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

**WASHINGTON, D.C. 20549**

 

**FORM 10-K**

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

 

**For the fiscal year ended December 31, 2009**

 

**OR**

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

 

**For the transition period from          to         **

 

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

 

**VitalImages, Inc.**

(Exact name of registrant as specified in its charter)

 

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

 

| **5850  Opus Parkway, Suite 300**    | ** ** | ** **     |
|-------------------------------------------|------------|----------------|
| **Minnetonka,  MN 55343-4414**            | ** ** | **55343-4414** |
| (Address of principal  executive offices) |       | (Zip Code)     |

 

**(952)487-9500**

(Registrant’stelephone number, including area code)

 

Securities registeredpursuant to Section 12(b) of the Act:

 

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

 

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

 

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

 

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

 

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

 

Indicate by check mark whether the registrant hassubmitted electronically and posted on its corporate Web site, if any, everyInteractive Data File required to be submitted and posted pursuant to Rule 405of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months(or for such shorter period that the registrant was required to submit and postsuch files).  Yes  o    No  o

 

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

 

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

 

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

 

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

 

As of June 30, 2009, the last day of the registrant’smost recently completed second fiscal quarter, the aggregate market value ofthe registrant’s common stock held by non-affiliates of the registrant was$161,839,241. The common stock is the registrant’s only class of votingstock.

 

Thenumber of shares outstanding of the issuer’s class of common stock as of March 9,2010 was 14,425,889 shares.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portionsof registrant’s definitive Proxy Statement in connection with the AnnualMeeting of Stockholders to be held May 11, 2010 (“2010 Proxy Statement”)are incorporated by reference into Part III of this Form 10-K, asindicated in Items 10 through 14 of Part III.

 

 

 

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Vital Images, Inc.

 

Form 10-K

 

Table of Contents

 
| Part I   |
|---------------|
|          |   |   |   |
| Item 1.       | Business |   | 2 |
| Item 1A.      | Risk Factors |   | 7 |
| Item 1B.      | Unresolved Staff  Comments |   | 16 |
| Item 2.       | Properties |   | 16 |
| Item 3.       | Legal Proceedings |   | 16 |
| Item 4.       | Reserved |   | 16 |
|          |   |   |   |
| Part II  |
|          |   |   |   |
| Item 5.       | Market for  Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases  of Equity Securities |   | 17 |
| Item 6.       | Selected  Financial Data (in thousands, except per share data) |   | 19 |
| Item 7.       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |   | 20 |
| Item 7A.      | Quantitative  and Qualitative Disclosures about Market Risk |   | 31 |
| Item 8.       | Financial  Statements and Supplementary Data |   | 32 |
| Item 9.       | Changes in and  Disagreements with Accountants on Accounting and Financial Disclosure |   | 32 |
| Item 9A.      | Controls and  Procedures |   | 32 |
| Item 9B.      | Other Information |   | 33 |
|          |   |   |   |
| Part III |
|          |   |   |   |
| Item 10.      | Directors,  Executive Officers and Corporate Governance |   | 34 |
| Item 11.      | Executive  Compensation |   | 34 |
| Item 12.      | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters |   | 34 |
| Item 13.      | Certain  Relationships and Related Transactions, and Director Independence |   | 34 |
| Item 14.      | Principal  Accountant Fees and Services |   | 34 |
|          |   |   |   |
| Part IV  |
|          |   |   |   |
| Item 15.      | Exhibits and  Financial Statement Schedules |   | 35 |
|          |   |   |
| Signatures    |   | 36 |

 

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**Part I**

 

**Cautionary Statement RegardingForward-Looking Information**

 

*Vital Images desires to takeadvantage of the “safe harbor” provisions of the Private Securities LitigationReform Act of 1995 (the “Reform Act”) and is filing this cautionarystatement in connection with the Reform Act. This Annual Report on Form 10-Kand any other written or oral statements made by us or on our behalfmay include forward-looking statements that reflect our current views withrespect to future events and future financial performance.**Certain statements inthis Annual Report on Form 10-K are “forward-looking statements”**within the meaning of Section 27(a) ofthe Securities Act of 1933 and Section 21E of the Securities Exchange Actof 1934. You can identify these forward-looking statements by our use of thewords “believes,” “anticipates,” “forecasts,” “projects,” “could,” “plans,” “expects,”“may,” “will,” “would,” “intends,” “estimates” and similar expressions, whetherin the negative or affirmative.**We wish to caution you that any forward-lookingstatements made by us or on our behalf are subject to uncertainties and otherfactors that could cause such statements to be wrong.**Wecannot guarantee that we actually will achieve these plans, intentions orexpectations. Actual results or events could differ materially from the plans,intentions and expectations disclosed in the forward-looking statements that wemake.These statementsare only predictions and speak only of our views as of the date the statementswere made. Although we believe that the expectations reflected in theforward-looking statements are reasonable, we cannot guarantee future results,levels of activity, and/or performance of achievements. We do not assume anyobligation to update or revise any forward-looking statements that we make,whether as a result of new information, future events or otherwise.*

 

*Factors that may impact forward-looking statementsinclude, among others,**our abilities to maintain the technologicalcompetitiveness of our current products, develop new products, successfullymarket our products, respond to competitive developments, develop and maintainpartnerships with providers of complementary technologies, manage our costs andthe challenges that may come with growth of our business, and attract andretain qualified sales, technical and management employees. We are alsoaffected by the growth and regulation of the medical technology industry, includingthe acceptance of advanced visualization by hospitals, clinics, anduniversities, product clearances and approvals by the United States Food andDrug Administration and similar regulatory bodies outside the United States,and reimbursement and regulatory practices by Medicare, Medicaid, and privatethird-party payer organizations. We are also affected by other factorsidentified in our filings with the Securities and Exchange Commission, some ofwhich are set forth in the section entitled “Item 1A. Risk Factors” inthis Annual Report on Form 10-K (and many of which we have discussed inprior filings). Although we have attempted to list comprehensively theseimportant factors, we also wish to caution investors that other factorsmay prove to be important in the future in affecting our operatingresults. New factors emerge from time to time, and it is not possible for us topredict all of these factors, nor can we assess the impact each factor orcombination of factors may have on our business.*

** **

**Item 1. Business**

** **

#### **OurBusiness**

#### ** **

Vital Images, Inc. (“VitalImages,” “we,” “us,” or “our”) is a leading provider of advanced visualizationand image analysis solutions for use by medical professionals in clinicalanalysis and therapy planning for medical conditions. We provide software,customer education, software maintenance and support, professional servicesand, on occasion, third-party hardware to our customers. Our technology rapidlytransforms complex data generated by diagnostic imaging equipment into functionaldigital images that can be manipulated and analyzed using our specializedapplications to better understand internal anatomy and pathology. Our solutionsare designed to improve physician workflow and productivity, enhance theability to make clinical decisions, facilitate less invasive patient care, andcomplement often significant capital investments in diagnostic imagingequipment made by our customers. Our software is compatible with equipment fromall major manufacturers of diagnostic imaging equipment, such as computedtomography (“CT”) scanners, and can be integrated into picture archive andcommunication systems (“PACS”). Many hospitals use PACS to acquire, distributeand archive medical images and diagnostic reports, reducing the need for film andincreasing reliance on advanced visualization solutions such as ours. We alsooffer a Web-based solution that provides physicians with anywhere, anytimeaccess to medical images and visualization tools through any Internet-enabledcomputer.

 

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We were founded andincorporated in Iowa in September 1988, and we re-incorporated inMinnesota in March 1997. Our principal executive offices are located at5850 Opus Parkway, Suite 300, Minnetonka, MN 55343 (telephone (952)487-9500, facsimile (952) 487-9510, e-mail — info@vitalimages.com ). From May 24,1994 through May 11, 1997, we were a wholly-owned subsidiary of Bio-Vascular, Inc.,which is now known as Synovis Life Technologies, Inc.

 

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

 

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

 

#### **Productsand Services**

#### ** **

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

 

Our products initiallywere used by radiologists on dedicated workstations to interpret data generatedby scanning equipment. Our main product for this type of use was and remains *Vitrea®.*Over time, other medical specialists, primarilycardiologists, began to use advanced visualization software on dedicatedworkstations. As additional types of specialists began desiring access to thebenefits provided by advanced visualization tools, we began to integrate ourproducts onto workstations connected to PACS and to offer a server-basedadvanced visualization solution called *ViTALConnect®.*

 

In 2008, we furtherexpanded access to our advanced visualization products throughout the entiretyof the hospital enterprise with our introduction, at that time, of *Vital Enterprise*.  Ourenterprise offerings expand the relevance of our advanced visualization optionsproducts beyond the radiology department to referring physicians and surgicalspecialists, particularly in the areas of cardiology, cardiovascular, oncology,neurology and gastroenterology. Our current enterprise offering is called *Vitrea Enterprise Suite,* which combines all of ourproprietary advanced visualization tools into one offering, and may include ourproprietary back-end data management software, *Vital ImageManagement System*. *Vitrea Enterprise Suite *canbe used by every medical professional that practices with our customer’senterprise. Both our enterprise and workstation products also serve as anintegration platform for applications offered by our visualization technologypartners.

 

Our products work withequipment from all major manufacturers of diagnostic imaging systems, includingToshiba Medical Systems Corporation (“Toshiba”), GE Healthcare (“GE”), SiemensMedical Systems, Inc. (“Siemens”) and Philips Medical Systems (“Philips”).Our products may also be integrated into PACS, such as those marketed by 

 

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McKesson Corporation (“McKesson”)and Sectra AB (“Sectra”), and run on off-the-shelf third-party computerhardware.

 

In addition to softwareproducts and installation services, we provide maintenance and supportservices, as well as certain other services, such as professional consultingservices and customer education. We offer maintenance and support services forour software solutions pursuant to which we provide error correction, softwareenhancements, updates and upgrades, telephone support and other general supportservices. We provide customer education services for our customers, both inconnection with their acquisition of our software and as independent purchases.We conduct customer education programs for our software at our headquarters inMinnetonka, Minnesota, at customers’ locations and at various designatedlocations through the United States.

 

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

 

#### **Marketingand Distribution**

#### ** **

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

 

Our marketing partnersinclude Toshiba, which markets our software to**its customers through its subsidiaries and distributors worldwide.Our agreement with Toshiba commenced in 2001, and it has been extended multipletimes, most recently through December 31, 2013. The Marketing andDistribution Agreement, which was entered into by Toshiba and us on November 21,2008, is a typical reseller or distributor agreement, under which Toshibaresells our imaging products in connection with its sales of its own scannerequipment. Under the Marketing and Distribution Agreement, Toshiba markets andresells our products to its customers. Our sales team may provide assistance toToshiba in its sales efforts, in a similar manner to how our sales team providesassistance to our other resellers, and we provide back-up technical support forproblems that Toshiba cannot resolve. The Marketing and Distribution Agreementensures a minimum amount of purchases from us by Toshiba. Because purchases byToshiba have exceeded their commitments, these minimum purchase obligationshave not been triggered to date, nor do we have reason to expect theseprovisions to be triggered in the future. Sales through Toshiba are a materialportion of our revenues, comprising approximately 54% of our 2009 revenues, 52%of our 2008 revenues and 47% of our 2007 revenues.

 

We also have marketingand reseller agreements with several other companies, such as McKesson, Sectraand Cerner Corp., under which these companies may resell our products to theircustomers as add-on components to their products.

 

#### **GeographicInformation**

#### ** **

Our export sales andlong-lived assets by significant geographic areas are presented in Note 10 ofthe Consolidated Financial Statements in our 2009 Annual Report on Form 10-K,listed in Item 15(a)(1) of the Form 10-K.

 

#### **Researchand Development**

#### ** **

#### **Our research and development activities are focused on the development ofnew products and on improvements to existing products. Research and developmentexpense was $16.3 million, $20.3 million and $18.5 million for the years ended December 31,2009, 2008 and 2007, respectively.**

#### ** **

In addition to ourMarketing and Distribution Agreement with Toshiba, noted above, we also haveentered into a Technology Development Agreement, which became effective on January 8,2009 and calls for development of 

 

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software or clinicalapplications by us under Product Development Plans, as such term is defined inthe Technology Development Agreement. Each Product Development Plan isseparately entered into between Toshiba and us and discusses the key featuresof the project, including the product to be developed, development milestones,and the amount and timing of funding to be provided by Toshiba for thedevelopment effort. Upon completion of the project, we can sell the productthat is developed both through Toshiba and, after a 180-day exclusivity period,through our direct sales force, although the exclusivity period may be waivedfor certain projects. We dedicate a specific number of our personnelexclusively to each project that is funded by Toshiba. The TechnologyDevelopment Agreement currently will terminate six months following the end ofall active Product Development Plans, although it may renew upon writtenagreement by Toshiba and us. If at any time no projects are ongoing during theterm of the Technology Development Agreement, Toshiba will continue to providefunding to us at the rates set forth in the Agreement for up to six months forany of our personnel who are assigned to and actively engaged on projectsrelated to errors reported in any project software that was previouslyreleased. In addition, Toshiba will also continue to provide funding for thededicated project personnel for up to six months during the term, if no projectis ongoing, or for up to six months after the term, to assist us to coverreallocation and/or termination costs. Funding received by us under theTechnology Development Agreement is accounted for as an offset to research anddevelopment expense. We recognized a credit to research and developmentexpenses of $1.1 million under the Technology Development Agreement in 2009.

 

#### **Competition**

#### ** **

The advancedvisualization market is highly competitive, subject to rapid change and issignificantly affected by new product introductions and other market activitiesof industry participants. Our products compete based on a multitude of factors,including quality, performance, functionality, clinical features, quality ofsupport and service, reputation, brand and price. Our primary competitors arediagnostic imaging system suppliers, which are typically large, multinationalcompanies with far greater financial and technical resources. They also havewell-established sales and distribution networks for their products. Thesecompanies, including GE, Siemens, and Philips, develop and market medicalimaging systems, such as CT and MR equipment, which may be purchased withintegrated medical imaging capabilities. Our software works on the productsoffered by each of these companies. To win business against equipmentmanufacturers, we must convince customers to buy our solution separately from theirpurchase of imaging equipment instead of buying integrated systems from ourcompetitors or we must persuade them that introducing our enterprise productthroughout their hospitals will provide them with unique benefits not providedby our competitors.

 

We also face competitionfrom PACS vendors and other suppliers of medical imaging systems and software.PACS companies sometimes provide medical imaging capability in addition totheir image archiving and networking products. Some of the diagnostic equipmentmanufacturers, including GE and Philips, also offer PACS that comprise a largeshare of the PACS market. Vendors of hospital, clinical and radiologyinformation systems have also diversified into the PACS and medical imagingproduct lines, either through internal development or business development andpartnership channels. These companies, which may be large or small,attempt to offer an integrated system covering a full range of administrative,clinical and radiology information management capabilities to healthcareproviders. Other suppliers of medical imaging systems and software, such asTeraRecon, Inc., compete on the basis of volume rendering or othervisualization technologies, specific applications or market niches. We areseeing additional competitors enter our market, but have yet to see thesecompetitors attain a meaningful share of the market.

 

#### **IntellectualProperty**

#### ** **

We rely primarily on acombination of trade secret and copyright law, employee and third-partynondisclosure agreements and other protective measures to protect intellectualproperty rights pertaining to our products and technologies. We do not own allof the software and other technologies used in our products, but we believe wehave the necessary licenses from third parties to use that technology in ourcurrent products. It may be necessary to renegotiate with such thirdparties for any new versions of current products or any new products. Suchthird-party licenses may not be available on reasonable terms, or at all.

 

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#### **GovernmentalRegulation**

#### ** **

As medical devices, oursoftware solutions are subject to extensive and rigorous regulation by numerousgovernmental authorities, principally the U.S. Food and Drug Administration (“FDA”)and corresponding foreign agencies. In the United States, the FDA administersthe Federal Food, Drug, and Cosmetic Act, its amendments (the “FD&C Act”)and its related regulations. The FD&C Act and these regulations classifymedical devices as Class I, II or III devices, which are subject togeneral controls, special controls or pre-market approval requirements,respectively. Most Class I and II devices, as well as some Class IIIdevices, can be cleared for marketing pursuant to a 510(k) pre-marketnotification. The process of obtaining a 510(k) clearance typically cantake several months to a year or longer.

 

Class III devicesgenerally require more stringent clinical investigation and pre-marketclearance requirements. In such cases, the FDA will require that themanufacturer submit a pre-market approval (“PMA”) application that must bereviewed and approved by the FDA prior to the sale and marketing of the devicein the United States. The process of obtaining a PMA can be expensive,uncertain and lengthy, frequently requiring anywhere from one to several yearsfrom the date of FDA submission, if approval is obtained at all. Moreover, aPMA, if granted, may include significant limitations on the indicated usesfor which a product may be marketed.

 

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

 

There can be no assurancethat future FDA review processes will not involve delays or that clearanceswill be granted on a timely basis. In recent years, the FDA has increased itslevel of scrutiny of medical devices involving software, which requires us toproduce additional documentation about the safety and effectiveness of ourdevices in order to obtain regulatory clearance, and which can lengthen thetime required to obtain such clearance. Further, if any of our current or future products become classified as Class IIIdevices, they could be subject to an even more expensive, uncertain and lengthyapproval process, and approval, if granted, could include significantlimitations on the indicated uses for which a product may be marketed.

 

We are also subject toregulation in foreign countries in which we sell our products. Many of theregulations applicable to our products in such countries are similar to thoseof the FDA, but the regulations in several countries, particularly in Asia, maybe more particular than those of the FDA, and significantly greater time andresources may be required to obtain approval in those countries. Our ability tosuccessfully market and sell our products in foreign markets depends in largepart on our ability to comply with such foreign regulatory requirements.Our products have been Conformité Europeene (“CE”) marked, indicatingconformance with applicable sections of the Medical Device Directive 93/42/EEC,as amended by 2007/47/EC, which allows the products to be marketed in themember countries of the European Communities.

 

We are also subject toperiodic inspections by the FDA and similar foreign regulatory agencies, whoseprimary purpose is to audit our compliance with quality system regulationsestablished by the FDA and other applicable government standards. Regulatoryaction may be initiated in response to audit deficiencies or productperformance problems. We believe that our manufacturing and quality controlprocedures comply with all applicable requirements of the FDA and foreign regulatoryagencies in countries in which we sell our products. We have received andmaintain ISO 13485: 2007 Certification.

 

Medicare and Medicaidlaws and regulations may impact the financial arrangements through whichwe market, sell and distribute our products and services to patients who areMedicare or Medicaid beneficiaries. Violations of these laws and regulationsmay result in civil and criminal penalties, including substantial finesand imprisonment. In a number of states, the scope of these laws andregulations has been extended to include the provision of services or productsto all patients, regardless of the source of payment, although there isvariation from state to state as to the exact provisions of such laws orregulations. In other states, and on a national level, several health carereform initiatives have been proposed which would have a similar impact.We believe that our operations and our marketing, sales and distributionpractices currently comply with all current applicable fraud and abuse andphysician anti-referral laws and regulations.

 

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#### **Employees**

#### ** **

As of December 31,2009, we had 246 full-time employees, with 87 involved in research anddevelopment, 70 in sales and marketing, 51 in technical support functions and38 in administrative functions. We believe our relationship with our employeesis good.

 

## **Item1A.         Risk Factors**

## ** **

The discussion of ourbusiness and operations included in this annual report on Form 10-K shouldbe read together with the risk factors set forth below. They describe variousrisks and uncertainties to which we are or may become subject. These risks anduncertainties, together with other factors described elsewhere in this report,have the potential to affect our business, financial condition, results ofoperations, cash flows, strategies or prospects in a material and adversemanner. New risks may emerge at any time, and we cannot predict those risks orestimate the extent to which they may affect financial performance. Each of therisks described below could adversely impact the value of our securities. Thesestatements, like all statements in this report, speak only as of the date ofthis report (unless another date is indicated), and we undertake no obligationto update or revise the statements in light of future developments.

 

*We offer only one line ofproducts, which is advanced visualization software, related services andhardware, and if our products do not continue to gain market acceptance, ourfinancial results would be adversely affected.*

* *

Our current marketsuccess depends on our ability to successfully market advanced visualizationsoftware for clinical use, and on the ability and willingness of physicians touse enterprise-wide advanced visualization medical imaging software in clinicalanalysis and therapy planning. Our enterprise-wide advanced visualizationsoftware products are alternatives to the conventional methods traditionallyused for viewing medical images in the clinical setting. Often, a purchase by acustomer of our products means that it has chosen not to utilize software thatwas provided in connection with the customer’s purchase of a scanner, which meansthat the customer may pay additional amounts to obtain our products.  The acceptance of our products by physiciansand other clinicians will depend on our ability to educate those users as tothe speed, ease-of-use and other benefits offered by our products and systems,as well as our timely introduction of new features and functions. There can beno assurance that users will prefer advanced visualization and analysissoftware solutions over less expensive 2D medical imaging software or that wewill succeed in our efforts to further develop, commercialize and achievemarket acceptance for our products or for any other product in the clinicalsetting.  If our single line of productsdoes not continue to gain market acceptance, our financial results will beadversely affected.

 

*A substantial portion ofour revenue is derived from sales of our software in connection with customerpurchases of computer tomography, or CT, scanners, and any decline in thepurchase of CT scanners or any difficulty we have in growing sales separatelyfrom sales of CT scanners could have a material adverse effect on our resultsof operations and financial condition.*

* *

Our business historicallywas tied to sales of our advanced visualization products on a workstationbasis, which were typically purchased concurrently with a customer’s purchaseof CT imaging equipment. The market for CT imaging equipment was downsignificantly in 2009 and is not expected to recover to its past levels withinthe foreseeable future.  In order to improve the marketability of ourproducts separately from sales of CT imaging equipment, during 2008, we evolvedour products and business model into sales throughout a customer’s enterprise.We have sold our enterprise-wide advanced visualization products through ourdirect sales channel since then and began to grow sales of it through ourreseller channel during 2009.  However,there can be no assurance that sales of our enterprise-wide advancedvisualization product through our reseller channel will not remain dependentupon the CT sales cycle, or that such products will be sold by our resellers atthe same level as they previously sold our advanced visualization products on aworkstation.

 

*We presently depend onToshiba for a significant portion of our total revenues. A reduction in thebusiness from Toshiba could adversely affect our revenues and could seriouslyharm our business.*

* *

One of our principaldistribution channels is to sell our medical imaging software in connectionwith medical imaging equipment sold by Toshiba. Sales to Toshiba accounted for54% of our total revenue for the year ended December 31, 2009, 52% of ourtotal revenue for the year ended December 31, 2008 and 47% of our totalrevenue 

 

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for the year ended December 31,2007. Toshiba’s accounts receivable represented 36% of our accounts receivableat December 31, 2009 and 42% at December 31, 2008. Except for ouragreement with Toshiba, we have no significant purchase commitments from any ofour customers or business partners, and we generally make sales pursuant toindividual transactions. Our joint distribution agreement with Toshibacommenced in 2001 and has been extended multiple times, most recently through December 31,2013. However, Toshiba does have the ability to conduct in-house development ofadvanced visualization capabilities for all Toshiba modalities which could leadto a reduction in Toshiba’s need for our products in the future. A reduction,delay, or cancellation of orders from Toshiba, or our inability to collectaccounts receivable from Toshiba, likely would have a material adverse effecton our financial condition and operating results.

 

*We operate in a singleindustry and are therefore dependent upon payer reimbursement rates and marketdemand for advanced visualization products and services. If reimbursement ratesdecline or if our market does not grow as we expect, our business, results ofoperations and financial condition will be adversely affected.*

* *

State and federalgovernmental agencies and private payers are putting pressure on reimbursementrates for advanced visualization examinations, which can negatively affectdemand for our products. Many of the major hospitals and medical researchcenters within the United States have already purchased scanners, PACS andadvanced visualization technologies, causing future sales to be upgrades orreplacements instead of new installations, potentially lengthening the salescycles as customers feel less urgency to purchase and implement new systems.

 

Given the uncertaintiesassociated with the developing stage of many of the geographic and medicalspecialty markets that we believe represent growth opportunities, there can beno assurance that they will develop in the manner we anticipate or that theywill not require a level of investment greater than we expect. Additionally,some of our customers finance their acquisitions through third-party lenders. With the unpredictability of credit availability in the lending market, somecustomers who would otherwise purchase our products may not be able to obtainsufficient financing and therefore will not complete their purchases.  Accordingly, there can be no assurance thatthe advanced visualization industry will provide growth opportunities for usand our software products or that our business strategies will be successful asthe industry continues to evolve. Ultimately, if the advanced visualizationindustry fails to develop as we expect, our business, results of operations andfinancial condition will be materially and adversely affected.

 

*Most of our products areused with CT scanning equipment, and are therefore dependent upon the amount ofuse of CT equipment. If usage of CT equipment is reduced, our business, resultsof operations and financial condition will be adversely affected.*

* *

Most of our products areused with CT scanning equipment, which uses ionizing radiation to generateimages of the body.  Recently, media andregulatory concern has been directed at the dosage of radiation that may begiven to a patient undergoing a CT scan. The optimal radiation dose is “no more or less than what is necessary toproduce a high-quality image,” according to a recent FDA white paper.  If the current concern results in a reductionin market demand for CT scans, it is likely that the demand for our productscould also be reduced.  Unless we aresuccessful in developing significant usage for our products other than inconnection with CT image data, if the CT equipment manufacturers are unable todevelop scanners that produce meaningful data at lower doses of radiation or weare unable to develop software that provides useful images based on the lowerdosage levels, our financial results could be adversely affected.  Further, recent healthcare regulatory reformseeks to increase the percentage of time of utilization for each scanner thatis used in the United States. Utilization reform, while increasing usage of existing scanners, couldreduce demand for future scanner purchases, and reduced demand for scannerpurchases could materially and adversely affect our business, results ofoperations and financial condition.

