**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

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**FORM 10-K/A**

 

**(Amendment No. 2)**

 

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

 

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**VITAL IMAGES, INC.**

(Exact name of Registrant asspecified in its charter)

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

 

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Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Actof 1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days. Yes    ý    No    o

 

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

 

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

 

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

 

Thenumber of shares outstanding of the issuer’s classes of common stock as ofFebruary 28, 2003: Common stock, $.01 Par Value – 9,039,714.

 

DOCUMENTS INCORPORATED BYREFERENCE

 

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

 

 

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**EXPLANATORYNOTE**

 

VitalImages, Inc. (the “Company”) is filing this Amendment No. 2 to its AnnualReport on Form 10-K for the year ended December 31, 2002, which wasoriginally filed March 28, 2003 and amended by Amendment No. 1 filed onSeptember 23, 2003 (collectively, the “Form 10-K”), principally to amendspecific items of the Form 10-K to reflect: (1) the change in classification ofcertain customer support costs, which had previously been reported as a salesand marketing expense rather than as cost of revenue – maintenance andservices, and (2) the change in classification of amortization expense relatedto technology licensed from a third party, which had, prior to the thirdquarter of 2003, been reported as research and development expense rather thanas cost of revenue- license fees. In addition, the Company has enhanced certainpreviously included disclosures regarding accounting policies related torevenue recognition. The changes in classification had no effect on theCompany’s previously reported revenue, operating income, net income (loss) ornet income (loss) per share, nor did the changes in classifications affect theCompany’s balance sheets or statements of shareholders’ equity and cash flows.This Amendment No. 2 amends only the portions of the Form 10-K set forthherein; the remainder of the Form 10-K is unchanged and is not reproduced inthis Amendment No. 2. This Amendment No. 2 does not reflect events occurringafter the original filing of the Form 10-K.

 

ThisAmendment No. 2 contains changes to the following disclosures:

 
| •  Part I – Item 1. Business                                                                                    |
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| •   “Maintenance and Support”                                                                              |
| •   “Employees”                                                                                            |
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| •  Part II - Item 6. Selected Financial Data                                                                         |
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| •  Part II - Item 7. Management’s Discussion  and Analysis of Financial Condition and Results of Operations     |
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| •  Part II - Item 8. Financial Statements and  Supplementary Data – Vital Images, Inc. Statements of Operations |
|                                                                                                                           |
| •  Part II- Item 8. Financial Statements and  Supplementary Data- Notes to Financial Statements                      |
| •   Note 2- Summary of Significant Accounting Policies- Revenue  Recognition                                         |
| •   Note 10- Licensed Technology                                                                                     |
| •   Note 14 Quarterly Financial Data (Unaudited)                                                                     |
|                                                                                                                           |
| •  Part IV - Item 15. Exhibits, Financial  Statements Schedules and Reports on Form 8-K                              |

 

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VITAL IMAGES, INC.

FORM 10-K/A

Amendment No. 2

 

TABLE OF CONTENTS

 
| PART I   |                                                                                        |
|----------|---------------------------------------------------------------------------------------------|
|     |                                                                                        |   |
| Item 1.  | Business                                                                                    |   |
|     |                                                                                        |   |
| PART II  |                                                                                        |
|     |                                                                                        |   |
| Item 6.  | Selected  Financial Data                                                                    |   |
| Item 7.  | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |   |
| Item 8.  | Financial  Statements and Supplementary Data                                                |   |
|     |                                                                                        |   |
| PART IV  |                                                                                        |
|     |                                                                                        |   |
| Item 15. | Exhibits, Financial Statement Schedules and Reports on Form 8-K                             |   |
|     |                                                                                        |   |
|     | Signatures                                                                                  |   |

 

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Item 1.                                     BUSINESS

 

VitalImages, Inc. (“Vital Images” or the “Company”) was incorporated in Iowa inSeptember 1988.  InMarch 1997, the Company re-incorporated under the laws of the state ofMinnesota.  The Company’s principalexecutive offices are located at 3300 Fernbrook Lane N., Suite 200, Plymouth, MN55447 (telephone (763) 852-4100, facsimile (763) 852-4110, e-mail –info@vitalimages.com ).  FromMay 24, 1994 through May 11, 1997, the Company was a wholly-ownedsubsidiary of Bio-Vascular, Inc. (“Bio-Vascular”), now known as Synovis LifeTechnologies, Inc..

 

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

 

TheCompany also makes available free of charge through its Internet website(http://www.vitalimages.com) the Company’s Annual Report on Form 10-K,Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and, ifapplicable, amendments to those reports filed or furnished pursuant to theExchange Act as soon as reasonably practicable after the Company electronicallyfiles such material with, or furnishes it to, the SEC.

 

BusinessDescription

 

VitalImages develops, markets and supports 3D medical imaging software for useprimarily in disease screening, clinical diagnosis and therapy planning.  The Company’s software applies proprietarycomputer graphics and image processing technologies to a wide variety of datasupplied by computed tomography (“CT”) scanners and magnetic resonance (“MR”)imaging devices.  Vital Images’ productsallow clinicians to create both two- and three-dimensional views of humananatomy and to non-invasively navigate within these images to better visualizeand understand internal structures and pathologies.  The Company believes that its high-speed visualization technologyand customized protocols cost-effectively bring 3D visualization and analysisinto the routine, day-to-day practice of medicine.  The Company, which operates in a single business segment, marketsits products to healthcare providers and to manufacturers of diagnostic imagingsystems through a direct sales force in the United States and independentdistributors in international markets.

 

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

 

TheCompany believes that growing acceptance of 3D medical imaging offers VitalImages numerous market expansion opportunities.  Research and development efforts are currently focused on usingthe Company’s base of visualization technology to expand to other imagingmodalities, such as x-ray angiography, as well as

 

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expandingthe features and functions in the current modalities.  Vital Images is also developing 3D medical imaging software toolsfor less-invasive screening applications, such as CT colonography for coloncancer screening, surgical planning, intra-operative visualization andreal-time interventional 3D visualization.

 

TheCompany has a marketing and distribution agreement with Toshiba Corporation,Medical Systems Company (“Toshiba”), which names *Vitrea 2* as Toshiba’s primary 3D software for use with theirCT scanners in the United States and in more than 50 countries in North andSouth America, Europe, the Middle East, Africa, Australia and Asia, exceptJapan. The agreement runs through September 30, 2003.  Sales by the Company to Toshiba accountedfor approximately 34%, 27% and 27% of the Company’s total revenue for the yearsended December 31, 2002, 2001 and 2000, respectively.  See “Business – Marketing and Distribution”and “– Dependence on Major Customers.”

 

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

 

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

 

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

 

Technology

 

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

 

Volume rendering is an advanced technique for displayingthree-dimensional views on a computer monitor that the Company believes hassignificant advantages over the alternative technique, known as “surfacerendering.”  Volume rendering permitsthe direct display of all of the imaging data without mathematical modeling andallows interactive control of the level of “transparency” of the data.  By comparison, surface

 

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rendering requires the creation of artificial surfaces based onselected imaging data, and the usefulness of the resulting visual image islargely dependent on where these surfaces are “set” by the clinical technician.  Volume rendering is not dependent on thecreation of artificial surfaces and allows visualization of varying componentsthat might otherwise be eliminated from a surface rendered image due to surfaceapproximation.  Because volume renderinguses all of the data and information collected by the imaging equipment, theCompany believes visualization processes that use volume rendering provideclinicians with better images to define and display pathology and anatomy in amore useful manner.

 

Until the last several years, most medical imaging companies largelyoverlooked volume rendering because the computer power necessary to performvolume rendering was significantly more expensive and intensive than therequirements for surface rendering.  TheCompany’s experience with volume rendering has its basis in the efforts ofVincent J. Argiro, Ph.D., the founder of the Company, who developedthree-dimensional visualization software using volume rendering as an aid inhis research in developmental neuroscience. Dr. Argiro focused on accelerating the performance of volume renderingon standard computer platforms.  As aresult of his work, he developed expertise in accelerated volume rendering,which forms the core of the Company’s volume rendering technology.  Because the performance of standard computerplatforms has increased while the relative cost of such performance hasdecreased, the Company believes that volume rendering has become a moreaccessible imaging solution for routine clinical applications.

 

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

 

Industry Background

 

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

 

Both of these imaging technologies capture data that provide aphysician with a graphical representation of the inside of the human body.  These images have traditionally been viewedas a series of two-dimensional, cross-sectional slices on x-ray-type film.  As computer processing speed increased, softwareperformance improved and networking technologies developed, manufacturers ofscanning equipment began offering integrated systems that allowed clinicians toview, analyze and manipulate these medical images in a digital environment.  These systems first visualized individualslices, or pictures, on a computer monitor and later provided views of multipleslices.  More recently, medical imagingsystems began to permit viewing and manipulation of large, multiple slice datasets as a single, three-dimensional image on a computer workstation.  Today, the 3D medical imaging industryinvolves the creation, visualization, manipulation, analysis and communicationof medical images in two, three and four dimensions.

 

Initially, the 3D medical imaging industry and the markets for 3Dmedical imaging products lagged the market for imaging devices due to the lackof industry standards for the generation, transmission and storage of medicalimaging data and due to computer costs and performance considerations.  After a time, many of the technical and costbarriers to growth in the 3D medical imaging industry and the PACS industrybegan to erode.  In particular, themedical industry embraced an image transmission and archiving standard calledDICOM, promulgated by the American College of Radiology and the NationalElectronic Manufacturer’s Association. This standard permits imaging, visualization, networking and archivingsystems from different vendors to work cooperatively within a singlenetwork.  In addition, the cost-to-performanceratio of computer products used in visualization and PACS has improveddramatically, bringing the prices for 3D medical imaging capabilities and PACSwithin the grasp of most healthcare providers. The Company believes that the

 

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acceptance of industry standards such as DICOM and the improvements inthe cost-to-performance ratio for clinical workstations will support continuedmarket growth in the 3D medical imaging and PACS industries.

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Markets

 

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

 

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

 

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

 

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

 

As discussed above, the overall market for 3D medicalimaging software and systems is developing rapidly, as the related technologyand products that define this market are relatively new and undergoing rapidchange.  Medical imaging software andsystem solutions for diagnostic radiology have existed for the last severalyears.  The use of medical imagingsoftware and systems to assist in surgical planning and navigation has onlybegun to emerge in clinical practice in the last few years.  While medical imaging software and systemshave been used in these applications and to support cancer treatment planningin the past, the Company believes that perspective, three-dimensional volumerendering represents an underutilized resource to practitioners for diagnosticscreening and radiology, surgical planning and navigation and cancer treatmentplanning.

 

Strategy

 

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

 

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

 

•                       Furtherdevelop applications for the Company’s 3D medical imaging technology.  The Company intends to leverage its corecompetencies in volume rendering, computer graphics and clinicalapplications.  The Company plans todevelop and offer a full range of 3D medical imaging software tools for diseasescreening, radiological diagnosis, therapy planning and intra-operativevisualization.  The Company believesthat significant new opportunities exist for the application of its innovativetechnologies for the diagnosis and treatment of cardiovascular disease, cancerand orthopedics.

 

•                       Furtherpenetrate the 3D medical imaging market. The Company intends to expand its sales and marketing staff and increaseits marketing efforts in order to continue building momentum for the acceptanceand purchase of *Vitrea 2* and its other products.  A key challenge for the Company involves reaching and educatingphysicians and clinicians as to the benefits of the *Vitrea 2* software.  By convincing the ultimate users of thebenefits of its system, the Company

 

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believes that it can successfully influencepurchasing decisions for medical institutions purchasing or upgrading theirimaging technology.  In addition, theCompany will work to expand its appeal by implementing additional 2D capabilityas well as ensuring that its technology will easily integrate into hospitalnetworks.

