**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-K**

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

 

**For thefiscal year ended December 31, 2005**

 

**OR**

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

 

**For the transition period from              to              **

 

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

 

**VitalImages, Inc.**

(Exact name of registrant as specified in its charter)

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

 

**(952) 487-9500**

(Registrant’s telephone number, including area code)

 

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

 

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

 

**Common Stock, $.01 par value; Preferred Stock PurchaseRights**

(Title of Class)

 

**Notapplicable.**

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

 

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

Yeso         No ý

 

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

Yeso         No ý

 

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

 

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

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer”in Rule 12b-2 of the Exchange Act.

 

Largeaccelerated filer o   Acceleratedfiler ý   Non-accelerated filer o

 

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

 

As of June 30, 2005, the last day of the registrant’smost recently completed second fiscal quarter, the aggregate market value ofthe registrant’s common stock held by non-affiliates of the registrant was $222,505,490.The common stock is the registrant’s only class of voting stock.

 

Thenumber of shares outstanding of the issuer’s class of common stock as of February 28,2006 was 13,049,312 shares.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portionsof registrant’s definitive Proxy Statement in connection with the AnnualMeeting of Stockholders to be held May 4, 2006 (“2006 Proxy Statement”)are incorporated by reference into Part III of this Form 10-K, asindicated in Items 10 through 14 of Part III.

 

 

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Vital Images, Inc.

Form 10-K

 

Table of Contents

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

 

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**Part I**

 

**Cautionary Statement Regarding Forward-LookingInformation**

 

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

 

*Factors that may impact forward-looking statementsinclude, among others,**our abilities to maintain the technological competitiveness of ourcurrent products, develop new products, successfully market our products,respond to competitive developments, develop and maintain partnerships withproviders of complementary technologies, manage our costs and the challengesthat may come with growth of our business, and attract and retainqualified sales, technical and management employees. We are also affected bythe growth and regulation of the medical technology industry, including the acceptanceof enterprise-wide advanced visualization by hospitals, clinics, anduniversities, and reimbursement and regulatory practices by Medicare, Medicaid,and private third-party payer organizations. We are also affected by otherfactors identified in our filings with the Securities and Exchange Commission,some of which are set forth in the section entitled “Item 1A.Risk Factors”in this Annual Report on Form 10-K (and many of which we have discussed inprior filings).**Although we have attemptedto list comprehensively these important factors, we also wish to cautioninvestors that other factors may prove to be important in the future inaffecting our operating results. New factors emerge from time to time, and itis not possible for us to predict all of these factors, nor can we assess theimpact each factor or combination of factors may have on our business.*

 

**Item 1. Business**

 

**Our Business**

 

Vital Images, Inc. (“VitalImages,” “we,” “us,” or “our”) is a leading provider of enterprise-wideadvanced visualization and analysis solutions for use by medical professionalsin clinical analysis and therapy planning. We provide software, third partyhardware, training, software maintenance, and professional services to ourcustomers. Our technology utilizes high-speed volume visualization andanalysis, as well as network communications based on DICOM and Internetprotocols. *Vitrea*®,our flagship software product, rapidly creates accurate, interactive 2D, 3D,and 4D images from information generated by standard computed tomography (“CT”),magnetic resonance (“MR”), and positron emission tomography (“PET”) scanners. *ViTALConnect*TM Software, our Web enabled medical diagnostictool, allows physicians anywhere, anytime access to interactive 2D, 3D, and 4Dadvanced visualization tools.

 

Our products and services address the growing interest amongradiologists, cardiologists, oncologists and other specialists to improve theirworkflow and productivity. Our software provides visualization and analysistools to assist physicians in clinical analysis through standaloneworkstations, PACS (Picture Archiving and Communication Systems) integrations, Web-basedremote viewing and analysis. PACS enable hospitals and clinics to acquire,distribute and archive medical images and diagnostic reports, eliminating theneed for film and enhancing productivity. Our Web-based and PACS-based systemsallow multiple physicians to collaboratively use enterprise-wide advancedvisualization and analysis solutions in their medical practices.

 

*Vitrea* and *ViTALConnect*are our two primary software products. *Vitrea* providesadvanced visualization for radiological and surgical applications. It**providesimage clarity, processing speed, and ease-of-use. We offer several optionalmodules, allowing physicians to customize their *Vitrea* software according to their unique requirements. Ourproducts assist 

 

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physicians in analysisand planning therapies for major neurological, cardiovascular, andgastrointestinal disorders. Our customers acquire *Vitrea*underseveral different licensing models, including enterprise licenses, workstationlicenses, and floating licenses, which are similar to concurrent use licenses. Wehave licensed approximately 2,750 copies of *Vitrea and ViTALConnect*to, among others, hospitals, clinics, imaging centers and cardiology centers.

 

As specialists outside the radiology department increasingly rely on *Vitrea*as a diagnostic and communicationstool, demand for access to advanced visualization is growing across thehealthcare enterprise. To address this market opportunity, we work with leadingPACS providers to provide distributed access to *Vitrea.* *ViTALConnect*,our thin-client Web-based solution, is marketed for more remote viewingrequirements.

 

*ViTALConnect*allows physicians and other users to access 2D, 3D and 4D enterprise-wideadvanced visualization capabilities, including the ability to measure, rotate,analyze and segment images, all with a personal computer using a Web-enabledbrowser. The ability of any computer connected to the Internet to useViTALConnect to access these capabilities distinguishes ViTALConnect from otherenterprise-wide advanced visualization analysis solutions. ViTALConnect enablesaccess to advanced visualization images from anywhere and at anytime, allowingphysicians to obtain immediate access to critical care situations while usingany desktop or laptop computer that is connected to the Internet, in comparisonwith many competitive offerings, which require use of a computer workstationthat is explicitly configured for visualization. With ViTALConnect, users canemploy a PC or notebook computer to process, analyze, review and distributemulti-dimensional medical images securely over the Web. In addition, a collaborationmode allows several physicians in different locations to confer whileinteracting with the same images in real time.

 

In connection with salesof *Vitrea*and *ViTALConnect*,we also provide training and installation services to our customers. As we entermore complex transactions involving uses of our software in many areas of ahospital enterprise, as opposed to uses of our software on one computerworkstation, some of our customers may also purchase consulting servicesfrom us.

 

Our software solutionsare used with medical diagnostic equipment, primarily in clinical analysis andtherapy planning. Our software applies proprietary technologies to a variety ofdata supplied by CT, MR and PET scanners to allow medical clinicians to create2D, 3D and 4D views of human anatomy and to non-invasively navigate withinthese images to better visualize and understand internal structures andpathologies. We market *Vitrea*and *ViTALConnect* both as standalone software packages and as part ofintegrated software and hardware systems to radiologists, surgeons, primarycare physicians and medical researchers. Our main customers are hospitals andclinics, university medical schools, and diagnostic imaging companies. Wemarket our products and services to these customers both directly through ourown sales force and indirectly through digital imaging equipment manufacturersand PACS companies, who sell our products with products they either manufactureor acquire from third parties.

 

Our products work withequipment from all major manufacturers of diagnostic imaging systems, includingToshiba Medical Systems Corporation, GE Medical Systems, Siemens MedicalSystems, Inc. and Philips Medical Systems. Our products may also beintegrated into PACS, such as those marketed by McKesson Information Systems,Sectra and DR Systems, and run on off-the-shelf third party computer hardwaremanufactured by companies such as Dell, Inc. and Hewlett-Packard Company.

 

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

 

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

 

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You may also obtain copies of our SEC filings on the SEC’s website at www.sec.gov or at the SEC’s Public Reference Room at 450 Fifth Street N.W., Washington, D.C. 20549. You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330.

 

**Market Opportunity**

 

Medical practices in theareas of diagnostic imaging, surgery and cancer treatment have changeddramatically over the past 20 years, due in part to the introduction of avariety of image acquisition, post processing, visualization, analysis,computer, networking, catheter and surgical navigation technologies. The resulthas been the rapid adoption and increased use of CT, MR and PET scanners andthe incorporation of new physician-care practices based on the imaginginformation provided by these devices.

 

CT, MR, US and PETimaging technologies capture data that provide a physician with a graphicalrepresentation of the inside of the human body. These images have traditionallybeen viewed as a series of two-dimensional, cross-sectional slices onx-ray-type film. As computer processing speed increased, software performanceimproved and networking technologies developed, manufacturers of scanningequipment began offering integrated systems that allowed clinicians to view,analyze and manipulate these medical images in a digital environment.

 

Medical imaging systemsfirst visualized individual slices, or pictures, on a computer monitor andlater provided views of multiple slices. More recently, medical imaging systemsbegan to permit viewing and manipulation of large, multiple slice data sets asa single, three-dimensional image on a computer workstation. Today, theenterprise-wide advanced visualization industry involves the creation,visualization, manipulation, analysis and communication of medical images intwo, three and four dimensions (collectively, “enterprise-wide advancedvisualization software”).

 

Initially, theenterprise-wide advanced visualization and analysis industry and the marketsfor these products lagged the market for imaging devices due to the lack ofindustry standards for the generation, transmission and storage of medicalimaging data, lack of acquired image resolution to optimize the benefits of advancedvisualization and analysis techniques, and high computer costs and inadequate performance considerations. Manyof the technical and cost barriers to growth in the enterprise-wide advancedvisualization and analysis industry and the PACS industry are eroding. Inparticular, the medical industry embraced an image transmission and archivingstandard called Digital Imaging and Communications in Medicine (“DICOM”), whichis promulgated by the American College of Radiology and the National ElectricalManufacturers Association. This standard permits imaging, visualization,networking and archiving systems from different vendors to work cooperativelywithin a single network. In addition, the cost-to-performance ratio of computerproducts used in visualization and PACS has improved dramatically, bringing theprices for enterprise-wide advanced visualization and analysis capabilities andPACS within the grasp of most healthcare providers. The acceptance of industrystandards such as DICOM and the improvements in the cost-to-performance ratiofor clinical workstations will support continued market growth in theenterprise-wide advanced visualization and analysis and PACS industries.

 

The growing acceptance of3D and 4D medical imaging offers us numerous market expansion opportunities. Researchand development efforts are currently focused on using our base ofvisualization technology to expand to other imaging modalities, such as x-rayangiography, as well as expanding the features and functions in the current modalities.We are also enhancing our software tools for less invasive applications, suchas CT angiography for examining cardiac and other vascular disease, CTcolonography for colon imaging, and CT Lung for examining lung diseases.

 

The diagnostic medical imagingmarket continues to expand both its geographic boundaries and its definitiveboundaries. Long defined as the market for CT, MR, PET, ultrasound and otherimaging modalities, the diagnostic imaging market has grown to include bothPACS and enterprise-wide advanced visualization systems, which have becomeintegral technologies for many radiology practices around the world. Theimaging analysis market has grown beyond diagnostic imaging to be an integral part ofboth screening and treatment protocols. The quality of imaging and theconcomitant ability to quantify results puts advanced visualization andanalysis further into the domain of disease characterization and treatment.

 

We continue to see growthin the imaging technology market, particularly in the top tier of the market. Increasedimage resolution results in increasingly large data handling requirements anddata management solutions for manipulation. We foresee continued growth inimaging procedures performed as a result of the growing use of imagingtechnology to non-invasively detect, diagnose and characterize disease. New enterprise-wideadvanced visualization and analysis applications will be in increasing demandto enhance diagnostic accuracy and speed in optimizing data value.

