93 | % | 6.40 | % |
|                             |        |                                       |        |  |  |  |  |  |  |  |

 

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

 
|                        |   | **For the  Years Ended December 31,** |        |
|-----------------------------|--------|---------------------------------------|-------------|
|                        |   | **2002**                              |        | **2001** |   | **2000** |   |
| Expected option  life       |   | 8.0                                   |  years | 8.0 |  years | 8.0 |  years |   |
| Expected  volatility factor |   | 85.9                                  | %           | 90.8 | % | 92.6 | % |   |
| Expected  dividend yield    |   | 0                                     | %           | 0 | % | 0 | % |   |
| Risk-free  interest rate    |   | 2.81                                  | %           | 5.00 | % | 5.18 | % |   |
|                             |        |                                       |             |  |  |  |  |  |  |  |  |  |

 

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*Warrants*

 

In December 1999, the Company completed a private placement of1,650,000 units at $3.25 per unit.  Eachunit consisted of one share of the Company’s common stock and a redeemable,five-year warrant to purchase an additional share of common stock at $3.75 pershare.  The warrants were immediatelyexercisable and expired in December 2004. The warrants could be redeemed by the Company at any time beforeDecember 2004 at a redemption price of $.01 per warrant, upon notice of suchredemption, provided that (i) the closing bid price of the Company’s commonstock exceeded $5.75 per share for any thirty consecutive trading days prior tosuch notice and (ii) a registration statement covering the resale of thewarrant shares had been filed by the Company with the Securities and ExchangeCommission and was effective as of the date of such notice. The Companysatisfied the conditions for redemption of the warrants as of December 7, 2000.In December 2001, the Company called for redemption of all outstandingwarrants.  As of December 31, 2002,1,650,000 warrants had been exercised, generating proceeds of approximately$1,719,000 and $4,468,000 during 2002 and 2001, respectively.

 

The Company also issued warrants to the underwriter in the December1999 private placement to purchase 163,651 share of the Company's common stockat $3.25 per share. The warrants were immediately exercisable and expire inDecember 2004. During 2002 and 2001, 42,492 and 18,940, respectively, of thesewarrants were exercised and converted to 44,017 shares of common stock. Thesewarrant exercises generated approximately $6,000 and $22,000 for the yearsended December 31, 2002 and 2001, respectively. In conjunction with theseexercises during 2002 and 2001, 12,559 and 4,856 shares, respectively, wereforfeited as part of cashless exercises. As of December 31, 2002, 102,219 ofthe warrants remained outstanding.

 

*Rights Plan*

 

In April 1997, theCompany declared a dividend distribution of one Preferred Stock Purchase Rightfor each outstanding share of the Company’s common stock (the “Rights”).  With certain exceptions, the Rights become exercisableonly in the event that (i) an acquiring party accumulates 15% or more of theCompany’s common stock, (ii) a party announces an offer to acquire 15% or moreof the Company’s common stock, or (iii) the acquisition of a substantial amountof the Company’s common stock by a person whom the Board of Directors hasdetermined is an Adverse Person as defined in the underlying RightsAgreement.  Each Right entitles theholder to purchase one-thousandth of a share of the Company’s Series A JuniorPreferred Stock at a price of $20.00 (the “Exercise Price”).  If a person or group becomes the beneficialowner of 15% or more of the Company’s common stock or the Board of Directorsdetermines that a person is an Adverse Person, each holder of a Right shallthereafter have the right to receive preferred stock having a fair market valueequal to two times the Exercise Price. Upon the occurrence of certain mergers, combinations or acquisitions ofthe Company’s assets, each holder of a Right shall thereafter have the right toreceive that number of shares of common stock of the acquiring company whichequals the Exercise Price of the Right divided by one-half of the currentmarket price of such common stock as of the date of the occurrence of theevent.  The Company is generallyentitled to redeem the Right at $.001 per Right at any time until ten daysfollowing the acquisition of 15% or more of the Company’s common stock or tendays after the point at which the Company’s Board of Directors determines thata person is an Adverse Person, as defined by the Rights Agreement.  The Rights expire on April 30, 2007, if notpreviously redeemed or exercised.