 

•                       Continueto seek collaborative partnerships with leading medical institutions.  The Company has historically sought out anddeveloped collaborative relationships with several prestigious medicalinstitutions to develop and test the Company’s visualization tools.  The Company will continue to pursuecollaborations to focus on developing products that will improve clinicaloutcomes and reduce costs for the practices of medical imaging and surgery.

 

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

 

 Productsand Product Development

 

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

 

*Vitrea 2* capitalizes on the Company’sexperience in 3D medical imaging and provides clinicians with an easy-to-usetool for disease screening, radiological diagnosis and therapy planning.  It represents the Company’s most importantstep to date as a provider of a range of clinical tools for broad distributionto the 3D medical imaging market.  *Vitrea 2’s*primary features are its high-speed rendering capability and the ability toprovide two- and three-dimensional viewing for routine diagnosis and therapyplanning, without requiring the user to be trained in computer graphicstechniques.  The Company believes thatboth of these features - speed and ease-of-use - now make it possible to use three-dimensionalmedical imaging in daily clinical routines. A *Vitrea2* user, following a built-in clinical workflow, can view the imagedata in two, three or four dimensions using visualization settings based onspecific clinical applications stored within the system as dedicatedvisualization protocols.  The user maythen interactively navigate around, or “fly through,” the image to viewclinically relevant anatomies and pathologies. *Vitrea2*software also allows the user to capture views by

 

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taking “snapshots,” which can be integrated into customized reports forelectronic transmission and archiving through a DICOM network or sent toanother location via the Internet.

 

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

 

The Company offers *Vitrea 2* primarily as an integratedsoftware and hardware system, consisting of *Vitrea 2*software installed on a personalcomputer (“PC”).  Pursuant to purchasingarrangements between the Company and computer resellers, the Company purchasespersonal computers at a nominal discount, installs its *Vitrea 2*software, andmarkets the package as an integrated 3D medical imaging solution, therebyimplementing the Company’s strategy to develop, market, sell and support anintegrated 3D medical imaging workstation. Currently, *Vitrea 2* operates on PC workstations from Omni Tech, Inc.,Hewlett-Packard Company and Dell Computer Corporation.  The Company also sells software licenseswithout the related workstation hardware. The list price for a base model integrated workstation and softwarepackage is approximately $99,000, and the list price for the *Vitrea 2*software without a workstation is approximately $81,000.

 

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

 

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

 

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

 

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

 

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

 

Automated Vessel Measurements.  In October 2001, the Company introducedits Automated Vessel Measurements software option to assist physicians incharacterizing the course and dimensions of diseased blood vessels.  The Automated Vessel Measurements option isdesigned to support activities such as pre-surgical diagnosis, evaluation andstent planning in the abdominal aorta, carotid arteries, coronary arteries andrenal arteries.

 

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

 

Maintenance and Support.  In addition to its system and softwareproducts, the Company also offers maintenance and support services to itscustomers, as well as certain other services such as installation and training.  In connection with the licensing of *Vitrea 2*software,the Company markets annual maintenance services for both *Vitrea 2* software and theintegrated *Vitrea2* system, pursuant to which the Company provides software updates,minor feature enhancements, error correction, telephone support and generalmaintenance services for an annual fee of approximately $7,000.  Outside of these maintenance services, theCompany is required by FDA regulations to provide certain levels of support toend users as a result of the use of its products as medical devices.  Maintenance services currently marketed bythe Company do not include installation, training and other services, whetheron- or off-site, as such services are charged separately by the Company.

 

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

 

The Company expensed $4,143,000, $3,359,000 and $3,036,000 incurred inits research and development efforts in each of the fiscal years endedDecember 31, 2002, 2001 and 2000, respectively.

 

CollaborativeRelationships

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

•                       UCLAMedical Center

 

•                       DukeUniversity Medical Center

 

•                       Universityof Iowa Hospital and Clinics

 

•                       MallinckrodtInstitute of Radiology at the Washington University School of Medicine

 

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•                       Universityof Minnesota-Fairview University Medical Center

 

•                       NorthwesternUniversity Medical Center

 

•                       MassachusettsGeneral Hospital

 

•                       StanfordUniversity Medical Center

 

•                       YaleUniversity School of Medicine

 

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

 

Competition

 

The 3Dmedical imaging market is developing and growing rapidly.  It is intensely competitive, subject torapid change and significantly affected by new product introductions and othermarket activities of industry participants. The Company’s primary competitors are the various diagnostic imagingsystem suppliers, which are typically large, multinational companies, havingfar greater financial and technical resources than the Company. They also havewell-established sales and distribution networks for their products. Thesecompanies, including GE Medical Systems, Siemens Medical Systems, Inc. andPhilips Medical Systems, are engaged in the business of developing andmarketing medical imaging systems, such as CT and MR equipment.  These competitors offer 3D medical imagingcapabilities integrated with their products in addition to the 2D medicalimaging capabilities typically provided as a part of the operator’s console onthe imaging equipment itself.  This medicalimaging capability may be internally developed by these companies, or it may belicensed from independent vendors.  Inorder to compete effectively with these companies, Vital Images must convincecustomers to separate their purchasing decisions regarding the imagingequipment itself from the selection and purchase of the 3D medical imagingworkstations instead of purchasing an entire integrated system manufactured byone entity.  To a lesser extent, theCompany also faces competition from other medical imaging systems and softwaresuppliers, PACS vendors, hospital, radiology and clinical system suppliers, andinternal development projects sponsored by hospital radiology departments.

 

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

 

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

 

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

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

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

 

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

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

•                       Serveboth original equipment manufacturers (“OEM”) and end-user customers throughthe development of a modular end-user product that can easily be segmented forOEM customers.

 

The Company believes that product quality, performance, functionalityand features, quality of support and service, reputation and price are alsoimportant competitive factors.  TheCompany believes that customers will prefer *Vitrea 2* because it is simple, fast andaffordable.  While price has been lesssignificant than other factors, increasing competition in the 3D medicalimaging market may result in price reductions and reduced gross margins.  In particular, should one or more of thediagnostic imaging system suppliers choose to provide or distribute morecompetitive medical imaging products than those offered by the Company, theCompany’s business, financial condition and results of operations could bematerially adversely affected.

 

Marketing and Distribution

 

The Company markets *Vitrea 2* both as a software package and aspart of an integrated software and hardware system to radiologists, surgeons,primary care physicians and medical researchers.  The Company markets its products directly to end-user customers,such as hospitals and clinics, as well as to select diagnostic imagingcompanies, digital imaging equipment manufacturers and PACS companies forresale as a Vital Images branded product. In November 2001, the Company signed a joint venture agreement towork collaboratively on products and services in image-guided surgery andsurgical planning with the Surgical Navigation Technologies (SNT) division ofMedtronic, Inc. Under this agreement, the Company’s advanced visualizationtechnology will be integrated into Medtronic SNT’s image-guided surgeryproducts, and the two companies will collaborate on new surgical planningsoftware and service offerings.  InOctober 2001, the Company signed an exclusive agreement with E-Z-EM, Inc.to develop and distribute a dedicated CT colonography product.  In September 2000, the Company signed amarketing and distribution agreement with Toshiba America Medical Systems(“TAMS”), which named *Vitrea 2* asTAMS’ primary 3D software for use with their CT scanners in the UnitedStates.  In February 2002, theCompany announced that it had entered into a marketing and distributionagreement with Toshiba Corporation, Medical Systems Company to offer *Vitrea 2* to**its subsidiaries and distributors, including TAMS, in morethan 50 countries in North and South America, Europe, the Middle East, Africa,Australia and Asia, except Japan. The agreement ran through September 30,2002.  In January 2003, the Companyannounced that it had renewed the agreement through September 30, 2003.  See “Business – Dependence on MajorCustomers.”

 

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

 

The Company markets its products both domestically andinternationally.  In the United States,the Company markets its products through its direct sales force as well asthrough OEMs and resellers. Internationally, the Company markets its products through OEMs andresellers.  See Note 8 to the FinancialStatements - “Major Customers and Geographic Data” for information regardingthe Company’s export sales.  As ofDecember 31, 2002, the Company had 20 direct salespeople in the U.S., oneinternational reseller salesperson, one OEM customer and nine internationalresellers.

 

Customers and Customer Support

 

Through December 31, 2002, the Company has sold over 850 separatesoftware licenses for *Vitrea*,*Vitrea 2* and InnerviewGITMfor use in over 700 different sites, including hospitals, clinics, imagingcenters and other

 

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sites.  The Company’s customersinclude America’s most renowned hospitals, including the following 14 of thetop 17 hospitals listed in *U.S. News and World Report’s* honor roll oftop hospitals:

 

•                  JohnsHopkins Hospital

•                  MayoClinic 

•                  ClevelandClinic 

•                  MassachusettsGeneral Hospital 

•                  UCLAMedical Center

•                  DukeUniversity Medical Center

•                  UCSFMedical Center

•                  Barnes-JewishHospital 

•                  Brigham& Women’s Hospital

•                  Universityof Washington Medical Center

•                  NewYork Presbyterian Hospital

•                  Hospitalof the University of Pennsylvania

•                  StanfordUniversity Hospital

•                  Universityof Chicago Hospitals

 

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

 

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

 

Intellectual Property

 

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

 

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

 

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

 

Manufacturing and Service

 

The Company’s manufacturing efforts are limited to the production,quality assurance and distribution of its software, which is distributed onCD-ROM.  The software is sent to thecustomer site and loaded into a

 

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personal computer.  The softwarefor *Vitrea2* is loaded into the computer by Company personnel, as part of theCompany’s installation services, which are priced and billed incrementally tothe software license billing, or by an authorized reseller’s personnel as partof their installation services.  Inaddition to the loading of software into the computer, installation servicesgenerally include integrating *Vitrea 2* workstations into customers’computer networks, configuring the network requirements and verifying softwareoperability on site.

 

The Company relies primarily on its own software development as itscore competence.  The Company sourcescertain application and utility software from third parties, see “—IntellectualProperty” above, and the operating system for integrated computer workstationsfrom other parties.  In addition, theCompany sources systems components, computers and computer peripherals fromthird party suppliers.

 

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

 

Governmental Regulation

 

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

 

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

 

*Vitrea 2* is classified as a Class II medicaldevice and has received marketing clearance from the FDA as the result of a510(k) submission.  Specifically, *Vitrea 2*has been cleared to be marketed for use with CT and MR scanners, the Company’s *VScore*software options have been cleared for use in coronary artery calcium scoringand the Company’s CT Brain Perfusion option has been cleared for analyzing theblood flow of stroke victims.  Future products,add-on options to existing software, and expanded claims of efficacy willlikely require additional 510(k) applications.

 

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

 

The Company is also increasingly becoming subject to regulation inthose foreign countries in which it sells its products.  Many of the regulations applicable to theCompany’s products in such countries are similar to those of the FDA.  The Company’s ability to successfully marketand sell its products internationally depends in large part on its ability tocomply with such foreign regulatory requirements. *Vitrea 2* software has been

 

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Conformitee Europeene (“CE”) marked, indicating conformance withapplicable sections of the Medical Device Directive 93/42/EEC, which allows theproduct to be marketed in the member countries of the European Communities.

 

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

 

In January 2001, the Company announced that it had received ISO9001 Certification and an upgraded Class I Measurement CE Mark for its medicalimaging software products.