 

*We participate in ahighly competitive industry. If we fail to compete effectively, our results ofoperations and financial condition would be adversely affected.*

* *

We face intensecompetition in the advanced visualization industry. We expect technology tocontinue to develop rapidly, and our success will depend to a large extent onour ability to maintain a competitive position with our products. Ourcompetitors in the advanced visualization industry include large, establishedmanufacturers of CT and MR imaging equipment. Companies such as GE, Siemens andPhilips typically offer their own advanced visualization software andworkstations as part of their integrated imaging and scanner systems. Oursoftware works 

 

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on the products offeredby each of these companies. To win business against equipment manufacturers, wemust convince customers to buy our software solutions separately from theirpurchase of imaging equipment instead of buying integrated systems from ourcompetitors.

 

In addition to having acompetitive advantage in marketing advanced visualization tools as anintegrated part of their imaging products, many of our competitors havesignificantly greater capital and staffing resources for research anddevelopment, more recognizable brand names, and more well-established marketingand distribution networks. Although price has been less significant than otherfactors, increasing competition may result in price reductions and reducedgross margins. Additionally, we face competition from other entities, such asPACS vendors and developers of competitive or ancillary software packages. Theadvanced visualization market is characterized by rapid innovation and technologicalchange. For example, as scanners become faster and generate increasingly moreslices, our software must maintain its capability to handle the increased datavolumes generated by such scanners. We may devote time and resources to developproducts that do not obtain market acceptance or for which the market is muchsmaller than we expected when we planned the products. Products developed byour competitors may render our products obsolete or non-competitive. Similarly,our competitors may succeed in developing or marketing products that are viewedas providing superior clinical performance, enterprise access and performance,or are less expensive than our current or future products.

 

As a result, we may notbe able to compete effectively with such manufacturers or competing entities oneach or any particular factor, including price, features and service.

 

*As our products areaccessed by additional medical professionals throughout an enterprise, thesatisfaction of our customers may decrease.*

* *

Historically, ourproducts were used by radiologists who received education on the use of imagingproducts in medical school and continuing education programs and to whom weprovided training in connection with their purchases. For radiologists, use ofmedical imaging products is a relatively routine activity. As our products areused by additional medical professionals throughout an enterprise, they will beused by persons with less training and familiarity with imagingtechnologies.  Occasional and less-trained users of imaging technology mayfind use of our products to be more difficult than do radiologists, which couldincrease our time and expenses supporting these users, thus negativelyaffecting our gross margins for support services. Further, these users mayrealize less satisfaction than do our historical customers, negativelyaffecting the adoption of our products elsewhere in the enterprise. Finally,occasional and less-trained users are more likely to use our productsincorrectly. Although our products are intended to be secondary analyticaldevices, their incorrect use could result in errors by medical professionals intheir treatment of patients, lowering their satisfaction with our products andpotentially exposing us to legal and regulatory liability, which could affectour results of operations and ability to market our products.

 

*We may make futureacquisitions, which may be difficult to integrate, divert management resources,result in unanticipated costs or dilute our shareholders.*

* *

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

 

·                  we may have difficulty integrating thepurchased operations, technologies or products;

·                  we may incur substantial unanticipatedintegration costs;

·                  assimilating the acquired businesses maydivert significant management attention and financial resources from our otheroperations and could disrupt our ongoing business;

·                  acquisitions could result in the loss ofkey employees, particularly those of the acquired operations;

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

·                  acquisitions could adversely affect ourexisting business relationships with suppliers and customers;

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

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

 

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

 

*We sell our productsinternationally and are subject to various risks relating to such internationalactivities, which could harm our international sales and profitability.*

* *

During the years ended December 31,2009, 2008 and 2007, 34%, 29% and 19% of our total revenues, respectively, wereattributable to international sales. Toshiba has been the primary source of ourinternational sales. We are also developing direct international sales andmarketing efforts. By doing business in international markets, we are exposedto risks separate and distinct from those we face in our domestic operations.Our international business may be adversely affected by changing economicconditions in foreign countries. Because most of our sales are currentlydenominated in U.S. dollars, if the value of the U.S. dollar increases relativeto foreign currencies, our products could become more costly to theinternational consumer and therefore less competitive in international markets,which could adversely affect our profitability. Furthermore, the percentage ofsales denominated in non-U.S. currencies may increase in the future, in whichcase fluctuations in exchange rates could affect demand for our products.

 

Most of our business inmarkets outside the United States is provided through third parties with whomwe have marketing agreements. There can be no assurance that these thirdparties will wish to continue our relationships on an indefinite basis or underthe same terms as the business is currently conducted. Further, although wehave developed direct relationships with customers in markets outside theUnited States, we may not be successful in doing so at a sufficient level. Theloss of or adverse changes in our relationships with our third-party businesspartners, and our failure to establish sufficient direct relationships withcustomers outside the United States, would have a material adverse impact onour business, financial condition and results of operations.

 

Engaging ininternational business inherently involves a number of other difficulties andrisks, including:

 

·                  export restrictions and controls relatingto technology;

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

·                  pricing pressure that we may experience internationally;

·                  required compliance with existing and newforeign regulatory requirements and laws;

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

·                  laws and business practices favoringlocal companies;

·                  longer payment cycles;

·                  difficulties in enforcing agreements andcollecting receivables through foreign legal systems;

·                  political and economic instability;

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

·                  international terrorism and anti-Americansentiment;

·                  difficulties and costs of staffing andmanaging foreign operations;

·                  changes in currency exchange rates; and

·                  difficulties in enforcing intellectualproperty rights.

 

Our exposure to each ofthese risks may lower our revenues, increase our costs, lengthen our salescycle and require significant management attention. We cannot assure you thatone or more of these factors will not harm our business.

 

*If our internal controlover financial reporting is found to be inadequate, our financial results maynot be accurate, raising concerns for investors and potentially adverselyaffecting our stock price.*

* *

Under Section 404 ofthe Sarbanes-Oxley Act of 2002, we are required to evaluate and determine theeffectiveness of our internal controls over financial reporting. We havededicated a significant amount of time and resources to

 

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ensure compliance withthis legislation in recent years and will continue to do so for future periods.We may encounter problems or delays in completing the evaluation, theimplementation of improvements, and the receipt of a positive attestation, orany attestation at all, from our independent registered public accounting firm.In addition, our assessment of our internal controls may identifydeficiencies that need to be addressed in our internal controls over financialreporting or other matters that may raise concerns for investors as to theaccuracy of our reported financial results and adversely affect our stockprice.

 

*We may experiencefluctuations in operating results, which may result in volatility in the priceof our common stock.*

* *

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

 

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

·                  the size and number of licensetransactions can vary significantly;

·                  our dependence on Toshiba or any othermajor customer for a significant portion of our revenues;

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

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

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

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

·                  the number, timing and significance ofsoftware product enhancements and new software product announcements by us orour competitors;

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

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

 

*We are subject togovernment regulation of our products, which can result in additional costs orrestrict our ability to market our products.*

* *

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

 

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enhancements. Inaddition, the FDA, which is currently under political pressure regarding ahandful of products that it cleared over the past few years, including someproducts that are used for medical imaging, is reviewing the process by whichit grants clearance to products.  Severalof the potential changes could make the process to obtain regulatory clearancemore difficult, lengthy and expensive.  Amore difficult and expensive regulatory clearance process, in addition topotentially causing us to defer or choose not to conduct promising areas ofresearch and development, would by itself slow the time by which products forpatient care reach market and could materially and adversely affect ourbusiness and results of operations. Further, these changes could affect our products as well as the scanningequipment that produce the data from which our products produce images.  If the process becomes more difficult andexpensive, medical device manufacturers, including scanning and imaging companies,could increase prices to compensate for the additional risks and costs.  Increased prices could further reduce demandfor our products, which would materially and adversely affect our business,results of operations and financial condition.

 

Even if we obtainregulatory clearances and approvals to market a product from the FDA, theseapprovals may entail limitations on the indicated uses of the product. Productclearances and approvals by the FDA can also be withdrawn due to failure tocomply with regulatory standards or the occurrence of unforeseen problemsfollowing initial approval. The FDA could also limit or prevent thedistribution of our products and has the power to require the recall of suchproducts. FDA regulations depend heavily on administrative interpretation, andfuture interpretations made by the FDA or other regulatory bodies may adverselyaffect us. The FDA may inspect our facilities and operations to determinewhether we are in compliance with various regulations relating tospecification, development, documentation, validation, testing, quality controland product labeling. If the FDA determines that we are in violation of suchregulations, it could impose civil penalties, including fines, recall or seizeproducts and, in extreme cases, impose criminal sanctions.  If we determine that our facilities,operations or products are not in compliance with FDA requirements, we mayvoluntarily suspend our operations or recall products.

 

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

 

*The imposition ofrequirements under the Health Insurance Portability and Accountability Act of1996, or HIPAA, could adversely affect our business.*

* *

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

 

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*We are subject to variousfederal and state “fraud and abuse” laws, and if we are unable to fully complywith such laws, we could face substantial penalties, which may adversely affectour business.*

* *

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

 

·                  the federal Anti-Kickback Statute, whichprohibits persons from knowingly and willfully soliciting, offering, receivingor providing remuneration, directly or indirectly, in cash or in kind, toinduce either the referral of an individual, or furnishing or arranging for agood or service, for which payment may be made under federal health care programs(such as Medicare and Medicaid);

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

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

·                  state law equivalents to these federallaws, which may not be limited to government reimbursed items, and may notcontain identical exceptions.

 

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

 

*The protection of ourintellectual property may be uncertain, and we may face possible claims ofothers.*

* *

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

 

*We face the risk ofproduct liability claims, and our product liability and errors and omissionsinsurance coverage may not be adequate to pay products liability claims, whichcould have a material adverse effect on our financial condition.*

* *

Our business exposes usto the risk of product liability claims that is inherent in the manufacturingand marketing of medical devices, including those which may arise from themisuse or malfunction of, or design flaws in, our products. We may be subjectto product liability claims if our products cause, or merely appear to havecaused, an injury. Claims may be made by patients, healthcare providers orothers selling our products. Our product liability 

 

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and errors and omissionsinsurance is subject to deductibles and coverage limitations. Our currentproduct liability insurance may not continue to be available to us onacceptable terms, if at all, and, if available, the coverages may not beadequate to protect us against any future product liability claims. Further, ifadditional products are approved for marketing, we may seek additionalinsurance coverage. If we are unable to obtain insurance at an acceptable costor on acceptable terms with adequate coverages or otherwise protect againstpotential product liability claims, we will be exposed to significantliabilities, which may harm our business. A product liability claim, recall orother claim with respect to uninsured liabilities or for amounts in excess ofinsured liabilities could result in significant costs and damage to ourreputation and future results, any of which would cause significant harm to ourbusiness.

 

*If we fail to attract andretain qualified personnel, our business would be harmed.*

* *

Recruiting and retainingtalented personnel is critical to our success. There is intense competitionfrom other companies, research and academic institutions, government entitiesand other organizations for qualified personnel in the areas of our activities.We are located in Minnesota, but compete with companies nationally foremployees, particularly those with unique skill sets, and not all potentialemployees view moving to Minnesota favorably. Further, the pace of change in our industry is rapid, and to keep pacewe need to ensure that our existing employees continually upgrade theirknowledge and skills.  If we fail toidentify, attract, retain and motivate these highly skilled personnel, we maybe unable to continue our marketing and development activities and mayexperience interruptions or delays in the execution of our overall businessstrategy.

 

*We depend on third-partyreimbursement. A reduction or other change in reimbursement from third partiescould negatively affect our business.*

* *

Our products arepurchased by hospitals, clinics, imaging centers and other users, which billvarious third-party payers, such as government health programs, private healthinsurance plans, managed care organizations and other similar programs, for thehealthcare goods and services provided to their patients. There are currentlyCurrent Procedural Terminology, or CPT, reimbursement codes that describe mostof the diagnostic procedures that use our products. However, the amount ofreimbursement from third-party payers varies by site of service and geographiclocation and is subject to change. Payers may deny reimbursement if theydetermine that a product used in a procedure was not used in accordance withestablished payer protocol regarding cost-effective treatment methods or wasused for an unapproved indication. Third-party payers are increasinglychallenging the prices charged for medical services and, in some instances,have put pressure on service providers to lower their prices or reduce theirservices. We are unable to predict what changes will be made in thereimbursement methods used by third-party healthcare payers. Third-party payersmay not consider as cost effective the procedures in which our products areused. Reimbursement for such procedures may not be available or, if available,payers’ low reimbursement levels may adversely affect our ability to sell ourproducts on a profitable basis. In addition, there have been and may continueto be changes and proposals by legislators, regulators and third-party payersto curb further these costs in the future. For example, the Deficit ReductionAct of 2005, or the DRA, which was signed into law on February 8, 2006,imposed caps on Medicare payment rates for certain imaging services, includingMR and PET, furnished in physicians’ offices and other non-hospital basedsettings. Under the caps, payments for specified imaging services cannot exceedthe hospital outpatient payment rates for these services. Enactment of the DRAappeared to significantly affect one segment of our customer base, the standaloneimaging center, and also appeared to reduce demand for imaging products amongother segments of our customer base.  Afailure by hospitals and other users of our products to obtain reimbursementfrom third-party payers, changes in third-party payers’ policies towardreimbursement for procedures using our products, or legislative action couldhave a material adverse effect on our business, financial condition and resultsof operations.

 

*Healthcare reform maynegatively impact our business.*

* *

The levels of revenue andprofitability of medical technology companies may be affected by the efforts ofgovernment and third-party payers to contain or reduce the costs of healthcarethrough various means. In the United States, there has been, and we expect thatthere will continue to be, a number of federal, state and private proposals tocontrol healthcare costs. These proposals include legislative, regulatory andother initiatives and may contain measures intended to control public andprivate spending on healthcare as well as to provide universal public access tothe healthcare system. If enacted, these proposals may result in a substantialrestructuring of the healthcare delivery system. For example, the CongressionalBudget Office has issued a report suggesting that radiology benefit managerscould require pre-authorization, which could decrease the demand for imagingservices. Further, proposals during 2009 included a tax that would be assessedagainst medical device companies.  Ifsuch a tax is enacted at 

 

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rates discussed atvarious times, the amount we would owe could be a significant portion of ourcash flows from operations.  Significantchanges in the nation’s healthcare system could have a substantial impact onthe manner in which we conduct business and could have a material adverseeffect on our business, financial condition and results of operations.

 

*Consolidation in thehealthcare industry could lead to demands for price concessions or limit oreliminate our ability to sell to certain of our significant market segments.*

* *

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

 

*We may incur goodwillimpairment charges that adversely affect our operating results.*

* *

We review goodwill forimpairment annually and more frequently if events and circumstances indicatethat the asset may be impaired and that the carrying value may not berecoverable. We operate as one reporting unit and therefore compare our bookvalue to our market value (consisting of market capitalization plus a controlpremium of 25%). If the market value exceeds the book value, goodwill isgenerally considered not to be impaired.

 

*Failure of the global economyto recover from the recent downturn, or an extended delay in this recovery, mayadversely impact our ability to improve our financial results and grow ourbusiness.*

* *

We have been affected bythe general decline in the global economy, which resulted in contracted capitalspending by hospitals and lower interest rates on our cash and investments.Disruptions in the financial markets and the related economic downturn alsonegatively impacted customer purchasing and payment patterns.  Failure of the global economy to recover fromthis prolonged downturn, or an extended delay in this recovery, may have amaterial adverse effect on our financial condition and results of operations.

 

*We may issue shares ofpreferred stock without the consent of our holders of common stock, which couldadversely affect the rights of the holders of our common stock.*

* *

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

 

*We are subject to certainlaws and plans which may discourage takeover attempts that could be beneficialfor shareholders.*

* *

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

 

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*We have never paid anycash dividends and this practice is expected to continue which meansappreciation in our stock price will be our shareholders’ only opportunity toachieve a return on their investment in our common stock.*

* *

We have not paid cashdividends on our common stock in the past, and we do not intend to do so in theforeseeable future. Consequently, appreciation in the market price of ourcommon stock and the ability to sell shares at a profit represents ourshareholders’ only opportunity to achieve a return on their investment.

 

**Item 1B.        Unresolved Staff Comments**

 

None.

 

**Item 2.           Properties**

 

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

 

**Item 3.           Legal Proceedings**

 

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

 

**Item 4.           Reserved**

 

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**Part II**

 

**Item 5.****                              ****Market for Registrant’s CommonEquity, Related Stockholder Matters and Issuer Purchases of Equity Securities**

 

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

 
| ** **     | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------|------------|----------|------------|---------|------------|
| 2009           |       |     |       |    |       |
| Fourth Quarter |       | $        | 13.18      |    | $          | 11.35 |   |
| Third Quarter  |       | $        | 13.75      |    | $          | 10.19 |   |
| Second Quarter |       | $        | 12.25      |    | $          | 9.64 |   |
| First Quarter  |       | $        | 14.29      |    | $          | 8.54 |   |
|           |       |     |       |    |       |
| 2008           |       |     |       |    |       |
| Fourth Quarter |       | $        | 15.24      |    | $          | 10.23 |   |
| Third Quarter  |       | $        | 16.95      |    | $          | 11.86 |   |
| Second Quarter |       | $        | 17.13      |    | $          | 12.43 |   |
| First Quarter  |       | $        | 18.72      |    | $          | 13.89 |   |

 

We have never paid ordeclared any cash dividends on our common stock and do not intend to paydividends on our common stock in the foreseeable future. We expect to retainour future anticipated earnings to finance development and expansion of ourbusiness. As of February 28, 2010, there were approximately 5,900beneficial owners and approximately 500 registered holders of record of ourcommon stock.

 

On May 8, 2008, we announced a share repurchase program of up to$25.0 million of our common stock. On August 7, 2008, we announced additional repurchases of up to $15.0million of our common stock. On March 3, 2009, we announced additionalrepurchases of up to 1.0 million shares of our common stock. As of December 31,2009, we had purchased 3.3 millionshares of our common stock for $44.3 million through only open markettransactions. The active share repurchase program expires on March 1,2011.

 

The followingtable presents information with respect to purchases of our common stock madeduring the quarter ended December 31, 2009 by us or our “affiliatedpurchaser,” as defined in Rule 10b-18(a)(3) under the SecuritiesExchange Act of 1934.

 
| **Period**                | ** ** | **Total Number  of Shares  Purchased** | ** ** | **Average  Price Paid  per Share** | ** ** | **Total Number of  Shares Purchased as  Part of Publicly  Announced Plans or  Programs** | ** ** | **Maximum Number of  Shares that May Yet Be  Purchased Under the  Plans or Programs** | ** ** |
|---------------------------|------------|----------------------------------------|------------|-----------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------|------------|
| October 1-31,  2009  |       | —                                 |       | N/A                                     |       | —                                                                                                                           |       | 587,608                                                                                                                                 |       |
| November 1-30,  2009 |       | —                                 |       | N/A                                     |       | —                                                                                                                           |       | 587,608                                                                                                                                 |       |
| December 1-31,  2009 |       | —                                 |       | N/A                                     |       | —                                                                                                                           |       | 587,608                                                                                                                                 |       |
|                      |       | —                                 |       | N/A                                     |       | —                                                                                                                           |       | 587,608                                                                                                                                 |       |

 

##### **PerformanceGraph**

##### ** **

Since April 24,2007, our common stock has been quoted on The NASDAQ Global Select Market. FromJune 9, 2003 through April 23, 2007, our stock was quoted on TheNASDAQ Global Market. From September 29, 2000 through June 6, 2003,our common stock was quoted on The NASDAQ SmallCap Market (now known as TheNASDAQ Capital Market). The following graph shows changes during the periodfrom December 31, 2004 to 

 

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December 31, 2009 inthe value of $100 invested in: (1) Vital Images, Inc.’s common stock;(2) the Total Return Index for The NASDAQ Composite; and (3) NASDAQNon-Financial Stocks. The values of each investment as of the dates indicatedare based on share prices plus any dividends paid in cash, with the dividendsreinvested on the date they were paid. The calculations exclude tradingcommissions and taxes.

 

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

 

**COMPARISON OF 5 YEAR CUMULATIVETOTAL RETURN***

Among Vital Images, Inc.,The NASDAQ Composite Index

And The NASDAQNon-Financial Index

 

 

----

*$100 invested on 12/31/04in stock or index, including reinvestment of dividends.

Fiscal year endingDecember 31.

 
| ** **               | ** ** | **12/31/04** | ** ** | **12/31/05** | ** ** | **12/31/06** | ** ** | **12/31/07** | ** ** | **12/31/08** | ** ** | **12/31/09** | ** ** |
|--------------------------|------------|--------------|------------|--------------|------------|--------------|------------|--------------|------------|--------------|------------|--------------|------------|
| Vital  Images, Inc. |       | $            | 100.00     |         | $          | 156.12       |       | $            | 207.76     |         | $          | 107.88       |       | $ | 83.04 |   | $ | 75.76 |   |
| NASDAQ  Composite        |       | $            | 100.00     |         | $          | 101.33       |       | $            | 114.01     |         | $          | 123.71       |       | $ | 73.11 |   | $ | 105.61 |   |
| NASDAQ  Non-Financial    |       | $            | 100.00     |         | $          | 100.95       |       | $            | 111.39     |         | $          | 120.56       |       | $ | 70.46 |   | $ | 105.88 |   |

 

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## **Item6.**           Selected Financial Data (in thousands,except per share data)

 
| ** **                         | ** ** | **2009****(1)** | ** ** | **2008****(1)** | ** ** | **2007****(1)** | ** ** | **2006****(1)** | ** ** | **2005****(1)** | ** ** |
|------------------------------------|------------|-----------------|------------|-----------------|------------|-----------------|------------|-----------------|------------|-----------------|------------|
| **Years  ended December 31:** |       |            |       |            |       |            |       |            |       |            |       |
| Revenue                            |       | $               | 58,230     |            | $          | 68,141          |       | $               | 70,176     |            | $          | 70,512 |   | $ | 51,717 |   |
| Gross profit                       |       | 44,025          |       | 52,268          |       | 54,587          |       | 56,302          |       | 40,157          |       |
|                               |       |            |       |            |       |            |       |            |       |            |       |
| Operating expenses                 |       | 52,036          | (2)        | 62,093          | (4)        | 61,755          | (5)        | 49,371          |       | 32,592          | (6)        |
| Operating (loss) income            |       | (8,011          | )          | (9,825          | )          | (7,168          | )          | 6,931           |       | 7,565           |       |
|                               |       |            |       |            |       |            |       |            |       |            |       |
| Net (loss) income                  |       | $               | (21,252    | )(3)            | $          | (2,800          | )          | $               | 1,367      |            | $          | 6,583 |   | $ | 5,801 |   |
|                               |       |            |       |            |       |            |       |            |       |            |       |
| Net (loss) income per  share-basic |       | $               | (1.48      | )               | $          | (0.17           | )          | $               | 0.08       |            | $          | 0.49 |   | $ | 0.47 |   |
|                               |       |            |       |            |       |            |       |            |       |            |       |
| Weighted average common  shares    |       | 14,315          |       | 16,155          |       | 16,972          |       | 13,463          |       | 12,379          |       |
|                               |       |            |       |            |       |            |       |            |       |            |       |
| Net income per  share-diluted      |       | $               | (1.48      | )               | $          | (0.17           | )          | $               | 0.08       |            | $          | 0.46 |   | $ | 0.44 |   |
|                               |       |            |       |            |       |            |       |            |       |            |       |
| Weighted average common  shares    |       | 14,315          |       | 16,155          |       | 17,457          |       | 14,259          |       | 13,283          |       |
|                               |       |            |       |            |       |            |       |            |       |            |       |
| **At  December 31:**          |       |            |       |            |       |            |       |            |       |            |       |
| Working capital                    |       | $               | 121,034    |            | $          | 135,417         |       | $               | 173,905    |            | $          | 162,202 |   | $ | 45,604 |   |
| Total assets                       |       | $               | 172,062    |            | $          | 198,193         |       | $               | 230,996    |            | $          | 219,730 |   | $ | 91,151 |   |
| Long-term debt                     |       | $               | —     |            | $          | —          |       | $               | —     |            | $          | — |   | $ | — |   |
| Total stockholders’  equity   |       | $               | 146,722    |            | $          | 168,691         |       | $               | 202,216    |            | $          | 190,902 |   | $ | 68,789 |   |

 

----

(1)         Includes equity-based compensation of $3,867, $5,007,$5,987, $5,063 and $335 for the fiscal years 2009, 2008, 2007, 2006 and 2005,respectively.

(2)         Includes a $3,147 asset impairment charge related tothe implementation of the Company’s enterprise resource planning system in thesecond quarter of 2009.

(3)         Includes a $14,964 non-cash charge to the provisionfor income taxes to establish a full valuation allowance against the Company’sdeferred tax assets in the second quarter of 2009.