 

**(7) Income Taxes**

 

The income tax provision for each of the periodspresented represents state minimum taxes. As of December 31, 2002, the Company had net operating losscarryforwards of approximately $17,100,000 for federal income tax reportingpurposes and unused research and development credits of approximately $995,000,which expire in varying amounts from 2004 to 2022.  For financial reporting purposes, the Company has established avaluation allowance to completely reserve for the Company’s deferred taxasset.  This allowance was establishedbased upon management's conclusion that realization of this benefit is not presentlymore likely than not.  To the extentthat future operating results indicate that realization of this benefit is,more likely than not, management would reverse some or all of this valuationallowance which would result in an income tax 

 

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benefit.  Theutilization of these carryforwards may be subject to limitations based onfuture changes in ownership of the Company, pursuant to Section 382 of theInternal Revenue Code (the “Code”).

 

As a result of Bio-Vascular’s acquisition of the Company in May 1994,the Company experienced an ownership change as defined by Section 382 of theCode.  Under the Code, the amount ofpre-acquisition net operating loss carryforwards and research and developmentcredits that can be used to offset future taxable income and income taxes willbe limited.  As of the date of theCompany’s acquisition by Bio-Vascular, the Company had approximately $1,600,000of net operating loss carryforwards and approximately $137,000 of research andexperimentation credits, both of which will be subject to limitation under theCode.

 

The significant components of the Company’s tax-effected net deferredtax asset, based on an assumed effective tax rate of 40%, are:

 
|                                               |   | **December 31,** |      |
|----------------------------------------------------|--------|------------------|-----------|
|                                               |   | **2002**         |      | **2001** |   |
| Net operating loss  carryforwards                  |   | $                | 6,830,000 |   | $ | 6,920,000 |   |
| Research and development tax credit carryforwards  |   | 995,000          |      | 809,000 |   |
| Deferred compensation                              |   | 230,000          |      | 230,000 |   |
| Depreciation                                       |   | 322,000          |      | 284,000 |   |
| Other, net                                         |   | 221,000          |      | 197,000 |   |
| Net deferred tax assets before valuation allowance |   | 8,598,000        |      | 8,440,000 |   |
| Less valuation allowance                           |   | (8,598,000       | )         | (8,440,000 | ) |
| Net deferred tax asset                             |   | $                | —    |   | $ | — |   |

 

A reconciliation of income tax provision (benefit) computed using thefederal statutory rate to the tax provision reported in the Company'sstatements of operations is as follows:

 
|                                                          |   | **For the Years Ended December 31** |
|---------------------------------------------------------------|--------|-------------------------------------|
|                                                          |   | **2002**                            |   | **2001** |   | **2000** |
| Tax provision  (benefit) computed at the federal statory rate |   | $                                   | 276,000 |   | $ | (340,000) |   | $ | (893,000) |   |
| State taxes, net  of federal benefit                          |   | 24,000                              |   | (52,000) |   | (162,000) |
| Increase  (decrease) in tax from:                             |   |                                |   |   |   |   |
| Research and  development tax credits                         |   | (186,000)                           |   | (147,000) |   | (120,000) |
| Business meals  and entertainment                             |   | 26,000                              |   | 20,000 |   | 20,000 |
| Change in  valuation allowance (1)                            |   | (111,000)                           |   | 545,000 |   | 1,135,000 |
| Other, net                                                    |   | (7,000)                             |   | (14,000) |   | 32,000 |
| Privision for income taxes                                    |   | $                                   | 22,000 |   | $ | 12,000 |   | $ | 12,000 |   |
|                                                               |        |                                     |  |  |  |  |  |  |  |  |  |  |

 

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(1)           Excludes $269,000,$21,000 and $91,000 of valuation allowance established in 2002, 2001, and 2000,respectively, relating to certain stock option exercises that did not generatean income tax benefit for financial reporting purposes.