 

We are seeing increaseddemand for distributed models of enterprise-wide advanced visualizationanalysis and solutions, such as use of our products in integrated solutionswith hospitals’ PACS. Hospitals use PACS to enhance workflow and 

 

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boost productivity byeliminating the need to store and transfer bulky film. Adopting a PACS solutionis a significant investment for a hospital. Sales tend to encompass moredecision makers and follow a longer sales cycle than do sales of *Vitrea* on standalone workstations. Becauseof the distributed nature of a PACS, these opportunities usually involve more *Vitrea* licenses, making *Vitrea* accessible to more physicianswithin an environment. Similarly, we intend to include features that arecurrently contained within *Vitrea*within our Web-based *ViTALConnect*product, enabling the enterprise-wide advanced visualization analysis tools andworkflow contained within *Vitrea*to be accessed remotely by radiologists and physicians, in locations such astheir offices and homes.

 

We also expect marketgrowth due to a number of other advantages of enterprise-wide advancedvisualization, including the following:

 

•                        Recenttechnology improvements in CT and MR scanners enable them to generate anincreasing number of slices per exam, sometimes resulting in over 3,000 images,which is more than 10 times as many images as were generally attained in examsas few as  five years ago. To obtain thismany printed images on traditional x-ray film is quite expensive and may belogistically impractical. The use of film is in decline in large part becausehospitals and imaging centers are recognizing significant productivityopportunities by integrating enterprise-wide advanced visualization andanalysis solutions into PACS systems.

 

•                        Medicare,Medicaid, private insurance companies and managed care organizations areincreasingly approving reimbursement for procedures utilizing PET scanners,which has greatly increased the number of procedures performed. In addition, recentadvances in integrating CT and PET technologies and the clinical requirement tointegrate the anatomic and functional information into a single acquisitionhave contributed to an increase in the number of procedures performed utilizingsuch technology. Through our partnership with Mirada Solutions Limited (“Mirada”),we offer an optional module to *Vitrea*thatuses Mirada’s fusion technology toprovide clinicians with an integrated view of images generated by PETand PET/CT scanners.

 

•                        Drivenby a shortage of radiologists, hospital radiology departments are underpressure to perform as efficiently as possible. Thus, an increased caseload and images per case must be completed with the same or a fewer number of people.Speed in interpreting images is essential for increasing workflow productivity.Thus, there is a clear need for fast and efficient integrated 2D, 3D and 4Dvisualization and analysis tools, which can be used to generate and interpretimages at a much greater speed than traditional X-ray technology.

 

•                        Diagnosesbased on 2D images, or “slices,” require the clinician to “assemble” a mental3D and 4D image to understand the true anatomy and pathology. Given theindustry pressure to produce cost-effective outcomes, 3D visualization is avaluable tool for accelerating diagnoses, potentially eliminating unnecessarytests and treatment, optimizing the use of minimally invasive surgery andtherapies, and gaining additional insight for clinical decisions.

 

•                        Spatialrelationships are of paramount importance in surgery, and 3D views displayinganatomy and pathology can greatly aid in surgical planning. Enterprise-wideadvanced visualization has the potential to give surgeons enhanced 3D and 4Dviewing, providing them with more sophisticated information to make theirdecisions and  with which to plan theiroperative procedures. Interactive navigation of volume data from scanners may alsohave the capability to spare patients from invasive procedures like endoscopyor conventional angiography.

 

•                        Increaseduse of enterprise-wide advanced visualization technology has the potential toenhance radiologists’ ability to communicate their findings to fellowclinicians, referring physicians and patients. In addition, the integration ofthese clinical disciplines through electronic visualization, networking and theInternet could allow for greater cross-discipline coordination and reducedservice costs due to increased speed, access to information and the resultingability to perform consultative, interactive planning and examination oncomputer workstations.

 

•                        Thegrowing complexity of the number and uses of enterprise-wide advancedvisualization analysis solutions causes a related increase in the volume andtypes of consulting services demanded by our customers. As our customers useenterprise-wide advanced visualization analysis solutions in more unique ways,they are looking to us to help them identify and resolve potentialtechnological challenges to these uses.

 

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**Strategy**

 

Our goal is to be aleading provider of enterprise-wide advanced visualization and analysissolutions that improve clinical outcomes and reduce costs. To achieve thisgoal, we intend to implement the following key strategies:

 

•                        Developand maintain leading-edge technology*.*We intendto continue our overall strategy of developing and marketing leading-edgeclinical solutions for a variety of medical applications and deploying thesesolutions or solution components throughout the enterprise. As part ofthis strategy, we will continue to improve the speed and performance of *Vitrea*and *ViTALConnect*softwareto guarantee the timely accessibility of these tools. In particular, we will befocused on developing additional protocols that enhance the ease-of-use of *Vitrea*and *ViTALConnect*,as well as increasing the number of platforms on which the software operates.

 

•                        Furtherdevelop clinical applications and expand the applicability of these solutions. Weintend to leverage our core competencies in understanding clinical workflow,volume rendering, computer graphics and developing clinical applications. Weplan to develop and offer a full range of enterprise-wide advancedvisualization and analysis solutions. We believe that significant newopportunities exist for the current application of our innovative technologiesfor the analysis and treatment of cardiovascular disease, cancer andorthopedics.

 

•                        Furtherpenetrate the enterprise-wide advanced visualization and analysis market. Weintend to expand our sales and marketing staff and increase our marketingefforts to continue building momentum for the acceptance and purchase of *Vitrea*and *ViTALConnect*. Wehave a multiple-point strategy to increase our market penetration. Thisstrategy includes contacting and educating physicians and clinicians as to thebenefits of our high-performance advanced visualization software; expanding ourpartnership with Toshiba; developing and growing our technology and marketingrelationships with PACS vendors so that we can expand physician access withinthe healthcare enterprise through PACS- and Web-based solutions; offeringhigh-performance advanced visualization software options, as well asmaintenance and service, to our growing installed base; and working with othermanufacturers of diagnostic imaging equipment, software and other hardware thatworks with enterprise-wide advanced visualization solutions. By convincingusers of the benefits of our system, we believe that we can successfullyinfluence purchasing decisions for medical institutions that are making initialpurchases of or upgrades to their imaging technology. In addition, we willcontinue to work to expand our appeal by implementing additional 2D capabilityas well as ensuring that our technology will easily integrate into PACSnetworks.

 

•                        Furtherdevelop and market suites of related applications and services. Specialistsin areas such as cardiovascular disease, cancer and orthopedics willincreasingly desire integrated products and services in their areas of specialization,such as that provided by our ViTALCardiaTM suite of products for cardiologyspecialists.

 

•                        Continueto seek collaborative partnerships with leading medical institutions. Wehave historically sought out and developed collaborative relationships withmany prestigious medical institutions to develop and test our enterprise-wideadvanced visualization solutions. We will continue to pursue collaborations tofocus on developing products that will improve clinical outcomes and reducecosts for the practices of medical imaging and surgery.

 

•                        Continueto seek collaborative partnerships with leading medical technology companies. Inaddition to collaborations with medical institutions, we will continue tostrategically pursue relationships with leading medical technology companies toexpand our clinical, distribution, financial and/or technical capabilities forour enterprise-wide advanced visualization and analysis solutions. Suchrelationships include our development, marketing and/or distribution agreementswith Toshiba America Medical Systems; the Surgical Navigation Technologiesdivision of Medtronic; E-Z-EM; R2 Technology; McKesson Information Solutions;Sectra; CTI Mirada; Confirma, Inc; Medicsight PLC; Medis; and DR Systems, Inc.Referring physicians, surgeons and other clinicians are placing greater demandson radiologists to communicate their recommendations using the easier tointerpret 3D and 4D image reconstructions, as well as quantify analytic resultsthat will aid the diagnostic and treatment planning process. In fact, 3D and 4Dimages with appropriate measurements are becoming a common language betweenradiology and the surgical and interventional worlds. Delivering Vitrea througha hospital’s PACS solution, such as those provided by McKesson, Sectra, DRSystems and others, coupled with our “floating” license capabilities, whichgive multiple end users the opportunity to share access to enterprise-wideadvanced visualization, is an efficient 

 

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way to put advancedvisualization in the hands of more physicians throughout a healthcareenterprise. See “Business-Marketing and Distribution,” “–Intellectual Property”and “–Manufacturing and Service.”

 

**Products and Product Development**

 

*Vitrea**.**Vitrea* is our advanced medical imaging softwarefor diagnostic evaluation of computed tomography (CT), magnetic resonance (MR)and position emission tomography (PET) image data. *Vitrea* features real-time navigation of 3D volume data,permitting the user to create two-, three- and four-dimensional views of humananatomy and to interactively navigate within these images to better visualize,measure and understand internal structures and disease conditions. In addition,*Vitrea* utilizes an intuitiveclinical workflow and automatic settings to improve speed and simplicity overother visualization techniques.

 

*Vitrea* wasconceived in December 1995 as a new product for direct clinicalapplication. Its goal was to produce an easy-to-use clinical software tool toallow radiologists and other clinicians to use two- and three-dimensionalvisualization to evaluate patient data in their routine clinical processes. Specificationsfor this new product were developed in early 1996, with software developmentbeginning in late spring of that year. We submitted 510(k) documentation in September 1996for *Vitrea*, which was granted marketing clearance by the U.S. Food andDrug Administration (the “FDA”) in November 1996 for use as a clinicaldiagnostic and surgical planning device when used with CT and MR medicalimaging data. *Vitrea* was first released forsale to customers in October 1997. Due to its speed and ease-of-use, webelieve *Vitrea*was the first advanced visualization product with the ability toappeal primarily to the clinical market.

 

In December 1999, wereleased *Vitrea 2*, a Microsoft®Windows and Intel®-architecture-based version of our *Vitrea* software for 2D/3D visualization and analysis ofmedical image data. *Vitrea* 2 wasVital Images’ first advanced visualization software product available for theMicrosoft Windows operating system and provides the speed and ease-of-use themedical community demands for analysis and treatment planning in a clinicalenvironment. In March 2005, we released *Vitrea 2Version 3.7*, which has improved usability, quantification andnetworking features to meet the diagnostic and therapy planning needs of busyradiology departments.

 

*Vitrea*capitalizeson our experience in advanced visualization and analysis and providesclinicians with an easy-to-use tool for radiological analysis and therapyplanning. It represents our most important step to date as a provider of arange of clinical tools for broad distribution to the enterprise-wide advancedvisualization and analysis market. *Vitrea’s*primary features are its high-speed rendering capability, its ability toprovide 2D, 3D and 4D viewing, and its ability to classify disease by mergingmultimodality image techniques and quantifying results and temporal changes forroutine analysis and therapy planning. We believe that these features - speedand ease-of-use - now make it possible to use these solutions in daily clinicalroutines. A *Vitrea* user, following a built-inclinical workflow, can view the image data in two, three or four dimensionsusing visualization settings based on specific clinical applications storedwithin the system as dedicated visualization protocols. The user may theninteractively navigate around, or “fly through,” the image to view clinicallyrelevant anatomies and pathologies. *Vitrea*softwarealso allows the user to capture views by taking “snapshots,” which can beintegrated into customized reports for electronic transmission and archivingthrough a DICOM network or sent to another location via the Internet.

 

*Vitrea*softwareconforms to the latest medical imaging and computer industry standards, such as*OpenGL*TM computer graphics applicationprogramming interface and DICOM.

 

In addition to itsimmediate clinical applications, *Vitrea*incorporatesa number of additional technological advances, thereby making it adaptable toroutine clinical use in surgical navigation and cancer treatment planning andfor integration into diagnostic imaging equipment and PACS networksmanufactured and sold by other companies. In particular, *Vitrea*waswritten using advanced programming techniques, a modular, object-orienteddesign, C++ programming language, and a shared messaging structure. We believethese characteristics make it practical to modify *Vitrea*tosuit the clinical needs of the clinical enterprise, as well as allowingdiagnostic equipment and PACS network manufacturers to integrate *Vitrea*software into their product offerings, therebyproviding us the opportunity to leverage *Vitrea*developmentinvestment into new commercial areas.