(4)         Includes a $660 restructuring charge related to areduction in workforce of approximately 11% in November 2008.

(5)         Includes an $885 charge related to the separation ofJay D. Miller, our former Chief Executive Officer, in the fourth quarter of2007.

(6)         Includes a loss on operating lease of $493 related tothe relocation of our corporate headquarters in the first quarter of 2005.

 

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## **Item7.**           Management’s Discussion and Analysis ofFinancial Condition and Results of Operations

## ** **

##### **Executivesummary**

##### ** **

The financial results forVital Images, Inc. (also referred to as “we”, “us” and “our”) havecontinued to be affected by the general decline in the U.S. economy, which hasresulted in contracted capital spending by U.S. hospitals and lower interestrates on our cash and investments. Additionally, we have been impacted byweakness in the high-end computed tomography, or CT, and picture archiving andcommunication systems, or PACS, markets. We mitigated these negative factorsthrough significant cost-control measures, while continuing to make strategicinvestments. Vital Images, Inc. summary 2009 results were as follows:

 

·                  Total revenue of $58.2 million, compared to $68.1 million for 2008 and$70.2 million for 2007.

·                  Gross margin of 75.6%, compared to 76.7% for 2008 and 77.8% for 2007.

·                  Operating expenses of $52.0 million, compared to $62.1 million for 2008and $61.8 million for 2007.

·                  Operating loss of $8.0 million, compared to $9.8 million for 2008 and$7.2 million for 2007.

·                  Interest income of $1.1 million, compared to $4.6 million for 2008 and$8.9 million for 2007. A decline in interest rates resulted in a 0.8% return oninvestment in 2009, compared to 2.9% and 5.1% return on investments in 2008 and2007, respectively.

·                  Net loss of $21.3 million, or $(1.48) loss per diluted share, comparedto net loss of $2.8 million, or $(0.17) loss per diluted share, for 2008 andnet income of $1.4 million, or $0.08 per diluted share, for 2007. The net lossfor 2009 included $18.1 million of non-cash charges representing $(1.27) perdiluted share.

 

Total cash, cashequivalents and marketable securities were $142.2 million as of December 31,2009, compared to $147.0 million as of December 31, 2008. Working capital(defined as current assets less current liabilities) was $121.0 million as of December 31,2009, compared to $135.4 million as of December 31, 2008. The decrease incash, cash equivalents and marketable securities during 2009 was primarily theresult of repurchases of our common stock totaling $6.1 million under sharerepurchase programs authorized by our Board of Directors in 2008 and 2009. The decrease in working capital during2009 was primarily the result of purchases of noncurrent marketable securities,the balance of which increased $12.2 million during 2009.

 

##### **Overview**

##### ** **

We are a leading providerof advanced visualization and analysis solutions for use by medicalprofessionals in clinical analysis and therapy planning for medical conditions.We provide software, customer education, software maintenance and support,professional services and, on occasion, third-party hardware to our customers.Our technology rapidly transforms complex data generated by diagnostic imagingequipment into functional digital images that can be manipulated and analyzedusing our specialized applications to better understand internal anatomy andpathology. Our solutions are designed to improve physician workflow andproductivity, enhance the ability to make clinical decisions, facilitate lessinvasive patient care, and complement often significant capital investments indiagnostic imaging equipment made by our customers. Our software is compatiblewith equipment from all major manufacturers of diagnostic imaging equipment, suchas CT scanners, and can be integrated into PACS. Many hospitals use PACS toacquire, distribute and archive medical images and diagnostic reports, reducingthe need for film and increasing reliance on advanced visualization solutionssuch as ours. We also offer a Web-based solution that provides physicians withanywhere, anytime access to medical images and visualization tools through anyInternet-enabled computer.

 

We operate and manage ourbusiness as a single business segment — the development and marketing ofsoftware and related services for advanced visualization and analysis solutionsfor use by medical professionals in clinical analysis and therapy planning. Wemarket our products and services through a direct sales force, resellers andindependent distributors in the United States and in international markets. Ourcommon stock is currently traded on The NASDAQ Global Select Market under thesymbol “VTAL.”

 

##### **Criticalaccounting policies and estimates**

##### ** **

Our discussion andanalysis of financial condition and results of operations are based upon ourConsolidated Financial Statements, which have been prepared in accordance withaccounting principles generally accepted in the United States of America. Thenotes to the Consolidated Financial Statements contained in this Annual Report

 

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describe oursignificant accounting policies used in the preparation of the ConsolidatedFinancial Statements. The preparation of these financial statements requires usto make estimates and assumptions that affect the reported amounts of assetsand liabilities and disclosure of contingent assets and liabilities at the dateof the financial statements and the reported amounts of revenues and expensesduring the reporting periods. Actual results could differ from those estimates.We continually evaluate our critical accounting policies and estimates.

 

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

 

*Allowance for doubtful accounts*

 

We maintain an allowancefor doubtful accounts in an amount estimated to be sufficient to provideadequate protection against losses resulting from extending credit to ourcustomers. In judging the adequacy of the allowance for doubtful accounts, weconsider multiple factors, including historical bad debt experience, thegeneral economic environment, the need for specific client reserves and theaging of our outstanding receivables. A portion of this provision is includedin operating expenses as a general and administrative expense and a portion ofthis provision is included as a reduction of license revenue. A considerableamount of judgment is required in assessing these factors. If the factorsutilized in determining the allowance do not reflect future performance, then achange in the allowance for doubtful accounts would be necessary in the periodsuch determination has been made, which would impact future results ofoperations. As of December 31, 2009, the allowance for doubtful accountswas $736,000 for gross accounts receivable of $12.9 million.

 

###### *Deferredtaxes*

###### * *

Significantjudgment is required in determining the realizability of our deferred taxassets. We must assess the likelihood that our net deferred tax assets will berecovered from future taxable income, and to the extent we believe thatrecovery is not likely, we must establish a valuation allowance. Considerationsfor determining the realizability of our deferred tax assets primarily involvecumulative pre-tax income for financial reporting purposes, cumulative taxableincome for the past three years, estimated future pre-tax income for financialreporting purposes and estimated future taxable income from our core business.We also consider the expiration dates and amounts of net operating losscarryforwards and other tax credits, and estimate the impact of future taxdeductions from the exercise of stock options. These estimates are projectedthrough the life of the related deferred tax assets based on assumptions whichwe believe to be reasonable and consistent with current operating results.After giving consideration to the above factors, during the three months ended June 30,2009, we recorded a non-cash charge of $15.0 million to the provision forincome taxes to establish a full valuation allowance against our deferred taxassets. If pretax results improve in future periods, we may be able to utilizethe deferred tax assets to reduce tax payments.

 

###### *Goodwill*

###### * *

We account forgoodwill in accordance with the provisions of Accounting Standards Codification(ASC) Topic 350, *Intangibles — Goodwill and Other*.Under this accounting guidance, goodwill and intangible assets with indefinitelives are reviewed for impairment annually or more frequently if events orchanges in circumstances indicate that the asset might be impaired. The firststep of the goodwill impairment test, used to identify potential impairment,compares the fair value of a reporting unit with its carrying amount, includinggoodwill. We operate as one reporting unit and therefore compare the book valueto the market value (consisting of market capitalization plus a control premiumof 25%). As of December 31, 2009, we had 14.3 million shares outstanding,a closing stock price of $12.69 per share, a market value of $227.3 million,and a book value of $146.7 million, which would indicate that our goodwill of$9.1 million was not impaired. If the market value exceeds the book value,goodwill is considered not impaired, and thus the second step of the impairmenttest is not necessary. If our book value exceeds the market value, the secondstep of the goodwill impairment test is performed to measure the amount ofimpairment loss, if any. The second step of the goodwill impairment test, usedto measure the amount of impairment loss, compares the implied fair value ofthe goodwill with the book value of the goodwill. If the carrying value of thegoodwill exceeds the implied fair value of the goodwill, an impairment losswould be recognized in an amount equal to the excess. If market conditionscontinue to fluctuate, we may incur goodwill impairment charges that adverselyaffect our financial position and operating results.

 

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###### *Revenue Recognition*

###### * *

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

 

We recognizerevenue in accordance with ASC Topic 985, *Revenue Recognition*.We recognize revenue when it is realized or realizable and earned. We considerrevenue realized or realizable and earned when we have persuasive evidence ofan arrangement, the product has been shipped or the services have been providedto the customer, the sales price is fixed or determinable, and collectabilityis probable.

 

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

 

###### *Equity-based compensation*

###### * *

We recognizeequity-based compensation expense under the fair value recognition provisionsof ASC Topic 718, *Compensation — Stock Compensation*.We recognize equity-based compensation net of an estimated forfeiture rate andrecognize compensation cost only for those shares expected to vest over therequisite service period of the award.

 

The fair value ofeach option award is estimated as of the date of grant using the Black-Scholesoption valuation model. The Black-Scholes option valuation model requires thedevelopment of assumptions that are input into the model. These assumptions arethe expected stock volatility, the risk-free interest rate, the option’sexpected life and the dividend yield on the underlying stock. Expectedvolatility is calculated based on the historical volatility of our common stockover the expected option life and other appropriate factors. Risk-free interestrates are calculated based on continuously compounded U.S. Treasury risk-freerates for the appropriate term. Prior to March 9, 2006, the expected lifeof stock options was calculated by performing a detailed analysis of allhistorical stock option information available. On March 9, 2006, we beganto grant options with a five-year legal life instead of the eight-year legallife that had historically been used. As a result, we elected to use the “simplified”method, to estimate the expected life of options granted on and after March 9,2006. We will utilize the simplified method until sufficient historicalinformation becomes available on the five-year legal life options. The dividendyield is assumed to be zero, as we have never paid or declared any cashdividends on our common stock and do not intend to pay dividends on our commonstock in the foreseeable future. The expected forfeiture rate is estimatedbased on historical experience.

 

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

 

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##### ** **

##### **Results of Operations**

##### ** **

The following table sets forth information from ourStatements of Operations, expressed as a percentage of total revenue.

 
| ** **                            | ** ** | **For the Year Ended December 31,** | ** ** |
|---------------------------------------|------------|------------------------------------------|------------|
| ** **                            | ** ** | **2009**                                 | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                  |       |                                     |       |   |   |   |   |
| Revenue:                              |       |                                     |       |   |   |   |   |
| License fees                          |       | 39.1                                     | %          | 50.3 | % | 56.5 | % |
| Maintenance and  services             |       | 57.9                                     |       | 47.6 |   | 42.0 |   |
| Hardware                              |       | 3.0                                      |       | 2.1 |   | 1.5 |   |
| Total revenue                         |       | 100.0                                    |       | 100.0 |   | 100.0 |   |
|                                  |       |                                     |       |   |   |   |   |
| Cost of revenue:                      |       |                                     |       |   |   |   |   |
| License fees                          |       | 5.7                                      |       | 7.2 |   | 6.7 |   |
| Maintenance and  services             |       | 15.9                                     |       | 14.8 |   | 14.2 |   |
| Hardware                              |       | 2.8                                      |       | 1.3 |   | 1.0 |   |
| Impairment of patent                  |       | —                                   |       | — |   | 0.3 |   |
| Total cost of revenue                 |       | 24.4                                     |       | 23.3 |   | 22.2 |   |
|                                  |       |                                     |       |   |   |   |   |
| Gross profit                          |       | 75.6                                     |       | 76.7 |   | 77.8 |   |
|                                  |       |                                     |       |   |   |   |   |
| Operating expenses:                   |       |                                     |       |   |   |   |   |
| Sales and marketing                   |       | 38.8                                     |       | 40.8 |   | 42.0 |   |
| Research and  development             |       | 28.1                                     |       | 29.9 |   | 26.3 |   |
| General and  administrative           |       | 17.1                                     |       | 19.4 |   | 19.7 |   |
| Asset impairment                      |       | 5.4                                      |       | — |   | — |   |
| Restructuring charge                  |       | —                                   |       | 1.0 |   | — |   |
| Total operating  expenses             |       | 89.4                                     |       | 91.1 |   | 88.0 |   |
|                                  |       |                                     |       |   |   |   |   |
| Operating (loss) income               |       | (13.8                                    | )          | (14.4 | ) | (10.2 | ) |
|                                  |       |                                     |       |   |   |   |   |
| Interest income                       |       | 1.9                                      |       | 6.8 |   | 12.6 |   |
| (Loss) income before  income taxes    |       | (11.9                                    | )          | (7.6 | ) | 2.4 |   |
|                                  |       |                                     |       |   |   |   |   |
| (Benefit) provision for  income taxes |       | 24.6                                     |       | (3.5 | ) | 0.5 |   |
|                                  |       |                                     |       |   |   |   |   |
| Net (loss) income                     |       | (36.5                                    | )%         | (4.1 | )% | 1.9 | % |

 

##### **Revenue (dollars inthousands)**

 
| ** **               | ** ** | **For the Year Ended December 31,** | ** ** | **Increase (Decrease)** | ** ** | **Percent Increase (Decrease)** | ** ** |
|--------------------------|------------|------------------------------------------|------------|-------------------------|------------|---------------------------------|------------|
| ** **               | ** ** | **2009**                                 | ** ** | **2008**                | ** ** | **2007**                        | ** ** | **2008 to 2009** | ** ** | **2007 to 2008** | ** ** | **2008 to 2009** | ** ** | **2007 to 2008** | ** ** |
| Revenues:                |       |                                     |       |                    |       |                            |       |   |   |   |   |   |   |   |   |
| License fees             |       | $                                        | 22,766     |                    | $          | 34,290                          |       | $ | 39,673 |   | $ | (11,524 | ) | $ | (5,383 | ) | (34 | )% | (14 | )% |
| Maintenance and services |       | 33,717                                   |       | 32,436                  |       | 29,487                          |       | 1,281 |   | 2,949 |   | 4 | % | 10 | % |
| Hardware                 |       | 1,747                                    |       | 1,415                   |       | 1,016                           |       | 332 |   | 399 |   | 23 | % | 39 | % |
| Total revenue            |       | $                                        | 58,230     |                    | $          | 68,141                          |       | $ | 70,176 |   | $ | (9,911 | ) | $ | (2,035 | ) | (15 | )% | (3 | )% |

 

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

##### ** **

The following table sets forth information on licensefee revenue by source:

 
| ** **                       | ** ** | **For the Year Ended December 31,** | ** ** | **Increase (Decrease)** | ** ** | **Percent Increase  (Decrease)** | ** ** |
|----------------------------------|------------|------------------------------------------|------------|-------------------------|------------|----------------------------------|------------|
| ** **                       | ** ** | **2009**                                 | ** ** | **2008**                | ** ** | **2007**                         | ** ** | **2008 to  2009** | ** ** | **2007 to  2008** | ** ** | **2008 to  2009** | ** ** | **2007 to  2008** | ** ** |
| License  fee revenue:            |       |                                     |       |                    |       |                             |       |   |   |   |   |   |   |   |   |
| Direct  and other distributors   |       | $                                        | 4,493      |                    | $          | 11,014                           |       | $ | 17,532 |   | $ | (6,521 | ) | $ | (6,518 | ) | (59 | )% | (37 | )% |
| Toshiba                          |       | 18,273                                   |       | 23,276                  |       | 22,141                           |       | (5,003 | ) | 1,135 |   | (21 | )% | 5 | % |
| Total  license fees              |       | $                                        | 22,766     |                    | $          | 34,290                           |       | $ | 39,673 |   | (11,524 | ) | (5,383 | ) | (34 | )% | (14 | )% |
|                             |       |                                     |       |                    |       |                             |       |   |   |   |   |   |   |   |   |
| Percent  of license fee revenue: |       |                                     |       |                    |       |                             |       |   |   |   |   |   |   |   |   |
| Direct  and other distributors   |       | 20                                       | %          | 32                      | %          | 44                               | %          |   |   |   |   |   |   |   |   |
| Toshiba                          |       | 80                                       |       | 68                      |       | 56                               |       |   |   |   |   |   |   |   |   |
| Total  license fee revenue       |       | 100                                      | %          | 100                     | %          | 100                              | %          |   |   |   |   |   |   |   |   |
|                                  |            |                                          |            |                         |            |                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The decreases in license fee revenue for 2009 and 2008, compared to2008 and 2007, respectively, were driven by the general decline in the U.S.economy starting in 2008 and continuing through 2009, which resulted inincreased pricing pressures and contracted capital spending by U.S. hospitals.

 

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

 
| ** **                         | ** ** | **For the Year Ended December 31,** | ** ** | **Increase (Decrease)** | ** ** | **Percent Increase  (Decrease)** | ** ** |
|------------------------------------|------------|------------------------------------------|------------|-------------------------|------------|----------------------------------|------------|
| ** **                         | ** ** | **2009**                                 | ** ** | **2008**                | ** ** | **2007**                         | ** ** | **2008 to  2009** | ** ** | **2007 to  2008** | ** ** | **2008 to 2009** | ** ** | **2007 to 2008** | ** ** |
| Maintenance  and services revenue: |       |                                     |       |                    |       |                             |       |   |   |   |   |   |   |   |   |
| Maintenance  and support           |       | $                                        | 28,792     |                    | $          | 26,656                           |       | $ | 22,811 |   | $ | 2,136 |   | $ | 3,845 |   | 8 | % | 17 | % |
| Customer  education                |       | 3,511                                    |       | 4,478                   |       | 5,590                            |       | (967 | ) | (1,112 | ) | (22 | )% | (20 | )% |
| Professional  services             |       | 1,414                                    |       | 1,302                   |       | 1,086                            |       | 112 |   | 216 |   | 9 | % | 20 | % |
| Total  maintenance and services    |       | $                                        | 33,717     |                    | $          | 32,436                           |       | $ | 29,487 |   | $ | 1,281 |   | $ | 2,949 |   | 4 | % | 10 | % |

 

In 2009 and 2008, maintenance and services revenue was positivelyimpacted by sales of our products on an enterprise basis, as a largerpercentage of each enterprise sale is allocated to maintenance and servicesrevenue than has historically been allocated for sales ofour products on aworkstation basis, as enterprise sales carry higher maintenance and servicespricing. As was the case in 2009 and 2008, we expect that in future periods,although sales of our enterprise offering will result in proportionately lowerlicense revenue upon sale, we will benefit from a recurring revenue stream frommaintenance and services contracts.

 

The increase in maintenance and support revenue in 2009, compared to2008, was due to an increase in the number of customers on maintenancecontracts resultingfrom additional license sales. The increase in maintenance and supportrevenue in 2008, compared to 2007, was primarily driven by an increase in thenumber of customers on maintenance contracts, resulting from both additional licensesales and improvement in the percentage of our existing customers onmaintenance contracts.

 

An overall decrease in the number of license sales in 2009 and 2008, ascompared to 2008 and 2007, respectively, contributed to lower customereducation revenue in both 2009 and 2008.

 

Professional services revenue, which includes installation and otherimplementation-related services, increased in 2009 and 2008, due to increasesin professional services resulting from sales of our product on an enterprisebasis and the timing of services provided.

 

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##### **Hardware revenue**

##### ** **

Hardware revenueincreased 23% to $1.7 million in 2009, compared to $1.4 million in 2008, whichwas a 39% increase from $1.0 million in 2007. Hardware revenue increased due tothe increased sales of our product on an enterprise basis, for which ourcustomers frequently purchase hardware from us. Sales of hardware systemsare not core to our strategy and will fluctuate from period to period dependingupon the needs of our customers.

 

##### **Cost of revenue and grossprofit**

##### ** **

Gross profitdecreased 16% to $44.0 million in 2009, compared to $52.3 million in 2008,which was a 4% decrease from $54.6 million in 2007. Gross margin percentagedecreased slightly to 75.6% in 2009 from 76.7% in 2008 and 77.8% in 2007, dueto pricing pressures on new license sales and a greater percentage of total revenuerelating to maintenance and services, which carries lower margins than licensefees.

 

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

 
| ** **                | ** ** | **For the Year Ended December 31,** | ** ** | **Increase (Decrease)** | ** ** | **Percent Increase  (Decrease)** | ** ** |
|---------------------------|------------|------------------------------------------|------------|-------------------------|------------|----------------------------------|------------|
| ** **                | ** ** | **2009**                                 | ** ** | **2008**                | ** ** | **2007**                         | ** ** | **2008 to 2009** | ** ** | **2007 to 2008** | ** ** | **2008 to  2009** | ** ** | **2007 to  2008** | ** ** |
| Gross  profit:            |       |                                     |       |                    |       | ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| License  fees             |       | $                                        | 19,465     |                    | $          | 29,368                           |       | $ | 34,948 |   | $ | (9,903 | ) | $ | (5,580 | ) | (34 | )% | (16 | )% |
| Maintenance  and services |       | 24,435                                   |       | 22,347                  |       | 19,559                           |       | 2,088 |   | 2,788 |   | 9 | % | 14 | % |
| Hardware                  |       | 125                                      |       | 553                     |       | 322                              |       | (428 | ) | 231 |   | (77 | )% | 72 | % |
| Impairment  of patent     |       | —                                   |       | —                  |       | (242                             | )          | — |   | 242 |   | — | % | (100 | )% |
| Total  gross profit       |       | $                                        | 44,025     |                    | $          | 52,268                           |       | $ | 54,587 |   | $ | (8,243 | ) | $ | (2,319 | ) | (16 | )% | (4 | )% |
|                      |       |                                     |       |                    |       |                             |       |   |   |   |   |   |   |   |   |
| Gross  margin:            |       |                                     |       |                    |       | ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| License  fees             |       | 85.5                                     | %          | 85.6                    | %          | 88.1                             | %          |   |   |   |   |   |   |   |   |
| Maintenance  and services |       | 72.5                                     | %          | 68.9                    | %          | 66.3                             | %          |   |   |   |   |   |   |   |   |
| Hardware                  |       | 7.2                                      | %          | 39.0                    | %          | 31.7                             | %          |   |   |   |   |   |   |   |   |
| Total  gross margin       |       | 75.6                                     | %          | 76.7                    | %          | 77.8                             | %          |   |   |   |   |   |   |   |   |

 

Fluctuations inlicense fee gross margin are generally a result of average sales prices,changes in the product mix, and the mix between direct sales and sales todistribution partners, as well as mix between domestic and international sales.License fee gross margin remained relatively flat in 2009, compared to 2008, asa decrease in amortization expense was offset by pricing pressures and anincrease, as a percent of total revenue, in sales through our distributionpartners, which have lower margins. License fee gross margin decreased in 2008,compared to 2007, due to an increase in revenue, as a percent of total revenue,from international sales through our distribution partners, which typicallyhave lower margins than U.S. direct sales.

 

Maintenance and services gross margin increased during 2009 and 2008,compared to 2008 and 2007, respectively, as a larger percentage of eachenterprise sale is allocated to maintenance and services revenue than hashistorically been allocated for sales of our products on a workstation basis,as enterprise sales carry higher maintenance and services pricing, without acorresponding increase in costs. In addition, in 2009 and 2008, we recognizedbenefits of $552,000 and $391,000, respectively, to maintenance and supportrevenue arising from Toshiba billing adjustments. We will continue to investin our customer education, installation, professional services and customersupport areas in the future to adequately support our growing installed base ofcustomers. We had 51,53 and 55 maintenance and services personnel as of December 31, 2009, 2008and 2007, respectively.

 

Gross margin forhardware decreased in 2009, compared to 2008, and increased in 2008, comparedto 2007. Variances in gross margin for hardware are expected, as hardware salesare not a substantial part of the sales strategy.

 

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During the thirdquarter 2007, we recognized a $242,000 patent impairment charge related to apatent application acquired in the HInnovation, Inc. acquisition in February 2004.This patent application was rejected by the United States Patent and TrademarkOffice on August 23, 2007, and we decided not to pursue this applicationfurther. The impairment was recorded as a separate item in cost of revenue, andit is included in the total gross margin percentage above.