 

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

 

Third Party Reimbursement and CostContainment

 

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

 

In response to the focus of national attention on rising health carecosts, a number of changes to reduce costs have been proposed or have begun toemerge.  There have been, and maycontinue to be, proposals by legislators and regulators and third party payersto reduce these costs.  There has also beena significant increase in the number of Americans enrolling in some form of managedcare plan and, in addition, many hospitals participate in or have agreementswith HMOs.  It has become a typicalpractice for hospitals to affiliate themselves with as many managed care plansas possible.  Higher managed carepenetration typically

 

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drives down the prices of healthcare procedures, which in turn placespressure on medical supply prices.  Thiscauses hospitals to implement tighter vendor selection and certificationprocesses by reducing the number of vendors used, purchasing more products fromfewer vendors and trading discounts on price for guaranteed higher volumes tovendors.  Hospitals have also sought tocontrol and reduce costs over the last decade by joining group purchasing organizationsor purchasing alliances.  The Companycannot predict what continuing or future impact these practices, the existingor proposed legislation, or such third party payer measures may have on itsfuture business.

 

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

 

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

 

Employees

 

As of February 28, 2003, the Company had 105 full-time employees,with 35 involved in research and development, 33 in sales and marketing, 18 intechnical support functions for maintenance and services and 19 inadministrative functions.  The Companyis not a party to any collective bargaining agreement involving its employeesand believes its relationship with its employees is good.

 

ImportantFactors

 

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

 

Historical Operating Losses

 

For the year ended December 31, 2002 the Company had operatingincome of $677,000.  The Company hadoperating losses of $1,055,000 and $2,787,000 for the years endedDecember 31, 2001 and 2000, respectively, and, with the exceptions of thefiscal years ended December 31, 2002 and October 31, 1995, hasincurred operating losses each year since 1990.  As of December 31, 2002, the Company’s accumulated deficitwas $20,088,000.  The Company’s abilityto maintain annual profitability will depend on, among other things, itsability to successfully market its products, make new product offerings,respond to competitive developments and attract and retain qualified sales,technical and management employees. There can be no assurance that the Company will continue to achieveprofitable operations on an annual basis. See “Item 7. Management’s Discussion and Analysis of Financial Conditionand Results of Operations.”

 

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New Product Acceptance

 

The Company’s success depends on its ability to successfully market its*Vitrea 2*software for clinical use, and the ability and willingness of physicians to usetwo- and three-dimensional medical imaging software in disease screening,clinical diagnosis and therapy planning and other diagnosis, surgical, andtreatment protocols.  Thethree-dimensional medical imaging software offered by *Vitrea 2* represents a newalternative to the conventional methods traditionally used for viewing medicalimages in the clinical setting.  Theacceptance of *Vitrea 2* by physicians and other clinicians will depend onthe Company’s ability to educate those users as to the speed, ease-of-use andother benefits offered by the *Vitrea 2* system, as well as the timelyintroduction of new features and functions by the Company.  There can be no assurance that users willprefer three-dimensional medical imaging software over less expensivetwo-dimensional medical imaging software, or that the Company will succeed inits efforts to further develop, commercialize, and achieve market acceptancefor its *Vitrea2* product or for any other product in the clinical setting.  See “Business—Technology,” “—IndustryBackground,” “—Markets” and “—Competition.”

 

Substantial Reliance on a Single Product

 

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

 

Dependence on Market Growth 

 

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

 

Need for Additional Capital

 

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

 

The timing of the Company’s future capital requirements will depend ona number of factors, including, but not limited to, the ability of Vital Imagesto successfully market its products; the ability and willingness of physiciansto use two- and three-dimensional medical imaging software in diseasescreening, clinical diagnosis and therapy planning and other diagnosis,surgical, and treatment protocols; the impact of competition in the 3D medicalimaging business; the ability of the Company to differentiate its products fromcompeting products; the capital equipment budget constraints of some potentialpurchasers; the ability of the Company to

 

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build an effective sales and distribution force; and the ability toenhance existing products and develop new products on a timely basis.  To the extent that the Company’s operationsdo not progress as anticipated, additional capital may be required.  There can be no assurance that any requiredadditional capital will be available on acceptable terms, or at all, and thefailure to obtain any such required capital would have a material adverseeffect on Vital Images’ business.  Theissuance of additional equity securities may result in dilution of currentshareholder voting and ownership interests. See “Item 7. Management’s Discussion and Analysis of Financial Conditionand Results of Operations.”

 

Highly Competitive Industry

 

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

 

Risk of Technological Obsolescence

 

The 3D medical imaging market is characterized by rapid innovation andtechnological change.  There can be noassurance that the Company will be able to compete effectively in themarketplace or that products developed by its competitors will not render itsproducts obsolete or non-competitive.  Similarly,there can be no assurance that the Company’s competitors will not succeed indeveloping or marketing products that are viewed as providing superior clinicalperformance or are less expensive than the Company’s products currentlymarketed or to be developed.

 

Dependence on Major Customers

 

One of the Company’s principal distribution channels is to sell its *Vitrea 2*medical imaging software for inclusion with the delivery of medical imagingequipment being sold by Toshiba Corporation, Medical Systems Company(“Toshiba”).  Sales by the Company toToshiba accounted for approximately 34%, 27% and 27% of the Company’s totalrevenue for the years ended December 31, 2002, 2001 and 2000,respectively. Management believes a limited number of large customers maycontinue to account for a significant portion of the Company’s revenue duringany given period for the foreseeable future. Except for its marketing and distribution agreements with Toshiba,Medtronic SNT and E-Z-EM, Inc., the Company currently has no long-term purchaseor other agreements with any of its customers and sales are generally madepursuant to purchase orders.  Areduction, delay, or cancellation of orders from one or more of its significantcustomers likely would have a material adverse effect on the Company’soperating results.  See“Business-Marketing and Distribution.”

 

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Impact of Purchase Commitments

 

In November 2002, the Company entered into an agreement with R2Technology, Inc. (“R2”) to distribute R2’s lung nodule CAD software product(“lung CAD Product”) in conjunction with the Company’s products.  Upon the later of either the date on whichR2 is able to meet CE certification requirements and produce a “Declaration ofConformance” for the lung CAD product or the completion of the milestones inthe development plan with respect to the lung CAD product that will bedistributed in Europe, the Company is required to begin purchasing the lung CADproduct over the next three years.  Thetotal purchase commitment will be to a maximum of $5.6 million worth of productover the three-year commitment period. The purchase commitment price the Company has to pay will be reduced ifthe selling price of the lung CAD product when sold directly to end-users by R2falls below a specified price.

 

Fluctuations in Operating Results

 

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

 

Government Regulation

 

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

 

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

 

The Company markets its products both domestically andinternationally.  Internationalregulatory bodies have established varying regulations governing productstandards, packaging requirements, labeling requirements, import restrictions,tariff regulations, duties and tax requirements.  The inability or failure of the Company to comply with thevarying regulations or the imposition of new regulations could restrict itsability to sell its

 

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products internationally and could thereby adversely affect theCompany’s business.  See“Business—Governmental Regulation.”

 

Health Insurance Portability andAccountability Act of 1996 (“HIPAA”)

 

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

 

Uncertain Protection for IntellectualProperty; Possible Claims of Others

 

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

 

Product Liability Risk; Limited InsuranceCoverage

 

The manufacture and sale of products used in the practice of medicineentail significant risk of product liability claims.  While the Company currently maintains product liability insurancein the amount of $11,000,000 per occurrence and $12,000,000 in total and alsomaintains errors and omissions coverage in the amount of $11,000,000 peroccurrence and in total, there can be no assurance that its coverage limitswill be adequate to protect the Company from any liabilities it might incur inconnection with the sale of its products, or that the Company will be able tomaintain this level of coverage in the future. The Company also may require increased product liability

 

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coverage as additional products and updates are released.  Such insurance is expensive and in thefuture may not be available on acceptable terms, if at all.  A successful product liability claim orseries of such claims against the Company in excess of the Company’s insurancecoverage could have a material adverse effect on its business.

 

Dependence on Key Employee; Need to Hire AdditionalPersonnel

 

The Company depends upon the continued active participation of Dr.Vincent J. Argiro, its Chief Technology Officer and Founder.  Loss of the services of Dr. Argiro couldhave a material adverse effect on the Company’s future business.  Dr. Argiro does not have an employmentagreement with the Company, but he does have a confidentiality andnon-competition agreement with the Company.** **TheCompany maintains key person life insurance coverage on Dr. Argiro’s life inthe amount of $500,000.

 

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

 

Management of Growth

 

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

 

Dependence on Third-Party Reimbursement

 

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

 

Uncertainty of Health Care Reform

 

The levels of revenue and profitability of medical technology companiesmay be affected by the efforts of government and third party payers to containor reduce the costs of health care through various means.  In the United States there have been, andthe Company expects that there will continue to be, a number of federal,

 

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state, and private proposals to control health care costs.  These proposals may contain measuresintended to control public and private spending on health care as well as toprovide universal public access to the health care system.  If enacted, these proposals may result in asubstantial restructuring of the health care delivery system.  Significant changes in the nation’s healthcare system could have a substantial impact on the manner in which the Companyconducts its business and could have a material adverse effect on the Company’sbusiness, financial condition and results of operations.

 

Possible Issuances of Preferred Stock;Certain Anti-Takeover Considerations

 

The Company’s Articles of Incorporation authorize the Company’s Boardof Directors, without any action by its shareholders, to establish the rights andpreferences of up to 5,000,000 shares of currently undesignated preferredstock.  Such shares of preferred stockcould possess voting and conversion rights, which could adversely affect thevoting power of the holders of the common stock and may have the effect ofdelaying, deferring or preventing a change in control of the Company.  No shares of preferred stock or other seniorequity securities are currently designated and currently there is no plan todesignate or to issue any such securities. The Company is also subject to certain “anti-takeover” provisions of theMinnesota Business Corporation Act.  Inaddition, the Company has adopted a Shareholder Rights Plan (the “RightsAgreement”) designed to protect the Company and its shareholders from unsolicitedattempts to acquire the Company.  Thesemeasures may, in certain circumstances, deter or discourage takeover attemptsand other changes in control of the Company not approved by its Board ofDirectors and may have a depressive effect on any market for the Company’sstock.  As a result, the Company’sshareholders may lose opportunities to dispose of their shares at the higherprices typically available in takeover attempts or that may be available undera merger proposal.  In addition, thesemeasures may have the effect of permitting the Company’s current directors toretain their positions and place them in a better position to resist changesthat the Company’s shareholders may wish to make if they are dissatisfied withthe conduct of the Company’s business.

 

No Dividends

 

The Company has not paid cash dividends on its common stock in the pastand does not intend to do so in the foreseeable future.