 

**SoftwareOptions.**We have developed a number of value-added software options that work withthe base *Vitrea*platform. Theseoptions provide a variety of clinical information for specialized uses. Our options include the following:

** **

VScore.Our VScore software option allows clinicians tonon-invasively quantify calcium in the four major coronary arteries using CTimage data.

 

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CT Brain Perfusion. OurCT Brain Perfusion software option helps radiologists analyze blood flow ofstroke victims where the speed of analysis and treatment is often the primaryfactor in determining the extent of recovery.

 

Innerview GI. OurInnerview GI software option generates 2D and 3D images of the entire colon,increasing the speed and ease of locating and analyzing polyps. This optionprovides a less invasive, more comfortable diagnostic procedure than previouslypossible, improving patient compliance. We have also entered into an agreementwith London-based Medicsight to integrate Medicsight’s Colon CAR, orcomputer-assisted reader – an image analysis software tool to detect colonpolyps - into InnerviewGI.

 

Automated VesselMeasurements. Our Automated Vessel Measurements softwareoption helps physicians characterize the course and dimensions of diseasedblood vessels. Automated Vessel Measurements is designed to support activitiessuch as pre-surgical analysis, evaluation and stent planning in the abdominalaorta, carotid arteries, coronary arteries and renal arteries.

 

CT Cardiac. OurCT Cardiac software option defines the coronary anatomy and the degree ofluminal obstruction of the coronary arteries. It is commonly used to determinethe extent of obstructive coronary artery disease and to assess the feasibilityand appropriateness of various forms of therapy or surgical interventions. Inthe first quarter of 2005, the CT Cardiac option was enhanced with the additionof the cardiac functional analysis (CFA) capability that enables measurement ofblood volume changes in the left ventricle of the heart.

 

Vessel Probe. OurVessel Probe software option is a complementary product to the CT Cardiacsoftware option. It is used to define vascular anatomy and the degree ofluminary obstruction in vessels other than the coronary arteries. With thisoption, physicians can determine the extent of obstructive vascular disease andassess the feasibility of various forms of therapy or surgical interventions.

 

CT Lung and Lung Tools. OurCT Lung software option provides fast and simple-to-use visualization andmeasurement of nodules in the lung. CT Lung can play a key role in analysis,treatment, follow up comparisons and inter-departmental communication. Thisoption is designed to improve the detection and measurement accuracy andproductivity of radiologists and oncologists when reviewing chest CT exams.

 

Concurrent License. OurConcurrent License option gives multiple end users the ability to share asingle *Vitrea* license within a facility. Whilelimiting the number of simultaneous users to the number of *Vitrea* licenses purchased, the Concurrent Licenseoption allows *Vitrea*to be accessed frommultiple reading stations within an enterprise.

 

SoftRead.Our SoftRead option, when used with concurrent licensing, allows physicians toview studies in 2D when the Vitrea workstation is already in use. It supportsdata from multiple sources of diagnostic equipment, and it can providecomparisons between multiple studies.

 

3D-Angio. Our 3D-Angio software optionconverts and displays Toshiba digital angiograms, allowing views of patientangiographic data in 2D and 3D from an unlimited number of viewing angles. Mostof Vitrea’s standard visualization capabilities for CT and MR images areavailable for use with 3D-Angio datasets.

 

ImageChecker® CT. Through ourpartnership with R2 Technology, Inc., we offer the ImageChecker CTsoftware option, which is a clinically-focused option that seamlesslyintegrates the ImageChecker®CT (ICCT) software into the Vitrea software. R2 Technology Inc.’s ICCT softwareis an advanced image analysis and visualization system designed to assistradiologists in the detection of pulmonary nodules during review ofmulti-detector CT (MDCT) exams of the chest.

 

Fusion7DTM. Through our partnership with CTIMirada Solutions, we offer the Fusion7D software option. Fusion7D is the onlycommercially available package with the deformable fusion component. Fusion7Denables physicians to visualize images, fuse studies from multiple modalities,calculate and display standard uptake values and communicate their findings toreferring physicians.

 

CADstreamTM. Through our partnership with Confirma, Inc.,we offer the CADstream software option. CADstream enhances the efficiency andworkflow of breast MRI studies by automating data analysis, improving imagemanagement and correcting for patient movement, which assists radiologists inthe interpretation, standardization and reporting of these data-intensivestudies. CADstream’s core automated features include adaptive imageregistration (2D/3D), multiplanar reformatting, subtractions, angiogenesismaps, curves, maximum intensity 

 

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projections(MIPs), volume summaries and SureLocTM for interventional planning.

 

QMass® MR. Throughour partnership with Medis, we offer the QMass software option. QMass featuresinclude Automatic left ventricular contour detection; sart right ventricularcontour drawing; calculation of both global and regional functional parameters,including cardiac output, ejection fraction, myocardial mass, wall thickness,wall thickening, and wall motion; regional wall thickness, wall thickening andthinning and wall motion results; and export of analysis results in variousformats.

 

*ViTALConnect.**ViTALConnect* is a thin-client Web-enabled medicaldiagnostic tool that allows physicians to use PCs or notebook computers toaccess interactive 2D, 3D and 4D advanced visualization. Building on our knowledgeand understanding of advanced diagnostic workflow, *ViTALConnect*offers users the access that is critical in today’s hospital enterprise. *ViTALConnect*enables users to make quick diagnosticdecisions, review studies and perform advanced analysis from anywhere atanytime. Also a communication tool, *ViTALConnect*includes collaboration capabilities that enable multiple physicians indifferent locations to confer while interacting with the same data in real time.

 

As specialists outside the radiology department increasingly rely on *Vitrea*as a diagnostic and communicationstool, demand for access to advanced visualization is growing across thehealthcare enterprise. *ViTALConnect*allows these specialists to use enterprise-wide advanced visualization. With *ViTALConnect*, users can employ a PC or notebook computer toprocess, analyze, review and distribute multi-dimensional medical imagessecurely over the Web.

 

**Maintenance and Support**

 

In addition to system andsoftware products, we market maintenance and support services, as well ascertain other services, such as installation and training. In connection withlicensing *Vitrea*and *ViTALConnect* software,we offer annual maintenance and support services for both *Vitrea*and *ViTALConnect*pursuant to which we provide software updates, minor feature enhancements,error correction, telephone support and other general support services. Ourmaintenance and support services do not include installation, training andother services, whether on- or off-site, which can be purchased separately.

 

**Marketing and Distribution**

 

We market *Vitrea* and *ViTALConnect*both as standalone software packages and as part of integrated softwareand hardware systems to radiologists, surgeons, primary care physicians andmedical researchers. We market our products directly to end-user customers andthrough several business partners, including diagnostic imaging equipmentmanufacturers, PACS companies, and software developers, all of whom sell ourproducts with products they either manufacture or acquire from third parties.

 

Our marketing partnersinclude Toshiba Medical Systems Corporation (“Toshiba”), which markets *Vitrea* to**itscustomers through its subsidiaries and distributors in more than 50 countriesthroughout the world. This agreement has been extended by amendment three times.The most recent amendment extended the agreement through December 31, 2006.Our agreement with Toshiba names *Vitrea*asToshiba’s primary enterprise-wide advanced visualization software for use with itsCT scanners. Sales through Toshiba are a material portion of our revenues,comprising approximately 47% of our 2005 revenues, 50% of our 2004 revenues,and 42% of our 2003 revenues. See “Business – Marketing and Distribution” and “–Dependence on Major Customers.”

 

We have a jointdistribution agreement with McKesson Information Systems, a primary provider ofPACS, under which each company has been granted the right to distribute theother party’s products. We also have marketing and reseller agreements with DRSystems, Inc. and Eclipsys, Inc., under which these companies willresell our products to their customers as add-on components to their products.

 

See Note 9 to theFinancial Statements, “Major Customers and Geographic Data,” for informationregarding our export sales. As of December 31, 2005, we had 38 salespeoplein the U.S., one salesperson supporting our international resellers, one OEMreseller in the United States and 15 international resellers. Many of ourinternational resellers are also Toshiba resellers.

 

**CollaborativeRelationships**

 

We have formedcollaborative relationships with some of the leading universities andphysicians in medicine and medical imaging to develop what we believe to be themost innovative and clinically relevant medical imaging solutions. We haveentered into clinical collaboration agreements with universities and physiciansto:

 

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•                  Identifynew clinical applications where noninvasive imaging software can improveclinical outcomes and reduce costs;

•                  Assistin the development of clinical routines that incorporate our clinical solutionsin normal diagnostic and therapy planning practices;

•                  Consultin the development of new features that facilitate and improve analysis andtherapy planning for our future products;

•                  Assessthe clinical value of our clinical solutions for given applications; and

•                  Developautomated clinical protocols for CT or MR data.

 

**Competition**

 

The enterprise-wideadvanced visualization and analysis market is developing and growing rapidly. Itis intensely competitive, subject to rapid change and significantly affected bynew product introductions and other market activities of industry participants.Our primary competitors are diagnostic imaging system suppliers, which aretypically large, multinational companies with far greater financial andtechnical resources. They also have well-established sales and distributionnetworks for their products. These companies, including GE Medical Systems,Siemens Medical Systems, Inc., and Philips Medical Systems, develop andmarket medical imaging systems, such as CT and MR equipment, which may bepurchased with integrated medical imaging capabilities. Our software works onthe products offered by each of these companies. To win business againstequipment manufacturers, we must convince customers to buy our solutionseparately from their purchase of imaging equipment, instead of buyingintegrated systems from our competitors.

 

We also face competitionfrom PACS vendors and other suppliers of medical imaging systems and software. PACScompanies sometimes provide medical imaging capability in addition to theirimage archiving and networking products. Vendors of hospital, clinical andradiology information systems have also diversified into the PACS and medicalimaging product lines, either through internal development or businessdevelopment and partnership channels. These companies, which may be largeor small, attempt to offer an integrated system covering a full range ofadministrative, clinical and radiology information management capabilities tohealthcare providers. Other suppliers of medical imaging systems and software, suchas TeraRecon, Inc., compete on the basis of volume rendering or othervisualization technologies, specific applications or market niches.

 

Our competitive strengthis based on several factors, including our ability to do the following:

 

•                  Providedifferentiated solutions that operate in multi-vendor network and image sourceenvironments;

•                  Provideclinical quality, integrated 2D, 3D and 4D images, volume rendered at highspeed with interactive navigation on a relatively low-cost standard computer;

•                  Builduser interfaces that are easy for physicians and clinicians to use so that theydo not need to be advanced technology experts to derive value fromenterprise-wide advanced visualization analysis and solutions;

•                  Integrateclinical knowledge from our collaborative clinical partners into our products;

•                  Leverageour visualization and analysis technology across multiple clinical disciplines;

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

•                  ServeOEMs, PACS vendors and end-user customers through the development of a modularend-user product that can easily be segmented for OEM customers or integratedinto a PACS environment; and

•                  Offerour market-leading clinical applications into the broadening clinicalenterprise through Web-based deployable solutions.

 

We believe that productquality, performance, functionality and features, quality of support andservice, reputation, brand and price are also important competitive factors. Webelieve that customers will prefer our solutions because they are the best-in-class productivitytools for doctors. Although price has been less significant than other factors,increasing competition in the market may result in price reductions andreduced gross margins. In particular, should one or more of the diagnosticimaging system suppliers, with their greater size and scale, provide ordistribute more competitive medical imaging products than ours, our business,financial condition and results of operations could be materially adverselyaffected.