 

##### **Operating expenses**

##### ** **

The following is a comparison of operating expenses asa percent of revenue as well as the percent increase or decrease in the totalexpense:

 
| ** **                  | ** ** | **Percent of Revenue for the********Year Ended December 31,** | ** ** | **Percent Increase (Decrease)** | ** ** |
|-----------------------------|------------|--------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                  | ** ** | **2009**                                                           | ** ** | **2008**                        | ** ** | **2007** | ** ** | **2008 to 2009** | ** ** | **2007 to 2008** | ** ** |
| Operating  expenses:        |       |                                                               |       |                            |       |   |   |   |   |   |   |
| Sales  and marketing        |       | 38.8                                                               | %          | 40.8                            | %          | 42.0 | % | (19 | )% | (6 | )% |
| Research  and development   |       | 28.1                                                               |       | 29.9                            |       | 26.3 |   | (20 | )% | 10 | % |
| General  and administrative |       | 17.1                                                               |       | 19.4                            |       | 19.7 |   | (25 | )% | (4 | )% |
| Asset  impairment           |       | 5.4                                                                |       | —                          |       | — |   | 100 | % | — | % |
| Restructuring  charge       |       | —                                                             |       | 1.0                             |       | — |   | (100 | )% | 100 | % |
| Total  operating expenses   |       | 89.4                                                               | %          | 91.1                            | %          | 88.0 | % | (16 | )% | 1 | % |

 

##### **Sales and marketing**

##### ** **

Sales and marketing expenses were as follows (dollarsin thousands):

 
| ** **                       | ** ** | **For the Year Ended********December 31,** | ** ** | **Increase (Decrease)** | ** ** | **Percent Increase  (Decrease)** | ** ** |
|----------------------------------|------------|-------------------------------------------------|------------|-------------------------|------------|----------------------------------|------------|
| ** **                       | ** ** | **2009**                                        | ** ** | **2008**                | ** ** | **2007**                         | ** ** | **2008 to 2009** | ** ** | **2007 to 2008** | ** ** | **2008 to  2009** | ** ** | **2007 to  2008** | ** ** |
| Salaries,  benefits and bonus    |       | $                                               | 8,841      |                    | $          | 10,590                           |       | $ | 9,982 |   | $ | (1,749 | ) | $ | 608 |   | (17 | )% | 6 | % |
| Overhead  and other expenses     |       | 3,558                                           |       | 4,050                   |       | 4,306                            |       | (492 | ) | (256 | ) | (12 | )% | (6 | )% |
| Commissions                      |       | 2,050                                           |       | 3,588                   |       | 4,634                            |       | (1,538 | ) | (1,046 | ) | (43 | )% | (23 | )% |
| Travel,  meals and entertainment |       | 2,424                                           |       | 3,319                   |       | 3,450                            |       | (895 | ) | (131 | ) | (27 | )% | (4 | )% |
| Trade  shows and advertising     |       | 2,839                                           |       | 3,422                   |       | 3,612                            |       | (583 | ) | (190 | ) | (17 | )% | (5 | )% |
| Depreciation                     |       | 1,624                                           |       | 1,601                   |       | 1,311                            |       | 23 |   | 290 |   | 1 | % | 22 | % |
| Equity-based  compensation       |       | 1,243                                           |       | 1,265                   |       | 2,186                            |       | (22 | ) | (921 | ) | (2 | )% | (42 | )% |
| Total                            |       | $                                               | 22,579     |                    | $          | 27,835                           |       | $ | 29,481 |   | $ | (5,256 | ) | $ | (1,646 | ) | (19 | )% | (6 | )% |

 

The decrease insalaries and benefits costs in 2009, compared to 2008, resulted from decreasedaverage annual headcount. The decrease in commissions expense in 2009, comparedto 2008, was due to a decreased amount of direct sales. The decrease in otherexpense categories in 2009, compared to 2008, was primarily due to decreasedheadcount and other broad-based cost control measures.

 

The decrease inexpenses in 2008 compared to 2007 was due primarily to a decrease in commissionexpense related to the decrease in revenue and a decrease in equity-basedcompensation resulting from issuing equity awards at a lower exercise price, aswell as significant cancellations of equity awards resulting fromorganizational changes.

 

We had 70, 69 and89 sales and marketing personnel as of December 31, 2009, 2008 and 2007,respectively. The decrease in headcount as of December 31, 2008 was dueprimarily to the November 2008 reduction in force described in “Restructuringcharge.”

 

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##### **Research and development**

##### ** **

Research and development expenses were as follows(dollars in thousands):

 
| ** **                    | ** ** | **For the Year Ended********December 31,** | ** ** | **Increase (Decrease)** | ** ** | **Percent Increase  (Decrease)** | ** ** |
|-------------------------------|------------|-------------------------------------------------|------------|-------------------------|------------|----------------------------------|------------|
| ** **                    | ** ** | **2009**                                        | ** ** | **2008**                | ** ** | **2007**                         | ** ** | **2008 to 2009** | ** ** | **2007 to 2008** | ** ** | **2008 to  2009** | ** ** | **2007 to  2008** | ** ** |
| Salaries,  benefits and bonus |       | $                                               | 11,814     |                    | $          | 13,024                           |       | $ | 12,483 |   | $ | (1,210 | ) | $ | 541 |   | (9 | )% | 4 | % |
| Overhead  and other expenses  |       | 3,535                                           |       | 3,607                   |       | 3,406                            |       | (72 | ) | 201 |   | (2 | )% | 6 | % |
| Equity-based  compensation    |       | 945                                             |       | 1,179                   |       | 949                              |       | (234 | ) | 230 |   | (20 | )% | 24 | % |
| Depreciation                  |       | 869                                             |       | 1,044                   |       | 1,140                            |       | (175 | ) | (96 | ) | (17 | )% | (8 | )% |
| Consulting                    |       | 307                                             |       | 1,501                   |       | 498                              |       | (1,194 | ) | 1,003 |   | (80 | )% | 201 | % |
| Development  reimbursement    |       | (1,138                                          | )          | —                  |       | —                           |       | (1,138 | ) | — |   | 100 | % | — | % |
| Total                         |       | $                                               | 16,332     |                    | $          | 20,355                           |       | $ | 18,476 |   | $ | (4,023 | ) | $ | 1,879 |   | (20 | )% | 10 | % |

 

The decrease inresearch and development expenses in 2009, compared to 2008, was due to reducedheadcount resulting from our November 2008 reduction in force, lowerutilization of consultants and other cost control measures. Additionally,during the 2009 first quarter, we entered into a development agreement withToshiba, under which Toshiba provides funding in support of our research anddevelopment efforts, and the parties work collaboratively to develop anddeliver innovative technology advancements for Toshiba’s medical equipment andour advanced visualization software solutions. In 2009, we recognized a creditof $1.1 million to our research and development expenses for reimbursement fromToshiba for development costs we incurred under the co-development agreement.The decrease in other expense categories in 2009, compared to 2008, was primarilydue to decreased headcount and other broad-based cost control measures.

 

The major driverof higher research and development expenses in 2008 was new productinitiatives, resulting in increased consulting expense and increasedcompensation expense due to higher average headcount in 2008 compared to 2007.

 

We had 87, 114 and134 research and development personnel as of December 31, 2009, 2008 and2007, respectively. The decrease in headcount as of December 31, 2009, wasdue primarily to the termination of 20 employees in our Beijing office in August 2009in conjunction with our decision to discontinue test and product developmentactivities in Beijing. The decrease in headcount as of December 31, 2008was due primarily to the reduction in force described in “Restructuring charge.”

 

##### **General andadministrative**

##### ** **

General and administrative expenses were as follows(dollars in thousands):

 
| ** **                            | ** ** | **For the Year Ended********December 31,** | ** ** | **Increase (Decrease)** | ** ** | **Percent Increase  (Decrease)** | ** ** |
|---------------------------------------|------------|-------------------------------------------------|------------|-------------------------|------------|----------------------------------|------------|
| ** **                            | ** ** | **2009**                                        | ** ** | **2008**                | ** ** | **2007**                         | ** ** | **2008 to 2009** | ** ** | **2007 to 2008** | ** ** | **2008 to  2009** | ** ** | **2007 to  2008** | ** ** |
| Salaries,  benefits and bonus         |       | $                                               | 4,582      |                    | $          | 4,583                            |       | $ | 5,211 |   | $ | (1 | ) | $ | (628 | ) | (0 | )% | (12 | )% |
| Overhead  and other expenses          |       | 2,355                                           |       | 3,335                   |       | 2,943                            |       | (980 | ) | 392 |   | (29 | )% | 13 | % |
| Professional  and consulting services |       | 1,685                                           |       | 3,095                   |       | 3,181                            |       | (1,410 | ) | (86 | ) | (46 | )% | (3 | )% |
| Equity-based  compensation            |       | 1,356                                           |       | 2,230                   |       | 2,463                            |       | (874 | ) | (233 | ) | (39 | )% | (9 | )% |
| Total                                 |       | $                                               | 9,978      |                    | $          | 13,243                           |       | $ | 13,798 |   | $ | (3,265 | ) | $ | (555 | ) | (25 | )% | (4 | )% |

 

The decrease ingeneral and administrative expenses in 2009, compared to 2008, was due in partto a lower utilization of consultants and reduced headcount resulting from the November 2008reduction in force. Equity-based compensation decreased in 2009, compared to2008, as previously issued equity awards became fully vested and as headcountdecreased. The decrease in other expense categories in 2009, compared to 2008,was primarily due to decreased headcount and other broad-based cost controlmeasures.

 

Salaries, benefitsand bonus and equity-based compensation decreased for 2008, compared to 2007,as 2007 included an $885,000 pre-tax charge related to the separation of ourformer Chief Executive Officer. Of this charge,

 

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$580,000 isincluded in salaries, benefits and bonus and $305,000 is included inequity-based compensation for 2007. Overhead expenses increased in 2008,compared to 2007, due to the increase in infrastructure.

 

We had 38, 44 and49 general and administrative personnel as of December 31, 2009, 2008 and2007, respectively.  Decreases inheadcount were the result of our cost-control measures.

 

##### **Asset impairment**

##### ** **

In 2007, we beganthe implementation of an enterprise resource planning (“ERP”) system. The ERPsystem was intended to replace numerous disconnected business managementsoftware applications and link the data contained within these disconnectedsystems to enable better management of our business and derive more useful datafor various business functions, such as sales, marketing, finance and customersupport.

 

Phase 1 of theimplementation, which related to the replacement of our general ledger, wascompleted in 2007. The related capitalized costs are being depreciated overseven years and, as of December 31, 2009, the net book value of Phase 1was $626,000. Phase 2 of the implementation, which consisted of replacing ourvarious customer relationship management and order processing systems, was puton hold in 2008 in conjunction with our cost-control efforts, and we did notcapitalize any costs relating to Phase 2 subsequent to October 2008.During the three months ended June 30, 2009, we determined, in conjunctionwith continued cost-control measures, that we would not implement Phase 2. As aresult, in 2009 we recognized an asset impairment charge of $3.1 millionrelated to the Phase 2 implementation.

##### ** **

##### **Restructuring charge**

##### ** **

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

 

In connection with the reduction in workforce, weincurred certain charges in 2008 totaling $660,000, which were primarilycomprised of employee severance and other termination costs. The followingtable summarizes 2009 and 2008 restructuring transactions and related liabilitybalances (in thousands):

 
| ** **                         | ** ** | **Severance and  Other  Termination  Costs** | ** ** |
|------------------------------------|------------|----------------------------------------------|------------|
| Balance  at January 1, 2008   |       | $                                            | —     |   |
| Restructuring  charges             |       | 660                                          |       |
| Payments                           |       | (519                                         | )          |
| Balance  at December 31, 2008 |       | 141                                          |       |
| Payments                           |       | (141                                         | )          |
| Balance  at December 31, 2009 |       | $                                            | —     |   |

 

Actions withrespect to the above activities were completed in the fourth quarter of 2008,and we did not incur any significant additional charges in 2009 related to therestructuring plan announced in November 2008.

 

##### **Interest income**

##### ** **

We generated $1.1million of interest income in 2009, compared to $4.6 million in 2008 and $8.9million in 2007. A decline in interest rates resulted in a 0.8% return oninvestments in 2009, compared to a 2.9% and 5.1% return on investments in 2008and 2007, respectively.

 

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Interest income issignificantly impacted by changes in interest rates. We do not anticipate asignificant improvement in interest rates in 2010 compared to 2009 due togeneral market conditions; interest rate changes may have a significant impacton results.

 

##### **Income taxes**

##### ** **

During the threemonths ended June 30, 2009, we recorded a non-cash charge of $15.0 millionto the provision for income taxes to establish a full valuation allowanceagainst our deferred tax assets based on our assessment of cumulative pretaxresults in recent years and projections of cumulative pretax results in futureperiods.

 

During 2009, werecognized $194,000 in one-time tax benefits resulting from tax legislation,which enabled us to receive cash payment for the monetization of certainhistoric research and development tax credits. Also as a result of thelegislation, we recognized a $248,000 one-time tax benefit related to therefund of certain alternative minimum tax payments in prior years.

 

For 2010, weanticipate a consolidated tax provision of approximately $20,000 per quarterrelating entirely to foreign operations.

 

**Liquidity and capital resources**

 

The following table sets forth certain relevantmeasures of our liquidity and capital resources (in thousands):

 
| ** **                                        | ** ** | **As of December 31,** | ** ** |
|---------------------------------------------------|------------|-----------------------------|------------|
| ** **                                        | ** ** | **2009**                    | ** ** | **2008** | ** ** |
| Cash  and cash equivalents                        |       | $                           | 120,317    |   | $ | 109,706 |   |
| Marketable  securities                            |       | 21,907                      |       | 37,287 |   |
| Cash,  cash equivalents and marketable securities |       | $                           | 142,224    |   | $ | 146,993 |   |
|                                              |       |                        |       |   |   |
| Working  capital                                  |       | $                           | 121,034    |   | $ | 135,417 |   |
|                                              |       |                        |       |   |   |
| Debt                                              |       | $                           | —     |   | $ | — |   |

 

The decrease inour cash, cash equivalents and marketable securities as of December 31,2009, compared to December 31, 2008, was primarily the result ofrepurchases of our common stock totaling $6.1 million under share repurchaseprograms authorized by our Board of Directors in 2008 and 2009. The decrease inworking capital during 2009 was primarily the result of purchases of noncurrentmarketable securities, the balance of which increased $12.2 million during2009.

 

We believe ourexisting cash and investments will satisfy our foreseeable working capitalrequirements for at least the next 12 months. Additionally, we believe ourliquidity and strong balance sheet enable us to execute our repurchases ofcommon stock while still investing in our enterprise solution and marketingstrategy and remaining well positioned to pursue strategic acquisitions if andwhen they emerge.

 

We have investmentsin marketable securities that are classified and accounted for asavailable-for-sale. As of December 31, 2009, $9.7 million of ourmarketable securities mature within one year and the remaining $12.2 million ofour marketable securities mature in 2011.

 

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###### *Summary of Cash Flows*

###### * *

A summary of cash flows is as follows (in thousands):

 
| ** **                               | ** ** | **For the Year Ended December 31,** | ** ** |
|------------------------------------------|------------|------------------------------------------|------------|
| ** **                               | ** ** | **2009**                                 | ** ** | **2008** | ** ** | **2007** | ** ** |
| Cash  provided by (used in)              |       |                                     |       |   |   |   |   |
| Operating  activities                    |       | $                                        | 2,374      |   | $ | 8,581 |   | $ | 13,902 |   |
| Investing  activities                    |       | 12,668                                   |       | (10,246 | ) | (15,870 | ) |
| Financing  activities                    |       | (4,431                                   | )          | (35,314 | ) | 4,271 |   |
| Net  change in cash and cash equivalents |       | $                                        | 10,611     |   | $ | (36,979 | ) | $ | 2,303 |   |

###### * *

###### *Operating activities*

###### * *

Net cash providedby operating activities decreased $6.2 million to $2.4 million in 2009,compared to $8.6 million in 2008, due to an $18.4 million increase in net lossand a $7.3 million decrease from changes in operating assets and liabilities,offset by an $19.5 million increase in non-cash operating items. The $7.3million decrease in net cash from changes in operating assets and liabilitieswas primarily due to decreased sales and expenses in 2009, compared to 2008,and to the timing of receipts and payments in the ordinary course of business.Cash provided by non-cash operating items increased by $19.5 million in 2009 to$27.2 million, compared to $7.6 million in 2008, primarily resulted from a$14.7 million decrease in deferred tax assets due to a $15.0 million valuationallowance recorded in the second quarter of 2009 and a $3.1 million assetimpairment in the second quarter of 2009.

 

Net cash providedby operating activities decreased $5.3 million in 2008 to $8.6 million,compared to $13.9 million in 2007, due to a $4.2 million decrease in net incomeand a $1.9 million decrease in non-cash operating items, offset by a $791,000increase due to the timing of other receipts and payments in the ordinarycourse of business.

 

###### *Investing activities*

###### * *

Net cash providedby investing activities was $12.7 million in 2009, compared to cash used byinvesting activities of $10.2 million in 2008 and $15.9 million in 2007.

 

We used $21.7 million, $76.4 million and $60.0 million to purchaseinvestments in marketable securities during 2009, 2008 and 2007, respectively. We realized$36.8 million, $71.6 million and $50.7 million of proceeds from maturities andsales of marketable securities during 2009, 2008 and 2007, respectively. As of December 31,2009, the marketable securities consist of U.S. government obligations andcorporate commercial obligations.

 

We used $2.3million, $5.4 million and $6.6 million for purchases of propertyand equipment in 2009, 2008 and 2007, respectively. The purchases for all periodswere principally to upgrade computer equipment and to purchase computerequipment for new personnel. Purchases for 2008 and 2007 also included costsrelated to expanding our facilities. Additionally, in 2007, we began theimplementation of an enterprise resource planning (“ERP”) system. We continuedimplementation of the ERP during 2008 and 2009, though we recognized animpairment charge related to Phase 2 in the second quarter of 2009, as noted inthe “Asset impairment” section above. We anticipate that we will continue topurchase property and equipment in the normal course of business. The amountand timing of these purchases and the related cash outflows in future periodsare difficult to predict and depend on a number of factors, including thehiring of employees and the rate of change of computer hardware.

 

###### *Financing activities*

###### * *

Cash used by financing activities totaled $4.4 million and $35.3million in 2009 and 2008, respectively, compared to cash provided by financingactivities of $4.3 million in 2007. The primary use of cash in 2009 and 2008was for the

 

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repurchase of $6.1 million and $38.2 million of our common stock,respectively, under our share repurchase programs. The cash provided byfinancing activities in 2007 resulted primarily from the exercise of stockoptions granted under our stock plans and upon the exercise of warrants.

 

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

 

The following summarizes our contractual obligationsat December 31, 2009 and the effect such obligations are expected to haveon our liquidity and cash flow in future periods (in thousands).

 
| ** **        | ** ** | **Total**  | ** ** | **Less than 1  Year** | ** ** | **1 to 3 Years** | ** ** | **3 to 5 Years** | ** ** | **More than 5  Years** | ** ** |
|-------------------|------------|------------|------------|-----------------------|------------|------------------|------------|------------------|------------|------------------------|------------|
| ** **        | ** ** | ** ** |       |                  |       |             |       |             |       |                   |       |
| Operating  leases |       | $          | 2,228      |                  | $          | 1,026            |       | $                | 1,202      |                   | $          | — |   | $ | — |   |
|                   |            |            |            |                       |            |                  |            |                  |            |                        |            |  |  |  |  |  |

 

Off-balance-sheet arrangements

 

We did not haveany off-balance sheet arrangements as of December 31, 2009 or 2008.

 

Purchase commitments

 

We had no significant outstanding purchase commitments as of December 31,2009. We have entered into a number of technology licensing agreements thatprovide for the payment of royalties when we sell our software products; we arenot obligated for any minimum payments under such agreements.

 

##### **Foreign currencytransactions**

##### ** **

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

 

##### **Inflation**

##### ** **

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

 

##### **Recent accountingpronouncements**

##### ** **

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

 

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

## ** **

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

 

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

 

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

 

##### **Interest rate risk**

##### ** **

We place our cash,cash equivalents and marketable securities with a high-quality financialinstitution and have investment guidelines relative to diversification andmaturities designed to maintain safety and liquidity. As of December 31,2009, we had cash, cash equivalents and marketable securities totaling $142.2million. If, during 2009, average short-term interest rates decreased by 0.5%from 2009 average rates, based on our quarterly average balance of cash, cashequivalents and marketable securities, our interest income from short-terminvestments would have decreased by approximately $690,000.

##### ** **

##### **Foreign currency risk**

##### ** **

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

 

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

## ** **

Our financialstatements and Report of Independent Registered Public Accounting Firmthereon, all of which are included in this Annual Report on Form 10-K, arelisted in Item 15(a)(1) of this Form 10-K.

 

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

## ** **

Not applicable.

 

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

## ** **

##### **Evaluation of disclosurecontrols and procedures**

##### ** **

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

 

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

 

##### **Management’s report oninternal control over financial reporting**

##### ** **

Our management isresponsible for establishing and maintaining adequate internal control overfinancial reporting. Our internal control over financial reporting is a processdesigned to provide reasonable assurance regarding the reliability of financialreporting and the preparation of financial statements for external purposes inaccordance with generally accepted accounting principles. Because of itsinherent limitations, internal control over financial reporting may not preventor detect misstatements. Also, projections of any evaluation of effectivenessto future periods are subject to the risk that controls may become inadequatebecause of changes in conditions or that the degree of compliance withestablished policies or procedures may deteriorate.

 

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Our management,under the supervision of and with the participation of our Chief ExecutiveOfficer and Chief Financial Officer, has evaluated the effectiveness of ourinternal control over financial reporting as of the end of the period coveredby this report based on the criteria established in *InternalControl — Integrated Framework* issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO). Based on the results of thisevaluation, we concluded that our internal control over financial reporting waseffective as of the end of the period covered by this report.

 

The effectiveness of ourinternal control over financial reporting as of December 31, 2009 has beenaudited by PricewaterhouseCoopers LLP, an independent registered publicaccounting firm, as stated in their report which is included in Item 15(a)(1) ofthis Annual Report on Form 10-K.

##### ** **

##### **Changes in internalcontrol over financial reporting**

##### ** **

There were nochanges in internal control over financial reporting during the quarter ended December 31,2009 that have materially affected, or are reasonably likely to materiallyaffect, our internal control over financial reporting.

 

## **Item 9B.**         OtherInformation

## ** **

None.

 

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# **Table of Contents**

# ** **

# **Part III**

# ** **

Certain information required by Part III is omitted from thisAnnual Report on Form 10-K because we will file a definitive ProxyStatement relating to our 2010 Annual Meeting of Stockholders pursuant toSchedule 14A (the “Proxy Statement”) not later than 120 days afterthe end of the fiscal year covered by this Annual Report on Form 10-K, andcertain information included therein is incorporated herein by reference asindicated below.

 

## **Item 10.**         Directors,Executive Officers and Corporate Governance

## ** **

The informationrequired by this Item 10 will be included under the captions “Election ofDirectors” and “Information Concerning Directors, Nominees and ExecutiveOfficers” in our Proxy Statement for our 2010 annual meeting of shareholders.Information concerning the compliance of our officers, directors and 10%shareholders with Section 16(a) of the Securities Exchange Act of1934 is incorporated by reference to the information to be contained in the2010 proxy statement under the caption “Information Concerning DirectorsNominees and Executive Officers — Section 16(a) Beneficial OwnershipReporting Compliance.” The information regarding Audit Committee members and “AuditCommittee Financial Experts” is incorporated by reference to the information tobe contained in the 2010 proxy statement under the caption “Information ConcerningDirectors Nominees and Executive Officers — Board Committees.” The informationregarding our Code of Business Ethics is incorporated by reference to theinformation to be contained in the 2010 proxy statement under the heading “InformationConcerning Directors Nominees and Executive Officers — Code of Business Conductand Ethics.”

 

## **Item 11.**         ExecutiveCompensation

## ** **

The informationunder the captions “Information Concerning Directors, Nominees and ExecutiveOfficers — Director Compensation,” “Information Concerning Directors, Nomineesand Executive Officers — Compensation Discussion and Analysis,” “InformationConcerning Directors, Nominees and Executive Officers — Compensation CommitteeReport,” “Information Concerning Directors, Nominees and Executive Officers —Executive Compensation” and “Information Concerning Directors, Nominees andExecutive Officers — Compensation Committee Interlocks and InsiderParticipation”  to be contained in the2010 proxy statement is incorporated herein by reference.

 

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

## ** **

The informationunder the captions “Beneficial Ownership of Common Stock” and “InformationConcerning Directors, Nominees and Executive Officers — Securities Authorizedfor Issuers Under Equity Compensation Plans” to be contained in the 2010 proxystatement is incorporated herein by reference.

 

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

## ** **

The informationunder the caption “Information Concerning Directors, Nominees and ExecutiveOfficers — Independent Directors” and “Information Concerning Directors,Nominees and Executive Officers — Policy and Procedures with Respect to RelatedPerson Transactions” to be contained in the 2010 proxy statement isincorporated herein by reference.

 

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

## ** **

The informationunder the caption “Ratification of Appointment of PricewaterhouseCoopers LLP asIndependent Registered Public Accounting Firm” to be contained in the 2010proxy statement is incorporated herein by reference.

 

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# **Table of Contents**

# ** **

# **Part IV**

# ** **

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

## ** **

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

 
| (1)    | Financial  Statements                                                                                                                                                                                              |   |
|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|   |                                                                                                                                                                                                               |   |
|   | Report of Independent  Registered Public Accounting Firm                                                                                                                                                           | 37     |
|   | Consolidated  Balance Sheets as of December 31, 2009 and 2008                                                                                                                                                 | 38     |
|   | Consolidated Statements of Operations for the years  ended December 31, 2009, 2008 and 2007                                                                                                                   | 39     |
|   | Consolidated Statements of Stockholders’ Equity and  Comprehensive Income (Loss) for the years ended December 31, 2009, 2008  and 2007                                                                   | 40     |
|   | Consolidated Statements of Cash Flows for the years  ended December 31, 2009, 2008 and 2007                                                                                                                   | 41     |
|   | Notes to Consolidated Financial Statements                                                                                                                                                                         | 42     |
|   |                                                                                                                                                                                                               |   |
| (2)    | All other  schedules to the Consolidated Financial Statements required by  Article 12 of Regulation S-X are not required under the related  instructions or are inapplicable and therefore have been omitted. |   |
|   |                                                                                                                                                                                                               |   |
| (3)    | Listing  of Exhibits                                                                                                                                                                                               |   |
|   |                                                                                                                                                                                                               |   |
|   | The  Exhibits required to be a part of this Report are listed in the Index to  Exhibits.                                                                                                                      |   |

 

(b)         Exhibits

 

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

 

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# ** **

# **Signatures**

# ** **

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the Registrant has duly caused this Report to be signed on its behalf bythe undersigned, thereunto duly authorized, in Minneapolis, Minnesota, on the16th day of March, 2010.