 

**(8)Major Customers and Geographic Data**

 

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

 
|                          |   | **Significant  Customer**                     |   | **Revenue** |      | **Percentage  of  Total Revenue** |   |
|-------------------------------|--------|-----------------------------------------------|--------|-------------|-----------|-----------------------------------|--------|
| Year ended December 31,  2002 |   | Toshiba Corporation,  Medical Systems Company |   | $           | 7,246,000 |                              | 34     | % |
| Year ended December 31, 2001  |   | Toshiba Corporation,  Medical Systems Company |   | $           | 4,163,000 |                              | 27     | % |
| Year ended December 31, 2000  |   | Toshiba Corporation,  Medical Systems Company |   | $           | 2,819,000 |                              | 27     | % |

 

The Company’s accounts receivable are generally concentrated with asmall base of customers.  As of December31, 2002, there was one customer accounting for 21% of accounts receivable,while as of December 31, 2001, there was one customer accounting for 18% ofaccounts receivable.

 

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

 

Export revenue accounted for 10%, 8% and 7% of total revenue for theyears ended December 31, 2002, 2001 and 2000, respectively.  Substantially all of the Company’s exportsales are negotiated, invoiced and paid in U.S. dollars.

 

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Export sales by geographic area are summarized as follows:

 
|           |   | **For the Years Ended December 31,** |      |
|----------------|--------|--------------------------------------|-----------|
|           |   | **2002**                             |      | **2001** |   | **2000** |   |
|           |   |                                 |      |   |   |   |   |
| Europe         |   | $                                    | 1,094,000 |   | $ | 706,000 |   | $ | 389,000 |   |
| Asia-Pacific   |   | 709,000                              |      | 300,000 |   | 195,000 |   |
| Canada         |   | 161,000                              |      | 207,000 |   | 26,000 |   |
| Latin  America |   | 11,000                               |      | 14,000 |   | 108,000 |   |
| Other          |   | 38,000                               |      | — |   | 36,000 |   |
|           |   | $                                    | 2,013,000 |   | $ | 1,227,000 |   | $ | 754,000 |   |

 

**(9)Employee Benefit Plan**

 

The Company maintains the Vital Images, Inc. Salary Savings Plan (the“Plan”), which is intended to qualify under Section 401(k) of the InternalRevenue Code, as amended.  The Plancovers substantially all employees. Each employee may elect to contribute to the Plan through payrolldeductions of up to 25% of his or her salary, subject to certainlimitations.  At the discretion of theBoard of Directors, the Company may make matching contributions equal to apercentage of the salary reduction contributions or other discretionaryamounts.  There were no contributions tothe Plan by the Company in 2002, 2001 and 2000.

 

**(10)Licensed Technology**

 

In July 2001, the Company entered into an agreement to licensetechnology from a third party.  TheCompany paid an aggregate of $750,000 to the licensor in 2001.  The Company recorded this $750,000 purchaseas licensed technology and is amortizing it over the estimated useful life ofthe technology of 75 months.  As part ofthis agreement, the Company is also obligated to pay the licensor royalties onthe sales of certain products as defined in the agreement.  During 2002 and 2001, $608,000 and $211,000,respectively, of such royalties were incurred and were reported as cost ofrevenue for license fees.

 

**(11)Development Agreements**

 

In November 2001, the Company entered into a development and licenseagreement with Surgical Navigation Technologies, Inc., a division of Medtronic,Inc. (“MSNT”), to integrate certain Company technology into MSNT’s image-guidedsurgery products and to develop products and services for surgical planningwhich will be marketed and sold through MSNT. The Company received $400,000 upon execution of the agreement, which isincluded in deferred revenue in the current liabilities section of the balancesheet as of December 31, 2001.  During2002, the Company completed all services required under this agreement andrecognized the entire $400,000 as service revenue using the percentage ofcompletion method.