 

Limitations on Director Liability

 

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

 

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PART II

 

Item 6.                                     SELECTEDFINANCIAL DATA

 

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

 

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

 
|                                                       |   | **For the Years Ended  or As of  December 31,** |   |
|------------------------------------------------------------|--------|------------------------------------------------------|--------|
|                                                       |   | **2002**                                             |   | **2001** |   | **2000** |   | **1999** |   | **1998** |   |
|                                                       |   | **Restated (1)**                                     |   | **Restated (1)** |   | **Restated (1)** |   | **Restated (1)** |   | **Restated (1)** |   |
| **Statement of Operations Data:**                          |   |                                                 |   |   |   |   |   |   |   |   |   |
| Revenue                                                    |   | $                                                    | 21,116 |   | $ | 15,196 |   | $ | 10,628 |   | $ | 6,623 |   | $ | 4,527 |   |
| Gross margin                                               |   | 14,808                                               |   | 10,723 |   | 7,168 |   | 4,303 |   | 2,628 |   |
|                                                       |   |                                                 |   |   |   |   |   |   |   |   |   |
| Operating  expenses:                                       |   |                                                 |   |   |   |   |   |   |   |   |   |
| Selling,  general and administrative                       |   | 9,988                                                |   | 8,420 |   | 6,919 |   | 5,081 |   | 4,280 |   |
| Research and  development                                  |   | 4,143                                                |   | 3,358 |   | 3,036 |   | 2,525 |   | 1,815 |   |
| Operating  income (loss)                                   |   | 677                                                  |   | (1,055 | ) | (2,787 | ) | (3,303 | ) | (3,467 | ) |
|                                                       |   |                                                 |   |   |   |   |   |   |   |   |   |
| Net income  (loss)                                         |   | $                                                    | 790    |   | $ | (1,012 | ) | $ | (2,637 | ) | $ | (3,218 | ) | $ | (3,209 | ) |
|                                                       |   |                                                 |   |   |   |   |   |   |   |   |   |
| Net income  (loss) per share-basic                         |   | $                                                    | 0.09   |   | $ | (0.14 | ) | $ | (0.39 | ) | $ | (0.64 | ) | $ | (0.66 | ) |
|                                                       |   |                                                 |   |   |   |   |   |   |   |   |   |
| Weighted  average common shares outstanding – basic   |   | 8,861                                                |   | 7,075 |   | 6,760 |   | 5,046 |   | 4,841 |   |
|                                                       |   |                                                 |   |   |   |   |   |   |   |   |   |
| Net income  (loss) per share-diluted                       |   | $                                                    | 0.08   |   | $ | (0.14 | ) | $ | (0.39 | ) | $ | (0.64 | ) | $ | (0.66 | ) |
|                                                       |   |                                                 |   |   |   |   |   |   |   |   |   |
| Weighted  average common shares outstanding – diluted |   | 9,822                                                |   | 7,075 |   | 6,760 |   | 5,046 |   | 4,841 |   |
|                                                       |   |                                                 |   |   |   |   |   |   |   |   |   |
| **Balance Sheet Data:**                                    |   |                                                 |   |   |   |   |   |   |   |   |   |
| Working  capital                                           |   | $                                                    | 9,219  |   | $ | 6,094 |   | $ | 2,344 |   | $ | 5,409 |   | $ | 3,360 |   |
| Total assets                                               |   | 18,827                                               |   | 13,269 |   | 7,287 |   | 8,666 |   | 5,938 |   |
| Long-term  debt                                            |   | —                                               |   | — |   | — |   | — |   | — |   |
| Total  shareholders’ equity                           |   | 11,721                                               |   | 8,051 |   | 3,765 |   | 6,098 |   | 4,134 |   |

 

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(1)                The Company has restated its financialstatements to (1) change the classification of certain customer support costs,which had previously been reported as a sales and marketing expense rather thanas cost of revenue – maintenance and services, and (2) change theclassification of amortization expense related to technology licensed from athird party, which had, prior to the third quarter of 2003, been reported asresearch and development expense rather than as cost of revenue - license fees.The changes in these classifications: (1) increased cost of revenue -maintenance and services and reduced sales and marketing expense bycorresponding amounts and (2) increased cost of revenue- license fees andreduced research and development expense by corresponding amounts. Thesechanges in classifications had no effect on the Company’s previously reportedrevenue, operating income, net income (loss) or net income (loss) per share,nor did the changes in classifications affect the Company’s balance sheets orstatements of shareholders’ equity and cash flows. See Note 13 to the financialstatements.

 

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| Item 7. | MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND  RESULTS OF OPERATIONS |
|---------|---------------------------------------------------------------------------------------------|

 

**Overview**

 

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

 

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

 

**Critical AccountingPolicies and Estimates**

 

Management’s discussion and analysis of its financial position and resultsof operations are based upon the Company’s consolidated financial statements,which have been prepared in accordance with accounting principles generallyaccepted in the United States of America. The preparation of these financialstatements requires management to make estimates and assumptions that affectthe reported amounts of assets and liabilities and disclosure of contingentassets and liabilities as of the date of the financial statements and thereported amounts of revenue and expenses during the reporting periods.  Actual results could differ from thoseestimates.  The following representsthose critical accounting policies and estimates where materially differentamounts could be reported under different conditions or using different assumptions.

 

*Allowance for doubtful accounts.*  The Company maintains an allowance for doubtful accounts thatreflects the Company’s estimate of losses that may result from theuncollectibility of accounts receivable. The allowance for doubtful accounts is based primarily on an analysis ofindividual accounts for which the Company has information indicating thecustomer may not be able to pay amounts owed to the Company.  In these cases, based on the available factsand circumstances, the Company estimates the amount that will be collected fromsuch customers.  The Company alsoevaluates the collectibility of our accounts receivable in the aggregate basedon factors such as the aging of receivable amounts, customer concentrations,historical experience, and current economic trends and conditions.  The allowance for doubtful accounts isadjusted when additional information is received that impacts the amountreserved. If circumstances change, the Company’s estimates of the recoverabilityof accounts receivable could be reduced or increased by a material amount.  Such a change in estimated recoverabilitywould be accounted for in the period in which the facts that give rise to thechange become known.  As ofDecember 31, 2002, the Company had an allowance for doubtful accounts of$240,000.

 

*Deferred tax asset.* The Company records a valuation allowance toreduce its deferred tax asset to the amount that is more likely than not to berealized.  Presently the Companymaintains a valuation allowance to offset all of its net deferred taxasset.  While the Company has consideredfuture taxable income in assessing the need for the valuation allowance, in theevent the Company were to determine that it would be able to realize its deferredtax asset in the future in excess of its net recorded amount, an adjustment tothe deferred tax asset

 

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would increase income in the period such a determination was made andsuch a determination will become more likely if the Company continues togenerate income.  Likewise, should theCompany determine that it would not be able to realize all or part of its netdeferred tax asset in the future, an adjustment to the deferred tax asset wouldbe charged to income in the period such a determination was made.  As of December 31, 2002, the Companyhas recorded a valuation allowance against the deferred tax assets of$8,598,000. Despite the full valuation allowance, the income tax benefitsrelated to these deferred tax assets will remain available to offset futuretaxable income.

 

*Long-Lived Assets.*The Company periodicallyreviews the carrying amounts of property and equipment and intangible assetspurchased in the normal course of business to determine whether current eventsor circumstances, as defined in Statement of Financial Accounting Standard No144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” warrantadjustments to such carrying amounts. In reviewing the carrying values of property and equipment andintangible assets purchased in the normal course of business, the Companyconsiders, among other things, the future cash flows expected from the use ofthe asset.  To the extent theseestimated cash flows significantly change, an impairment would be identified.

 

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

 

Licensefees revenue is derived from the licensing of computer software.  Hardware revenue is derived from the sale ofsystem hardware, including peripheral equipment.  Maintenance and service revenue is derived from hardware andsoftware maintenance and from services consisting of installation, training andengineering services. The Company’s software licenses are always sold as partof an arrangement that includes a maintenance arrangement and ofteninstallation and training services. The Company generally sells hardware aspart of a system sale, which includes a software license and often installationand training services.  Occasionally,the Company sells hardware as part of a system upgrade or additional productsale.  Engineering services consist ofsoftware modification or development services that are sold separately to OEMs.

 

TheCompany recognizes revenue in accordance with AICPA Statement of Position(“SOP”) 97-2,  Software RevenueRecognition,  as amended by SOP 98-4 andSOP 98-9, as well as Technical Practice Aids issued from time to time by theAmerican Institute of Certified Public Accountants and Staff AccountingBulletin (SAB) No. 101.  The Companyrecognizes revenue when it is realized or realizable and earned.  The Company considers revenue realized orrealizable and earned when it has persuasive evidence of an arrangement, theproduct has been shipped or the services have been provided to the customer,the sales price is fixed or determinable and collectibility is probable.

 

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

 

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

 

*Software and Hardware*

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

 

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*Services*

Revenuefrom maintenance arrangements is deferred and recognized ratably over the termof the maintenance arrangements.

 

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

 

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

 

*Multiple-Element Arrangements*

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

 

**Expense Restatement—Change in Classifications**

 

VitalImages has restated its financial statements to (1) change the classificationof certain customer support costs, which had previously been reported as asales and marketing expense rather than as a cost of revenue – maintenance andservices, and (2) change the classification of amortization expense related totechnology licensed from a third party, which had, prior to the third quarterof 2003, been reported as research and development expense rather than as costof revenue - license fees.  The Companyhas made the appropriate modifications to the statements of operations to giveeffect to these changes in classification. The changes in these classifications: (1) increased cost of revenue -maintenance and services and reduced sales and marketing expense bycorresponding amounts and (2) increased cost of revenue - license fees andreduced research and development expense by corresponding amounts. The changesin classifications had no effect on the Company’s previously reported revenue,operating income, net income (loss) or net income (loss) per share, nor did thechanges in classifications affect the Company’s balance sheets or statements ofshareholders’ equity and cash flows. See Note 13 of the accompanying notes tothe financial statements for the amounts of these changes in classifications.

 

**Revenue**

 

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

 

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

 

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

 

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

 

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

 

**Gross Margin**

 

The Company’s gross margin percentage was 70% in 2002, down slightlyfrom 71% in 2001. The gross margin percentage was 67% in 2000.  The decrease in margin in 2002 compared to2001 was due to increasing costs for customer support resulting from theCompany’s growth, which was partially offset by the favorable impact of salesmix.  Revenue in 2002 included more ofhigher margin software license fee revenue and less of lower margin hardwarerevenue than in 2001.  The number ofcustomer support employees increased from 11 at December 31, 2001 to 17 atDecember 31, 2002.  The increase inmargin in 2001 compared to 2000 was due to the favorable impact of sales mix,which included more of higher margin software license fee revenue than in 2000.

 

The *Vitrea2* system, consisting of *Vitrea 2* software and third-party hardwareand peripherals, is designed to offer end users an integrated 3D medicalimaging system.  The Company receives anominal discount in purchasing the third-party hardware and peripheralcomponents of the *Vitrea 2*system, and the Company’s gross margin on theresale of these system components approximates its discount.  The Company anticipates that softwarelicense fee revenue as a percentage of the Company’s total revenue willincrease modestly in future periods and, therefore, management believes theoverall gross margin percentage will increase modestly in future periods.

 

**Sales and Marketing**

 

Sales and marketing expenses were $6,795,000, or 32% of total revenue,$5,761,000, or 38% of total revenue and $4,709,000, or 44% of total revenue,for 2002, 2001 and 2000, respectively. The increases in sales and marketing expenses from 2001 to 2002 and 2000to 2001 were primarily due to increased compensation costs as a result ofadditional personnel and increased sales commissions as a result of increasedrevenue.  Tradeshow and marketing costsincreased from 2001 to 2002, primarily due to the Company purchasing more spaceat tradeshows and attending additional tradeshows.  Depreciation expense increased in 2001 as compared with 2000,primarily due to equipment purchases used for the additional personnel,upgrades of computer equipment and equipment for tradeshows.  During these periods, sales and marketingexpenses as a percentage of revenue declined primarily due to the Company’sability to generate revenue growth without proportionately increasing sales andmarketing costs.  The Company expects salesand marketing costs to

 

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increase in future periods primarily as a result of the cost ofadditional sales and marketing personnel and management expects sales andmarketing expenses to increase as a percentage of total revenue in 2003.