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

 

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

 
| **Signature**                 | ** ** | **Title**                                                       | ** ** | **Date**            |
|-------------------------------|------------|-----------------------------------------------------------------|------------|---------------------|
|                          |       |                                                            |       |                |
| /s/ Michael H. Carrel         |       | President, Chief  Executive Officer and Director                |       | March 16, 2010 |
| Michael H. Carrel             |       | (Principal Executive  Officer)                                  |       |                |
|                          |       |                                                            |       |                |
| /s/Peter J. Goepfrich         |       | Chief Financial Officer  and Treasurer                          |       | March 16, 2010 |
| Peter J. Goepfrich            |       | (Principal Financial  Officer and Principal Accounting Officer) |       |                |
|                          |       |                                                            |       |                |
| /s/James B.  Hickey, Jr. |       | Chairman of the Board  and Director                             |       | March 16, 2010 |
| James B.  Hickey, Jr.    |       |                                                            |       |                |
|                          |       |                                                            |       |                |
| /s/ Oran E. Muduroglu         |       | Director                                                        |       | March 16, 2010 |
| Oran E. Muduroglu             |       |                                                            |       |                |
|                          |       |                                                            |       |                |
| /s/ Gregory J. Peet           |       | Director                                                        |       | March 16, 2010 |
| Gregory J. Peet               |       |                                                            |       |                |
|                          |       |                                                            |       |                |
| /s/Richard W. Perkins         |       | Director                                                        |       | March 16, 2010 |
| Richard W. Perkins            |       |                                                            |       |                |
|                          |       |                                                            |       |                |
| /s/Douglas M. Pihl            |       | Director                                                        |       | March 16, 2010 |
| Douglas M. Pihl               |       |                                                            |       |                |
|                          |       |                                                            |       |                |
| /s/Michael W. Vannier         |       | Director                                                        |       | March 16, 2010 |
| Michael W. Vannier            |       |                                                            |       |                |
|                          |       |                                                            |       |                |
| /s/Sven A. Wehrwein           |       | Director                                                        |       | March 16, 2010 |
| Sven A. Wehrwein              |       |                                                            |       |                |

 

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**Report of Independent RegisteredPublic Accounting Firm**

 

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

 

In our opinion,the accompanying consolidated balance sheets and the related consolidatedstatements of operations, of stockholders’ equity and comprehensive income(loss) and of cash flows present fairly, in all material respects, the financialposition of Vital Images, Inc. and its subsidiaries at December 31,2009 and December 31, 2008, and the results of its operations and its cashflows for each of the three years in the period ended December 31, 2009,in conformity with accounting principles generally accepted in the UnitedStates of America.  Also in our opinion,the Company maintained, in all material respects, effective internal controlover financial reporting as of December 31, 2009, based on criteriaestablished in Internal Control - Integrated Framework issued by the Committeeof Sponsoring Organizations of the Treadway Commission (COSO).  The Company’s management is responsible forthese financial statements, for maintaining effective internal control overfinancial reporting and for its assessment of the effectiveness of internalcontrol over financial reporting, included in Management’s Report on InternalControl over Financial Reporting appearing under Item 9A.  Our responsibility is to express opinions onthese financial statements and on the Company’s internal control over financialreporting based on our integrated audits. We conducted our audits in accordance with the standards of the PublicCompany Accounting Oversight Board (United States).  Those standards require that we plan andperform the audits to obtain reasonable assurance about whether the financialstatements are free of material misstatement and whether effective internalcontrol over financial reporting was maintained in all material respects.  Our audits of the financial statementsincluded examining, on a test basis, evidence supporting the amounts anddisclosures in the financial statements, assessing the accounting principlesused and significant estimates made by management, and evaluating the overallfinancial statement presentation.  Ouraudit of internal control over financial reporting included obtaining anunderstanding of internal control over financial reporting, assessing the riskthat a material weakness exists, and testing and evaluating the design andoperating effectiveness of internal control based on the assessed risk.  Our audits also included performing suchother procedures as we considered necessary in the circumstances.  We believe that our audits provide areasonable basis for our opinions.

 

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

 

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

 

 

/s/ PricewaterhouseCoopers LLP

Minneapolis, Minnesota

March 16, 2010

 

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**Vital Images, Inc.Consolidated Balance Sheets(In thousands, except per share amounts)**

** **
| ** **                                                                                                                                                                                  | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                  | ** ** | **2009**              | ** ** | **2008** | ** ** |
| **Assets**                                                                                                                                                                                  |       |                  |       |   |   |
| Current assets:                                                                                                                                                                             |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                                                                                   |       | $                     | 120,317    |   | $ | 109,706 |   |
| Marketable securities                                                                                                                                                                       |       | 9,673                 |       | 37,287 |   |
| Accounts receivable, net                                                                                                                                                                    |       | 12,196                |       | 13,047 |   |
| Deferred income taxes                                                                                                                                                                       |       | —                |       | 654 |   |
| Prepaid expenses and other current assets                                                                                                                                                   |       | 2,686                 |       | 2,179 |   |
| Total current assets                                                                                                                                                                        |       | 144,872               |       | 162,873 |   |
| Marketable securities                                                                                                                                                                       |       | 12,234                |       | — |   |
| Property and equipment, net                                                                                                                                                                 |       | 5,485                 |       | 11,519 |   |
| Deferred income taxes                                                                                                                                                                       |       | —                |       | 13,904 |   |
| Other intangible assets, net                                                                                                                                                                |       | 382                   |       | 808 |   |
| Goodwill                                                                                                                                                                                    |       | 9,089                 |       | 9,089 |   |
| Total assets                                                                                                                                                                                |       | $                     | 172,062    |   | $ | 198,193 |   |
|                                                                                                                                                                                        |       |                  |       |   |   |
| **Liabilities and Stockholders’  Equity**                                                                                                                                              |       |                  |       |   |   |
| Current liabilities:                                                                                                                                                                        |       |                  |       |   |   |
| Accounts payable                                                                                                                                                                            |       | $                     | 2,588      |   | $ | 3,792 |   |
| Accrued compensation                                                                                                                                                                        |       | 3,574                 |       | 2,936 |   |
| Accrued royalties                                                                                                                                                                           |       | 812                   |       | 1,057 |   |
| Other current liabilities                                                                                                                                                                   |       | 1,364                 |       | 1,947 |   |
| Deferred revenue                                                                                                                                                                            |       | 15,500                |       | 17,724 |   |
| Total current liabilities                                                                                                                                                                   |       | 23,838                |       | 27,456 |   |
| Deferred revenue                                                                                                                                                                            |       | 1,033                 |       | 1,164 |   |
| Deferred rent                                                                                                                                                                               |       | 469                   |       | 882 |   |
| Total liabilities                                                                                                                                                                           |       | 25,340                |       | 29,502 |   |
|                                                                                                                                                                                        |       |                  |       |   |   |
| Commitments and contingencies (Note 4)                                                                                                                                                      |       |                  |       |   |   |
|                                                                                                                                                                                        |       |                  |       |   |   |
| Stockholders’ equity:                                                                                                                                                                  |       |                  |       |   |   |
| Preferred stock: $0.01 par value; 5,000 shares  authorized; none issued or outstanding                                                                                                      |       | —                |       | — |   |
| Common stock: $0.01 par value; 40,000 shares  authorized; 14,330 issued and outstandingas of December 31, 2009; and 14,673  shares issued and outstanding as of December 31, 2008 |       | 143                   |       | 147 |   |
| Additional paid-in capital                                                                                                                                                                  |       | 168,058               |       | 168,738 |   |
| Accumulated deficit                                                                                                                                                                         |       | (21,632               | )          | (380 | ) |
| Accumulated other comprehensive income                                                                                                                                                      |       | 153                   |       | 186 |   |
| Total stockholders’ equity                                                                                                                                                             |       | 146,722               |       | 168,691 |   |
| Total liabilities and stockholders’ equity                                                                                                                                             |       | $                     | 172,062    |   | $ | 198,193 |   |

 

The accompanying notes are an integral part ofthe Consolidated Financial Statements.

 

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** **

**VitalImages, Inc.Consolidated Statements of Operations(In thousands, except for per share amounts)**

 
| ** **                                            | ** ** | **For the Year Ended  December 31,** | ** ** |
|-------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                            | ** ** | **2009**                                  | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                                  |       |                                      |       |   |   |   |   |
| Revenue:                                              |       |                                      |       |   |   |   |   |
| License  fees                                         |       | $                                         | 22,766     |   | $ | 34,290 |   | $ | 39,673 |   |
| Maintenance  and services                             |       | 33,717                                    |       | 32,436 |   | 29,487 |   |
| Hardware                                              |       | 1,747                                     |       | 1,415 |   | 1,016 |   |
| Total  revenue                                        |       | 58,230                                    |       | 68,141 |   | 70,176 |   |
|                                                  |       |                                      |       |   |   |   |   |
| Cost  of revenue:                                     |       |                                      |       |   |   |   |   |
| License  fees                                         |       | 3,301                                     |       | 4,922 |   | 4,725 |   |
| Maintenance  and services                             |       | 9,282                                     |       | 10,089 |   | 9,928 |   |
| Hardware                                              |       | 1,622                                     |       | 862 |   | 694 |   |
| Impairment  of patent                                 |       | —                                    |       | — |   | 242 |   |
| Total  cost of revenue                                |       | 14,205                                    |       | 15,873 |   | 15,589 |   |
|                                                  |       |                                      |       |   |   |   |   |
| Gross  profit                                         |       | 44,025                                    |       | 52,268 |   | 54,587 |   |
|                                                  |       |                                      |       |   |   |   |   |
| Operating  expenses:                                  |       |                                      |       |   |   |   |   |
| Sales  and marketing                                  |       | 22,579                                    |       | 27,835 |   | 29,481 |   |
| Research  and development                             |       | 16,332                                    |       | 20,355 |   | 18,476 |   |
| General  and administrative                           |       | 9,978                                     |       | 13,243 |   | 13,798 |   |
| Asset  impairment (Note 3)                            |       | 3,147                                     |       | — |   | — |   |
| Restructuring  charge                                 |       | —                                    |       | 660 |   | — |   |
| Total  operating expenses                             |       | 52,036                                    |       | 62,093 |   | 61,755 |   |
|                                                  |       |                                      |       |   |   |   |   |
| Operating  loss                                       |       | (8,011                                    | )          | (9,825 | ) | (7,168 | ) |
|                                                  |       |                                      |       |   |   |   |   |
| Interest  income                                      |       | 1,091                                     |       | 4,643 |   | 8,886 |   |
| (Loss)  income before income taxes                    |       | (6,920                                    | )          | (5,182 | ) | 1,718 |   |
|                                                  |       |                                      |       |   |   |   |   |
| Provision  (benefit) for income taxes                 |       | 14,332                                    |       | (2,382 | ) | 351 |   |
|                                                  |       |                                      |       |   |   |   |   |
| Net  (loss) income                                    |       | $                                         | (21,252    | ) | $ | (2,800 | ) | $ | 1,367 |   |
|                                                  |       |                                      |       |   |   |   |   |
| Net  (loss) income per share – basic             |       | $                                         | (1.48      | ) | $ | (0.17 | ) | $ | 0.08 |   |
| Net  (loss) income per share – diluted           |       | $                                         | (1.48      | ) | $ | (0.17 | ) | $ | 0.08 |   |
|                                                  |       |                                      |       |   |   |   |   |
| Weighted  average common shares outstanding - basic   |       | 14,315                                    |       | 16,155 |   | 16,972 |   |
| Weighted  average common shares outstanding - diluted |       | 14,315                                    |       | 16,155 |   | 17,457 |   |

 

The accompanying notes are an integral part ofthe Consolidated Financial Statements.

 

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

**(In thousands)**

 
| ** **                                                                                                     | ** ** | ** **       | ** ** | ** **  | ** ** | ** **       | ** ** | **Retained**      | ** ** | **Accumulated**        | ** ** | ** **        | ** ** | ** **        | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|------------------|------------|-------------|------------|------------------|------------|-------------------|------------|------------------------|------------|-------------------|------------|-------------------|------------|
| ** **                                                                                                     | ** ** | ** **       | ** ** | ** **  | ** ** | **Additional**   | ** ** | **Earnings /**    | ** ** | **Other**              | ** ** | **Total**         | ** ** | ** **        | ** ** |
| ** **                                                                                                     | ** ** | **Common Stock** | ** ** | **Paid-In** | ** ** | **(Accumulated** | ** ** | **Comprehensive** | ** ** | **Stockholders’** | ** ** | **Comprehensive** | ** ** |
| ** **                                                                                                     | ** ** | **Shares**       | ** ** | **Amount**  | ** ** | **Capital**      | ** ** | **Deficit)**      | ** ** | **Income / (Loss)**    | ** ** | **Equity**        | ** ** | **Income (Loss)** | ** ** |
|                                                                                                           |       |             |       |        |       |             | ** ** | ** **        |       |                   |       |              |       |              |       |
| Balances  as of December 31, 2006                                                                         |       | 16,908           |       | $           | 169        |             | $          | 189,669           |       | $                      | 1,053      |              | $          | 11                |       | $ | 190,902 |   | $ | 6,614 |   |
|                                                                                                           |       |             |       |        |       |             | ** ** | ** **        |       |                   |       |              |       |              |       |
| Issuance  of common stock upon exercise of stock options                                                       |       | 221              |       | 3           |       | 2,352            |       |              | ** ** | ** **             |       | 2,355             |       |              |       |
| Tax  benefit related to exercise of stock options and release of restricted stock                              |       |             |       |        |       | 1,443            |       |              | ** ** | ** **             |       | 1,443             |       |              |       |
| Issuance  of common stock under employee stock purchase plan                                                   |       | 27               |       | —      |       | 521              |       |              | ** ** | ** **             |       | 521               |       |              |       |
| Grant  of restricted stock to employees                                                                        |       | 14               |       | —      |       | —           |       |              | ** ** | ** **             |       | —            |       |              |       |
| Forfeiture  or cancellation of restricted stock                                                                |       | (5               | )          | —      |       | —           |       |              | ** ** | ** **             |       | —            |       |              |       |
| Common  stock surrendered for payment of payroll tax liability resulting from the vesting  of restricted stock |       | (12              | )          | —      |       | (347             | )          |              | ** ** | ** **             |       | (347              | )          |              |       |
| Stock-based  compensation                                                                                      |       |             |       |        |       | 5,987            |       |              | ** ** | ** **             |       | 5,987             |       |              |       |
| Change  in unrealized gain or loss on investments, net of tax                                                  |       |             |       |        |       |             |       |              | ** ** | (8                     | )          | (8                | )          | $                 | (8         | ) |
| Cumulative  translation adjustment                                                                             |       |             |       |        |       |             |       |              |       | (4                     | )          | (4                | )          | (4                | )          |
| Net  income                                                                                                    |       |             |       |        |       |             |       | 1,367             | ** ** | ** **             |       | 1,367             |       | 1,367             |       |
| Balances  as of December 31, 2007                                                                         |       | 17,153           |       | 172         |       | 199,625          |       | 2,420             |       | (1                     | )          | 202,216           |       | $                 | 1,355      |   |
|                                                                                                           |       |             |       |        |       |             | ** ** | ** **        |       |                   |       |              |       |              |       |
| Issuance  of common stock upon exercise of stock options                                                       |       | 243              |       | 2           |       | 1,927            |       |              | ** ** | ** **             |       | 1,929             |       |              |       |
| Tax  benefit related to exercise of stock options and release of restricted stock                              |       |             |       |        |       | 50               |       |              | ** ** | ** **             |       | 50                |       |              |       |
| Issuance  of common stock under employee stock purchase plan                                                   |       | 43               |       | —      |       | 490              |       |              | ** ** | ** **             |       | 490               |       |              |       |
| Grant  of restricted stock to employees                                                                        |       | 30               |       | —      |       | —           |       |              | ** ** | ** **             |       | —            |       |              |       |
| Forfeiture  or cancellation of restricted stock                                                                |       | (27              | )          | —      |       | —           |       |              | ** ** | ** **             |       | —            |       |              |       |
| Common  stock surrendered for payment of payroll tax liability resulting from the vesting  of restricted stock |       | (12              | )          | —      |       | (174             | )          |              | ** ** | ** **             |       | (174              | )          |              |       |
| Stock-based  compensation                                                                                      |       |             |       |        |       | 5,007            |       |              | ** ** | ** **             |       | 5,007             |       |              |       |
| Repurchases  of common stock                                                                                   |       | (2,757           | )          | (27         | )          | (38,187          | )          |              | ** ** | ** **             |       | (38,214           | )          |              |       |
| Change  in unrealized gain or loss on investments, net of tax                                                  |       |             |       |        |       |             |       |              | ** ** | 187                    |       | 187               |       | $                 | 187        |   |
| Net  loss                                                                                                      |       |             |       |        |       |             |       | (2,800            | )          | ** **             |       | (2,800            | )          | (2,800            | )          |
| Balances  as of December 31, 2008                                                                         |       | 14,673           |       | 147         |       | 168,738          |       | (380              | )          | 186                    |       | 168,691           |       | $                 | (2,613     | ) |
|                                                                                                           |       |             |       |        |       |             | ** ** | ** **        |       |                   |       |              |       |              |       |
| Issuance  of common stock upon exercise of stock options                                                       |       | 163              |       | 2           |       | 1,151            |       |              | ** ** | ** **             |       | 1,153             |       |              |       |
| Issuance  of common stock under employee stock purchase plan                                                   |       | 51               |       | —      |       | 496              |       |              | ** ** | ** **             |       | 496               |       |              |       |
| Grant  of restricted stock to employees                                                                        |       | 15               |       | —      |       | —           |       |              | ** ** | ** **             |       | —            |       |              |       |
| Common  stock surrendered for payment of payroll tax liability resulting from the vesting  of restricted stock |       | (10              | )          | —      |       | (119             | )          |              | ** ** | ** **             |       | (119              | )          |              |       |
| Stock-based  compensation                                                                                      |       |             |       |        |       | 3,867            |       |              | ** ** | ** **             |       | 3,867             |       |              |       |
| Repurchases  of common stock                                                                                   |       | (562             | )          | (6          | )          | (6,075           | )          |              | ** ** | ** **             |       | (6,081            | )          |              |       |
| Change  in unrealized gain or loss on investments, net of tax                                                  |       |             |       |        |       |             |       |              | ** ** | (33                    | )          | (33               | )          | $                 | (33        | ) |
| Net  loss                                                                                                      |       |             |       |        |       |             |       | (21,252           | )          | ** **             |       | (21,252           | )          | (21,252           | )          |
| Balances  as of December 31, 2009                                                                         |       | 14,330           |       | $           | 143        |             | $          | 168,058           |       | $                      | (21,632    | )                 | $          | 153               |       | $ | 146,722 |   | $ | (21,285 | ) |

 

The accompanying notes are an integral part ofthe Consolidated Financial Statements.

 

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**Vital Images, Inc.****Consolidated Statements of Cash Flows**

**(In thousands)**

 
| ** **                                                                         | ** ** | **For the Year Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                         | ** ** | **2009**                                 | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                                                               |       |                                     |       |   |   |   |   |
| Cash flows from  operating activities:                                             |       |                                     |       |   |   |   |   |
| Net (loss) income                                                                  |       | $                                        | (21,252    | ) | $ | (2,800 | ) | $ | 1,367 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                                     |       |   |   |   |   |
| Depreciation and  amortization of property and equipment                           |       | 4,843                                    |       | 4,919 |   | 4,517 |   |
| Amortization of  identified intangible assets                                      |       | 426                                      |       | 1,044 |   | 1,205 |   |
| Loss on disposal of  assets                                                        |       | 111                                      |       | — |   | — |   |
| Asset impairment                                                                   |       | 3,147                                    |       | — |   | 242 |   |
| Provision for doubtful  accounts                                                   |       | 279                                      |       | 519 |   | 239 |   |
| Deferred income taxes                                                              |       | 14,664                                   |       | (2,521 | ) | (16 | ) |
| Excess tax benefit from  stock transactions                                        |       | —                                   |       | (481 | ) | (1,395 | ) |
| Amortization of  discount and accretion of premium on marketable securities        |       | 238                                      |       | (473 | ) | (857 | ) |
| Employee stock-based  compensation                                                 |       | 3,867                                    |       | 5,007 |   | 5,987 |   |
| Amortization of  deferred rent                                                     |       | (394                                     | )          | (375 | ) | (338 | ) |
| Changes in operating  assets and liabilities:                                      |       |                                     |       |   |   |   |   |
| Accounts receivable                                                                |       | 572                                      |       | 2,396 |   | 3,388 |   |
| Prepaid expenses and  other assets                                                 |       | (507                                     | )          | 262 |   | (513 | ) |
| Accounts payable                                                                   |       | (936                                     | )          | 623 |   | (363 | ) |
| Accrued expenses and  other liabilities                                            |       | (329                                     | )          | (740 | ) | (1,142 | ) |
| Deferred revenue                                                                   |       | (2,355                                   | )          | 1,201 |   | 1,382 |   |
| Deferred rent                                                                      |       | —                                   |       | — |   | 199 |   |
| Net cash provided by  operating activities                                         |       | 2,374                                    |       | 8,581 |   | 13,902 |   |
|                                                                               |       |                                     |       |   |   |   |   |
| Cash flows from  investing activities:                                             |       |                                     |       |   |   |   |   |
| Purchases of property  and equipment                                               |       | (2,335                                   | )          | (5,434 | ) | (6,577 | ) |
| Purchases of marketable  securities                                                |       | (21,749                                  | )          | (76,395 | ) | (59,974 | ) |
| Proceeds from  maturities of marketable securities                                 |       | 36,752                                   |       | 70,002 |   | 49,931 |   |
| Proceeds from sales of  marketable securities                                      |       | —                                   |       | 1,581 |   | 750 |   |
| Net cash provided by  (used in) investing activities                               |       | 12,668                                   |       | (10,246 | ) | (15,870 | ) |
|                                                                               |       |                                     |       |   |   |   |   |
| Cash flows from  financing activities:                                             |       |                                     |       |   |   |   |   |
| Repurchases of common  stock                                                       |       | (6,081                                   | )          | (38,214 | ) | — |   |
| Proceeds from sale of  common stock under stock plans                              |       | 1,650                                    |       | 2,419 |   | 2,876 |   |
| Excess tax benefit from  stock transactions                                        |       | —                                   |       | 481 |   | 1,395 |   |
| Net cash (used in)  provided by financing activities                               |       | (4,431                                   | )          | (35,314 | ) | 4,271 |   |
|                                                                               |       |                                     |       |   |   |   |   |
| Net increase (decrease)  in cash and cash equivalents                              |       | 10,611                                   |       | (36,979 | ) | 2,303 |   |
|                                                                               |       |                                     |       |   |   |   |   |
| Cash and cash  equivalents, beginning of period                                    |       | 109,706                                  |       | 146,685 |   | 144,382 |   |
|                                                                               |       |                                     |       |   |   |   |   |
| Cash and cash  equivalents, end of period                                          |       | $                                        | 120,317    |   | $ | 109,706 |   | $ | 146,685 |   |
|                                                                               |       |                                     |       |   |   |   |   |
| Supplemental cash flow  information:                                               |       |                                     |       |   |   |   |   |
| Purchases of property  and equipment with accounts payable                         |       | $                                        | 97         |   | $ | 366 |   | $ | 525 |   |

 

The accompanying notes are an integral part ofthe Consolidated Financial Statements.

 

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**VitalImages, Inc.****Notes to Consolidated Financial Statements**

 

**1.**     Businessdescription

** **

Vital Images, Inc.(the “Company”) is a leading provider of advanced visualization and imageanalysis solutions for use by medical professionals in clinical analysis andtherapy planning for medical conditions. The Company provides software,customer education, software maintenance and support, professional servicesand, on occasion, third-party hardware to its customers. The Company’stechnology rapidly transforms complex data generated by diagnostic imagingequipment into functional digital images that can be manipulated and analyzedusing its specialized applications to better understand internal anatomy andpathology. The Company’s solutions are designed to improve physician workflowand productivity, enhance the ability to make clinical decisions, facilitateless invasive patient care, and complement often significant capitalinvestments in diagnostic imaging equipment made by its customers. The Company’ssoftware is compatible with equipment from all major manufacturers ofdiagnostic imaging equipment, such as computed tomography, or CT, scanners, andcan be integrated into picture archiving and communication systems, or PACS.Many hospitals use PACS to acquire, distribute and archive medical images anddiagnostic reports, reducing the need for film and increasing reliance onadvanced visualization solutions such as the Company’s. The Company also offersa Web-based solution that provides physicians with anywhere, anytime access tomedical images and visualization tools through any Internet-enabled computer.

 

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

 

Certainreclassifications have been made to prior period operating expense amounts inorder to conform to the current period presentation. Specifically, expensesrelated to certain product development related activities were reclassifiedfrom general and administrative expense and sales and marketing expense toresearch and development expense and therefore had no effect on previouslyreported stockholder’s equity, net loss, or net cash flows.