 

In 2001, the Company entered into an agreement with E-Z-EM, Inc.  Under the agreement, the Company developed asingle application CT Colonography product called InnerviewGITM, which ismarketed and sold through E-Z-EM, Inc. During 2001, the Company recorded service revenue totaling $348,000under this agreement.  In addition,E-Z-EM, Inc. purchased 82,332 shares of newly issued common stock of VitalImages, Inc. for approximately $552,000 cash.

 

**(12) Purchase Commitments**

 

In November 2002, the Company entered into an agreement with R2Technology, Inc. (“R2”) to distribute R2’s lung nodule CAD software product(“lung CAD Product”) in conjunction with the Company’s products.  Upon the later of either the date on which R2is able to meet CE certification requirements and produce a “Declaration ofConformance” for the lung CAD product or the completion of the milestones inthe development plan with respect to the lung CAD product that will bedistributed in Europe, the Company is required to begin purchasing the lung CADproduct over the next three years.  Thetotal purchase commitment will be up to a maximum of $5.6 million worth ofproduct over the three-year commitment period subject to adjustment based uponchanges in product selling prices.

 

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** **

**(13) Quarterly Financial Data(Unaudited)**

 

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

 
|                                                |   | **First   Quarter** |      | **Second   Quarter** |   | **Third   Quarter** |   | **Fourth   Quarter** |      |
|-----------------------------------------------------|--------|---------------------|-----------|----------------------|--------|---------------------|--------|----------------------|-----------|
|                                                |   |                |      |                 |   |                |   |                 |      |
| **2002:**                                           |   |                |      |                 |   |                |   |                 |      |
| Total revenue                                       |   | $                   | 4,443,000 |                 | $      | 4,874,000           |   | $                    | 5,593,000 |   | $ | 6,206,000 |   |
| Gross margin                                        |   | 3,477,000           |      | 3,757,000            |   | 4,511,000           |   | 4,919,000            |      |
| Net income  (loss)                                  |   | (247,000            | )         | 201,000              |   | 419,000             |   | 417,000              |      |
| Earnings (loss)  per share – basic             |   | (0.03               | )         | 0.02                 |   | 0.05                |   | 0.05                 |      |
| Earnings (loss)  per share – diluted           |   | (0.03               | )         | 0.02                 |   | 0.04                |   | 0.04                 |      |
|                                                |   |                |      |                 |   |                |   |                 |      |
| **2001:**                                           |   |                |      |                 |   |                |   |                 |      |
| Total revenue                                       |   | $                   | 3,331,000 |                 | $      | 3,682,000           |   | $                    | 3,633,000 |   | $ | 4,550,000 |   |
| Gross margin                                        |   | 2,529,000           |      | 2,769,000            |   | 2,899,000           |   | 3,689,000            |      |
| Net income  (loss)                                  |   | (622,000            | )         | (402,000             | )      | (132,000            | )      | 144,000              |      |
| Earnings (loss)  per share – basic and diluted |   | (0.09               | )         | (0.06                | )      | (0.02               | )      | 0.02                 |      |

 

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**SCHEDULEII**

 

VITAL IMAGES, INC.