 

**Research andDevelopment**

 

Research and development expenses were up 23% to $4,143,000, or 20% oftotal revenue in 2002, from $3,359,000, or 22% of total revenue, in 2001.  In addition, $211,000 of expenses wereclassified in cost of revenue during 2002 in connection with engineeringservices provided to others under various product development agreements.  The increase in expenses from 2001 to 2002was primarily due to increased compensation costs resulting from additionalpersonnel supporting the development of *Vitrea2*.  Research and developmentexpenses were up 13% to $3,359,000, or 22% of total revenue in 2001, from$3,036,000, or 29% of total revenue, in 2000. The increase was primarily due to increased compensation costs resultingfrom additional personnel supporting the development of *Vitrea 2* and increases in expenses tosupport clinical collaboration sites. There were also consecutive increases in annual depreciation expensebetween 2000 and 2002, primarily as the result of equipment purchases to supportthe additional personnel and to upgrade computer equipment.  The decreases in research and developmentexpenses as a percentage of revenue during these periods reflect the Company’sability to generate increased revenue more rapidly than it increases itsproduct development costs.  The Companyanticipates that research and development costs will increase in future periodsas the Company develops software tools for applications with large potentialmarkets, such as cardiovascular disease, disease screening applications such ascolon cancer, and surgical and therapy planning.  However, management expects research and development costs todecline as a percentage of total revenue in 2003.

 

**General andAdministrative**

 

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

 

**Operating Income(Loss)**

 

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

 

**Interest Income**

 

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

 

29

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**Income Taxes**

 

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

 

# **Liquidityand Capital Resources**

# ** **

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

 

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

 

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

 

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

 

Cash provided by financing activities totaled $2,862,000, $5,288,000and $303,000 in 2002, 2001 and 2000, respectively.  In December 2001, the Company called the outstandingwarrants issued as part of a private placement of common stock inDecember 1999.  All of the warrantholders elected to exercise the warrants rather than allowing the Company to redeemthem.  Purchases of common stockresulting from the exercise of these stock warrants generated approximately$1,725,000 and $4,491,000 in 2002 and 2001, respectively.  During October 2001, the Company sold82,332 shares of newly issued common stock of Vital Images, Inc. to

 

30

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

 

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

 

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

 

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

 

----

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

 

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

 

**Foreign CurrencyTransactions**

 

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

 

**Inflation**

 

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

 

**Recent AccountingPronouncements**

 

In June 2001, the Financial Accounting Standards Board approvedStatements of Financial Accounting Standards (“SFAS”) No. 141, “Business Combinations,”and No. 142, “Goodwill and Other Intangible Assets.” The statements eliminatethe pooling-of-interests method of accounting for business combinations andrequire that goodwill and certain intangible assets not be amortized.  Instead, these assets will be reviewed forimpairment at least annually with any related losses recognized whenincurred.  SFAS No. 141 was generallyeffective for business combinations completed after June 30, 2001.  SFAS No. 142 was adopted by the Company onJanuary 1, 2002.  The adoption ofSFAS No. 141 and No. 142 had no impact on the Company’s financial position orresults of operations.

 

In October 2001, the Financial Accounting Standards Board issuedSFAS No. 144, “Accounting for the Impairment or Disposal of Long-LivedAssets.”  This statement addressesfinancial accounting and reporting for the impairment of long-lived assets andfor long-lived assets to be disposed of and supersedes SFAS No. 121 and APBOpinion No. 30.  SFAS No. 144 waseffective for the Company beginning January 1, 2002.  The adoption of SFAS No. 144 had no impacton the Company’s financial position or results of operations.

 

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

 

31

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In December 2002, theFASB issued SFAS No. 148, “Accounting for Stock-Based Compensation – TransitionDisclosure – an amendment of SFAS No. 123.” This Statement amends SFAS 123, “Accounting for Stock-BasedCompensation”, to provide alternative methods of transition for a voluntarychange to the fair value based method of accounting for stock-basedcompensation.  In addition, SFAS 148amends the disclosure requirements of SFAS 123 to require prominent disclosuresin both annual and interim financial statements about the method of accountingfor stock-based compensation and the effect of the method used on reported results.  SFAS 148 is effective for fiscal yearsending after December 15, 2002, and disclosure requirements are effectivefor interim periods beginning after December 15, 2002.  Disclosures required by SFAS 148 areincluded in the financial statements for the year ended December 31,2002.  The Company will begin making theadditional disclosures required by SFAS 148 in the first quarter of 2003.  The Company intends to continue to accountfor stock-based compensation using the intrinsic value method prescribed by APBOpinion No. 25 and related interpretations. Accordingly, the adoption of SFAS 148 will not impact the Company’sfinancial position or results of operations.

 

InNovember 2002, the FASB issued Interpretation No. 45, “Guarantor’sAccounting and Disclosure Requirements for Guarantees, Including IndirectGuarantees of Indebtedness of Others.” This interpretation elaborates on the disclosures required in financialstatements concerning obligations under certain guarantees.  It also clarifies the requirements relatedto the recognition of liabilities by a guarantor at the inception of certainguarantees.  The disclosure requirementsof this interpretation were effective for the Company on December 31, 2002and, accordingly, are reflected in the Company’s financial statements.  The recognition provisions of theinterpretation are effective for the Company in 2003 and are applicable only toguarantees issued or modified after December 31, 2002.  The Company does not expect the adoption ofthis interpretation to have a material impact on its financial position orresults of operations.

 

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

 

**Forward-LookingStatements**

 

This Annual Report on Form 10-K/A contains certain forward-lookingstatements within the meaning of the Private Securities Litigation Reform Actof 1995 and information that is based on management’s beliefs as well as onassumptions made by, and upon information currently available to, management.  When used in this Annual Report on Form10-K/A, the words “expect,” “anticipate,” “intend,” “plan,” “believe,” “seek,”and “estimate,” or similar expressions are intended to identify suchforward-looking statements.  However,this Annual Report on Form 10-K/A also contains other forward-lookingstatements.  Forward-looking statementsare not guarantees of future performance and are subject to certain risks,uncertainties and assumptions, including, but not limited to, the followingfactors, which could cause the Company’s future results and shareholder valuesto differ materially from those expressed in any forward-looking statementsmade by or on behalf of the Company: the dependence on market growth of theindustry in which the Company operates; the extent to which the Company’s productsgain market acceptance; the need for and availability of additional capital;the potential for litigation regarding patent and other intellectual propertyrights; the introduction of competitive products by others; dependence on majorcustomers; fluctuations in quarterly results; the progress of productdevelopment; the availability of third party reimbursement; and the receipt andtiming of regulatory approvals and other factors detailed from time to time inthe Company’s filings with the Securities and Exchange Commission, includingthose set forth under the heading “Important Factors” included in Item 1 ofthis Annual Report on Form 10-K/A.

 

32

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| Item 8. | FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA                                                                                                                                                                                           |
|---------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|    |                                                                                                                                                                                                                                  |   |
|    | The Company’s financial statements, supplemental schedule and  Report of Independent Auditors thereon, all of which are included in this  Annual Report on Form 10-K/A, are listed in Item 15 (a) (1) of this Form  10-K/A. |

 

33

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| PART IV  |
|----------|
|     |   |   |
| Item 15. | EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K |
|     |   |
|     | (a) (1)  The following  financial statements and supplemental schedule of Vital Images, Inc. and  Report of Independent Auditors thereon are included herein: |

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

 
|   | (a) (2) Included in Item 15 (a) (1) above                                                                                                                                                                            |
|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                 |   |
|   | All other schedules to the financial statements required by  Article 12 of Regulation S-X are not required under the related  instructions or are inapplicable and therefore have been omitted.                 |
|   |                                                                                                                                                                                                                 |
|   | (a) (3)                                                                                                                                                                                                              | LISTING OF EXHIBITS |
|   |                                                                                                                                                                                                                 |
|   | The Exhibits required to be a part of this Report are listed in the  Index to Exhibits, which follows the Financial Statement Schedule on  page 58.                                                             |
|   |                                                                                                                                                                                                                 |
|   | (b)                                                                                                                                                                                                                  | REPORTS ON FORM 8-K |
|   |                                                                                                                                                                                                                 |
|   | The Company had no Current Reports on Form 8-K during the year ended  December 31, 2002 or during the period from December 31, 2002 to  the date of the filing of the original Annual Report on Form 10-K. |
|   |                                                                                                                                                                                                                 |
|   | (c)                                                                                                                                                                                                                  | EXHIBITS |
|   |                                                                                                                                                                                                                 |
|   | Included in Item 15 (a) (3) above.                                                                                                                                                                                   |   |
|        |                                                                                                                                                                                                                      |  |  |

 

34

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SIGNATURES

 

Pursuant to the requirements of Section 13 or 15(d) of theSecurities Exchange Act of 1934, the Registrant has duly caused this Amendmentto the Annual Report on Form 10-K to be signed on its behalf by theundersigned, thereunto duly authorized, in Minneapolis, Minnesota, on the 2ndday of March 2004.

 

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

 

35

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**REPORT OF INDEPENDENTAUDITORS**

 

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

 

In our opinion, the financial statements listed in the index appearingunder Item 15(a)(1) present fairly, in all material respects, the financialposition of Vital Images, Inc. (the Company) at December 31, 2002 and2001, and the results of its operations and its cash flows for each of thethree years in the period ended December 31, 2002 in conformity withaccounting principles generally accepted in the United States of America.  In addition, in our opinion, the financialstatement schedule listed in the index appearing under Item 15(a)(1)presents fairly, in all material respects, the information set forth thereinwhen read in conjunction with the related financial statements.  These financial statements and financialstatement schedule are the responsibility of the Company’s management; ourresponsibility is to express an opinion on these financial statements andfinancial statement schedule based on our audits. We conducted our auditsof these statements in accordance with auditing standards generally accepted inthe United States of America, which require that we plan and perform the auditto obtain reasonable assurance about whether the financial statements are freeof material misstatement.  An auditincludes examining, on a test basis, evidence supporting the amounts anddisclosures in the financial statements, assessing the accounting principlesused and significant estimates made by management, and evaluating the overallfinancial statement presentation.  Webelieve that our audits provide a reasonable basis for our opinion.

 

Asdiscussed in Note 13 to the financial statements, the Company has restated itsstatements of operations for each of the three years in the period endedDecember 31, 2002, to reflect a change in the classification of certaincustomer support expenses and has restated its statements of operations for theyears ended December 31, 2002 and 2001 to reflect a change inclassification of certain amortization expense.

 

 
| /s/ PricewaterhouseCoopers LLP                                                        |   |
|---------------------------------------------------------------------------------------|--------|
|                                                                                  |
| Minneapolis, Minnesota                                                                |
| February 6, 2003, except Note 13 as to which the date is  February 10, 2004 |

 

36

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**VITAL IMAGES, INC.BALANCE SHEETS**

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

 

(Theaccompanying notes are an integral part of the financial statements.)