 

Operating expenses for the years ended December 31,2008 and 2007, as reported and as reclassified were as follows:

 
| ** **                  | ** ** | **For the Year Ended**     | ** ** | **For the Year Ended**     | ** ** |
|-----------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                  | ** ** | **December 31, 2008** | ** ** | **December 31, 2007** | ** ** |
| ** **                  | ** ** | **As Reported**            | ** ** | **As Reclassified**        | ** ** | **As Reported** | ** ** | **As Reclassified** | ** ** |
| Operating  expenses:        |       |                       |       |                       |       |   |   |   |   |
| Sales  and marketing        |       | $                          | 30,294     |                       | $          | 27,835 |   | $ | 31,991 |   | $ | 29,481 |   |
| Research  and development   |       | 17,131                     |       | 20,355                     |       | 15,204 |   | 18,476 |   |
| General  and administrative |       | 14,008                     |       | 13,243                     |       | 14,560 |   | 13,798 |   |
| Restructuring  charge       |       | 660                        |       | 660                        |       | — |   | — |   |
| Total  operating expenses   |       | $                          | 62,093     |                       | $          | 62,093 |   | $ | 61,755 |   | $ | 61,755 |   |

** **

**2.**     Summaryof significant accounting policies

** **

##### **Basis of presentation**

##### ** **

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

 

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##### ** **

##### **Use of estimates**

##### ** **

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

 

##### **Fair value of financialinstruments**

##### ** **

The Company’s financialinstruments consist primarily of cash, cash equivalents, and marketablesecurities, for which the current carrying amounts approximate fair marketvalues based on quoted market prices.

 

##### **Cash and cash equivalents**

##### ** **

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

 

##### **Marketable securities**

##### ** **

Managementdetermines the appropriate classification of marketable securities at the timeof purchase and reevaluates such designation as of each balance sheet date.Currently, all marketable securities held by the Company are classified asavailable-for-sale. Available-for-sale securities are carried at fair value asdetermined by quoted market prices with unrealized gains and losses, net oftax, reported as a separate component of stockholders’ equity. If an unrealizedloss for any investment is considered to be other-than-temporary, the loss willbe recognized in the consolidated income statement in the period thedetermination is made. The cost basis of securities sold is determined usingthe specific identification method. The cost of marketable securities isadjusted for amortization of premiums and accretion of discounts to maturity.Such amortization and accretion is included in interest income. Interest anddividends on securities classified as available-for-sale are included ininterest income.

 

The Companyadopted Accounting Standards Codification (ASC) Topic 820, *Fair ValueMeasurements*, as of January 1, 2008, with the exception of theapplication of Topic 820 to nonrecurring nonfinancial assets and nonfinancialliabilities which was adopted as of January 1, 2009.

 

Topic820 establishes a valuation hierarchy for disclosure of the inputs to valuationused to measure fair value. This hierarchy prioritizes the inputs into threebroad levels. Level 1 inputs are quoted prices (unadjusted) in active marketsfor identical assets or liabilities. Level 2 inputs are quoted prices forsimilar assets and liabilities in active markets or inputs that are observablefor the asset or liability, either directly or indirectly through marketcorroboration, for substantially the full term of the financial instrument.Level 3 inputs are unobservable inputs based on our own assumptions used tomeasure assets and liabilities at fair value. A financial asset’s or liability’sclassification within the hierarchy is determined based on the lowest levelinput that is significant to the fair value measurement.

 

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The following tables providethe assets and liabilities carried at fair value measured on a recurring basisas of December 31, 2009 and 2008 (in thousands):

 
| ** **                                        | ** ** | ** **                   | ** ** | **Fair Value Measurements at  December 31, 2009 Using** | ** ** |
|---------------------------------------------------|------------|------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                        | ** ** | **Total Carrying  Value at** | ** ** | **Quoted price in  active markets**                          | ** ** | **Significant other  observable inputs** | ** ** | **Significant  unobservable inputs** | ** ** |
| ** **                                        | ** ** | **December 31, 2009**   | ** ** | **(Level 1)**                                                | ** ** | **(Level 2)** | ** ** | **(Level 3)** | ** ** |
| Cash  equivalents:                                |       |                         |       |                                                         |       |   |   |   |   |
| Money  market                                     |       | $                            | 114,830    |                                                         | $          | 114,830 |   | $ | — |   | $ | — |   |
|                                              |       |                         |       |                                                         |       |   |   |   |   |
| Marketable  securities:                           |       |                         |       |                                                         |       |   |   |   |   |
| Corporate  debt                                   |       | 16,911                       |       | 16,911                                                       |       | — |   | — |   |
| Government  debt                                  |       | 4,996                        |       | 4,996                                                        |       | — |   | — |   |
| Total  marketable securities                      |       | 21,907                       |       | 21,907                                                       |       | — |   | — |   |
| Total  cash equivalents and marketable securities |       | $                            | 136,737    |                                                         | $          | 136,737 |   | $ | — |   | $ | — |   |

 
| ** **                                        | ** ** | ** **                   | ** **    | **Fair Value Measurements at  December 31, 2008 Using** | ** ** |
|---------------------------------------------------|------------|------------------------------|---------------|--------------------------------------------------------------|------------|
| ** **                                        | ** ** | **Total Carrying  Value at** | ** **    | **Quoted price in  active markets**                          | ** ** | **Significant other  observable inputs** | ** ** | **Significant  unobservable inputs** | ** ** |
| ** **                                        | ** ** | **December 31, 2008**   |          | **(Level 1)**                                                |       | **(Level 2)** |   | **(Level 3)** | ** ** |
|                                              |       |                         |          |                                                         |       |   |   |   |   |
| Cash  equivalents:                                |       |                         |          |                                                         |       |   |   |   |   |
| Money  market                                     |       | $                            |  108,102 |                                                         | $          | 108,102 |   | $ | — |   | $ | — |   |
|                                              |       |                         |          |                                                         |       |   |   |   |   |
| Marketable  securities:                           |       |                         |          |                                                         |       |   |   |   |   |
| Corporate  debt                                   |       | 2,255                        |          | 1,998                                                        |       | 257 |   | — |   |
| Government  debt                                  |       | 35,032                       |          | 35,032                                                       |       | — |   | — |   |
| Total  marketable securities                      |       | 37,287                       |          | 37,030                                                       |       | 257 |   | — |   |
| Total  cash equivalents and marketable securities |       | $                            | 145,389       |                                                         | $          | 145,132 |   | $ | 257 |   | $ | — |   |

 

Cash equivalentsand marketable securities measured at fair value using quoted market prices areclassified within Level 1 of the valuation hierarchy.

 

Marketablesecurities classified within Level 2 of the valuation hierarchy consisted of anasset-backed security. The valuation of this asset-backed security wasdetermined by reviewing quoted market prices for traded lots of the same orsimilar securities. This security was rated AAA and fully matured during 2009.The Company did not realize any loss on this security.

 

As of December 31,2009 and 2008, the Company’s marketable securities were as follows (inthousands):

 
| ** **      | ** ** | **December 31, 2009** | ** ** | **December 31, 2008** | ** ** |
|-----------------|------------|----------------------------|------------|----------------------------|------------|
| ** **      | ** ** | **Adjusted Cost  Basis**   | ** ** | **Aggregate Fair  Value**  | ** ** | **Net Unrealized  Gains / (Losses)** | ** ** | **Adjusted  Cost Basis** | ** ** | **Aggregate Fair  Value** | ** ** | **Net Unrealized  Gains / (Losses)** | ** ** |
|            |       |                       |       |                       |       |   |   |   |   |   |   |   |   |
| Corporate debt  |       | $                          | 16,766     |                       | $          | 16,911 |   | $ | 145 |   | $ | 2,253 |   | $ | 2,255 |   | $ | 2 |   |
| Government debt |       | 4,988                      |       | 4,996                      |       | 8 |   | 34,742 |   | 35,032 |   | 290 |   |
|            |       | $                          | 21,754     |                       | $          | 21,907 |   | $ | 153 |   | $ | 36,995 |   | $ | 37,287 |   | $ | 292 |   |

 

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As of December 31,2009 and 2008, the Company’s gross unrealized gains and losses were as follows(in thousands):

 
| ** **      | ** ** | **December 31, 2009**   | ** ** | **December 31, 2008**      | ** ** |
|-----------------|------------|------------------------------|------------|---------------------------------|------------|
| ** **      | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  (Losses)** | ** ** | **Net Unrealized  Gains / (Losses)** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  (Losses)** | ** ** | **Net Unrealized  Gains / (Losses)** | ** ** |
| Corporate debt  |       | $                            | 145        |                            | $          | — |   | $ | 145 |   | $ | 9 |   | $ | (7 | ) | $ | 2 |   |
| Government debt |       | 8                            |       | —                          |       | 8 |   | 290 |   | — |   | 290 |   |
|            |       | $                            | 153        |                            | $          | — |   | $ | 153 |   | $ | 299 |   | $ | (7 | ) | $ | 292 |   |

 

The carryingvalues of available-for-sale securities are at fair value. There were nomaterial realized gains or losses on any investments for the years ended December 31,2009, 2008 or 2007.

 

The Companyanalyzes its investments for impairment on an ongoing basis. Factors consideredin determining whether an unrealized loss is a temporary loss or another-than-temporary loss include the length of time and extent to which thesecurities have been in an unrealized loss position and the Company’s abilityand intent to hold the investment for a period of time sufficient to allow forany anticipated market recovery.

 

##### **Accounts receivable andallowance for doubtful accounts**

##### ** **

Accounts receivableare initially recorded at a selling price, which approximates fair value uponthe sale of goods or services to customers. The Company maintains an allowancefor doubtful accounts to reflect accounts receivable at net realizable value.In judging the adequacy of the allowance for doubtful accounts, the Companyconsiders multiple factors, including historical bad debt experience, thegeneral economic environment, the need for specific client reserves and theaging of the Company’s receivables. A portion of this provision is included inoperating expenses as a general and administrative expense and a portion ofthis provision is included as a reduction of license revenue. A considerableamount of judgment is required in assessing these factors. If the factorsutilized in determining the allowance do not reflect future performance, then achange in the allowance for doubtful accounts would be necessary in the periodsuch determination has been made, which would impact future results ofoperations.

 

##### **Concentration of creditrisk**

##### ** **

Financialinstruments that potentially subject the Company to concentrations of creditrisk consist primarily of cash and cash equivalents, marketable securities andtrade accounts receivable. Deposits with the Company’s bank may exceed theamount of insurance provided on such deposits. The Company’s investment policy,approved by its Investment Committee, limits the amount the Companymay invest in any one type of investment, thereby reducing credit riskconcentrations. A significant portion of the Company’s accounts receivablerelates to Toshiba Medical Systems Corporation, McKesson Corporation andMedtronic Inc., totaling 36%, 14% and 12% of accounts receivable, respectively,as of December 31, 2009. The Company reviews the creditworthiness of itscustomers prior to product shipment and generally does not require collateral.

 

##### **Property and equipment**

##### ** **

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

 

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##### **Long-lived assets**

##### ** **

The Companyreviews long-lived assets (or asset groups) for impairment whenever events orchanges in circumstances indicate the carrying amount may not berecoverable, in accordance with ASC Topic 360, *Property,Plant and Equipment*. Events or changes in circumstances that indicatethe carrying amount may not be recoverable include, but are not limitedto, a significant decrease in the market value of the business or assetacquired, a significant adverse change in the extent or manner in which thebusiness or asset acquired is used, or a significant adverse change in thebusiness climate. If such events or changes in circumstances are present, theundiscounted cash flows method is used to determine whether the asset isimpaired. Cash flows would include the estimated terminal value of the assetand exclude any interest charges. To the extent the carrying value of the assetexceeds the undiscounted cash flows over the estimated remaining life of theasset, the impairment is measured using the discounted cash flows. The discountrate utilized would be based on management’s best estimate of the related risksand return at the time the impairment assessment is made.

 

##### **Goodwill**

##### ** **

The Companyaccounts for goodwill in accordance with the provisions of ASC Topic 350, *Intangibles — Goodwill and Other*. Under this accountingguidance, goodwill and intangible assets with indefinite lives are reviewed forimpairment annually or more frequently if events or changes in circumstancesindicate that the asset might be impaired. The first step of the goodwillimpairment test, used to identify potential impairment, compares the fair valueof a reporting unit with its carrying amount, including goodwill. The Companyoperates as one reporting unit and therefore compares the book value to themarket value (market capitalization plus a control premium). If the marketvalue exceeds the book value, goodwill is considered not impaired, and thus thesecond step of the impairment test is not necessary. If the Company’s bookvalue exceeds the market value, the second step of the goodwill impairment testis performed to measure the amount of impairment loss, if any. The second stepof the goodwill impairment test, used to measure the amount of impairment loss,compares the implied fair value of the goodwill with the book value of thegoodwill. If the carrying value of the goodwill exceeds the implied fair valueof the goodwill, an impairment loss would be recognized in an amount equal tothe excess. Any loss recognized cannot exceed the carrying amount of goodwill.The Company completed the annual goodwill impairment assessment as of December 31,2009, in which no impairment was recorded. If market conditions continue tofluctuate, the Company may incur goodwill impairment charges that adverselyaffect its financial position and operating results.

 

##### **Revenue recognition**

##### ** **

The Companyrecognizes revenue in accordance with ASC Topic 985, *RevenueRecognition*. The Company recognizes revenue when it is realized orrealizable and earned. The Company considers revenue realized or realizable andearned when it has persuasive evidence of an arrangement, the product has beenshipped or the services have been provided to the customer, the sales price isfixed or determinable, and collectability is probable.

 

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

 

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

 

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recognizes revenuefrom Resellers on a sell-in basis if the Reseller i) assumes all risk of thepurchase, ii) has the ability and obligation to pay regardless of receivingpayment from the end user, and iii) all other revenue recognition criteria aremet. The majority of revenue generated through Resellers has been on a sell-inbasis. The following are other revenue recognition criteria applied by theCompany:

 

·                  Software and Hardware — Revenue from license fees andhardware is recognized when shipment of the product has occurred, nosignificant Company obligations with regard to implementation remain and theCompany’s services are not considered essential to the functionality of otherelements of the arrangement.

 

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

 

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

 

·                  Subscription Arrangements — Revenue from subscriptionarrangements is recognized ratably over the subscription period. Revenue fromsubscription arrangements is allocated to license revenue, maintenance andservice revenue, and hardware revenue in a manner consistent with theallocation of revenue under the residual method for the same elements innon-subscription transactions.

 

**Equity-based compensation**

 

The Companyaccounts for equity-based compensation in accordance with ASC Topic 718, *Compensation — Stock Compensation*, which requires themeasurement and recognition of compensation expense for all equity-basedpayment awards made to employees and directors, including employee stockoptions, restricted stock and employee stock purchases related to the EmployeeStock Purchase Plan, based on estimated fair values.

 

Equity-basedcompensation expense recognized under ASC Topic 718 for the years endedDecember 31, 2009, 2008 and 2007 was $3.9 million, $5.0 million and $6.0million, respectively. 

 

Stock Options

 

ASC Topic 718requires companies to estimate the fair value of equity-based payment awards onthe date of grant using an option-pricing model. The Company uses theBlack-Scholes option-pricing model, which requires the input of assumptions, includingan estimate of the average period of time employees will retain vested stockoptions before exercising them, the estimated volatility of the Company’scommon stock price over the expected term, and the number of options that willultimately be forfeited before completing vesting requirements. Changes in theassumptions can materially affect the estimate of fair value of equity-basedcompensation and, consequently, the related expense recognized. The value ofthe portion of the award that is ultimately expected to vest is recognized asexpense over the requisite vesting period.

 

Equity-basedcompensation expense recognized for the years ended December 31, 2009,2008 and 2007 included compensation expense for equity-based payment awardsgranted on or prior to December 31, 2005 but not yet vested as of thatdate. Because equity-based compensation expense recognized for the years ended December 31,2009, 2008 and 2007 is based on awards ultimately expected to vest, it has beenreduced for estimated forfeitures.

 

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ASC Topic 718requires forfeitures to be estimated at the time of grant and revised, ifnecessary, in subsequent periods if actual forfeitures differ from thoseestimates.

 

The following table illustrates how equity-basedcompensation was allocated to the income statement as well as the effect on netincome of all equity-based compensation recognized (in thousands, except pershare data):

 
| ** **                                          | ** ** | **For the Year Ended  December 31,** | ** ** |
|-----------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                          | ** ** | **2009**                                  | ** ** | **2008** | ** ** | **2007** | ** ** |
| Cost of revenue                                     |       | $                                         | 323        |   | $ | 333 |   | $ | 389 |   |
| Sales and marketing                                 |       | 1,243                                     |       | 1,265 |   | 2,186 |   |
| Research and  development                           |       | 945                                       |       | 1,179 |   | 949 |   |
| General and  administrative                         |       | 1,356                                     |       | 2,230 |   | 2,463 |   |
| Equity-based  compensation before income taxes      |       | 3,867                                     |       | 5,007 |   | 5,987 |   |
| Income tax benefit                                  |       | (1,354                                    | )          | (1,771 | ) | (1,964 | ) |
| Total equity-based  compensation after income taxes |       | $                                         | 2,513      |   | $ | 3,236 |   | $ | 4,023 |   |

 

For purposes ofcalculating the fair value of options, the weighted average fair value ofoptions granted during 2009, 2008 and 2007 were $3.74, $5.50 and $13.47,respectively. The weighted-average fair values for the options were based onthe fair values on the dates of grant. The fair values for the options werecalculated using the Black-Scholes option-pricing model, with the followingweighted-average assumptions and expense adjusted using the following expectedforfeiture rate assumptions:

 
| ** **                  | ** ** | **For the Year Ended December 31,** | ** ** |
|-----------------------------|------------|----------------------------------------------------|------------|
| ** **                  | ** ** | **2009**                                           | ** ** | **2008** | ** ** | **2007** | ** ** |
| Expected option life        |       | 3.69 years                                         |       | 3.75 years |   | 3.75 years |   |
| Expected volatility  factor |       | 49                                                 | %          | 46 | % | 52 | % |
| Expected dividend yield     |       | 0                                                  | %          | 0 | % | 0 | % |
| Risk-free interest rate     |       | 1.67                                               | %          | 2.33 | % | 4.46 | % |
| Expected forfeiture  rate   |       | 2                                                  | %          | 1 | % | 1 | % |

 

Prior to March 9,2006, the expected life of stock options was calculated by performing adetailed analysis of all historical stock option information available. On March 9,2006, the Company began to grant options with a five-year legal life instead ofthe eight-year legal life that it had previously used. As a result, the Companyhas elected to use the “simplified” method to estimate the expected life ofoptions granted on and after March 9, 2006. The Company will utilize thesimplified method until sufficient historical information becomes available onthe five-year legal life options. The expected volatility is calculated basedon the historical volatility of the Company’s common stock over the expectedoption life and other appropriate factors. The expected dividend yield is basedon the Company’s intent not to issue dividends for the foreseeable future.Risk-free interest rates are calculated based on continuously compounded U.S.Treasury risk-free rates for the appropriate term. The expected forfeiture rateis estimated based on historical experience.

 

As of December 31,2009, there was $5.4 million of unrecognized compensation expense related tostock options that is expected to be recognized over a weighted-average periodof 2.6 years.

 

Restricted Stock

 

The Company has grantednonvested shares of common stock (“restricted stock”) to certain employeesunder its 1997 Stock Option and Incentive Plan and 2006 Long-Term IncentivePlan. With the exception of shares of restricted stock subject to performancevesting, as noted below, restricted stock generally vests 25% annuallybeginning one year after the grant date. The Company records equity-basedcompensation expense equal to the fair market value of the common stock on thedate of grant ratably over the vesting period. Equity-based compensationexpense related to restricted stock was $328,000, $491,000 and $741,000 for theyears ended December 31, 2009, 2008 and 2007, respectively.

 

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In the first quarter of 2007, the Company granted shares of restrictedstock with performance-based vesting to certain employees. The Company granteda total of 13,500 restricted shares with a total grant-date fair value of$464,000. As of December 31, 2009, after forfeitures, 6,700 restrictedshares with a total grant-date fair value of $230,000 remained outstanding.Vesting of the awards was dependent upon achievement of certain Companyperformance metrics for fiscal years 2007 through 2009. The performance metricswere not achieved for the years ended December 31, 2009, 2008 and 2007,and therefore the awards, all of which remain unvested, will be forfeited upon theCompany’s filing its Form 10-K for the year ended December 31, 2009.No equity-based compensation expense for the awards was recognized for theyears ended December 31, 2009, 2008 and 2007. The first quarter of 2007was the only period in which the Company granted restricted stock awards withperformance-based vesting.

 

As of December 31, 2009, there was $440,000 of unrecognizedcompensation expense related to restricted stock awards that is expected to berecognized over a weighted-average period of 2.4 years. The aggregate fairvalue of restricted stock that vested was $325,000, $488,000 and $1.0 millionfor the years ended December 31, 2009, 2008 and 2007, respectively.

 

Employee Stock Purchase Plan

 

Employee Stock Purchase Plan (“ESPP”) compensation expense was$156,000, $154,000 and $161,000 for the years ended December 31, 2009,2008 and 2007, respectively.

 

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

 
| ** **                    | ** ** | **For the Year Ended December 31,** | ** ** |
|-------------------------------|------------|------------------------------------------|------------|
| ** **                    | ** ** | **2009**                                 | ** ** | **2008** | ** ** | **2007** | ** ** |
| Expected life of ESPP options |       | 3 months                                 |       | 3 months |   | 3 months |   |
| Expected volatility factor    |       | 42                                       | %          | 46 | % | 51 | % |
| Expected dividend yield       |       | 0                                        | %          | 0 | % | 0 | % |
| Risk-free interest rate       |       | 0.15                                     | %          | 1.81 | % | 4.59 | % |

 

ASC Topic 718 requires the benefits of tax deductions from the exerciseof stock options and settlement of restricted stock awards in excess of thecompensation cost recognized for those options and stock awards to beclassified as financing cash inflows rather than operating cash inflows on aprospective basis. This amount is shown as “Excess tax benefit from stocktransactions” on the Consolidated Statement of Cash Flows.

 

The Company has elected to calculate its historical pool of windfalltax benefits (that is, the amount that would have accumulated as of theadoption date of ASC Topic 718) using the alternative (“short-cut”) method andthe “tax law ordering approach” to determine when the historic tax benefits arerealized (tax benefits realized based on provisions in the tax law thatidentify the sequence in which stock option deductions are utilized for taxpurposes). The Company will continue to track the balance of the pool ofwindfall tax benefits based on windfalls or shortfalls incurred after theadoption date.

 

##### **Research and development costs**

##### ** **

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

 

##### **Income taxes**

 

The Company provides for income taxes using the liability method underASC Topic 740, *Income Taxes*, which requiresrecognition of deferred tax assets and liabilities for the expected future taxconsequences of events that have

 

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been included in the financial statements. Under this statement,deferred tax assets and liabilities are determined based on the differencebetween the financial statement and tax basis of assets and liabilities usingenacted tax rates in effect for the year in which the differences are expectedto reverse. Deferred tax assets are reduced by a valuation allowance when it ismore likely than not that some component or all of the deferred tax assets willnot be realized. Tax rate changes are reflected in income during the periodsuch changes are enacted.

 

##### **Computation of net income per share**

##### ** **

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

 

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

 
| ** **                                                                              | ** ** | **For the Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                              | ** ** | **2009**                                 | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                                                                              | ** ** | ** **                               | ** ** | ** ** | ** ** | ** ** | ** ** |
| Numerator:                                                                              |       |                                     |       |   |   |   |   |
| Net (loss) income                                                                       |       | $                                        | (21,252    | ) | $ | (2,800 | ) | $ | 1,367 |   |
|                                                                                    |       |                                     |       |   |   |   |   |
| Denominator:                                                                            |       |                                     |       |   |   |   |   |
| Denominator for weighted average common shares  outstanding – basic                |       | 14,315                                   |       | 16,155 |   | 16,972 |   |
|                                                                                    |       |                                     |       |   |   |   |   |
| Dilution associated with the company’s stock based  compensation plans             |       | —                                   |       | — |   | 485 |   |
|                                                                                    |       |                                     |       |   |   |   |   |
| Denominator:                                                                            |       |                                     |       |   |   |   |   |
| Denominator for weighted average common shares  outstanding – diluted              |       | 14,315                                   |       | 16,155 |   | 17,457 |   |
|                                                                                    |       |                                     |       |   |   |   |   |
| Net (loss) income per share – basic                                                |       | $                                        | (1.48      | ) | $ | (0.17 | ) | $ | 0.08 |   |
| Net (loss) income per share – diluted                                              |       | $                                        | (1.48      | ) | $ | (0.17 | ) | $ | 0.08 |   |
|                                                                                    |       |                                     |       |   |   |   |   |
| Antidilutive stock options and restricted stock  awards excluded from above calculation |       | 2,689                                    |       | 2,515 |   | 809 |   |

 

##### **Comprehensive income (loss)**

##### ** **

Comprehensive income (loss) as defined by ASC Topic 220, *Comprehensive Income*, includes net income and items definedas other comprehensive income. This accounting guidance requires that itemsdefined as other comprehensive income, such as foreign currency translationadjustments and unrealized gains and losses on certain marketable securities,be separately classified in the financial statements. Such items are reportedin the consolidated statements of stockholders’ equity as comprehensive income(loss).