 

**Customersand Customer Support**

 

Through December 31,2005, we had sold approximately 2,750 separate software licenses for *Vitrea* and *ViTALConnect*,**for use in over 1,700 different sites, including hospitalsand teaching hospitals, clinics, and imaging centers, both in major cities 

 

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as well as in smallerpopulation areas.

 

We are committed to rapidresponse to customer service requests. Customer support representatives areavailable during business hours and on an on-call basis to answer questionsabout the operation, maintenance and repair of our products.

 

**IntellectualProperty**

 

We rely primarily on acombination of trade secret and copyright law, employee and third-partynondisclosure agreements and other protective measures to protect intellectualproperty rights pertaining to our products and technologies. We also have agrowing portfolio of patents for our technology. Because of the rapid pace oftechnological change in the medical software industry, we believe that theknowledge, ability and experience of our personnel; new product developmentsand enhancements; and ongoing, reliable product maintenance and support will enhanceour competitive position.

 

We do not own all of thesoftware and other technologies used in our products, but we believe we havethe necessary licenses from third parties for using that technology in ourcurrent products. It may be necessary to renegotiate with such thirdparties for any new versions of current products or any new products. Suchthird party licenses may not be available on reasonable terms, or at all.

 

**Manufacturingand Service**

 

Our manufacturing effortsare limited to the production, quality assurance and distribution of oursoftware, which is distributed on CD-ROM. After we send software to ourcustomers, it is loaded into a workstation, either by our personnel, personnelfrom one of our authorized resellers, or our customers’ personnel. If ourpersonnel load the software, it is as part of our installation services. Inaddition to loading software into the workstation, our installation servicesgenerally include implementation of *Vitrea* and *ViTALConnect* software into customers’ computer networks,configuring the network requirements and verifying software operability onsite.

 

We rely primarily on ourown software development as our core competence. We obtain certain applicationand utility software from third parties (see “—Intellectual Property” above)and use a third party operating system for integrated computer workstations. Inaddition, we obtain systems components, computers and computer peripherals fromthird party suppliers.

 

We have also signedreseller distribution agreements that allow us to distribute products fromcertain third parties. These third party products include R2’s ImageChecker CTsoftware applications for the detection of lung nodules; Mirada’s Fusion 7Dsoftware application for the anatomical alignment of two different image datasets from two different types of diagnostic equipment, such as combining imagesfrom CT and PET scanners; Confirma’s CADstream breast MRI software; and Medis’sQMass MR software.

 

**GovernmentalRegulation**

 

As medical devices, oursoftware solutions are subject to extensive and rigorous regulation by numerousgovernmental authorities, principally the FDA and corresponding foreignagencies. In the United States, the FDA administers the Federal Food, Drug, andCosmetic Act, its amendments (the “FD&C Act”) and its related regulations. TheFD&C Act and these regulations classify medical devices as Class I, IIor III devices, which are subject to general controls, special controls orpre-market approval requirements, respectively. Most Class I and IIdevices, as well as some Class III devices, can be cleared for marketingpursuant to a 510(k) pre-market notification. The process of obtaining a 510(k)clearance typically can take several months to a year or longer.

 

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

 

*Vitrea* and *ViTALConnect* are classified as Class II medical devicesand have received marketing clearances from the FDA as the result of 510(k)pre-market notifications. Specifically, *Vitrea, ViTALConnect*andthe Company’s add-on options have been cleared to be marketed for use with CT,MR, and PET scanners. Future products, add-on options to existing software, andexpanded claims of efficacy will likely require additional 510(k) pre-marketnotifications.

 

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There can be no assurancethat future FDA review processes will not involve delays or that clearanceswill be granted on a timely basis. If our current or future products becomeclassified as Class III devices, they could be subject to a moreexpensive, uncertain and lengthy approval process, and approval, if granted,could include significant limitations on the indicated uses for which a productmay be marketed.

 

We are also increasinglybecoming subject to regulation in foreign countries in which we sell ourproducts. Many of the regulations applicable to our products in such countriesare similar to those of the FDA. Our ability to successfully market and sellour products in foreign markets depends in large part on our ability tocomply with such foreign regulatory requirements. *Vitrea*softwarehas been Conformitee Europeene (“CE”) marked, indicating conformance withapplicable sections of the Medical Device Directive 93/42/EEC, which allows theproducts to be marketed in the member countries of the European Communities.

 

We are also subject toperiodic inspections by the FDA and similar foreign regulatory agencies, whoseprimary purpose is to audit our compliance with quality system regulationsestablished by the FDA and other applicable government standards. Regulatoryaction may be initiated in response to audit deficiencies or productperformance problems. We believe that our manufacturing and quality controlprocedures comply with all applicable requirements of the FDA and foreignregulatory agencies in countries in which we sell our products. We havereceived and maintain ISO 13485: 2003 Certification.

 

Medicare and Medicaidlaws and regulations may impact the financial arrangements through whichwe market, sell and distribute our products and services to patients who areMedicare or Medicaid beneficiaries. Violations of these laws and regulations may resultin civil and criminal penalties, including substantial fines and imprisonment. Ina number of states, the scope of these laws and regulations has been extendedto include the provision of services or products to all patients, regardless ofthe source of payment, although there is variation from state to state as tothe exact provisions of such laws or regulations. In other states and, on anational level, several health care reform initiatives have been proposedwhich would have a similar impact. We believe that our operations and ourmarketing, sales and distribution practices currently comply with all currentfraud and abuse and physician anti-referral laws and regulations, to the extentthey are applicable.

 

**ThirdParty Reimbursement and Cost Containment**

 

Our products arepurchased primarily by hospitals, clinics, imaging centers and other users thatbill various third party payers for the services provided to the patients. Thesepayers, which include Medicare, Medicaid, private insurance companies andmanaged care organizations, reimburse part or all of the costs and feesassociated with the diagnostic procedures utilizing our products. The medicalimaging services performed using our software, except for disease screeningprocedures, are covered by current CPT codes (Current Procedural Terminology,as defined by the Centers for Medicare & Medicaid Services). As such,hospitals providing services using our enterprise-wide advanced visualizationsolutions can seek reimbursement for such services by using existing approvedCPT codes. Medicare and Medicaid reimbursement for hospitals is based on afixed amount for admitting a patient with a specific diagnosis. Because of thisfixed reimbursement method, hospitals have incentives to use less costlymethods in treating Medicare and Medicaid patients, and they will frequentlymake capital expenditures to take advantage of less costly treatmenttechnologies. Often, reimbursement is reduced to reflect the availability of a new procedure or technique and, as aresult, hospitals are generally willing to implement new cost-savingtechnologies before these downward adjustments take effect. Likewise, becausethe rate of reimbursement for certain physicians who perform certainprocedures has been, and may in the future, be reduced in the event ofchanges in the resource-based relative value scale method of paymentcalculation, physicians may seek greater cost efficiency in treatment tominimize any negative impact of reduced reimbursement. Any amendments toexisting reimbursement rules and regulations that restrict or terminatethe reimbursement eligibility (or the extent or amount of coverage) of medicalprocedures using our products or the eligibility (or the extent or amount ofcoverage) of our products could have a material adverse impact on our business.

 

In response to the focusof national attention on rising health care costs, a number of changes toreduce costs have been proposed or have begun to emerge. There have been, and may continueto be, proposals by legislators and regulators and third party payers to reducethese costs. There has also been a significant increase in the number ofAmericans enrolling in some form of managed care plan and, in addition,many hospitals participate in or have agreements with HMOs. It has become atypical practice for hospitals to affiliate themselves with as many managedcare plans as possible. Higher managed care penetration typically drives downthe prices of healthcare procedures, which in turn places pressure on medicalsupply prices. This causes hospitals to implement tighter vendor selection andcertification processes by reducing the number of vendors used, purchasing moreproducts from fewer vendors and trading discounts on price for guaranteedhigher volumes to vendors. Hospitals have also sought to control and reducecosts over the last decade by joining group purchasing organizations orpurchasing alliances. We cannot predict what continuing or future impact thesepractices, the existing or 

 

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proposed legislation, orsuch third party payer measures may have on our future business.

 

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

 

The HIPAA regulations arecausing our customers to request that we sign “business associate” agreementswith them. A “business associate” is a person or entity that performs certainfunctions or activities that involve the use or disclosure of protected healthinformation on behalf of, or provides services to, a covered entity. By law,the HIPAA Privacy Rule applies only to covered entities – health plans,health care clearinghouses, and certain health care providers. However, mosthealth care providers do not carry out all of their health care activities andfunctions by themselves. Instead, they often use the services of a variety ofother persons or businesses. The Privacy Rule allows covered providers andhealth plans to disclose protected health information to these “businessassociates” if the providers or plans obtain satisfactory assurances that thebusiness associate will use the information only for the purposes for which itwas engaged by the covered entity, will safeguard the information from misuse,and will help the covered entity comply with some of the covered entity’sduties under the Privacy Rule. Covered entities may disclose protectedhealth information to an entity in its role as a business associate *only* to help the covered entity carry outits health care functions – not for the business associate’s independent use orpurposes, except as needed for the proper management and administration of thebusiness associate.

 

**Employees**

 

As of February 28,2006, we had 200 full-time employees, with 82 involved in research anddevelopment, which includes 15 in China, 55 in sales and marketing, 34 intechnical support functions and 34 in administrative functions. We believe ourrelationship with our employees is good.

 

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

 

Discussion of our business and operations included in this annualreport on Form 10-K should be read together with the risk factors set forthbelow. They describe various risks and uncertainties to which we are, or maybecome subject. These risks and uncertainties, together with other factorsdescribed elsewhere in this report, have the potential to affect our business,financial condition, results of operations, cash flows, strategies or prospectsin a material and adverse manner.  Newrisks may emerge at any time, and we cannot predict those risks or estimate theextent to which they may affect financial performance. Each of the risksdescribed below could adversely impact the value of our securities.  These statements, like all statements in thisreport, speak only as of the date of this report (unless another date isindicated), and we undertake no obligation to update or revise the statementsin light of future developments.

 

*Market Acceptance*

 

Our success depends onour ability to continue to successfully market *Vitrea*and *ViTALConnect* software for clinical use,and on the ability and willingness of physicians to use enterprise-wideadvanced visualization software medical imaging software in clinical analysisand therapy planning. The enterprise-wide advanced visualization softwareoffered by *Vitrea*and *ViTALConnect*are alternatives to the conventional methods traditionally used for viewingmedical images in the clinical setting. The acceptance of *Vitrea*and *ViTALConnect* by physicians and otherclinicians will depend on our ability to educate those users as to the speed,ease-of-use and other benefits offered by the *Vitrea*and*ViTALConnect* systems, as well as ourtimely introduction of new features and functions. There can be no assurancethat users will prefer advanced visualization and analysis software solutionsover less expensive two-dimensional medical imaging software or that we willsucceed in our efforts to further develop, commercialize, and achieve marketacceptance for *Vitrea*and *ViTALConnect*or for any other product in the clinical setting. Further, all of our businessin markets outside the United States is provided through third parties with whomwe have marketing agreements. There can be no assurance that these thirdparties will wish to continue our relationships on an indefinite basis or underthe same terms as the business is currently conducted. Further, although weplan to develop direct relationships with customers in markets outside theUnited States, there can be no assurance that we will be successful in doing so.The loss of or adverse changes in our relationships with our third partybusiness partners, and our failure to establish direct relationships withcustomers outside the United States, would have a material adverse impact onour business, financial condition, and results of operations.

 

*Substantial Reliance on a SingleProduct*

 

Revenue related to *Vitrea*constituted 95% of our total revenues for the yearended December 31, 2005, 96% of our total revenues for the year ended December 31,2004, and 98% of our total revenues for the year ended December 31, 2003. We anticipate that revenue from thesale of *Vitrea*will continue to account for asubstantial portion of our revenue for the foreseeable future. As such, if *Vitrea*became disfavored by physicians, it would have amaterial adverse impact on our business, financial condition, and results ofoperations.