VALUATION AND QUALIFYING ACCOUNTS

 
| **Description**                   |   | **Balance as    of   Beginning   of Period** |    | **Charges   to   Cost and   Expenses** |   | **Deductions/  Write-Offs** |   | **Balance   as of End   of Period** |    |
|-----------------------------------|--------|----------------------------------------------|---------|----------------------------------------|--------|-----------------------------|--------|-------------------------------------|---------|
|                              |   |                                         |    |                                   |   |                        |   |                                |    |
| Allowance for  doubtful accounts: |   |                                         |    |                                   |   |                        |   |                                |    |
|                              |   |                                         |    |                                   |   |                        |   |                                |    |
| Year ended  December 31, 2002     |   | $                                            | 185,000 |                                   | $      | 64,000                      |   | $                                   | 9,000   |   | $ | 240,000 |   |
|                              |   |                                         |    |                                   |   |                        |   |                                |    |
| Year ended  December 31, 2001     |   | $                                            | 215,000 |                                   | $      | 114,000                     |   | $                                   | 144,000 |   | $ | 185,000 |   |
|                              |   |                                         |    |                                   |   |                        |   |                                |    |
| Year ended  December 31, 2000     |   | $                                            | 93,000  |                                   | $      | 122,000                     |   | $                                   | —  |   | $ | 215,000 |   |

 

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**VITAL IMAGES, 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 (File No. 0-22229)).                                                                                                                                            |
|         |   |                                                                                                                                                                                                                                                                                                         |
| 3.2          |   | By-laws of the Company (incorporated by reference to  Exhibit 3.2 to the Company’s registration statement on Form 10 (File No.  0-22229)).                                                                                                                                                              |
|         |   |                                                                                                                                                                                                                                                                                                         |
| 4.1          |   | Form of common stock Certificate of the Company  (incorporated by reference to Exhibit 4.3 to the Company’s registration  statement on Form 10 (File No. 0-22229)).                                                                                                                                     |
|         |   |                                                                                                                                                                                                                                                                                                         |
| 4.2          |   | Rights Agreement, dated effective as of May 1, 1997  between the Company and American Stock Transfer and Trust Company, which  includes as Exhibit B the form of Rights Certificate (incorporated by  reference to Exhibit 4.4 to the Company’s registration statement on Form 10  (File No. 0-22229)). |
|         |   |                                                                                                                                                                                                                                                                                                         |
| 4.3          |   | Certificate of Designation, Preferences and Rights  of Series A Junior Preferred Stock of the Company (incorporated by reference  to Exhibit 4.5 to the Company’s registration statement on Form 10 (File No.  0-22229)).                                                                               |
|         |   |                                                                                                                                                                                                                                                                                                         |
| 10.1         |   | Form of Distribution Agreement, effective as of May  2, 1997 between Bio-Vascular, Inc. and the Company (incorporated by reference  to Exhibit 10.1 to the Company’s registration statement on Form 10 (File No.  0-22229)).                                                                            |
|         |   |                                                                                                                                                                                                                                                                                                         |
| 10.2         |   | Form of Employee Benefits Agreement, effective as of  May 2, 1997, between Bio-Vascular, Inc. and the Company** (incorporated by  reference to Exhibit 10.2 to the Company’s registration statement on Form 10  (File No. 0-22229)).                                                                    |
|         |   |                                                                                                                                                                                                                                                                                                         |
| 10.3         |   | Form of Tax Sharing Agreement, effective as of May  2, 1997, between Bio-Vascular, Inc. and the Company (incorporated by  reference to Exhibit 10.3 to the Company’s registration statement on Form 10  (File No. 0-22229)).                                                                            |
|         |   |                                                                                                                                                                                                                                                                                                         |
| 10.4         |   | Form of Transition Services Agreement, effective as  of May 2, 1997 between Bio-Vascular, Inc. and the Company (incorporated by  reference to Exhibit 10.4 to the Company’s registration statement on Form 10  (File No. 0-22229)).                                                                     |

 