 

37

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**VITALIMAGES, INC.**

**STATEMENTS OFOPERATIONS**

 
|                                                       |   | **For the  Years Ended December 31,** |       |
|------------------------------------------------------------|--------|--------------------------------------------|------------|
|                                                       |   | **2002**                                   |       | **2001** |   | **2000** |   |
|                                                       |   | **Restated (Note 13)**                     |       | **Restated (Note 13)** |   | **Restated (Note 13)** |   |
| Revenue:                                                   |   |                                       |       |   |   |   |   |
| License fees                                               |   | $                                          | 14,211,640 |   | $ | 10,082,897 |   | $ | 7,037,227 |   |
| Maintenance and services                                   |   | 4,019,639                                  |       | 2,450,037 |   | 1,411,583 |   |
| Hardware                                                   |   | 2,884,795                                  |       | 2,662,702 |   | 2,179,381 |   |
| Total revenue                                              |   | 21,116,074                                 |       | 15,195,636 |   | 10,628,191 |   |
|                                                       |   |                                       |       |   |   |   |   |
| Cost of revenue:                                           |   |                                       |       |   |   |   |   |
| License fees                                               |   | 1,250,426                                  |       | 703,593 |   | 238,775 |   |
| Maintenance and services                                   |   | 2,862,459                                  |       | 1,656,207 |   | 1,328,679 |   |
| Hardware                                                   |   | 2,195,182                                  |       | 2,112,982 |   | 1,893,075 |   |
| Total cost of revenue                                      |   | 6,308,067                                  |       | 4,472,782 |   | 3,460,529 |   |
|                                                       |   |                                       |       |   |   |   |   |
| Gross margin                                               |   | 14,808,007                                 |       | 10,722,854 |   | 7,167,662 |   |
|                                                       |   |                                       |       |   |   |   |   |
| Operating expenses:                                        |   |                                       |       |   |   |   |   |
| Sales and marketing                                        |   | 6,795,377                                  |       | 5,761,416 |   | 4,708,604 |   |
| Research and development                                   |   | 4,143,257                                  |       | 3,358,506 |   | 3,036,016 |   |
| General and administrative                                 |   | 3,192,735                                  |       | 2,657,998 |   | 2,209,999 |   |
| Total operating expenses                                   |   | 14,131,369                                 |       | 11,777,920 |   | 9,954,619 |   |
|                                                       |   |                                       |       |   |   |   |   |
| Operating income (loss)                                    |   | 676,638                                    |       | (1,055,066 | ) | (2,786,957 | ) |
|                                                       |   |                                       |       |   |   |   |   |
| Interest income, net                                       |   | 134,870                                    |       | 55,089 |   | 161,726 |   |
| Income (loss) before income taxes                          |   | 811,508                                    |       | (999,977 | ) | (2,625,231 | ) |
|                                                       |   |                                       |       |   |   |   |   |
| Income taxes                                               |   | 22,000                                     |       | 12,000 |   | 12,000 |   |
|                                                       |   |                                       |       |   |   |   |   |
| Net income (loss)                                          |   | $                                          | 789,508    |   | $ | (1,011,977 | ) | $ | (2,637,231 | ) |
|                                                       |   |                                       |       |   |   |   |   |
| Net income (loss) per share – basic                   |   | $                                          | 0.09       |   | $ | (0.14 | ) | $ | (0.39 | ) |
|                                                       |   |                                       |       |   |   |   |   |
| Weighted average common shares outstanding  – basic   |   | 8,861,132                                  |       | 7,074,906 |   | 6,760,233 |   |
|                                                       |   |                                       |       |   |   |   |   |
| Net income (loss) per share – diluted                 |   | $                                          | 0.08       |   | $ | (0.14 | ) | $ | (0.39 | ) |
|                                                       |   |                                       |       |   |   |   |   |
| Weighted average common shares outstanding  – diluted |   | 9,821,798                                  |       | 7,074,906 |   | 6,760,233 |   |

 

(The accompanying notes are anintegral part of the financial statements.)

 

38

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**VITAL IMAGES, INC.**

**STATEMENTS OF SHAREHOLDERS’ EQUITY**

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

 

(The accompanying notes are an integral partof the financial statements.)

 

39

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**VITALIMAGES, INC.**

**STATEMENTS OF CASHFLOWS**

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

 

(The accompanying notes are an integral partof the financial statements.)

 

40

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**VITAL IMAGES, INC.**

**NOTESTO FINANCIAL STATEMENTS**

 

**(1) BusinessDescription and Background**

 

*Business Description*

 

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

 

*Background*

 

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

 

**(2) Summary ofSignificant Accounting Policies**

 

*Use of Estimates*

 

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

 

*Cash Equivalents and Marketable Securities*

 

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

 

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

 

41

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*Concentration of Credit Risk*

 

Cash and cash equivalents are primarily maintained with one financialinstitution. Deposits with the bank may exceed the amount of insurance providedon such deposits. Generally, these deposits may be redeemed upon demand and,therefore, bear minimal risk. Financial instruments that potentially subjectthe Company to concentrations of credit risk consist principally of marketablesecurities. Marketable securities consist of U.S. government agency notes andcertificates of deposits. The Company’s investment policy, approved by theBoard of Directors, limits the amount the Company may invest in any one type ofinvestment, thereby reducing credit risk concentrations.  The Company’s customer base is generallyconcentrated with a small base of customers. The Company reviews the creditworthiness of its customers prior toproduct shipment and generally does not require collateral.

 

*Trade Accounts Receivable*

 

Trade accountsreceivable are initially recorded at fair value upon the sale of goods orservices to customers.  They are statednet of allowances for uncollectible accounts, which represent estimated lossesresulting from the inability of customers to make the required payments.  When determining the allowances foruncollectible accounts, management takes several factors into considerationincluding the overall composition of accounts receivable aging, prior historyof accounts receivable write-offs, the type of customer and day-to-dayknowledge of specific customers. Changes in the allowances for uncollectible accounts are recorded as baddebt expense and are included in general and administrative expense in thestatements of operations.

 

*Property and Equipment*

 

Property and equipment are stated at cost.  Depreciation is computed using the straight-line method over therelated asset’s estimated useful life, generally three to seven years.  Depreciation expense was $895,000, $747,000and $719,000 for each of the years ended December 31, 2002, 2001, and2000, respectively.  Leaseholdimprovements are amortized over the shorter of their estimated useful lives orthe remaining terms of the related leases. The asset cost and related accumulated depreciation or amortization areadjusted for asset retirement or disposal with the resulting gain or loss, ifany, credited or charged to results of operations.

 

*Impairment of Long-Lived Assets*

 

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

 

*Revenue Recognition.*

 

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

 

42

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Licensefees revenue is derived from the licensing of computer software.  Hardware revenue is derived from the sale ofsystem hardware, including peripheral equipment.  Maintenance and service revenue is derived from hardware andsoftware maintenance and from services consisting of installation, training andengineering services. The Company’s software licenses are always sold as partof an arrangement that includes a maintenance arrangement and ofteninstallation and training services. The Company generally sells hardware aspart of a system sale, which includes a software license and often installationand training services.  Occasionally,the Company sells hardware as part of a system upgrade or additional productsale.  Engineering services consist ofsoftware modification or development services that are sold separately to OEMs.

 

TheCompany recognizes revenue in accordance with AICPA Statement of Position(“SOP”) 97-2,  Software RevenueRecognition,  as amended by SOP 98-4 andSOP 98-9, as well as Technical Practice Aids issued from time to time by theAmerican Institute of Certified Public Accountants and Staff AccountingBulletin (SAB) No. 101.  The Companyrecognizes revenue when it is realized or realizable and earned.  The Company considers revenue realized orrealizable and earned when it has persuasive evidence of an arrangement, theproduct has been shipped or the services have been provided to the customer,the sales price is fixed or determinable and collectibility is probable.

 

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

 

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

 

*Software and Hardware*

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

 

*Services*

Revenuefrom maintenance arrangements is deferred and recognized ratably over the termof the maintenance arrangements.

 

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

 

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

 

*Multiple-Element Arrangements*

TheCompany enters into arrangements with customers that include a combination ofsoftware products, system hardware, specified upgrades, maintenance orinstallation and training services.  Forsuch arrangements, the Company recognizes revenue using the residual valuemethod.  The Company allocates the totalarrangement fee among each deliverable element of the arrangement based on therelative fair value of each of the deliverable elements determined based onvendor-specific objective evidence. The fair value of maintenance services is basedupon the renewal rate for continued service arrangements.  The fair value of installation and trainingservices is established based upon separate pricing for the services. Insoftware arrangements for which the Company does not have vendor-specific objectiveevidence of fair value for all

 

43

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elements,revenue is deferred until the earlier of when vendor-specific objectiveevidence is determined for the undelivered elements (residual method) or whenall elements have been delivered.

 

*Research and Development Costs*

 

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

 

*Income Taxes*

 

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

 

*Computation of Net Income (Loss) Per Share*

 

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

 

44

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

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

 

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

 

*Stock-Based Compensation*

* *

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

 

45

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

 

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

 

*Recent Accounting Pronouncements*

 

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

 

In October 2001, the Financial Accounting Standards Board issuedSFAS No. 144, “Accounting for the Impairment or Disposal of Long-LivedAssets.”  This statement addressesfinancial accounting and reporting for the impairment of long-lived assets andfor long-lived assets to be disposed of and supersedes SFAS No. 121 and APBOpinion No. 30.  SFAS No. 144 waseffective for the Company beginning January 1, 2002.  The adoption of SFAS No. 144 had no impacton the Company’s financial position or results of operations.

 

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

 

46

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In December 2002, theFASB issued SFAS No. 148, “Accounting for Stock-Based Compensation – TransitionDisclosure – an amendment of SFAS No. 123.” This Statement amends SFAS 123, “Accounting for Stock-Based Compensation”,to provide alternative methods of transition for a voluntary change to the fairvalue based method of accounting for stock-based compensation.  In addition, SFAS 148 amends the disclosurerequirements of SFAS 123 to require prominent disclosures in both annual andinterim financial statements about the method of accounting for stock-basedcompensation and the effect of the method used on reported results.  SFAS 148 is effective for fiscal yearsending after December 15, 2002, and disclosure requirements are effectivefor interim periods beginning after December 15, 2002.  Disclosures required by SFAS 148 areincluded in the financial statements for the year ended December 31, 2002.  The Company will begin making the additionaldisclosures required by SFAS 148 in the first quarter of 2003.  The Company intends to continue to accountfor stock-based compensation using the intrinsic value method prescribed by APBOpinion No. 25 and related interpretations. Accordingly, the adoption of SFAS 148 will not impact the Company’sfinancial position or results of operations.

 

InNovember 2002, the FASB issued Interpretation No. 45, “Guarantor’sAccounting and Disclosure Requirements for Guarantees, Including IndirectGuarantees of Indebtedness of Others.” This interpretation elaborates on the disclosures required in financialstatements concerning obligations under certain guarantees.  It also clarifies the requirements relatedto the recognition of liabilities by a guarantor at the inception of certainguarantees.  The disclosure requirementsof this interpretation were effective for the Company on December 31, 2002and, accordingly, are reflected in the Company’s financial statements.  The recognition provisions of the interpretationare effective for the Company in 2003 and are applicable only to guaranteesissued or modified after December 31, 2002.  The Company does not expect the adoption of this interpretationto have a material impact on its financial position or results of operations.

 

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

 

**(3) Property andEquipment, net**

 

Property and Equipment consisted of thefollowing at December 31:

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

 

**(4) Deferred Revenue**

 

Deferred revenue consists primarily of service revenue, which isrecognized as the services are performed, and maintenance revenue, which isrecognized on a straight-line basis over the term of the arrangement.

 

47

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**(5) Operating LeaseCommitments**

 

The Company leases its office facilities in Plymouth, Minnesotapursuant to terms of a non-cancelable operating lease, as amended, that expireson July 31, 2005.  Under the termsof the lease, the Company is required to pay a portion of the lessor’soperating costs.

 

Total rent expense, including an allocation of the lessor’s operatingcosts, was $596,000, $554,000 and $476,000 for the years endedDecember 31, 2002, 2001 and 2000, respectively.