 

*Dependence on Major Customers*

 

One of our principaldistribution channels is to sell our *Vitrea*medicalimaging software in connection with medical imaging equipment sold by Toshiba. Salesto Toshiba accounted for 47% of our total revenue for the year ended December 31,2005, 50% of our total revenue for the year ended December 31, 2004, and 42%of our total revenue for the year ended December 31, 2003. Toshiba’saccount receivable represented 36% of the Company’s accounts receivable at December 31,2005 and 23% at December 31, 2004.A limited number of large customers may continue to account for asignificant portion 

 

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of our revenue during anygiven period for the foreseeable future. Except for our agreement with Toshiba,we have no long-term purchase commitments from any of our customers or businesspartners, and we generally make sales pursuant to individual transactions. Althoughour agreement with Toshiba has been extended by amendment three times, mostrecently through December 31, 2006, we can provide no assurance that ouragreement with Toshiba will be extended beyond December 31, 2006. Areduction, delay, or cancellation of orders from one or more of our significantcustomers, or our inability to collect accounts receivable from thesecustomers, likely would have a material adverse effect on our financialcondition and operating results.

 

*Impact of Purchase Commitments toThird Parties*

 

As part of ourbusiness, we may offer third party products as components within ourproducts or as optional modules to our products. As a condition of entering intothese agreements, or for other business reasons, the third parties may requireus to commit to purchase a certain volume of their products, irrespective ofthe amount of their products that we sell to our customers. If we enter into sucha volume commitment with a third party but do not sell a sufficient volume of itsproducts, then we may be required to pay the third party directly for thedeficit in sales. We incurred such an event during the fourth quarter of 2005,in which we did not sell a sufficient volume of our partner R2 Technology, Inc.’s(“R2”) lung nodule computer-aided-diagnosis software product to meet ourquarterly purchase commitment under our contract with R2, resulting in a lossof approximately $410,000 in the fourth quarter of 2005. There can be noassurance that we will not have similar deficits in future quarters undercommitments we may have made to R2 or other providers of third partyproducts. Regarding R2, our commitment is for approximately $414,000 perquarter through the quarter ended March 31, 2006. The contractualcommitments continue through the quarter ended June 30, 2008, but they may bereduced during each quarter after the quarter ended March 31, 2006 to thelowest of: (i) the quarterly commitment in the preceding quarter; (ii) thequarterly commitment of the preceding quarter multiplied by the percent bywhich the R2 Lung CAD product revenue in the preceding quarter fell below thatquarter’s quarterly commitment, up to a maximum decline of twenty-three percent(23%); or (iii) two times the R2 Lung CAD product revenue generated by R2during the preceding quarter through all other sales, marketing anddistribution channels, excluding R2 Lung CAD product revenue generated throughthe agreement with us; provided, that**if at any timeduring the remainder of the agreement the quarterly commitment is less than$414,000 and R2 Lung CAD Product revenue for a quarter exceeds $414,000, ourquarterly commitment for the next quarter will again be $414,000, and thequarterly commitment for the following quarters may again be subject tothe above adjustment. Additionally, at the end of every fourth quarter underthe R2 agreement, if the aggregate revenue generated under the agreement in theprevious four quarters exceeded $1,665,000, the remaining quarterly commitmentsshall be reduced by the amount of excess divided by the number of quartersremaining under the agreement. As of December 31, 2005, the remainingpotential aggregate Applicable Minimums range from a minimum of approximately$414,000 to a maximum of approximately $4.1 million.

 

*Dependence on Market Growth*

 

The enterprise-wideadvanced visualization industry in which we market our products is stilldeveloping due to the fairly recent availability of high-resolution CT, MR andcombined CT-PET scanners, high-performance computers at reduced prices, therecent adoption of industry standards for the generation, transmission andstorage of medical imaging data, and changing medical practices. Historically,there has been a perception that enterprise-wide advanced visualization was tooslow, unresolved or difficult for clinical use. This perception was due largelyto the relatively slower processing speed of available workstations and thereality that true volumetric acquisition was not previously available. Webelieve that the recent advances in scanner acquisition resolution, theaffordability of high-performance computers and the development of industrystandards for the generation, transmission, and storage of imaging data willprovide opportunities for substantial growth in the medical software industry. However,given the uncertainties associated with the developing stage of this market,there can be no assurance that it will continue to develop in the manner weanticipate. Accordingly, there can be no assurance that the enterprise-wideadvanced visualization industry will provide growth opportunities for us andour software products or that our business strategies will be successful as theindustry continues to evolve. Ultimately, if the enterprise-wide advanced visualizationindustry fails to develop as we expect, our business, results of operations andfinancial condition will be materially and adversely affected.

 

*Highly Competitive Industry*

 

We face intensecompetition in the enterprise-wide advanced visualization industry. We expecttechnology to continue to develop rapidly, and our success will depend to alarge extent on our ability to maintain a competitive position with ourproducts. Our competitors in the enterprise-wide advanced visualizationindustry include large, established manufacturers of CT and MR imagingequipment. Companies such as GE Healthcare, Siemens Medical Systems, Inc.and Philips Medical Systems typically offer their own enterprise-wide advancedvisualization software and workstations as part of their integratedimaging and scanner systems. Our software works on the products offered by eachof these companies. To win business 

 

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against equipmentmanufacturers, we must convince customers to buy our software solutionsseparately from their purchase of imaging equipment instead of buyingintegrated systems from our competitors.

 

In addition to having acompetitive advantage in marketing enterprise-wide advanced visualization toolsas an integrated part of their imaging products, our competitors havesignificantly greater capital and staffing resources for research anddevelopment that are critical to success in the dynamic enterprise-wideadvanced visualization industry, more recognizable brand names, and morewell-established marketing and distribution networks. Although price has beenless significant than other factors, increasing competition may result inprice reductions and reduced gross margins. Additionally, we face competitionfrom other entities, such as PACS vendors and developers of competitive orancillary software packages. We may not be able to compete effectivelywith such manufacturers or competing entities.

 

*Risk of TechnologicalObsolescence*

 

The enterprise-wideadvanced visualization market is characterized by rapid innovation andtechnological change. We may be unable to compete effectively in themarketplace, and products developed by our competitors may render ourproducts obsolete or non-competitive. Similarly, our competitors may succeedin developing or marketing products that are viewed as providing superiorclinical performance or are less expensive than our current or future products.

 

*Sarbanes-Oxley Compliance*

 

Under Section 404 ofthe Sarbanes-Oxley Act of 2002, we are required to evaluate and determine theeffectiveness of our internal controls over financial reporting. We havededicated a significant amount of time and resources to ensure compliance withthis legislation for the year ended December 31, 2005 and will continue todo so for future fiscal periods. We may encounter problems or delays incompleting the review and evaluation, the implementation of improvements andthe receipt of a positive attestation, or any attestation at all, from ourindependent registered public accounting firm. In addition, our assessment ofour internal controls may identify deficiencies that need to be addressedin our internal controls over financial reporting or other matters that may raiseconcerns for investors and therefore adversely affect our stock price.

 

*Fluctuations in Operating Results*

 

We may experiencesignificant fluctuations in future annual and quarterly operating results. Ifthese fluctuations occur, they may result in volatility in the price ofour common stock. Quarterly revenue and operating results may fluctuate asa result of a variety of factors that are outside of our control including, butnot limited to, the timing of significant orders, the timing of productenhancements and new product introductions by us or our competitors, thepricing of our products, changes in customers’ budgets, and competitiveconditions. Our quarterly license and services revenue may fluctuate and may bedifficult to forecast for a variety of reasons, including the following:

 

•                  asignificant number of our existing and prospective clients’ decisions regardingwhether to enter into license agreements with us are made within the last fewweeks or days of each quarter;

•                  thesize of license transactions can vary significantly;

•                  adecrease in license fee revenue may likely result in a decrease inservices revenue in the same or subsequent quarters;

•                  clientsmay unexpectedly postpone or cancel projects due to changes in theirstrategic priorities, project objectives, budget or personnel;

•                  theuncertainty caused by potential business combinations in the software industry may causeclients and prospective clients to cancel, postpone or reduce capital spendingprojects on software;

•                  clientevaluations and purchasing processes vary significantly from company tocompany, and a client’s internal approval and expenditure authorization processcan be difficult and time consuming to complete, even after selection of avendor;

•                  thenumber, timing and significance of software product enhancements and new softwareproduct announcements;

•                  existingclients may decline to renew support for our products, and marketpressures may limit our ability to increase support fees or requireclients to upgrade from older versions of our products;

•                  prospectiveclients may decline or defer the purchase of new products or releases ifwe do not have sufficient client references for those products; or

•                  wemay have to defer revenues under our revenue recognition policies.

 

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*Government Regulation*

 

Our products are subjectto regulation by the FDA and by comparable agencies in foreign countries. Inthe United States, the FDA regulates the development, introduction,manufacturing, labeling and record keeping procedures for medical devices,including 3D medical imaging software and systems. The process of obtainingmarketing clearance from the FDA for new products and new applications forexisting products can be time-consuming and expensive. All of our currentproducts have received marketing clearance from the FDA pursuant to 510(k)pre-market notifications. *Vitrea 2* and *ViTALConnect* and our add-on options have been cleared to bemarketed for use with CT, MR and PET scanners. The FDA may not grant clearance with respect to our futureproducts or enhancements, or future FDA review may involve delays thatcould adversely affect our ability to market such future products orenhancements. In addition, our future products or enhancements may besubject to a more lengthy and expensive pre-market approval process with theFDA.

 

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

 

We market our productsboth domestically and internationally. International regulatory bodies haveestablished varying regulations governing product standards, packaging requirements,labeling requirements, import restrictions, tariff regulations, duties and taxrequirements. Our inability or failure to comply with the varying regulations,or the imposition of new regulations, could restrict our ability to sell ourproducts internationally and could adversely affect our business.

 

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

 

The HIPAA regulations arecausing our customers to request that we sign “business associate” agreementswith them. A “business associate” is a person or entity that performs certainfunctions or activities that involve the use or disclosure of protected healthinformation on behalf of, or that provides services to, a covered entity. Bylaw, the HIPAA Privacy Rule applies only to covered entities – healthplans, health care clearinghouses, and certain health care providers. However,most health care providers do not carry out all of their health care activitiesand functions by themselves. Instead, they often use the services of a varietyof other persons or businesses. The Privacy Rule allows covered providersand health plans to disclose protected health information to these “businessassociates” if the providers or plans obtain satisfactory assurances that thebusiness associate will use the information only for the purposes for which itwas engaged by the covered entity, will safeguard the information from misuse,and will help the covered entity comply with some of the covered entity’sduties under the Privacy Rule. Covered entities may disclose protectedhealth information to an entity in its role as a business associate only to help the covered entity carryout its health care functions – not for the business associate’s independentuse or purposes, except as needed for the proper management and administrationof the business associate. These agreements are necessary for us in the normalcourse of servicing and supporting our products. If we are not willing to orare unable to enter into a business associate agreement with current andpotential customers, such customers may not purchase our products orservices, which would have a material adverse effect on our business, financialcondition, or results of operations.