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| 10.5   |   | Incentive Stock Option Adjustment Plan**  (incorporated by reference to Exhibit 10.5 to the Company’s registration  statement on Form 10 (File No. 0-22229)).                                                                                               |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                             |
| 10.6   |   | 1990 Stock Option Plan** (incorporated by reference  to Exhibit 10.6 to the Company’s registration statement on Form 10 (File No.  0-22229)).                                                                                                               |
|   |   |                                                                                                                                                                                                                                                             |
| 10.7   |   | 1992 Stock Option Plan** (incorporated by reference  to Exhibit 10.7 to the Company’s registration statement on Form 10 (File No.  0-22229)).                                                                                                               |
|   |   |                                                                                                                                                                                                                                                             |
| 10.8   |   | 1992 Director Stock Option Adjustment Plan**  (incorporated by reference to Exhibit 10.8 to the Company’s registration  statement on Form 10 (File No. 0-22229)).                                                                                           |
|   |   |                                                                                                                                                                                                                                                             |
| 10.9   |   | 1995 Stock Incentive Adjustment Plan** (incorporated  by reference to Exhibit 10.9 to the Company’s registration statement on Form  10 (File No. 0-22229)).                                                                                                 |
|   |   |                                                                                                                                                                                                                                                             |
| 10.10  |   | Employee Stock Purchase Plan** (incorporated by  reference to Exhibit 10.10 to the Company’s registration statement on Form 10  (File No. 0-22229)).                                                                                                        |
|   |   |                                                                                                                                                                                                                                                             |
| 10.11  |   | 1997 Stock Option and Incentive Plan** (incorporated  by reference to Exhibit 10.11 to the Company’s registration statement on Form  10 (File No. 0-22229)).                                                                                                |
|   |   |                                                                                                                                                                                                                                                             |
| 10.12  |   | 1997 Director Stock Option Plan** (incorporated by  reference to Exhibit 10.12 to the Company’s registration statement on Form 10  (File No. 0-22229)).                                                                                                     |
|   |   |                                                                                                                                                                                                                                                             |
| 10.17  |   | Joint Development Agreement dated August 14, 1996  between the Company and ATL Ultrasound, Inc.* (incorporated by reference to  Exhibit 10.18 to the Company’s registration statement on Form 10 (File No.  0-22229)).                                      |
|   |   |                                                                                                                                                                                                                                                             |
| 10.18  |   | Sales and Marketing Agreement dated August 14, 1996  between the Company and ATL Ultrasound, Inc.* (incorporated by reference to  Exhibit 10.19 to the Company’s registration statement on Form 10 (File No.  0-22229)).                                    |
|   |   |                                                                                                                                                                                                                                                             |
| 10.19  |   | Software License Agreement dated August 1, 1997  between the Company and Duke University (incorporated by reference to Exhibit  10.20 to the Company’s Annual Report on Form 10-K for the year ended December  31, 1997 (File No. 0-22229)).                |
|   |   |                                                                                                                                                                                                                                                             |
| 10.22  |   | Non-qualified Stock Option  Agreement dated February 24, 1998 between the Company and Douglas M. Pihl**  (incorporated by reference to Exhibit 10.23 to the Company’s Annual Report on  Form 10-K for the year ended December 31, 1997 (File No. 0-22229)). |

 