 

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

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

 

**(6) Shareholders’Equity**

 

*Stock Option Plans*

 

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

 

In May 1997,Bio-Vascular, as the sole shareholder of the Company, approved and adopted theVital Images, Inc. 1997 Stock Option and Incentive Plan (the “Stock OptionPlan”), which became effective on the Distribution Date.  Under the terms of the plan, the Board ofDirectors may grant options and other stock-based awards to key employees topurchase shares of the Company’s common stock at an option exercise price equalto or greater than 85% of the fair market value on the date of grant.  The options are exercisable at such times,in installments or otherwise, as the Board of Directors may determine.  Generally, these options are incentive stockoptions with a term of eight years and are exercisable as to 28% of the totalgrant one year after the date of grant and 2% per month thereafter.  In May 2002, the shareholders of the Companyapproved an increase of 500,000 common shares, bringing the total number ofshares of common stock that may be issued or awarded under the Stock OptionPlan to 3,000,000.  As of December 31,2002, there were 901,801 shares available for the grant of awards under theStock Option Plan.

 

48

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Also in May 1997, Bio-Vascular, as the sole shareholder of the Company,approved and adopted the Vital Images, Inc. 1997 Director Stock Option Plan (the“Director Plan”) (together with the Stock Option Plan, the “1997 Plans”), whichbecame effective on the Distribution Date. 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 granted under the Director Plan are generallygranted with an option price equal to the fair market value on the date ofgrant, with a term of eight years, are non-qualified options and becomeexercisable in three equal annual installments beginning on the first occurringDecember 31 after the date of grant. In May 2002, the shareholders of the Company approved an increase of 90,000common shares, bringing the total number of shares of common stock that may beissued or awarded under the Director Plan to 300,000.  As of December 31, 2002, there were 115,000 shares availablefor the grant of awards under the Director Plan.

 

Certain non-plan options were granted to certain officers of theCompany in 1998, 1999 and 2002.  InFebruary 1998, the Company reserved and granted 300,000 non-qualified,non-plan options to an officer of the Company. These non-plan options have a term of eight years, vest over a two yearperiod and were granted at exercise prices at least equal to fair market valueof the Company’s common stock on the date of grant.  In December 1999, 100,000 of these non-plan options werecanceled.  As of December 31, 2002,the remaining 200,000 are still outstanding. In December 1999, the Company granted 175,000 non-qualified,non-plan options to another officer of the Company.  These non-plan options had a term of eight years, wereexercisable as to 28% of the total grant one year after the date of grant and2% per month thereafter and were granted at exercise prices at least equal tofair market value of the Company’s common stock on the date of grant.  In February 2002, 80,500 of thesenon-plan options were canceled and the remaining 94,500 options were exercisedin 2002.  In March 2002, theCompany granted an additional 165,000 non-qualified, non-plan options toanother officer of the Company.  Thesenon-plan options have a term of eight years, are exercisable as to 28% of thetotal grant one year after the date of grant and 2% per month thereafter andwere granted at exercise prices at least equal to fair market value of theCompany’s common stock on the date of grant. As of December 31, 2002, these options are still outstanding.

 

*Non-Employee Options*

 

In December 2000, the Company granted 10,000 options to a non-employee consultant.  Options to purchase 5,000 shares vest over a four-year period and the remaining options will vest immediately when a specified milestone is achieved.  In December 2001, the Company granted a total of 4,000 options to two non-employee consultants and in December 2002, the Company granted another 4,000 options to two non-employee consultants.  These options vest over a four-year period.  All of the non-plan options have a term of eight years and were granted at exercise prices at least equal to fair market value of the Company’s common stock on the date of grant. The Company records compensation expense related to these arrangements based upon the fair values of the options during the periods the consultants provide services. Such fair values are measured using the Black-Scholes option-pricing model. The fair value of these options was approximately $98,000 at December 31, 2002. The Company recorded approximately $18,000, $10,000 and $0 of compensation expense related to these options for each of the years ended December 31, 2002, 2001 and 2000, respectively.

 

49

 

The following table summarizes stock option activity for 2002, 2001 and 2000:

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

 

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

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

 

*Employee Stock Purchase Plan*

 

The 1997 Employee Stock Purchase Plan (the “ESPP”) was approved andadopted by Bio-Vascular, as the sole shareholder of the Company, in May1997.  The ESPP, which became effectiveon July 1, 1997, enables eligible employees to purchase the Company’scommon stock at 85% of the fair market value of the stock on the date anoffering commences or on the date an offering terminates, whichever islower.  The ESPP covers an aggregate ofup to 250,000 shares of common stock that can be issued and sold toparticipating employees of the Company through a series of three-monthofferings, beginning July 1, 1997. The ESPP covers

 

50

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substantially all employees, subject to certain limitations.  Each employee may elect to have up to 10% ofhis or her base pay withheld and applied toward the purchase of shares in eachsuch offering.  Purchases under the ESPPfor 2002 were 24,539 shares, generating proceeds to the Company of $130,608 atan average purchase price of $5.32; for 2001, there were 25,487 shares,generating proceeds to the Company of $91,652 at an average purchase price of$3.60; and for 2000, there were 21,589 shares, generating proceeds to theCompany of $85,965 at an average purchase price of $3.99.  As of December 31, 2002, there are114,448 shares of common stock reserved for purchases under the ESPP.

 

*Stock-Based Compensation*

 

For purposes ofcalculating the fair value of FASB Statement No. 123, the weighted average fairvalues of options granted were:

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

 

The weighted average fair values for the 1997 Plans and the non-plan optionswere based on the fair values on the dates of grant.  The fair values of options under the ESPP were based on the 15percent purchase discount.  The fairvalues for the 1997 Plans and the non-plan options were calculated using theBlack-Scholes option-pricing model with the following assumptions:

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

 

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

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

 

*Warrants*

 

In December 1999, the Company completed a private placement of1,650,000 units at $3.25 per unit.  Eachunit consisted of one share of the Company’s common stock and a redeemable,five-year warrant to purchase an additional share of common stock at $3.75 pershare.  The warrants were immediatelyexercisable and expired in December 2004. The warrants could be redeemed by the Company at any time beforeDecember 2004 at a redemption price of $.01 per warrant, upon notice ofsuch redemption, provided that (i) the closing bid price of the Company’scommon stock exceeded $5.75 per share for any thirty consecutive trading daysprior to such notice and (ii) a registration statement covering the resale ofthe warrant shares had been filed by the Company with the Securities andExchange Commission and was effective as of the date of such notice. TheCompany satisfied the conditions for redemption of the warrants as ofDecember 7, 2000. In December 2001, the Company called for redemptionof all outstanding warrants.  As ofDecember 31, 2002, 1,650,000

 

51

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warrants had been exercised, generating proceeds of approximately$1,719,000 and $4,460,000 during 2002 and 2001, respectively.

 

The Company also issued warrants to the underwriter in theDecember 1999 private placement to purchase 163,651 shares of theCompany’s common stock at $3.25 per share. The warrants were immediately exercisable and expire inDecember 2004.  During 2002 and2001, 42,492 and 18,940, respectively, of these warrants were exercised andconverted to 44,017 shares of common stock. These warrant exercises generated approximately $6,000 and $22,000 forthe years ended December 31, 2002 and 2001, respectively.  In conjunction with these exercises during2002 and 2001, 12,559 and 4,856 shares, respectively, were forfeited as part ofcashless exercises.  As ofDecember 31, 2002, 102,219 of these warrants remained outstanding.

 

*Rights Plan*

 

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

 

**(7) Income Taxes**

 

The income taxprovision for each of the periods presented represents state minimumtaxes.  As of December 31, 2002,the Company had net operating loss carryforwards of approximately $17,100,000for federal income tax reporting purposes and unused research and developmentcredits of approximately $995,000, which expire in varying amounts from 2004 to2022.  For financial reporting purposes,the Company has established a valuation allowance to completely reserve for theCompany’s deferred tax asset.  Thisallowance was established based upon management’s conclusion that realizationof this benefit is not presently more likely than not.  To the extent that future operating resultsindicate that realization of this benefit is more likely than not, managementwould reverse some or all of this valuation allowance which would result in anincome tax benefit.  The utilization ofthese carryforwards may be subject to limitations based on future changes inownership of the Company, pursuant to Section 382 of the Internal RevenueCode (the “Code”).

 

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

 

52

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

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

 

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

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

 

----

(1)               Excludes$269,000, $21,000 and $91,000 of valuation allowance established in 2002, 2001and 2000, respectively, relating to certain stock option exercises that did notgenerate an income tax benefit for financial reporting purposes.

 

**(8) Major Customersand Geographic Data**

 

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

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

 

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

 

53

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

 

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

 

Export sales by geographic area are summarized as follows:

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

 

**(9) Employee BenefitPlan**

 

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

 

**(10) Licensed Technology**

 

In July 2001, the Company entered into an agreement to licensetechnology from a third party.  TheCompany paid an aggregate of $750,000 to the licensor in 2001.  The Company recorded this $750,000 purchaseas licensed technology and is amortizing it over the estimated useful life ofthe technology of 75 months.  Thisamortization expense is reported as cost of revenue - license fees.  As part of this agreement, the Company isalso obligated to pay the licensor royalties on the sales of certain productsas defined in the agreement.  During2002 and 2001, $608,000 and $211,000, respectively, of such royalties wereincurred and were reported as cost of revenue for license fees.

 

**(11) DevelopmentAgreements**

 

In November 2001, the Company entered into a development andlicense agreement with Surgical Navigation Technologies, Inc., a division ofMedtronic, Inc. (“MSNT”), to integrate certain Company technology into MSNT’simage-guided surgery products and to develop products and services for surgicalplanning which will be marketed and sold through MSNT.  The Company received $400,000 upon executionof the agreement, which is included in deferred revenue in the currentliabilities section of the balance sheet as of December 31,2001.  During 2002, the Companycompleted all services required under this agreement and recognized the entire$400,000 as service revenue using the percentage of completion method.

 

**In 2001, the Company entered into an agreement withE-Z-EM, Inc.  Under the agreement, theCompany developed a single application CT Colonography product calledInnerviewGITM, which is marketed and sold through E-Z-EM, Inc.  During 2001, the Company recorded servicerevenue totaling $348,000 under this**

 

54

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agreement.  In addition, E-Z-EM,Inc. purchased 82,332 shares of newly issued common stock of Vital Images, Inc.for approximately $552,000 cash.

 

**(12) Purchase Commitments**

 

In November 2002, the Company entered into an agreement with R2Technology, Inc. (“R2”) to distribute R2’s lung nodule CAD software product(“lung CAD Product”) in conjunction with the Company’s products.  Upon the later of either the date on whichR2 is able to meet CE certification requirements and produce a “Declaration ofConformance” for the lung CAD product or the completion of the milestones inthe development plan with respect to the lung CAD product that will bedistributed in Europe, the Company is required to begin purchasing the lung CADproduct over the next three years.  Thetotal purchase commitment will be up to a maximum of $5.6 million worth ofproduct over the three-year commitment period subject to adjustment based uponchanges in product selling prices.