 

*Uncertain Protection forIntellectual Property; Possible Claims of Others*

 

Although we have receivedpatents and have filed patent applications with respect to certain aspects ofour technology, we generally do not rely on patent protection with respect toour products and technologies. Instead, we rely primarily on a combination oftrade secret and copyright law, employee and third-party nondisclosureagreements and other protective measures to protect intellectual propertyrights pertaining to our products and technologies. Such measures may notprovide meaningful protection of our trade secrets, know-how or otherintellectual property in the event of any unauthorized use, misappropriation ordisclosure. Others may independently develop similar technologies orduplicate our technologies. In addition, to the extent that we apply for anypatents, such applications may not result in issued patents or, if issued,such patents may not be valid or of value. We do not believe that ourproducts and technologies infringe any existing patents or intellectualproperty rights of third parties. However, our products and technologies may infringeexisting patents or intellectual property rights of third parties. The costs ofprosecuting or defending an intellectual property claim could be substantialand could adversely affect our business, even if we are ultimately successfulin prosecuting or defending any such claims. If our products or technologiesare found to infringe the rights of a third party, we could be required to paysignificant damages or license fees or cease production, any of which couldhave a material adverse effect on our business.

 

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*Product Liability Risk; LimitedInsurance Coverage*

 

The manufacture and saleof products used in the practice of medicine entail significant risk of productliability claims. We currently maintain product liability insurance andcoverage limits that we consider to be reasonable. However, our coverage limitsmay not be adequate to protect us from any liabilities we might incur inconnection with claims in connection with our products. Further, we may notbe able to maintain the same level of coverage in the future. We may alsoneed increased product liability coverage as we release additional products andupdates. Such insurance is expensive and may not be available onacceptable terms, if at all. A successful product liability claim or series ofsuch claims against us in excess of our insurance coverage could have amaterial adverse effect on our business, financial condition, or results of operations.

 

*Need to Hire Additional Personnel*

 

Our ability to enhanceand develop markets for our current products and to introduce new products tothe marketplace also depends on our ability to attract and retain qualifiedscientific and management personnel. We compete for such personnel with othercompanies, academic institutions, and government entities and organizations,many of which have greater capital resources, name recognition, and researchand development capabilities. There can be no assurance that we will besuccessful in recruiting or retaining such personnel. We may not be ableto recruit and retain such personnel, which would have a material adverseeffect on our business.

 

*Management of Growth*

 

Ourability to grow successfully requires an effective planning and managementprocess. The expansion and growth of our business could place a significantstrain on our management systems, infrastructure and other resources. To managegrowth successfully, we must continue to improve and expand our systems andinfrastructure in a timely and efficient manner. In addition, the success ofany acquisition, such as our acquisition of HInnovation, Inc. in February 2004,will depend on our ability to successfully integrate the acquired business withour business. Our controls, systems, procedures and resources may not beadequate to support a changing and growing company. If management fails torespond effectively to changes and growth in business, including acquisitions,such failure could have a material adverse effect on our business, financialcondition, or results of operations.

 

*Dependence on Third-PartyReimbursement*

 

Our products arepurchased by hospitals, clinics, imaging centers and other users, which billvarious third party payers, such as government health programs, private healthinsurance plans, managed care organizations and other similar programs, for thehealth care goods and services provided to their patients. There are currentlyCurrent Procedural Terminology (CPT) reimbursement codes for most of thediagnostic procedures that use our products. However, the amount of suchreimbursement varies by location and is subject to change. Payers may denyreimbursement if they determine that a product used in a procedure was not usedin accordance with established payer protocol regarding cost-effectivetreatment methods or was used for an unapproved indication. Third party payersare increasingly challenging the prices charged for medical services and, insome instances, have put pressure on service providers to lower their prices orreduce their services. We are unable to predict what changes will be made inthe reimbursement methods used by third party healthcare payers. Third partypayers may not consider as cost effective the procedures in which ourproducts are used. Reimbursement for such procedures may not be availableor, if available, payers’ low reimbursement levels may adversely affectour ability to sell our products on a profitable basis. In addition, there havebeen and may continue to be proposals by legislators, regulators and thirdparty payers to curb further these costs in the future. A failure by hospitalsand other users of our products to obtain reimbursement from third partypayers, changes in third party payers’ policies toward reimbursement forprocedures using our products or legislative action could have a materialadverse effect on our business, financial condition, or results of operations.

 

*Uncertainty of Health Care Reform*

 

The levels of revenue andprofitability of medical technology companies may be affected by theefforts of government and third party payers to contain or reduce the costs ofhealth care through various means. In the United States, there have been, andwe expect that there will continue to be, a number of federal, state, andprivate proposals to control health care costs. These proposals may containmeasures intended to control public and private spending on health care as wellas to provide universal public access to the health care system. If enacted,these proposals may result in a substantial restructuring of the healthcare delivery system. Significant changes in the nation’s health care systemcould have a substantial impact on the manner in which we conduct business andcould have a material adverse effect on our business, financial condition andresults of operations.

 

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*Possible Issuances of PreferredStock*

 

Our Articles ofIncorporation authorize our Board of Directors, without any action by the holdersof our common stock, to establish the rights and preferences of up to 5,000,000shares of currently undesignated preferred stock. These shares of preferredstock could possess voting and conversion rights that could adversely affectthe voting power of the holders of the common stock or dilute their ownershiprights, and it may have the effect of delaying, deferring or preventing achange in control of Vital Images. No shares of preferred stock or other seniorequity securities are currently designated, and currently we have no plan todesignate or issue any such securities.

 

*Anti-Takeover Considerations*

 

We are subject to “anti-takeover”provisions of the Minnesota Business Corporation Act. In addition, we haveadopted a Shareholder Rights Plan (the “Rights Agreement”) designed to protectagainst unsolicited attempts to acquire Vital Images. These measures may deteror discourage takeover attempts and other changes in control that are notapproved by our Board of Directors, and they may have a depressive effecton any market for our common stock. As a result, our shareholders may loseopportunities to dispose of their shares at the higher prices typicallyavailable in takeover attempts or that may be available under a mergerproposal. In addition, these measures may have the effect of permittingour current directors to retain their positions and place them in a betterposition to resist changes that shareholders may wish to make if they aredissatisfied with the conduct of our business.

 

*No Dividends*

 

We have not paid cashdividends on our common stock in the past, and we do not intend to do so in theforeseeable future. Any payment of dividends will be in the sole discretion ofour Board of Directors.

 

*Limitations on Director Liability*

 

As permitted by Minnesotalaw, our Articles of Incorporation provide that members of our board ofdirectors shall not be personally liable to us or our shareholders for monetarydamages for breach of fiduciary duty as a director, with certain exceptions. Theseprovisions may discourage shareholders from bringing suit against adirector for breach of fiduciary duty and may reduce the likelihood ofderivative litigation brought by shareholders on our behalf against a director.In addition, our Bylaws provide for mandatory indemnification of directors andofficers to the fullest extent permitted by Minnesota law.

 

**Item 1B. Unresolved StaffComments**

 

We have not received anywritten comments that were issued more than 180 days before December 31,2005, the end of the fiscal year covered by this report, from the Securitiesand Exchange Commission staff regarding our periodic or current reports underthe Securities Exchange Act of 1934 that remain unresolved.

 

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**Item 2.****                                   Properties**

 

Our principal office islocated in an office building in Minnetonka, Minnesota, where we currentlyoccupy approximately 41,000 square feet under a lease that expires January 31,2012. We are adding an additional approximately 26,500 square feet in ouroffice building on a phased plan between now and the first quarter of 2007, andhave the right under our lease to expand into an additional approximately20,000 square feet in 2009. We also have a small office in Beijing, China, forour operations in that country.

 

We consider our currentfacilities adequate for our current needs, but continued growth in headcountand our expansion into Europe could require us to obtain additional space. Webelieve that suitable additional space will be available as and if needed.

 

**Item 3.****                                   LegalProceedings**

 

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

 

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

 

There was no mattersubmitted to the vote of security holders during the fourth quarter of the fiscalyear ended December 31, 2005.

 

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**Part II**

 

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

 

The Company’s commonstock is quoted on The Nasdaq Global Market (formerly The Nasdaq NationalMarket) under the symbol “VTAL.”  Thetable below reflects the high and low per share closing sale prices of theCompany’s common stock as reported by The Nasdaq Global Market for each of theperiods indicated. Such prices reflect inter-dealer prices, do not includeadjustments for retail mark-ups, markdowns or commissions, and may notnecessarily represent actual transactions.

 

| ** **     | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------|------------|----------|------------|---------|------------|
| 2005           |       |     |       |    |       |
| Fourth Quarter |       | $        | 28.17      |    | $          | 20.58 |   |
| Third Quarter  |       | $        | 22.26      |    | $          | 18.00 |   |
| Second Quarter |       | $        | 18.95      |    | $          | 14.37 |   |
| First Quarter  |       | $        | 16.14      |    | $          | 13.60 |   |
|           |       |     |       |    |       |
| 2004           |       |     |       |    |       |
| Fourth Quarter |       | $        | 16.95      |    | $          | 12.18 |   |
| Third Quarter  |       | $        | 12.60      |    | $          | 9.84 |   |
| Second Quarter |       | $        | 12.39      |    | $          | 9.26 |   |
| First Quarter  |       | $        | 20.01      |    | $          | 9.34 |   |

 

The Company has neverpaid or declared any cash dividends on its common stock and does not intend topay dividends on its common stock in the near future. To date, the Company hasincurred cumulative operating losses and presently expects to retain its futureanticipated earnings to finance development and expansion of its business. Asof February 28, 2006, there were approximately 7,700 beneficial owners andapproximately 850 registered holders of record of the Company’s common stock.

 

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**Item 6.****                                   SelectedFinancial Data**

 
| ** **                                                 | ** ** | **2005**                                      | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
|------------------------------------------------------------|------------|-----------------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| ** **                                                 | ** ** | **(in thousands, except for per share data)** | ** ** |
| **Years ended December 31:**                          |       |                                          |       |     |       |     |       |     |       |     |       |
| Revenue                                                    |       | $                                             | 51,717     |     | $          | 36,122   |       | $        | 27,300     |     | $          | 21,116 |   | $ | 15,196 |   |
| Gross  profit                                              |       | 40,157                                        |       | 25,675   |       | 20,229   |       | 14,808   |       | 10,723   |       |
|                                                       |       |                                          |       |     |       |     |       |     |       |     |       |
| Operating  expenses                                        |       | 32,592                                        | (1)        | 25,161   | (2)        | 18,294   |       | 14,131   |       | 11,778   |       |
| Operating  income (loss)                                   |       | 7,565                                         |       | 514      |       | 1,935    |       | 677      |       | (1,055   | )          |
|                                                       |       |                                          |       |     |       |     |       |     |       |     |       |
| Net  income (loss)                                         |       | $                                             | 5,801      |     | $          | 296      |       | $        | 8,462      | (3)      | $          | 790 |   | $ | (1,012 | ) |
|                                                       |       |                                          |       |     |       |     |       |     |       |     |       |
| Net  income (loss) per share-basic                         |       | $                                             | 0.47       |     | $          | 0.03     |       | $        | 0.83       |     | $          | 0.09 |   | $ | (0.14 | ) |
|                                                       |       |                                          |       |     |       |     |       |     |       |     |       |
| Weighted  average common shares outstanding – basic   |       | 12,379                                        |       | 11,632   |       | 10,189   |       | 8,861    |       | 7,075    |       |
|                                                       |       |                                          |       |     |       |     |       |     |       |     |       |
| Net  income (loss) per share-diluted                       |       | $                                             | 0.44       |     | $          | 0.02     |       | $        | 0.71       |     | $          | 0.08 |   | $ | (0.14 | ) |
|                                                       |       |                                          |       |     |       |     |       |     |       |     |       |
| Weighted  average common shares outstanding – diluted |       | 13,283                                        |       | 12,536   |       | 11,848   |       | 9,822    |       | 7,075    |       |
|                                                       |       |                                          |       |     |       |     |       |     |       |     |       |
| **At December 31:**                                   |       |                                          |       |     |       |     |       |     |       |     |       |
| Working  capital                                           |       | $                                             | 45,604     |     | $          | 30,996   |       | $        | 31,915     |     | $          | 9,219 |   | $ | 6,094 |   |
| Total  assets                                              |       | $                                             | 91,151     |     | $          | 69,284   |       | $        | 53,063     |     | $          | 18,827 |   | $ | 13,269 |   |
| Long-term  debt                                            |       | $                                             | —     |     | $          | —   |       | $        | —     |     | $          | — |   | $ | — |   |
| Total  stockholders’ equity                           |       | $                                             | 68,789     |     | $          | 54,554   |       | $        | 44,594     |     | $          | 11,721 |   | $ | 8,051 |   |

 

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(1)          Includes a loss onoperating lease of $493 related to the Company’s facility move in the firstquarter of 2005.