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| 10.26  |   | Lease agreement dated  October 19, 1999 between St. Paul Properties, Inc. and the Company  (incorporated by reference to Exhibit 10.27 to the Company’s Form 10-Q for  the quarter ended September 30, 1999 (File No. 0-22229)).                                                                                    |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                     |
| 10.27  |   | Vital Images, Inc. and  Toshiba America Medical Systems, Inc. Reseller Agreement * (incorporated by  reference to Exhibit 10.27 to the Company’s Form 10-Q for the quarter ended  September 30, 2000 (File No. 0-22229)).                                                                                           |
|   |   |                                                                                                                                                                                                                                                                                                                     |
| 10.28  |   | Employment Agreement dated  December 27, 1999 between the Company and Albert Emola** (incorporated by  reference to Exhibit 10.28 to the Company’s Annual Report on Form 10-K for  the year ended December 31, 2000 (File No. 0-22229)).                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                     |
| 10.29  |   | Non-qualified Stock Option  Agreement dated December 28, 1999 between the Company and Albert Emola**  (incorporated by reference to Exhibit 10.29 to the Company’s Annual Report on  Form 10-K for the year ended December 31, 2000 (File No. 0-22229)).                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                     |
| 10.30  |   | Form of Change in Control  Agreement between the Company and Albert Emola and Gregory S. Furness**  (incorporated by reference to Exhibit 10.30 to the Company’s Annual Report on  Form 10-K for the year ended December 31, 2000 (File No. 0-22229)).                                                              |
|   |   |                                                                                                                                                                                                                                                                                                                     |
| 10.31  |   | Form of Change in Control  Agreement between the Company and Vincent J. Argiro, Ph.D., Steven P.  Canakes, David M. Frazee, Jay D. Miller and Robert C. Samec** (incorporated  by reference to Exhibit 10.31 to the Company’s Annual Report on Form 10-K for  the year ended December 31, 2000 (File No. 0-22229)). |
|   |   |                                                                                                                                                                                                                                                                                                                     |
| 10.32  |   | Technology License  Agreement between PointDX, Inc. and Vital Images, Inc.* (incorporated by  reference to Exhibit 10.32 to the Company’s Form 10-Q for the quarter ended  September 30, 2001 (File No. 0-22229)).                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                                                                     |
| 10.33  |   | Development, Supply,  Marketing and Distribution Agreement between Vital Images, Inc. and E-Z—EM,  Inc.* (incorporated by reference to Exhibit 10.33 to the Company’s Form 10-Q  for the quarter ended September 30, 2001 (File No. 0-22229)).                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                     |
| 10.34  |   | Development and License  Agreement between Vital Images, Inc. and Surgical Navigation Technologies,  Inc. (incorporated by reference to Exhibit 10.34 to the Company’s Annual  Report on Form 10-K for the year ended December 31, 2001 (File No. 0-22229)).                                                        |

 

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| 10.35  |   | Marketing and Distribution  Agreement between Vital Images, Inc. and Toshiba Corporation, Medical Systems  Company * (incorporated by reference to Exhibit 10.35 to the Company’s Form  10-Q for the quarter ended March 31, 2002 (File No. 0-22229)). |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                        |
| 10.36  |   | Severance Agreement dated  February 9, 2002 between the Company and Albert Emola (incorporated by  reference to Exhibit 10.36 to the Company’s Form 10-Q for the quarter ended  March 31, 2002** (File No. 0-22229)).                                  |
|   |   |                                                                                                                                                                                                                                                        |
| 10.37  |   | Amendment No. 1 to  Marketing and Distribution Agreement between Vital Images, Inc. and Toshiba  Corporation, Medical Systems Company (filed herewith electronically)  (Confidential treatment has been requested for portions of this exhibit).            |
|   |   |                                                                                                                                                                                                                                                        |
| 10.38  |   | Product Distribution  Agreement between Vital Images, Inc. and R2 Technology, Inc. (filed herewith  electronically) (Confidential treatment has been requested for portions of  this exhibit).                                                              |
|   |   |                                                                                                                                                                                                                                                        |
| 10.39  |   | Employment Agreement dated  February 9, 2002 between the Company and Jay D. Miller** (filed herewith  electronically).                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                        |
| 10.40  |   | Form of Change in Control  Agreement between the Company and Jay D. Miller** (filed herewith  electronically).                                                                                                                                              |
|   |   |                                                                                                                                                                                                                                                        |
| 10.41  |   | Non-qualified Stock Option  Agreement dated December 28, 2002 between the Company and Jay D. Miller**  (filed herewith electronically).                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                        |
| 23.1   |   | Consent of  PricewaterhouseCoopers LLP (filed herewith electronically).                                                                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                        |
| 99.1   |   | Certification Pursuant to  18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002 (filed herewith electronically).                                                                                                   |
|   |   |                                                                                                                                                                                                                                                        |
| 99.2   |   | Certification Pursuant to  18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002 (filed herewith electronically).                                                                                                   |

 

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

 

** Indicates a management contract or compensatory plan or arrangement.

 

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