 

##### **Recent accounting pronouncements**

##### ** **

In October 2009, the Financial Accounting Standards Board (FASB)issued Accounting Standards Update (ASU) No. 2009-13, *Multiple-Deliverable Revenue Arrangements—a consensusof the FASB Emerging Issues Task Force*, that provides amendments tothe criteria for separating consideration in multiple-deliverable arrangements.The ASU does not apply to arrangements for which industry specific allocationand measurement guidance exists, such as long-term construction contracts andsoftware transactions. ASU No. 2009-13 is effective for the Companybeginning January 1, 2011. The Company may elect to adopt the provisionsprospectively to new or materially modified arrangements beginning on theeffective date or retrospectively for all periods presented. The Company 

 

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does not expect that the adoption of this standard will have a materialimpact on the Company’s consolidated financial statements.

 

 In October 2009, the FASB issued ASU No. 2009-14, *Certain Revenue Arrangements That Include SoftwareElements—a consensus of the FASB Emerging Issues Task Force*, thatreduces the types of transactions that fall within the current scope of softwarerevenue recognition guidance. Existing software revenue recognition guidancerequires that its provisions be applied to an entire arrangement when the saleof any products or services containing or utilizing software when the softwareis considered more than incidental to the product or service. The ASU alsoprovides guidance on how to allocate transaction consideration when anarrangement contains both deliverables within the scope of software revenueguidance (software deliverables) and deliverables not within the scope of thatguidance (non-software deliverables). ASU No. 2009-14 is effective for theCompany beginning January 1, 2011. The Company may elect to adopt theprovisions prospectively to new or materially modified arrangements beginningon the effective date or retrospectively for all periods presented. However,the Company must elect the same transition method for this guidance as thatchosen for ASU No. 2009-13. The Company does not expect that the adoptionof this standard will have a material impact on the Company’s consolidatedfinancial statements.

 

In January 2010, the FASB issued ASU No. 2010-6, *Improving Disclosures About Fair Value Measurements*, thatamends existing disclosure requirements under ASC Topic 820 by adding requireddisclosures about items transferring into and out of levels 1 and 2 in the fairvalue hierarchy; adding separate disclosures about purchase, sales, issuances,and settlements relative to level 3 measurements; and clarifying, among otherthings, the existing fair value disclosures about the level of disaggregation.For the Company this ASU is effective for the first quarter of 2010, except forthe requirement to provide level 3 activity of purchases, sales, issuances, andsettlements on a gross basis, which is effective beginning the first quarter of2011. Since this standard impacts disclosure requirements only, its adoptionwill not have a material impact on the Company’s consolidated results ofoperations or financial condition.

 

**3.**              Financial statement components

** **

##### **Allowance for doubtful accounts**

##### ** **

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

 
| ** **        | ** ** | **For the Year Ended December 31,** | ** ** |
|-------------------|------------|------------------------------------------|------------|
| ** **        | ** ** | **2009**                                 | ** ** | **2008** | ** ** | **2007** | ** ** |
|              |       |                                     |       |   |   |   |   |
| Beginning balance |       | $                                        | 638        |   | $ | 505 |   | $ | 266 |   |
| Provision         |       | 279                                      |       | 519 |   | 239 |   |
| Write-offs        |       | (181                                     | )          | (386 | ) | — |   |
| Recoveries        |       | —                                   |       | — |   | — |   |
| Ending balance    |       | $                                        | 736        |   | $ | 638 |   | $ | 505 |   |

 

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##### **Property and equipment, net**

 

The components of property and equipment were as follows (inthousands):

 
| ** **                                     | ** ** | **December 31,** | ** ** |
|------------------------------------------------|------------|-----------------------|------------|
| ** **                                     | ** ** | **2009**              | ** ** | **2008** | ** ** |
|                                           |       |                  |       |   |   |
| Equipment                                      |       | $                     | 14,734     |   | $ | 13,551 |   |
| Furniture and fixtures                         |       | 4,092                 |       | 3,993 |   |
| Computer software                              |       | 4,358                 |       | 7,572 |   |
| Leasehold improvements                         |       | 2,629                 |       | 2,521 |   |
| Total property and equipment                   |       | 25,813                |       | 27,637 |   |
| Less accumulated depreciation and amortization |       | (20,328               | )          | (16,118 | ) |
| Property and equipment, net                    |       | $                     | 5,485      |   | $ | 11,519 |   |

 

In 2007, the Company began the implementation of an enterprise resourceplanning (“ERP”) system. The ERP system was intended to replace numerousdisconnected business management software applications and link the datacontained within these disconnected systems to enable better management of theCompany’s business and derive more useful data for various business functions,such as sales, marketing, finance and customer support.

 

Phase 1 of the implementation, which related to the replacement of theCompany’s general ledger, was completed in 2007. The related capitalized costsare being depreciated over seven years and, as of December 31, 2009, thenet book value of Phase 1 was $626,000. Phase 2 of the implementation, whichconsisted of replacing the Company’s various customer relationship managementand order processing systems, was put on hold in 2008 in conjunction with itscost-control efforts. In 2009, the Company determined, in conjunction withcontinued cost-control measures, that it would not implement Phase 2. As aresult, in 2009 the Company recognized an asset impairment charge of $3.1 millionrelated to the Phase 2 implementation.

 

##### **Other intangible assets, net**

 

Acquired intangible assets subject to amortization were as follows (inthousands):

 
| ** **                                      | ** ** | **December 31, 2009** | ** ** | **December 31, 2008**    | ** ** |
|-------------------------------------------------|------------|----------------------------|------------|-------------------------------|------------|
| ** **                                      | ** ** | **Gross Carrying  Value**  | ** ** | **Accumulated  Amortization** | ** ** | **Net Carrying  Value** | ** ** | **Gross Carrying  Value** | ** ** | **Accumulated  Amortization** | ** ** | **Net Carrying  Value** | ** ** |
|                                            |       |                       |       |                          |       |   |   |   |   |   |   |   |   |
| Software technology                             |       | $                          | 3,400      |                          | $          | (3,400 | ) | $ | — |   | $ | 3,400 |   | $ | (3,334 | ) | $ | 66 |   |
| Patents and patent applications                 |       | 2,500                      |       | (2,118                        | )          | 382 |   | 2,500 |   | (1,758 | ) | 742 |   |
| Total intangible assets subject to amortization |       | $                          | 5,900      |                          | $          | (5,518 | ) | $ | 382 |   | $ | 5,900 |   | $ | (5,092 | ) | $ | 808 |   |

 

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

 

Intangible assets subject to amortization are amortized on astraight-line basis over the estimated period of benefit. Amortization expensewas $426,000, $1.0 million and $1.2 million for the years ended December 31,2009, 2008 and 2007, respectively. The estimated future annual amortizationexpense for identified intangible assets is as follows (in thousands):

 
| 2010   |   | $  | 360    |   |
|--------|--------|----|--------|--------|
| 2011   |   | 22 |   |
|   |   | $  | 382    |   |

 

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The preceding expected amortization expense is an estimate. Actualamortization expense may differ from estimates due to additionalintangible asset acquisitions, impairment of intangible assets, acceleratedamortization of intangible assets, and other events.

 

##### **Goodwill**

##### ** **

There were no changes to the carrying value of goodwill for the yearsended December 31, 2009 and 2008. The Company’s goodwill has never beenimpaired.

 

##### **Deferred revenue**

##### ** **

The components of deferred revenue were as follows (in thousands):

 
| ** **                            | ** ** | **December 31,** | ** ** |
|---------------------------------------|------------|-----------------------|------------|
| ** **                            | ** ** | **2009**              | ** ** | **2008** | ** ** |
|                                  |       |                  |       |   |   |
| Maintenance and support               |       | $                     | 13,043     |   | $ | 13,912 |   |
| Customer education                    |       | 2,036                 |       | 3,034 |   |
| Professional services                 |       | 848                   |       | 788 |   |
| Software                              |       | 255                   |       | 616 |   |
| Hardware and other                    |       | 351                   |       | 538 |   |
| Total deferred revenue                |       | 16,533                |       | 18,888 |   |
| Less current portion                  |       | (15,500               | )          | (17,724 | ) |
| Long-term portion of deferred revenue |       | $                     | 1,033      |   | $ | 1,164 |   |

 

**4.**              Commitments and contingencies

** **

##### **Operating lease commitments**

##### ** **

The Company rents office space and certain office equipment underoperating leases. In addition to minimum lease payments, the office leasesrequire payment of a proportionate share of real estate taxes and buildingoperating expenses. Total rent expense, including an allocation of the lessor’soperating costs, was $1.8 million, $1.8 million and $1.7 million for the yearsended December 31, 2009, 2008 and 2007, respectively.

 

In March 2004, the Company signed a non-cancelable operating leasefor a new office facility in Minnetonka, Minnesota. The new lease term startedin February 2005 and expires in January 2012. The Company moved intothe Minnetonka location and moved out of its Plymouth, Minnesota location in February 2005.

 

The Company recorded deferred rent of $1.6 million in the first quarterof 2005 relating to estimated payments by the Minnetonka lessor for the benefitof the Company. Such payments are considered lease incentives under ASC Topic840, *Leases*, and are amortized as a reductionof rent expense over the term of the Minnetonka lease.

 

During the year ended December 31, 2007, the Company expanded itsMinnetonka headquarters and received leasehold improvements paid for by theMinnetonka lessor of $199,000. Such leasehold improvements were recorded as anasset by the Company and amortized over the shorter of their estimated usefullives or the remaining terms of the related leases, with a corresponding amountrecorded as deferred rent and amortized as a reduction of rent expense over theterm of the Minnetonka lease.

 

The deferred rent balance was $882,000 ($413,000 was classified ascurrent) and $1.3 million ($394,000 was classified as current) as of December 31,2009 and 2008, respectively.

 

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The minimum lease payments, excluding estimated taxes and operatingcost rent obligations, are approximately (in thousands):

 
| **Year** | ** ** | **Amount** | ** ** |
|----------|------------|------------|------------|
| 2010     |       | $          | 1,026      |   |
| 2011     |       | 1,020      |       |
| 2012     |       | 182        |       |
| Total    |       | $          | 2,228      |   |

 

##### **Other items**

 

Under general contract terms, the Company sometimes includes anindemnification clause in its software licensing agreement providing that theCompany will indemnify the licensee against liability and damages arising fromany claims of patent, copyright, trademark or trade secret infringement by theCompany’s software. The Company has incurred insignificant costs as a result ofthis type of indemnification clause, and the Company does not maintain aproduct warranty liability related to such indemnification clauses.

 

The Company has entered into various employment agreements with certainexecutives of the Company, which include provisions for severance paymentssubject to certain conditions and events.

 

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

 

The Company is involved in various claims and legal actions in thenormal course of business. Management is of the opinion that the outcome ofsuch legal actions will not have a significant adverse effect on the Company’sfinancial position, results of operations or cash flows. Notwithstandingmanagement’s belief, an unfavorable resolution of some or all of these matterscould materially affect the Company’s future results of operations or cashflows.

 

**5.**              Stockholders’ equity

** **

##### **Background**

##### ** **

On October 28, 1996, the Board of Directors of Bio-Vascular, Inc.(“Bio-Vascular”), now known as Synovis Life Technologies, Inc., the formerparent of the Company, approved a plan to spin off and establish the Company asan independent, publicly-owned company. On May 12, 1997 (the “DistributionDate”), Bio-Vascular distributed all of the shares of the Company to theshareholders of Bio-Vascular (the “Distribution”), and on that date the Companybegan operating as an independent public company. All Bio-Vascular shareholdersof record as of May 5, 1997 received one share of the Company’s commonstock for each two shares of Bio-Vascular stock held on that date and cash inlieu of fractional shares.

 

##### **ShareRepurchase Program**

##### ** **

During 2008, the Company’sBoard of Directors approved a share repurchase program, which authorized openmarket transactions of up to $40.0 million, including fees and expenses, of theCompany’s common stock. On March 3, 2009, the Company announced additionalrepurchases of up to 1.0 million shares of its common stock.  The program authorizes management torepurchase shares from time to time, depending on market conditions. During 2008,the Company completed stock repurchases of 2.8 million shares for $38.2million, inclusive of fees and expenses. During 2009, the Company completedstock repurchases of 562,000 shares for $6.1 million, inclusive of fees andexpenses. As of December 31, 2009, the Company had purchased 3.3 million shares of its common stock for $44.3 millionthrough open market transactions. The maximum number of shares that may yet bepurchased under the plans or programs was 588,000 shares as of December 31,2009. The active share repurchase program expires on March 1, 2011.

 

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At time of repurchase, shares are returned to the status of authorizedand unissued shares. The Company has accounted for the repurchases asconstructively retired and recorded such repurchases as a reduction of commonstock and additional paid-in capital.

 

##### **Stockoption plans**

##### ** **

In May 1997, Bio-Vascular, Inc., which is now known asSynovis Life Technologies, Inc., as the sole shareholder of the Company,approved and adopted the Vital Images, Inc. 1997 Stock Option andIncentive Plan (the “1997 Plan”), which became effective on the DistributionDate. Under the terms of the 1997 Plan, the Board of Directors or a committeeof the Board may grant options and other equity-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 are exercisable at such times, in installments orotherwise, as the Board of Directors or a committee of the Boardmay determine. Generally, these options have a term of five or eight yearsand are exercisable as to 28% of the total grant one year after the date ofgrant and 2% per month thereafter. The total number of shares of common stockthat may be issued or awarded under the 1997 Plan was 4,100,000 shares.The 1997 Plan expired on March 19, 2007, and no more rights to purchaseshares will be granted from it.

 

Also in May 1997, Bio-Vascular, as the sole shareholder of theCompany, approved and adopted the Vital Images, Inc. 1997 Director StockOption Plan (the “Director Plan”), which became effective on the DistributionDate. The Director Plan provides non-employee directors with automatic grantsof stock options and allows the Board of Directors to make additionaldiscretionary option grants to any or all directors. Options that are grantedunder the Director Plan are granted with an option price equal to the fairmarket value on the date of grant, have a term of five or eight years, arenon-qualified options, and become exercisable in three equal annualinstallments beginning on the first occurring December 31 after the dateof grant. The total number of shares of common stock that may be issued orawarded under the Director Plan was 500,000 shares. The Director Plan expiredon March 19, 2007, and no more rights to purchase shares will be grantedfrom it.

 

On May 4, 2006, the shareholders of the Company approved the VitalImages, Inc. 2006 Long-Term Incentive Plan (the “2006 Plan”). The 2006Plan provides that the total number of shares of the Company’s common stockthat may be subject to options, restricted stock awards and other equityawards granted under the 2006 Plan shall not exceed 900,000 shares. On June 3,2008, the shareholders of the Company approved an amendment to the 2006 Plan toincrease the shares reserved under the plan by 1.6 million shares, resulting intotal shares reserved for issuance under the 2006 Plan of 2.5 million shares.The 2006 Plan provides the Board of Directors or a committee of the Board theauthority to grant incentive stock options qualified as such under Section 422of the Internal Revenue Code of 1986 and nonqualified stock options, awards ofrestricted stock, stock appreciation rights, other equity-based awards,cash-based awards or any combination of such awards subject to the terms of the2006 Plan. As of December 31, 2009, 894,106 shares remained available forthe grant of awards under the 2006 Plan.

 

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The following table summarizes stock option activity for 2009, 2008 and2007:

 
| ** **                                     | ** ** | **Shares Underlying  Options** | ** ** | **Weighted-Average  Exercise Price Per  Share** | ** ** | **Weighted-Average  Remaining  Contractual Term  (in years)** | ** ** | **Aggregate  Intrinsic  Value (in  thousands)** | ** ** |
|------------------------------------------------|------------|--------------------------------|------------|-------------------------------------------------|------------|---------------------------------------------------------------|------------|-------------------------------------------------|------------|
|                                           |       |                           |       |                                            |       |                                                          |       |                                            |       |
| Total outstanding as of December 31, 2006 |       | 1,797,179                      |       | $                                               | 16.24      |                                                          |       |                                            |       |   |
|                                           |       |                           |       |                                            |       |                                                          |       |                                            |       |
| Options granted                                |       | 469,595                        |       | $                                               | 30.99      |                                                          |       |                                            |       |   |
| Options exercised                              |       | (220,604                       | )          | $                                               | 10.68      |                                                          |       |                                            |       |   |
| Options cancelled                              |       | (64,766                        | )          | $                                               | 26.66      |                                                          |       |                                            |       |   |
|                                           |       |                           |       |                                            |       |                                                          |       |                                            |       |
| Total outstanding as of December 31, 2007 |       | 1,981,404                      |       | $                                               | 20.03      |                                                          |       |                                            |       |   |
|                                           |       |                           |       |                                            |       |                                                          |       |                                            |       |
| Options granted                                |       | 1,081,070                      |       | $                                               | 14.77      |                                                          |       |                                            |       |   |
| Options exercised                              |       | (242,525                       | )          | $                                               | 7.95       |                                                          |       |                                            |       |   |
| Options cancelled                              |       | (367,090                       | )          | $                                               | 23.93      |                                                          |       |                                            |       |   |
|                                           |       |                           |       |                                            |       |                                                          |       |                                            |       |
| Total outstanding as of December 31, 2008 |       | 2,452,859                      |       | $                                               | 18.32      |                                                          |       |                                            |       |   |
|                                           |       |                           |       |                                            |       |                                                          |       |                                            |       |
| Options granted                                |       | 576,220                        |       | $                                               | 9.86       |                                                          |       |                                            |       |   |
| Options exercised                              |       | (163,008                       | )          | $                                               | 7.07       |                                                          |       |                                            |       |   |
| Options cancelled                              |       | (226,304                       | )          | $                                               | 20.52      |                                                          |       |                                            |       |   |
|                                           |       |                           |       |                                            |       |                                                          |       |                                            |       |
| Total outstanding as of December 31, 2009 |       | 2,639,767                      |       | $                                               | 16.98      |                                                          | 2.73       |                                            | $          | 2,182 |   |
| Options exercisable as of:                     |       |                           |       |                                            |       |                                                          |       |                                            |       |
| December 31, 2007                         |       | 1,206,104                      |       | $                                               | 14.71      |                                                          |       |                                            |       |   |
| December 31, 2008                         |       | 1,259,018                      |       | $                                               | 18.98      |                                                          |       |                                            |       |   |
| December 31, 2009                         |       | 1,470,633                      |       | $                                               | 19.67      |                                                          | 2.28       |                                            | $          | 563 |   |

 

Various price ranges and weighted average information for optionsoutstanding and exercisable as of December 31, 2009 are as follows:

 
| ** **                          | ** ** | **Options Outstanding** | ** ** | **Options Exercisable**                                             | ** ** |
|-------------------------------------|------------|-------------------------|------------|---------------------------------------------------------------------|------------|
| **Range of********Exercise Prices** | ** ** | **Number  Outstanding** | ** ** | **Weighted Average  Remaining  Contractual Life********(in years)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number  Exercisable** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| $                                   | 7.25       | -                       | $          | 9.60                                                                |       | 460,324 |   | 3.17 |   | $ | 8.79 |   | 114,974 |   | $ | 8.81 |   |
| $                                   | 9.94       | -                       | $          | 12.60                                                               |       | 497,215 |   | 2.52 |   | $ | 11.91 |   | 178,165 |   | $ | 12.04 |   |
| $                                   | 12.64      | -                       | $          | 15.24                                                               |       | 506,952 |   | 3.27 |   | $ | 15.10 |   | 221,344 |   | $ | 15.08 |   |
| $                                   | 15.25      | -                       | $          | 16.57                                                               |       | 493,887 |   | 3.14 |   | $ | 15.70 |   | 367,366 |   | $ | 15.85 |   |
| $                                   | 16.65      | -                       | $          | 32.14                                                               |       | 553,924 |   | 1.82 |   | $ | 27.41 |   | 484,566 |   | $ | 27.10 |   |
| $                                   | 32.16      | -                       | $          | 35.70                                                               |       | 127,465 |   | 2.21 |   | $ | 33.36 |   | 104,218 |   | $ | 33.41 |   |
|                                |       |                    |       | 2,639,767                                                           |       | 2.73 |   | $ | 16.98 |   | 1,470,633 |   | $ | 19.67 |   |

 

The aggregate intrinsic value of options (that is, the amount by whichthe market price of the stock on the date of exercise exceeded the exerciseprice of the option) exercised during the years ended December 31, 2009,2008 and 2007 was $773,000, $1.5 million and $4.4 million, respectively. TheCompany issues new shares when stock option awards are exercised. Cash receivedfrom the exercise of stock options for the years ended December 31, 2009,2008 and 2007 was $1.2 million, $1.9 million and $2.4 million, respectively.The total tax benefit related to tax deductions from options exercised for theyears ended December 31, 2009, 2008 and 2007 was $255,000, $490,000 and$1.5 million, respectively.

 

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##### **Cash Tender Offer for Employee Stock Options**

##### ** **

On February 22, 2010, the Company filed a cash tender offer forcertain employee stock options. The tender offer is planned to terminate,unless otherwise extended by the Company in its sole discretion, 20 businessdays after its commencement. The tender offer applies to outstanding stockoptions held by employees with an exercise price equal to or greater than$25.00 per share. The price to be offered for each eligible stock option is adiscount to its Black-Scholes fair value. The Company’s management mayparticipate in this offer, but non-employee members of the Company’s board ofdirectors may not. As of February 16, 2010, there were approximately406,000 eligible options. If all eligible options are tendered and accepted inthe offer, the aggregate cash purchase price would be approximately $213,000.

 

As a result of the tender offer, the Company will incur an equity-basedcompensation charge of up to $760,000, consisting of the remaining unamortizedequity-based compensation expense associated with the eligible options tenderedin the offer. This charge would be reflected in the financial results of thefiscal quarter in which the offer is completed, currently anticipated to be thefirst quarter of 2010.

 

The tender offer is subject to a number of other terms and conditionsset forth in the offering documents. Neither the Company’s management nor itsboard of directors makes any recommendation in connection with the tenderoffer.

 

##### **Restricted stock**

##### ** **

The Company grants nonvested shares of commonstock (“restricted stock”) to certain employees under the 1997 Plan and the2006 Plan. The restricted stock generally vests 25% annually beginning one yearafter the grant date.  The followingtable summarizes the restricted stock activity for the years ended December 31,2009, 2008 and 2007:

 
| ** **                                     | ** ** | **Restricted********Shares** | ** ** | **Weighted-Average  Grant Date Fair  Value Per Share** | ** ** |
|------------------------------------------------|------------|------------------------------|------------|----------------------------------------------------------------------------|------------|
| Total outstanding as of December 31, 2006 |       | 115,677                      |       | $                                                                          | 21.65      |   |
| Shares granted                                 |       | 14,250                       |       | $                                                                          | 34.21      |   |
| Shares vested                                  |       | (35,677                      | )          | $                                                                          | 20.88      |   |
| Shares forfeited/cancelled                     |       | (4,647                       | )          | $                                                                          | 24.53      |   |
| Total outstanding as of December 31, 2007 |       | 89,603                       |       | $                                                                          | 23.81      |   |
| Shares granted                                 |       | 30,000                       |       | $                                                                          | 13.74      |   |
| Shares vested                                  |       | (29,816                      | )          | $                                                                          | 20.98      |   |
| Shares forfeited/cancelled                     |       | (27,210                      | )          | $                                                                          | 25.42      |   |
| Total outstanding as of December 31, 2008 |       | 62,577                       |       | $                                                                          | 19.63      |   |
| Shares granted                                 |       | 15,000                       |       | $                                                                          | 12.02      |   |
| Shares vested                                  |       | (28,085                      | )          | $                                                                          | 18.64      |   |
| Shares forfeited/cancelled                     |       | (369                         | )          | $                                                                          | 24.48      |   |
| Total outstanding as of December 31, 2009 |       | 49,123                       |       | $                                                                          | 17.83      |   |

 

The total tax benefit related to tax deductions from restricted stockvested during the years ended December 31, 2009, 2008 and 2007 was$118,000, $183,000 and $368,000, respectively.

 

##### **Employee stock purchase plan**

##### ** **

The ESPP was approved and adopted byBio-Vascular, as the sole shareholder of the Company, in May 1997. TheESPP, which became effective on July 1, 1997, enables eligible employeesto purchase the Company’s common stock at a price equal to 85% of the fairmarket value of the stock on the date an offering period commences or on thedate an offering period terminates, whichever is lower. Shares of common stockare offered under the ESPP during a series of offering periods, with eachoffering period running for a calendar quarter. On June 3, 2008, the shareholders of the Company approved anamendment to the ESPP to increase, from 250,000 shares of common stock to400,000 shares of common stock, the number of aggregate shares of common stockthat can be issued and sold to participating employees of the Company under theESPP. The ESPP covers substantially all employees,

 

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subject to certain limitations. Each employeemay elect to have up to 10% of his or her base pay withheld and appliedtoward the purchase of shares in each such offering period. As of December 31,2009, 82,258 shares of common stock remained reserved for future purchasesunder the ESPP.

 

**6.**              Income taxes

** **

The Company has adopted accounting guidance related to uncertain taxpositions. This accounting guidance prescribes a recognition threshold andmeasurement attribute for recognition and measurement of a tax position takenor expected to be taken in a tax return. It also provides guidance onde-recognition, classification, interest and penalties, accounting in interimperiods, disclosure and transition. The adoption of uncertain tax positionguidance did not have a material impact on the Company’s Consolidated FinancialStatements. Additionally, the adoption of the guidance had no impact onretained earnings or the gross liability for uncertain tax positions. TheCompany had no uncertain tax positions as of December 31, 2009 and 2008.