(2)          Includes $1,000 ofacquired in-process research and development charge relating to the acquisitionof HInnovation, Inc. in February 2004.

(3)          Includes a net taxbenefit of $6,313 resulting from the reversal of the Company’s valuationallowance for its net deferred tax assets, net of other current year state andfederal income taxes.

 

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

 

**Executivesummary**

 

Vital Images, Inc. (alsoreferred to as “we”, “us” and “our”) achieved significant growth in 2005. Totalrevenue increased 43% to $51.7 million in 2005 compared to $36.1 million in 2004.Pretax income was $8.6million in 2005 compared to $883,000 in 2004. Net income in 2005 was $5.8million, or $0.44 per diluted share, compared to $296,000, or $0.02 per dilutedshare, in 2004. Our 2005 results included amortization of identifiedintangibles of $1.4 million and a loss on operating lease of $493,000 relatedto a facilities move in the first quarter of 2005. Our 2004 results included amortizationof identified intangibles of $1.2 million and an acquired in-process researchand development (“IPR&D”) charge of $1.0 million related to the acquisitionof HInnovation in February 2004.

 

Ourbalance sheet continued to strengthen. Total cash, cash equivalents andmarketable securities were $49.8 million as of December 31, 2005 comparedto $35.7 million as of December 31, 2004. Working capital was $45.6million as of December 31, 2005 compared to $31.0 million as of December 31,2004. Working capital was net of deferred revenue of $11.2 million and $8.1million as of December 31, 2005 and 2004, respectively.

 

Throughoutour history, a significant portion of our revenue has been generated from theU.S. CT market. Going forward, we anticipate a growing contribution from othersources, including an expanding picture archive and communicationsystems (“PACS”) market, salesof Web-based products and sales to our growing installed customer base.

 

**Overview**

 

We are a leading providerof enterprise-wide advanced visualization and analysis solutions for use bymedical professionals in clinical analysis and therapy planning. We providesoftware, third party hardware, training, software maintenance, andprofessional services to our customers. Our technology utilizes high-speedvolume visualization and analysis, as well as network communications based onDICOM and Internet protocols. *Vitrea*®,our flagship software product, rapidly creates accurate, interactive 2D, 3D,and 4D images from information generated by standard computed tomography (“CT”),magnetic resonance (“MR”), and positron emission tomography (“PET”) scanners. *ViTALConnect*TM Software, our Web enabled medical diagnostictool, allows physicians anywhere, anytime access to interactive 2D, 3D, and 4Dadvanced visualization tools.

 

Our products and services address the growing interest amongradiologists, cardiologists, oncologists and other specialists to improve theirworkflow and productivity. Our software provides visualization and analysistools to assist physicians in clinical analysis through standaloneworkstations, PACS (Picture Archiving and Communication Systems) integrations,and Web-based remote viewing and analysis. PACS enable hospitals and clinics toacquire, distribute and archive medical images and diagnostic reports,eliminating the need for film and enhancing productivity. Our Web-based andPACS-based systems allow multiple physicians to collaboratively useenterprise-wide advanced visualization and analysis solutions in their medicalpractices.

 

We operate and manage ourbusiness as a single business segment – the development and marketing ofsoftware and related services for enterprise-wide advanced visualization andanalysis solutions for use by medical professionals in clinical analysis andtherapy planning. We market our products and services through a direct salesforce and independent distributors in the United States and in internationalmarkets. Our common stock is currently traded on The Nasdaq Global Market underthe symbol “VTAL.”

 

**Critical accounting policies and estimates**

 

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

 

We believe the criticalaccounting polices listed below reflect significant judgments, estimates andassumptions used in the 

 

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preparation of our consolidatedfinancial statements.

 

*Allowancefor doubtful accounts*

 

We maintain an allowance for doubtful accounts at anamount estimated to be sufficient to provide adequate protection against lossesresulting from extending credit to our customers. In judging the adequacy ofthe allowance for doubtful accounts, we consider multiple factors, includinghistorical bad debt experience, the general economic environment, the need forspecific client reserves and the aging of our outstanding receivables. Thisprovision is included in operating expenses as a general and administrativeexpense in the consolidated statements of operations. A considerable amount ofjudgment is required in assessing these factors. If the factors utilized indetermining the allowance do not reflect future performance, then a change inthe allowance for doubtful accounts would be necessary in the period suchdetermination has been made, which would impact future results of operations. Asof December 31, 2005, the allowance for doubtful accounts was $320,000 forgross accounts receivable of $14.7 million.

 

*Deferred taxes*

 

Significant judgment isrequired in determining the realizability of our deferred tax assets. We mustassess the likelihood that our net deferred tax assets will be recovered fromfuture taxable income, and to the extent we believe that recovery is notlikely, we must establish a valuation allowance. To the extent that weestablish a valuation allowance, it must include an expense within the taxprovision in the statement of operations. As of December 31, 2005, theconsolidated balance sheet included net deferred tax assets of $9.7 million.

 

Ourmethodology for determining the realizability of our deferred tax assetsinvolves estimates of future taxable income from our core business, the estimatedimpact of future tax deductions from the exercise of stock options outstandingas of each balance sheet date, and the expiration dates and amounts of netoperating loss carryforwards and other tax credits. These estimates areprojected through the life of the related deferred tax assets based onassumptions which we believe to be reasonable and consistent with currentoperating results.

 

Althoughwe had cumulative pre-tax income for financial reporting purposes for the threeyears ended December 31, 2005, we did not pay any significant income taxesfor that period due to tax deductions from the exercise of stock options aswell as our utilization of net operating losses. In assessing the realizabilityof our deferred tax assets as of each balance sheet date, we consideredevidence regarding our ability to generate sufficient future taxable income torealize our deferred tax assets. The primary evidence considered included thecumulative pre-tax income for financial reporting purposes for the past threeyears; the estimated impact of future tax deductions from the exercise of stockoptions outstanding as of December 31, 2005; and the estimated futuretaxable income based on historical operating results.

 

Aftergiving consideration to these factors, we concluded that it was more likelythan not that tax loss carryforwards will be realized prior to expiration andother tax credits that expire prior to 2010 will not be utilized due to theestimated future tax deductions from the exercise of stock options outstandingas of December 31, 2005 as well as utilization of tax loss carryforwards. Asa result, we have a valuation allowance of $289,000 as of December 31,2005 relating to net operating losses and tax credits that expire prior to2010.

 

Wealso concluded that it was more likely than not that the net deferred taxassets of $9.7 million as of December 31, 2005 and the estimated futuretax deductions from the exercise of stock options outstanding as of December 31,2005 would be utilized prior to expiring. Based on this conclusion, we willrequire approximately $55.6 million in cumulative future taxable income to begenerated at various times over the next 20 years to realize the related netdeferred tax assets of $9.7 million as of December 31, 2005 as well as theestimated future tax deductions from the exercise of stock options outstandingand in-the-money as of December 31, 2005.

 

If we adjust either ourestimates of future taxable income or tax deductions from the exercise of stockoptions down, or our stock price increases significantly without an increase intaxable income, causing us to believe that our deferred tax assets will not beutilized, we may need to establish additional valuation allowances on ourdeferred tax assets, which could materially impact our financial position andresults of operations.

 

*Long-lived assets*

 

We review long-livedassets for impairment whenever events or changes in circumstances indicate thecarrying amount may not be recoverable, in accordance with Statement ofFinancial Accounting Standards (“SFAS”) No. 144, “Accounting for theImpairment or Disposal of Long-Lived Assets.” Events or changes in circumstances that indicate the carrying amount may 

 

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not be recoverable include,but are not limited to, a significant decrease in the market value of thebusiness or asset acquired, a significant adverse change in the extent ormanner in which the business or asset acquired is used, or a significantadverse change in the business climate. If such events or changes incircumstances are present, the undiscounted cash flows method is used todetermine whether the asset is impaired. Cash flows would include the estimatedterminal value of the asset and exclude any interest charges. To the extent thecarrying value of the asset exceeds the undiscounted cash flows over theestimated remaining life of the asset, the impairment is measured using thediscounted cash flows. The discount rate utilized would be based on our bestestimate of the related risks and return at the time the impairment assessmentis made.

 

Our long-lived assetsconsist of property and equipment of $5.4 million, licensed technology of $210,000and other intangible assets subject to amortization of $4.5 million as of December 31,2005.

 

*Goodwill*

 

We account for goodwillin accordance with the provisions of SFAS No. 142, “Goodwill and OtherIntangible Assets.”  Under SFAS No. 142,goodwill and intangible assets with indefinite lives are reviewed forimpairment annually or more frequently if events or changes in circumstancesindicate that the asset might be impaired. The first step of the goodwillimpairment test, used to identify potential impairment, compares the fair valueof a reporting unit with its carrying amount, including goodwill. We operate asone reporting unit and therefore compare the book value to the market value(market capitalization plus a control premium). If the market value exceeds thebook value, goodwill is considered not impaired, and thus the second step ofthe impairment test is not necessary. If our book value exceeds the marketvalue, the second step of the goodwill impairment test is performed to measurethe amount of impairment loss, if any. The second step of the goodwillimpairment test, used to measure the amount of impairment loss, compares theimplied fair value of the goodwill with the book value of the goodwill. If thecarrying value of the goodwill exceeds the implied fair value of the goodwill,an impairment loss would be recognized in an amount equal to the excess. Anyloss recognized cannot exceed the carrying amount of goodwill. After a goodwillimpairment loss is recognized, the adjusted carrying amount of goodwill is itsnew accounting basis. Subsequent reversal of a previously recognized goodwillimpairment loss is prohibited once the measurement of that loss is completed. Wecompleted the annual goodwill impairment assessment as of December 31, 2005,in which no impairment was identified. Goodwill was $6.1 million as of December 31,2005.

 

*Agreement with R2 Technology, Inc.*

 

In April 2005, weentered into an agreement with R2 Technology, Inc. (“R2”) to market R2’slung nodule CAD software product to our customers. The April 2005agreement replaced our November 2002 agreement with R2. Under the April 2005agreement, all previous commitments were cancelled and replaced with a newcommitment which began in the third quarter of 2005. The new commitmentprovides R2 with certain minimum quarterly revenues (“Applicable Minimums”)from the sale of certain R2 lung CAD related products and services (“R2 LungCAD Products”) over a 12-quarter period ending June 30, 2008. We willreceive a commission based on sales of R2 Lung CAD Products to our customers. Thisagreement states that to the extent the quarterly Applicable Minimum is notmet, we will pay R2 the difference between the Applicable Minimum and theactual R2 Lung CAD Product revenue achieved.

 

The Applicable Minimumsfor the quarters ending December 31, 2005 and March 31, 2006 are$414,000 per quarter. However, beginning in the quarter ending June 30,2006 and for each subsequent quarter thereafter, the Applicable Minimum will bereduced to the lowest of:

 

i)                                         theApplicable Minimum in the preceding quarter;

ii)                                      theApplicable Minimum of the preceding quarter multiplied by the percent by whichthe R2 Lung CAD Product revenue in the preceding quarter fell below thatquarter’s Applicable Minimum, up to a maximum decline of twenty-three percent(23%); or

iii)                                   twotimes the R2 Lung CAD Product revenue generated by R2 during the precedingquarter through all other sales, marketing and distribution channels, excludingR2 Lung CAD Product revenue generated from Customers under the agreement.