 

**(13) Restatement of cost ofrevenue, sales and marketing and research and development expenses**

 

TheCompany has restated its financial statements to (1) change the classificationof certain customer support costs, which had previously been reported as asales and marketing expense rather than as a cost of revenue — maintenance andservices and (2) change the classification of amortization expense related totechnology licensed from a third party, which had, prior to the third quarterof 2003, been reported as research and development expense rather than cost ofrevenue - license fees.  The Company hasmade the appropriate modifications to the statements of operations to giveeffect to these changes in classification. The changes in these classifications: (1) increased cost of revenue -maintenance and services and reduced sales and marketing expense bycorresponding amounts and (2) increased cost of revenue- license fees andreduced research and development expense by corresponding amounts. The changesin classifications had no effect on the Company’s previously reported revenue,operating income, net income (loss) or net income (loss) per share, nor did thechanges in classifications affect the Company’s balance sheets or statements ofshareholders’ equity and cash flows. The table below summarizes the effect ofthe changes in classifications.

 
|                       |   | **For the  Years Ended December 31,** |      |
|----------------------------|--------|--------------------------------------------|-----------|
|                       |   | **2002**                                   |      | **2001** |   | **2000** |   |
|                       |   | **As Reported**                            |      | **As Restated** |   | **As Reported** |   | **As Restated** |   | **As Reported** |   | **As Restated** |   |
| Cost of revenue:           |   |                                       |      |   |   |   |   |   |   |   |   |   |   |
| License fees               |   | $                                          | 1,130,426 |   | $ | 1,250,426 |   | $ | 643,593 |   | $ | 703,593 |   | $ | 238,775 |   | $ | 238,775 |   |
| Maintenance and services   |   | 1,126,273                                  |      | 2,862,459 |   | 552,861 |   | 1,656,207 |   | 385,950 |   | 1,328,679 |   |
| Hardware                   |   | 2,195,182                                  |      | 2,195,182 |   | 2,112,982 |   | 2,112,982 |   | 1,893,075 |   | 1,893,075 |   |
| Total cost of revenue      |   | 4,451,881                                  |      | 6,308,067 |   | 3,309,436 |   | 4,472,782 |   | 2,517,800 |   | 3,460,529 |   |
|                       |   |                                       |      |   |   |   |   |   |   |   |   |   |   |
| Gross margin               |   | 16,664,193                                 |      | 14,808,007 |   | 11,886,200 |   | 10,722,854 |   | 8,110,391 |   | 7,167,662 |   |
|                       |   |                                       |      |   |   |   |   |   |   |   |   |   |   |
| Operating expenses:        |   |                                       |      |   |   |   |   |   |   |   |   |   |   |
| Sales and marketing        |   | 8,531,563                                  |      | 6,795,377 |   | 6,864,762 |   | 5,761,416 |   | 5,651,333 |   | 4,708,604 |   |
| Research and development   |   | 4,263,257                                  |      | 4,143,257 |   | 3,418,506 |   | 3,358,506 |   | 3,036,016 |   | 3,036,016 |   |
| General and administrative |   | 3,192,735                                  |      | 3,192,735 |   | 2,657,998 |   | 2,657,998 |   | 2,209,999 |   | 2,209,999 |   |
| Total operating expenses   |   | 15,987,555                                 |      | 14,131,369 |   | 12,941,266 |   | 11,777,920 |   | 10,897,348 |   | 9,954,619 |   |
|                            |        |                                            |           |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

 

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

 
|                                                |   | **First  Quarter** |      | **Second  Quarter** |   | **Third  Quarter** |   | **Fourth  Quarter** |      |
|-----------------------------------------------------|--------|--------------------|-----------|---------------------|--------|--------------------|--------|---------------------|-----------|
| **2002:**                                           |   |               |      |                |   |               |   |                |      |
| Total revenue                                       |   | $                  | 4,443,000 |                | $      | 4,874,000          |   | $                   | 5,593,000 |   | $ | 6,206,000 |   |
| Gross margin – As previously reported          |   | 3,477,000          |      | 3,757,000           |   | 4,511,000          |   | 4,919,000           |      |
| Gross margin – As restated                     |   | 3,094,000          |      | 3,331,000           |   | 4,034,000          |   | 4,349,000           |      |
| Net income (loss)                                   |   | (247,000           | )         | 201,000             |   | 419,000            |   | 417,000             |      |
| Earnings (loss) per share – basic              |   | (0.03              | )         | 0.02                |   | 0.05               |   | 0.05                |      |
| Earnings (loss) per share – diluted            |   | (0.03              | )         | 0.02                |   | 0.04               |   | 0.04                |      |
|                                                |   |               |      |                |   |               |   |                |      |
| **2001:**                                           |   |               |      |                |   |               |   |                |      |
| Total revenue                                       |   | $                  | 3,331,000 |                | $      | 3,682,000          |   | $                   | 3,633,000 |   | $ | 4,550,000 |   |
| Gross margin – As previously reported          |   | 2,529,000          |      | 2,769,000           |   | 2,899,000          |   | 3,689,000           |      |
| Gross margin – As restated                     |   | 2,269,000          |      | 2,506,000           |   | 2,593,000          |   | 3,355,000           |      |
| Net income (loss)                                   |   | (622,000           | )         | (402,000            | )      | (132,000           | )      | 144,000             |      |
| Earnings (loss) per share – basic and  diluted |   | (0.09              | )         | (0.06               | )      | (0.02              | )      | 0.02                |      |

 

Asdescribed in Note 13, the Company has restated its previously reported grossmargin to reflect a change in the classification of certain customer supportcosts and amortization expense related to a technology license. The change hadno effect on revenue, net income (loss) or net income (loss) per share.

 

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**SCHEDULE II**

 

VITAL IMAGES, INC.

VALUATION AND QUALIFYING ACCOUNTS

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

 

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**VITALIMAGES, INC.FORM 10-K/A(Amendment No. 2)**

 

**INDEXTO EXHIBITS**

 
| **Item No.** |   | **Description**                                                                                                                                                                                                                                                                                              |
|--------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|         |   |                                                                                                                                                                                                                                                                                                         |
| 3.1          |   | Articles of Incorporation of the Company (incorporated by reference  to Exhibit 3.1 to the Company’s registration statement on Form 10 (File No.  0-22229)).                                                                                                                                            |
|         |   |                                                                                                                                                                                                                                                                                                         |
| 3.2          |   | By-laws of the Company (incorporated by reference to Exhibit 3.2 to  the Company’s registration statement on Form 10 (File No. 0-22229)).                                                                                                                                                               |
|         |   |                                                                                                                                                                                                                                                                                                         |
| 4.1          |   | Form of common stock Certificate of the Company (incorporated by  reference to Exhibit 4.3 to the Company’s registration statement on Form 10  (File No. 0-22229)).                                                                                                                                     |
|         |   |                                                                                                                                                                                                                                                                                                         |
| 4.2          |   | Rights Agreement, dated effective as of May 1, 1997 between the  Company and American Stock Transfer and Trust Company, which includes as  Exhibit B the form of Rights Certificate (incorporated by reference to  Exhibit 4.4 to the Company’s registration statement on Form 10 (File No.  0-22229)). |
|         |   |                                                                                                                                                                                                                                                                                                         |
| 4.3          |   | Certificate of Designation, Preferences and Rights of Series A Junior  Preferred Stock of the Company (incorporated by reference to Exhibit 4.5 to  the Company’s registration statement on Form 10 (File No. 0-22229)).                                                                                |
|         |   |                                                                                                                                                                                                                                                                                                         |
| 10.1         |   | Form of Distribution Agreement, effective as of May 2, 1997 between  Bio-Vascular, Inc. and the Company (incorporated by reference to Exhibit 10.1  to the Company’s registration statement on Form 10 (File No. 0-22229)).                                                                             |
|         |   |                                                                                                                                                                                                                                                                                                         |
| 10.2         |   | Form of Employee Benefits Agreement, effective as of May 2, 1997,  between Bio-Vascular, Inc. and the Company** (incorporated by reference to  Exhibit 10.2 to the Company’s registration statement on Form 10 (File No.  0-22229)).                                                                    |
|         |   |                                                                                                                                                                                                                                                                                                         |
| 10.3         |   | Form of Tax Sharing Agreement, effective as of May 2, 1997, between  Bio-Vascular, Inc. and the Company (incorporated by reference to Exhibit 10.3  to the Company’s registration statement on Form 10 (File No. 0-22229)).                                                                             |
|         |   |                                                                                                                                                                                                                                                                                                         |
| 10.4         |   | Form of Transition Services Agreement, effective as of May 2, 1997  between Bio-Vascular, Inc. and the Company (incorporated by reference to  Exhibit 10.4 to the Company’s registration statement on Form 10 (File No.  0-22229)).                                                                     |

 

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

 

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

 

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| 10.35  |   | Marketing and Distribution Agreement between Vital Images, Inc. and  Toshiba Corporation, Medical Systems Company * (incorporated by reference to Exhibit  10.35 to the Company’s Form 10-Q for the quarter ended March 31, 2002  (File No. 0-22229)).                                                                                          |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                      |
| 10.36  |   | Severance Agreement dated February 9, 2002 between the Company  and Albert Emola (incorporated by reference to Exhibit 10.36 to the Company’s  Form 10-Q for the quarter ended March 31, 2002** (File No. 0-22229)).                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                                                      |
| 10.37  |   | Marketing and Distribution Agreement between Vital Images, Inc. and  Toshiba Corporation, Medical Systems Company (incorporated by reference to  Exhibit 10.37 to the Company’s Annual Report on Form 10-K for the year ended  December 31, 2002 (File No. 0-22229)) (Confidential treatment has been  requested for portions of this exhibit). |
|   |   |                                                                                                                                                                                                                                                                                                                                                      |
| 10.38  |   | Product Distribution Agreement between Vital Images, Inc. and R2  Technology, Inc. (incorporated by reference to Exhibit 10.38 to the Company’s  Annual Report on Form 10-K for the year ended December 31, 2002 (File  No. 0-22229)) (Confidential treatment has been requested for portions of this  exhibit).                                |
|   |   |                                                                                                                                                                                                                                                                                                                                                      |
| 10.39  |   | Employment Agreement dated February 9, 2002 between the Company  and Jay D. Miller** (incorporated by reference to Exhibit 10.39 to the  Company’s Annual Report on Form 10-K for the year ended December 31,  2002 (File No. 0-22229)).                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                                                                                      |
| 10.40  |   | Form of Change in Control Agreement between the Company and Jay D.  Miller** (incorporated by reference to Exhibit 10.40 to the Company’s Annual  Report on Form 10-K for the year ended December 31, 2002 (File No.  0-22229)).                                                                                                                |
|   |   |                                                                                                                                                                                                                                                                                                                                                      |
| 10.41  |   | Non-qualified Stock Option Agreement dated December 28, 2002  between the Company and Jay D. Miller** (incorporated by reference to Exhibit  10.41 to the Company’s Annual Report on Form 10-K for the year ended  December 31, 2002 (File No. 0-22229)).                                                                                  |
|   |   |                                                                                                                                                                                                                                                                                                                                                      |
| 23.1   |   | Consent of PricewaterhouseCoopers LLP (filed herewith electronically).                                                                                                                                                                                                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                                                                      |
| 31.1   |   | Certification  of Chief Executive Officer Pursuant to Rules 13a-14(a)/15d-14(a) under the  Securities Exchange Act of 1934 and Section 302 of the Sarbanes-Oxley  Act of 2002 (filed herewith electronically).                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                                                      |
| 31.2   |   | Certification  of Chief Financial Officer Pursuant to Rules 13a-14(a)/15d-14(a) under the  Securities Exchange Act of 1934 and Section 302 of the Sarbanes-Oxley  Act of 2002 (filed herewith electronically).                                                                                                                                       |

 

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| 32.1   |   | Certification  of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as  Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (filed herewith electronically). |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                           |
| 32.2   |   | Certification  of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted  Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (filed herewith electronically). |

 

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*  Portions of such exhibit are treated as confidential pursuant to arequest for confidential treatment filed with the Commission by the Registrant.

 

** Indicates a managementcontract or compensatory plan or arrangement.

 

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