 

The Company did not have any material unrecognized tax benefits as of December 31,2009 and 2008. The Company recognizes potential accrued interest and penaltiesrelated to unrecognized tax benefits as a component of income tax expense. Tothe extent interest and penalties are not assessed with respect to uncertaintax positions, amounts accrued will be reduced and reflected as a reduction ofthe overall income tax provision. The Company recorded no interest andpenalties during the year ended December 31, 2009 and 2008 and had noaccrued interest and penalties as of December 31, 2009. The Company is nolonger subject to U.S. federal tax examinations by tax authorities for taxyears before 2006. The Company is open to state tax audits until the applicablestatute of limitations expires.

 

The components of income before income taxes were as follows (inthousands):

 
| ** **                  | ** ** | **For the Year Ended December 31,** | ** ** |
|-----------------------------|------------|------------------------------------------|------------|
| ** **                  | ** ** | **2009**                                 | ** ** | **2008** | ** ** | **2007** | ** ** |
| Income before income taxes: |       |                                     |       |   |   |   |   |
| U.S.                        |       | $                                        | (7,343     | ) | $ | (5,710 | ) | $ | 1,313 |   |
| International               |       | 423                                      |       | 528 |   | 405 |   |
|                        |       | (6,920                                   | )          | (5,182 | ) | 1,718 |   |
|                             |            |                                          |            |  |  |  |  |  |  |  |

 

The income tax provision included the following components (inthousands):

 
| ** **                 | ** ** | **For the Year Ended December 31,** | ** ** |
|----------------------------|------------|------------------------------------------|------------|
| ** **                 | ** ** | **2009**                                 | ** ** | **2008** | ** ** | **2007** | ** ** |
| Current income taxes:      |       |                                     |       |   |   |   |   |
| Federal                    |       | $                                        | —     |   | $ | — |   | $ | 112 |   |
| State                      |       | —                                   |       | — |   | 140 |   |
| Foreign                    |       | 107                                      |       | 139 |   | 115 |   |
|                       |       | 107                                      |       | 139 |   | 367 |   |
| Deferred income taxes:     |       |                                     |       |   |   |   |   |
| Federal                    |       | 14,417                                   |       | (2,296 | ) | 93 |   |
| State                      |       | (192                                     | )          | (225 | ) | (109 | ) |
| Foreign                    |       | —                                   |       | — |   | — |   |
|                       |       | 14,225                                   |       | (2,521 | ) | (16 | ) |
| Provision for income taxes |       | $                                        | 14,332     |   | $ | (2,382 | ) | $ | 351 |   |

 

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During 2009, the Company recognized $194,000 in one-time tax benefitsresulting from tax legislation, which enabled the Company to receive cashpayment for the monetization of certain historic research and development taxcredits. Also as a result of the legislation, the Company recognized a $248,000one-time tax benefit related to the refund of certain alternative minimum taxpayments in prior years.

 

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

 
| ** **                                                      | ** ** | **For the Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                      | ** ** | **2009**                                 | ** ** | **2008** | ** ** | **2007** | ** ** |
| Tax provision (benefit) computed at the federal  statutory rate |       | $                                        | (2,353     | ) | $ | (1,762 | ) | $ | 584 |   |
| State taxes, net of federal benefit                             |       | (111                                     | )          | (132 | ) | 96 |   |
| Increase (decrease) in tax from:                                |       |                                     |       |   |   |   |   |
| Stock-based compensation                                        |       | 49                                       |       | 52 |   | 244 |   |
| Research and development tax credits                            |       | (495                                     | )          | (725 | ) | (682 | ) |
| Business meals and entertainment                                |       | 93                                       |       | 119 |   | 119 |   |
| Foreign tax rate differential                                   |       | (36                                      | )          | (39 | ) | (23 | ) |
| Change in valuation allowance                                   |       | 17,205                                   |       | 108 |   | (4 | ) |
| Other, net                                                      |       | (20                                      | )          | (3 | ) | 17 |   |
| Provision (benefit) for income taxes                            |       | $                                        | 14,332     |   | $ | (2,382 | ) | $ | 351 |   |

 

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

 
| ** **                                      | ** ** | **December 31, 2009** | ** ** | **December 31, 2008**    | ** ** |
|-------------------------------------------------|------------|----------------------------|------------|-------------------------------|------------|
| ** **                                      | ** ** | **Deferred tax  assets**   | ** ** | **Deferred tax  liabilities** | ** ** | **Deferred tax  assets** | ** ** | **Deferred tax  liabilities** | ** ** |
|                                            |       |                       |       |                          |       |   |   |   |   |
| Net operating loss carryforwards                |       | $                          | 5,464      |                          | $          | — |   | $ | 4,418 |   | $ | — |   |
| Research and development tax credit             |       | 4,585                      |       | —                        |       | 4,285 |   | — |   |
| Equity-based compensation                       |       | 4,329                      |       | —                        |       | 3,736 |   | — |   |
| Depreciation and amortization                   |       | 1,598                      |       | —                        |       | 1,286 |   | — |   |
| Accrued expenses and allowances                 |       | 813                        |       | —                        |       | 760 |   | — |   |
| Deferred revenue                                |       | 388                        |       | —                        |       | 425 |   | — |   |
| Other                                           |       | 23                         |       | —                        |       | 270 |   | — |   |
| Identified intangible assets                    |       | —                     |       | 140                           |       | — |   | 295 |   |
| Unrealized gain on investments                  |       | —                     |       | 56                            |       | — |   | 106 |   |
| Total deferred taxes before valuation allowance |       | 17,200                     |       | 196                           |       | 15,180 |   | 401 |   |
| Less valuation allowance                        |       | (17,200                    | )          | (196                          | )          | (221 | ) | — |   |
| Net deferred taxes                              |       | $                          | —     |                          | $          | — |   | $ | 14,959 |   | $ | 401 |   |

 

**Realizability of deferred tax assets**

 

Companies are required to assess whether a valuation allowance shouldbe recorded against their deferred tax assets based on the consideration of allavailable evidence, using a “more likely than not” realization standard. Thefour sources of taxable income that must be considered in determining whetherdeferred tax assets will be realized are: 1) future reversals of existingtaxable temporary differences; 2) future taxable income exclusive of reversingtemporary differences and carryforwards; 3) taxable income in prior carrybackyears if carryback is permitted under the tax law; and 4) tax planningstrategies.

 

The Company has evaluated its deferred tax assets each reportingperiod, including making an assessment of cumulative pretax results in recentyears and projections of cumulative pretax results in future periods. As ageneral guideline, the Company considered the cumulative pretax results fromthe most recent three years. A significant

 

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negative factor in the Company’s assessment at June 30, 2009 wasthat the Company would transition to a three-year historical cumulative pretaxloss during 2009, as highly profitable quarters in 2006 were removed from thecumulative three-year pretax results. In addition, uncertain near-term marketand economic conditions reduced the Company’s ability to rely on projections offuture taxable income in assessing the realization of the Company’s deferredtax assets. As a result, during the three months ended June 30, 2009, theCompany recorded a non-cash charge of $15.0 million to the provision for incometaxes to establish a full valuation allowance against its deferred tax assets.If pretax results improve in future periods, the Company may be able to utilizethe deferred tax assets to reduce tax payments.

 

##### **Net operating loss carryforwards and other tax creditcarryforwards**

##### ** **

The Company had federal tax losscarryforwards of approximately $15.5 million, representing a $5.3 milliondeferred tax asset as of December 31, 2009. The federal tax losscarryforwards will expire in 2019 through 2028 if not utilized. The Company hada full valuation allowance against this deferred tax asset as of December 31,2009.

 

The Company had state tax loss carryforwardsof approximately $3.7 million, representing a $199,000 deferred tax asset as ofDecember 31, 2009. The state tax loss carryforwards will expire at variousdates through 2025 if not utilized. The Company had a full valuation allowanceagainst this deferred tax asset as of December 31, 2009.

 

The Company had other federal and state taxcredits and carryforwards of approximately $4.7 million, representing a $4.7million deferred tax asset as of December 31, 2009. The federal and statecredits and carryforwards will expire in 2010 through 2029 if not utilized. TheCompany had a full valuation allowance against this deferred tax asset as of December 31,2009.

 

Changes in the valuation allowance were as follows (in thousands):

 
| ** **        | ** ** | **For the Year Ended December 31,** | ** ** |
|-------------------|------------|------------------------------------------|------------|
| ** **        | ** ** | **2009**                                 | ** ** | **2008** | ** ** | **2007** | ** ** |
|              |       |                                     |       |   |   |   |   |
| Beginning balance |       | $                                        | 221        |   | $ | 139 |   | $ | 185 |   |
| Additions         |       | 17,225                                   |       | 108 |   | — |   |
| Reversals         |       | (442                                     | )          | — |   | (4 | ) |
| Write-offs        |       | —                                   |       | (26 | ) | (42 | ) |
| Ending balance    |       | $                                        | 17,004     |   | $ | 221 |   | $ | 139 |   |

 

##### **Net operating loss carryforward limitations**

##### ** **

Under Section 382 of the InternalRevenue Code of 1986, certain stock transactions which significantly changeownership, including the sale of stock and the granting of options to purchasestock, could limit the amount of net operating loss carryforwards thatmay be utilized on an annual basis to offset taxable income in futureperiods. Management believes that any past changes in ownership, as defined by Section 382,would not materially impact the Company’s ability to utilize losscarryforwards.

 

**7.**              Employee benefit plan

** **

The Company maintains the Vital Images, Inc. Salary Savings Plan(the “Plan”), which is intended to qualify under Section 401(k) ofthe Internal Revenue Code of 1986, as amended. The Plan covers substantiallyall employees. Each employee may elect to contribute to the Plan throughpayroll deductions up to 100% of his or her salary, subject to certainlimitations. At the discretion of the Board of Directors, the Companymay make matching contributions equal to a percentage of the salaryreduction contributions or other discretionary amounts. The Company paidmatching contributions of $372,000, $412,000 and $410,000 in 2009, 2008 and2007, respectively.

 

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**8.**              Research and development

** **

In January 2009, the Company and Toshiba entered into adevelopment agreement under which Toshiba provides funding in support of theCompany’s research and development efforts, and the parties workcollaboratively to develop and deliver innovative technology advancements forToshiba’s medical equipment and the Company’s advanced visualization softwaresolutions. Software developed under the agreement is owned by the Company, andintellectual property in either party’s possession that may be useful in thedevelopment efforts or that is produced during the development activities issubject to cross-licenses. For payments received under the agreement, theCompany’s policy is to offset research and development expense in the period inwhich the related costs are incurred. The agreement does not provide forrecourse of payments previously offset against incurred expenses. The Companyreceived payments of $1,024,000 in 2009, and recognized credits of $1,137,000in 2009, to its research and development expense for reimbursement from Toshibato offset the development costs the Company incurred during the respectiveperiods under the agreement. The remaining unpaid balance of $113,000 wasincluded in other current assets as of December 31, 2009.

 

**9.**              Restructuring charge

** **

The Company reduced its workforce by approximately 11% under a planannounced in November 2008 in order to align the Company’s operations withmarket conditions and improve profitability in future periods. In connectionwith the reduction in workforce, the Company incurred certain charges in 2008totaling $660,000, which were primarily comprised of employee severance andother termination costs. The following table summarizes 2008 restructuringtransactions, subsequent payments, and related liability balances (inthousands):

 
| ** **                         | ** ** | **Severance and  Other  Termination  Costs** | ** ** |
|------------------------------------|------------|----------------------------------------------|------------|
| Balance at January 1,  2008   |       | $                                            | —     |   |
| Restructuring charges              |       | 660                                          |       |
| Payments                           |       | (519                                         | )          |
| Balance at  December 31, 2008 |       | 141                                          |       |
| Payments                           |       | (141                                         | )          |
| Balance at December 31,  2009 |       | $                                            | —     |   |

 

Actions with respect to the above activities were completed in thefourth quarter of 2008.

 

**10.**       Significant customers and geographic data

 

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

 
| ** **                          | ** ** | **For the Year Ended December 31,** | ** ** |
|-------------------------------------|------------|------------------------------------------|------------|
| ** **                          | ** ** | **2009**                                 | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                |       |                                     |       |   |   |   |   |
| Toshiba Medical Systems Corporation |       | $                                        | 31,457     |   | $ | 35,275 |   | $ | 32,710 |   |
| Percentage of total revenue         |       | 54                                       | %          | 52 | % | 47 | % |
|                                     |            |                                          |            |  |  |  |  |  |  |  |

 

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

 
| ** **                          | ** ** | **December 31,** | ** ** |
|-------------------------------------|------------|-----------------------|------------|
| ** **                          | ** ** | **2009**              | ** ** | **2008** | ** ** |
|                                |       |                  |       |   |   |
| Toshiba Medical Systems Corporation |       | 36                    | %          | 42 | % |
| McKesson Information Solutions LLC  |       | 14                    | %          | 7 | % |
| Medtronic Inc.                      |       | 12                    | %          | — | % |

 

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The majority of the Company’s long-lived assets are located in theUnited States.

 

Export revenue accounted for 34%, 29% and 19% of total revenue for theyears ended December 31, 2009, 2008 and 2007, respectively. The Company’sexport sales are primarily negotiated, invoiced and paid in U.S. dollars, witha portion of sales transactions denominated in foreign currencies.

 

Sales to customers located in the following geographic areas aresummarized as follows (in thousands):

 
| ** **       | ** ** | **For the Year Ended December 31,** | ** ** |
|------------------|------------|------------------------------------------|------------|
| ** **       | ** ** | **2009**                                 | ** ** | **2008** | ** ** | **2007** | ** ** |
|             |       |                                     |       |   |   |   |   |
| United States    |       | $                                        | 38,251     |   | $ | 48,473 |   | $ | 56,630 |   |
| Europe           |       | 10,881                                   |       | 11,316 |   | 8,378 |   |
| Asia and Pacific |       | 4,867                                    |       | 4,383 |   | 2,907 |   |
| Other foreign    |       | 4,231                                    |       | 3,969 |   | 2,261 |   |
|             |       | $                                        | 58,230     |   | $ | 68,141 |   | $ | 70,176 |   |

 

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

 

The following summarized unaudited quarterly financial data has beenprepared using the unaudited quarterly financial statements of the Company (inthousands, except per share data):

 
| ** **                                  | ** ** | **First Quarter** | ** ** | **Second Quarter** | ** ** | **Third Quarter** | ** ** | **Fourth Quarter** | ** ** |
|---------------------------------------------|------------|-------------------|------------|--------------------|------------|-------------------|------------|--------------------|------------|
|                                        |       |              |       |               |       |              |       |               |       |
| **2009**                                    |       |              |       |               |       |              |       |               |       |
| Total revenue                               |       | $                 | 14,788     |               | $          | 13,375            |       | $                  | 14,300     |   | $ | 15,767 |   |
| Gross profit                                |       | $                 | 11,232     |               | $          | 10,125            |       | $                  | 10,836     |   | $ | 11,832 |   |
| Net loss                                    |       | $                 | (251       | )                  | $          | (19,621           | )          | $                  | (750       | ) | $ | (630 | ) |
| Loss per share – basic and diluted (1) |       | $                 | (0.02      | )                  | $          | (1.37             | )          | $                  | (0.05      | ) | $ | (0.04 | ) |
|                                        |       |              |       |               |       |              |       |               |       |
| **2008**                                    |       |              |       |               |       |              |       |               |       |
| Total revenue                               |       | $                 | 17,317     |               | $          | 15,707            |       | $                  | 17,679     |   | $ | 17,438 |   |
| Gross profit                                |       | $                 | 13,397     |               | $          | 12,106            |       | $                  | 13,619     |   | $ | 13,146 |   |
| Net loss                                    |       | $                 | (594       | )                  | $          | (1,577            | )          | $                  | (243       | ) | $ | (386 | ) |
| Loss per share – basic and diluted (1) |       | $                 | (0.03      | )                  | $          | (0.09             | )          | $                  | (0.02      | ) | $ | (0.03 | ) |

 

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

 

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Tableof Contents

 

**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 dated March 13, 1997 (“Form 10”).                                                                    |
|          |       |                                                                                                                                                                                                                                                                            |
| 3.2           |       | By-laws of the Company, incorporated by reference to  Exhibit 3.2 to the Form 10.                                                                                                                                                                                     |
|          |       |                                                                                                                                                                                                                                                                            |
| 4.1           |       | Form of common stock certificate of the  Company, incorporated by reference to Exhibit 4.3 to the Form 10.                                                                                                                                                       |
|          |       |                                                                                                                                                                                                                                                                            |
| 10.1          |       | Employee Stock Purchase Plan, incorporated by  reference to Exhibit 10.10 to the Form 10.*                                                                                                                                                                            |
|          |       |                                                                                                                                                                                                                                                                            |
| 10.2          |       | 1997 Stock Option and Incentive Plan, as amended,  incorporated by reference to Exhibit 10.11 to the Form 10 and  Exhibit 99.9 to the Company’s Registration Statement on Form S-8  dated May 23, 2005.*                                          |
|          |       |                                                                                                                                                                                                                                                                            |
| 10.3          |       | 1997 Director Stock Option Plan, as amended,  incorporated by reference to Exhibit 10.12 to the Form 10 and  Exhibit 99.14 to the Company’s Registration Statement on Form S-8  dated May 23, 2005.*                                              |
|          |       |                                                                                                                                                                                                                                                                            |
| 10.4          |       | Form of Change in Control Agreement between  Vital Images, Inc. and Steven P. Canakes, incorporated by reference to  Exhibit 10.31 to the Company’s Annual Report on Form 10-K for the  year ended December 31, 2000.*                            |
|          |       |                                                                                                                                                                                                                                                                            |
| 10.5          |       | Employment Agreement dated September 8, 2005 by  and between Vital Images, Inc. and Steven P. Canakes, incorporated by  reference to Exhibit 99.7 to the Company’s Current Report on  Form 8-K dated September 12, 2005.*                         |
|          |       |                                                                                                                                                                                                                                                                            |
| 10.6          |       | Change in Control Agreement dated May 16, 2005,  by and between Vital Images, Inc. and Michael H. Carrel, incorporated by  reference to Exhibit 99.4 to the Company’s Current Report on  Form 8-K dated May 19, 2005.*                            |
|          |       |                                                                                                                                                                                                                                                                            |
| 10.7          |       | 2006 Long Term Incentive Plan incorporated by  reference to Exhibit 10.1 to the Company’s Current Report on  Form 8-K dated May 9, 2006.*                                                                                                                   |
|          |       |                                                                                                                                                                                                                                                                            |
| 10.8          |       | Employment Agreement dated January 12, 2008 by  and between Vital Images, Inc. and Michael H. Carrel, incorporated by  reference to Exhibit 10.13 to the Company’s Annual Report on  Form 10-K for the year ended December 31, 2007.*             |
|          |       |                                                                                                                                                                                                                                                                            |
| 10.9          |       | Employment Agreement dated January 12, 2008 by  and between Vital Images, Inc. and Peter J. Goepfrich, incorporated by  reference to Exhibit 10.14 to the Company’s Annual Report on  Form 10-K for the year ended December 31, 2007.*            |
|          |       |                                                                                                                                                                                                                                                                            |
| 10.10         |       | Separation and Non-Compete Agreement dated  January 16, 2008 by and between Vital Images, Inc. and Jay D.  Miller, incorporated by reference to Exhibit 10.19 to the Company’s  Annual Report on Form 10-K for the year ended December 31, 2007.* |

 

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| **Item  No.** | ** ** | **Description**                                                                                                                                                                                                                                                                                   |
|---------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|          |       |                                                                                                                                                                                                                                                                                              |
| 10.11         |       | Separation and Non-Compete Agreement dated  June 30, 2008 by and between Vital Images, Inc. and Philip I.  Smith, incorporated by reference to Exhibit 10.1 to the Company’s  Quarterly Report on Form 10-Q for the quarter ended June 30, 2008.*                   |
|          |       |                                                                                                                                                                                                                                                                                              |
| 10.12         |       | Separation and Non-Compete Agreement dated  September 11, 2008 by and between Vital Images, Inc. and Susan A.  Wood, Ph. D., incorporated by reference to Exhibit 10.1 to the Company’s  Quarterly Report on Form 10-Q for the quarter ended September 30,  2008.*  |
|          |       |                                                                                                                                                                                                                                                                                              |
| 10.13         |       | Offer letter dated August 5, 2008 by and  between Vital Images, Inc. and Vikram Simha, incorporated by reference  to Exhibit 10.17 to the Company’s Annual Report on Form 10-K for  the year ended December 31, 2008.* b                                            |
|          |       |                                                                                                                                                                                                                                                                                              |
| 10.14         |       | Employment Agreement dated August 6, 2008 by  and between Vital Images, Inc. and Vikram Simha, incorporated by  reference to Exhibit 10.18 to the Company’s Annual Report on  Form 10-K for the year ended December 31, 2008.*                                      |
|          |       |                                                                                                                                                                                                                                                                                              |
| 10.15         |       | Change in Control Agreement dated August 5,  2008, by and between Vital Images, Inc. and Vikram Simha, incorporated  by reference to Exhibit 10.19 to the Company’s Annual Report on  Form 10-K for the year ended December 31, 2008.*                              |
|          |       |                                                                                                                                                                                                                                                                                              |
| 10.16         |       | Offer letter dated December 10, 2008 by and  between Vital Images, Inc. and Reza A. Ghanbari, incorporated by  reference to Exhibit 10.20 to the Company’s Annual Report on  Form 10-K for the year ended December 31, 2008.*                                       |
|          |       |                                                                                                                                                                                                                                                                                              |
| 10.17         |       | Employment Agreement dated December 10, 2008 by  and between Vital Images, Inc. and Reza A. Ghanbari, incorporated by  reference to Exhibit 10.21 to the Company’s Annual Report on  Form 10-K for the year ended December 31, 2008.*                               |
|          |       |                                                                                                                                                                                                                                                                                              |
| 10.18         |       | Change in Control Agreement dated December 10,  2008, by and between Vital Images, Inc. and Reza A. Ghanbari,  incorporated by reference to Exhibit 10.22 to the Company’s Annual  Report on Form 10-K for the year ended December 31, 2008.*                       |
|          |       |                                                                                                                                                                                                                                                                                              |
| 10.19         |       | Marketing and Distribution Agreement between Vital  Images, Inc. and Toshiba Medical Systems Corporation dated  November 21, 2008, incorporated by reference to Exhibit 10.23 to  the Company’s Annual Report on Form 10-K for the year ended  December 31, 2008. b |
|          |       |                                                                                                                                                                                                                                                                                              |
| 10.20         |       | Development Agreement between Vital  Images, Inc. and Toshiba Medical Systems Corporation dated  January 8, 2009, incorporated by reference to Exhibit 10.24 to the  Company’s Annual Report on Form 10-K for the year ended  December 31, 2008. b                  |
|          |       |                                                                                                                                                                                                                                                                                              |
| 10.21         |       | Offer letter dated September 25, 2009 by and  between Vital Images, Inc. and Aaron Erkan Akyuz, filed herewith.*                                                                                                                                                                        |
|          |       |                                                                                                                                                                                                                                                                                              |
| 10.22         |       | Employment Agreement dated October 1, 2009 by  and between Vital Images, Inc. and Aaron Erkan Akyuz, filed herewith.*                                                                                                                                                                   |
|          |       |                                                                                                                                                                                                                                                                                              |
| 10.23         |       | Change in Control Agreement dated September 25,  2009, by and between Vital Images, Inc. and Aaron Erkan Akyuz, filed  herewith.*                                                                                                                                                       |

 

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| **Item  No.** | ** ** | **Description**                                                                                                                                                                                              |
|---------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|          |       |                                                                                                                                                                                                         |
| 21.1          |       | Subsidiaries of Registrant, filed herewith.                                                                                                                                                                  |
|          |       |                                                                                                                                                                                                         |
| 23.1          |       | Consent of PricewaterhouseCoopers LLP, filed  herewith.                                                                                                                                                      |
|          |       |                                                                                                                                                                                                         |
| 31.1          |       | Certification of Chief Executive Officer Pursuant to  Rules 13a-14(a)/15d-14(a) under the Securities Exchange Act of 1934  and Section 302 of the Sarbanes-Oxley Act of 2002, filed herewith. |
|          |       |                                                                                                                                                                                                         |
| 31.2          |       | Certification of Chief Financial Officer Pursuant to  Rules 13a-14(a)/15d-14(a) under the Securities Exchange Act of 1934  and Section 302 of the Sarbanes-Oxley Act of 2002, filed herewith. |
|          |       |                                                                                                                                                                                                         |
| 32.1          |       | Certification of Chief Executive Officer Pursuant to  18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002, filed herewith.                               |
|          |       |                                                                                                                                                                                                         |
| 32.2          |       | Certification of Chief Financial Officer Pursuant to  18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002, filed herewith.                               |

 

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*                 Indicates a management contract orcompensatory plan or arrangement.

 

b                   Portions of such exhibit are treated as confidentialpursuant to a request for that confidential treatment filed with the Commissionby Vital Images.

 

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