 

If at any time during theremainder of the R2 agreement, the Applicable Minimum is less than $414,000 andR2 Lung CAD Product revenue for a quarter exceeds $414,000, the ApplicableMinimum for the next quarter will be $414,000. Thereafter, the ApplicableMinimums will be subject to the above adjustment. Additionally, at the end ofevery fourth quarter under the April 2005 R2 agreement, if the aggregaterevenue generated under the agreement in the previous four quarters exceeded$1,665,000, the remaining Applicable Minimum per quarter shall be reduced bythe amount of excess divided by the number of quarters remaining under theagreement.

 

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The Applicable Minimumfor the quarter ended December 31, 2005 was not met by approximately$314,000 and, based on current estimates, we believe it is probable that theestimated aggregate Applicable Minimums will not be met for the quarter ending March 31,2006. Additionally, we estimate that the Applicable Minimum will be $0 after March 31,2006, as, based on information available to us, R2 has not generated any R2Lung CAD Product revenue through any other sales, marketing and distributionchannels, other than R2 Lung CAD Product revenue generated from Customers underthis agreement. Based on these results and future estimates, we recorded a$410,000 net loss to sales and marketing expense in the quarter ended December 31,2005 relating to this agreement to cover estimated losses through March 31,2006. The $410,000 net loss is based on the fourth quarter of 2005 shortfall of$314,000 and first quarter of 2006 Applicable Minimum of $414,000, offset bythe estimated forecasted revenues of $140,000, by the deferred commission feeson sales as of December 31, 2005 of $142,000 and estimated deferredcommission fee on forecasted revenues of $36,000. However, the estimatedaggregate Applicable Minimums are a subjective determination, and any changesto estimates and actual results could have an adverse impact on our financialposition and results of operations. As of December 31, 2005, the remainingpotential aggregate Applicable Minimums range from a minimum of approximately$414,000 to a maximum of approximately $4.1 million. Any future losses will berecorded under SFAS No. 5 “Accounting for Contingencies,” which requiresthe amount to be probable and estimable.

 

We have not recognizedany commission revenue relating to this agreement, as it was not considered tobe fixed or determinable due to the potential for payments by us to R2 relatingto the Applicable Minimums.

 

*Revenue Recognition*

 

We follow specific anddetailed guidelines in determining the proper amount of revenue to be recorded;however, certain judgments affect the application of our revenue recognitionpolicy. Revenue results are difficult to predict, and any shortfall in revenueor delay in recognizing revenue could cause our operating results to varysignificantly from period to period.

 

The significant judgmentsfor revenue recognition typically involve whether collectability can beconsidered probable and whether fees are fixed or determinable. In addition, ourtransactions often consist of multiple element arrangements, which must beanalyzed to determine the relative fair value of each element, the amount ofrevenue to be recognized upon shipment, if any, and the period and conditionsunder which deferred revenue should be recognized.

 

We recognize revenue inaccordance with American Institute of Certified Public Accountants (“AICPA”)Statement of Position (“SOP”) 97-2, Software Revenue Recognition, as amended bySOP 98-4 and SOP 98-9, as well as Technical Practice Aids issued from time totime by the AICPA, and SEC Staff Accounting Bulletin No. 104. We recognizerevenue when it is realized or realizable and earned. We consider revenuerealized or realizable and earned when it has persuasive evidence of anarrangement, the product has been shipped or the services have been provided tothe customer, the sales price is fixed or determinable, and collectability isprobable. Provided all other revenue recognition criteria are met, licenserevenue from Resellers is recognized on a sell-in or sell-through basisdepending on the arrangement with the Reseller. We recognize revenue fromResellers on a sell-in basis provided the Reseller i) assumes all risk of thepurchase, ii) has the ability and obligation to pay regardless of receivingpayment from the end user, and iii) has a history of timely payments.

 

License fees revenue isderived from the licensing of computer software. Hardware revenue is derivedfrom the sale of system hardware, including peripheral equipment. Maintenanceand service revenue is derived from software maintenance and from telephone support,installation, training and consulting services. Our software licenses arealways sold as part of an arrangement that includes maintenance andsupport and often installation and training services.

 

We license our softwareand sell products and services to end-users and also indirectly throughoriginal equipment manufacturers (“OEMs”) and independent distributors(collectively, “Resellers”). Terms offered by us do not generally differ basedon whether the customer is an OEM, an end-user or a Reseller. We generally offerterms that require payment within 30 to 90 days after product delivery. In raresituations where we offer terms that require payment beyond 90 days afterproduct delivery, revenue is deferred until the payment becomes due. We do notgenerally offer rights of return, acceptance clauses or price protection to ourcustomers. In rare situations where we provide rights of return or acceptanceclauses, revenue is deferred until the clause expires. We evaluate the creditworthiness of all customers. In circumstances in which we do not haveexperience selling to a customer and lack adequate credit information toconclude that collection is probable, revenue is deferred until the arrangementfees are collected and all other revenue recognition criteria in thearrangement have been met. Additionally:

 

•                  Softwareand Hardware – Revenue from license fees and hardware is recognized whenshipment of the product has occurred, no significant obligations with regard toproduct implementation remain and our services are not considered essential tothe functionality of other elements of the arrangement.

 

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•                  Services– Revenue from maintenance and support arrangements is deferred and recognizedratably over the term of the maintenance and support arrangements. Revenue fromtraining, installation and consulting services is recognized as the servicesare provided to customers.

 

•                  Multiple-ElementArrangements – We enter into arrangements with customers that include acombination of software products, system hardware, specified upgrades,maintenance and support, or installation and training services. For sucharrangements, we recognize revenue using the residual value method. We allocatethe total arrangement fee among the various elements of the arrangement basedon the relative fair value of each of the undelivered elements determined byvendor-specific objective evidence. The fair value of maintenance and supportservices is based upon the renewal rate for continued service arrangements. Thefair value of installation and training services is established based upon soldseparately pricing for the services. In software arrangements for which we donot have vendor-specific objective evidence of fair value for all elements,revenue is deferred until the earlier of when vendor-specific objectiveevidence is determined for the undelivered elements (residual method) or whenall elements for which we do not have vendor-specific objective evidence offair value have been delivered.

 

**Results of Operations**

 

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

 
| ** **                                    | ** ** | **For the Years Ended December 31,** | ** ** |
|-----------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                    | ** ** | **2005**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                          |       |                                      |       |   |   |   |   |
| Revenue:                                      |       |                                      |       |   |   |   |   |
| License  fees                                 |       | 68.1                                      | %          | 66.6 | % | 67.4 | % |
| Maintenance  and services                     |       | 27.7                                      |       | 26.4 |   | 25.1 |   |
| Hardware                                      |       | 4.2                                       |       | 7.0 |   | 7.5 |   |
| Total  revenue                                |       | 100.0                                     |       | 100.0 |   | 100.0 |   |
|                                          |       |                                      |       |   |   |   |   |
| Cost of revenue:                              |       |                                      |       |   |   |   |   |
| License  fees                                 |       | 9.1                                       |       | 11.1 |   | 6.7 |   |
| Maintenance  and services                     |       | 10.7                                      |       | 12.8 |   | 13.8 |   |
| Hardware                                      |       | 2.6                                       |       | 5.0 |   | 5.4 |   |
| Total  cost of revenue                        |       | 22.4                                      |       | 28.9 |   | 25.9 |   |
|                                          |       |                                      |       |   |   |   |   |
| Gross  profit                                 |       | 77.6                                      |       | 71.1 |   | 74.1 |   |
|                                          |       |                                      |       |   |   |   |   |
| Operating expenses:                           |       |                                      |       |   |   |   |   |
| Sales  and marketing                          |       | 32.7                                      |       | 33.8 |   | 34.1 |   |
| Research  and development                     |       | 15.8                                      |       | 17.5 |   | 18.9 |   |
| General  and administrative                   |       | 13.5                                      |       | 15.6 |   | 14.0 |   |
| Loss  on operating lease                      |       | 1.0                                       |       | — |   | — |   |
| Acquired  in-process research and development |       | —                                    |       | 2.8 |   | — |   |
| Total  operating expenses                     |       | 63.0                                      |       | 69.7 |   | 67.0 |   |
|                                          |       |                                      |       |   |   |   |   |
| Operating  income                             |       | 14.6                                      |       | 1.4 |   | 7.1 |   |
|                                          |       |                                      |       |   |   |   |   |
| Interest income                               |       | 2.1                                       |       | 1.0 |   | 0.8 |   |
| Income before income  taxes                   |       | 16.7                                      |       | 2.4 |   | 7.9 |   |
|                                          |       |                                      |       |   |   |   |   |
| Provision (benefit) for  income taxes, net    |       | 5.5                                       |       | 1.6 |   | (23.1 | ) |
| Net income                                    |       | 11.2                                      | %          | 0.8 | % | 31.0 | % |

 

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**Revenue**

 

Total revenue increased 43%to $51.7 million in 2005 from $36.1 million in 2004. Total revenue increased 32%to $36.1 million in 2004 from $27.3 million in 2003. The revenue growth wasdriven by an increase in our core revenue components of software license fees, includingrevenue from software options and maintenance and service revenue from a largerinstalled base of customers.

 

License fee revenueincreased 46% to $35.2 million from $24.1 million in 2004. License fee revenue increased31% to $24.1 million in 2004 from $18.4 million in 2003. The increase inlicense fee revenue was driven by an increase in the number of Vitrea licensessold and an increase in average revenue per Vitrea license sold due to anincrease in the sales price and an increase in the percentage of licenserevenue generated outside of our Toshiba relationship, as sales through Toshibahave lower average revenue per transaction. The installed base of Vitreacustomers increased from approximately 1,300 at December 31, 2003 toapproximately 1,900 at December 31, 2004 and to approximately 2,750 at December 31,2005. Revenue from Vitrea licenses increased 82% to $14.5 million in 2005 from$7.9 million in 2004, which was a decrease of 11% from $8.9 million in 2003. Vitreaoption revenue (includingthird party software) increased 24% to $19.9 million in 2005 from $16.0 million in 2004, which was a  78% increase from $9.0 million in 2003. In 2005, software license fee revenue fromsales through our distribution partnership with Toshiba increased 34% to $17.2million in 2005 from $12.9 million in 2004, which was a 55% increase from $8.3million in 2003. License fee revenue from Toshiba represented 49%, 54% and 45%of license fee revenue, respectively. All revenue from Toshiba represented 47%,50% and 42% of total revenue in 2005, 2004 and 2003, respectively.

 

Maintenanceand services revenue increased 50% to $14.3 million in 2005 compared to $9.5million in 2004. Maintenance and services revenue increased 39% to $9.5 millionin 2004 compared to $6.8 million in 2003. The $4.8 million increase in totalmaintenance and services revenue in 2005 included a $4.0 million increase inmaintenance revenue to $9.7 million, a $642,000 increase in training revenue to$3.7 million, and a $224,000 increase in installation revenue to $798,000. The$2.7 million increase in total maintenance and services revenue in 2004consisted of a $2.0 million increase in maintenance revenue to $5.8 million anda $1.1 million increase in training revenue to $3.1 million, offset by a$380,000 decrease in engineering services revenue from product developmentagreements with Medtronic Surgical Navigation Technologies (“SNT”), E-Z-EM, Inc.and Toshiba. The increases in maintenance revenues in each year were due to asignificant increase in our installed base of customers, as well as increasedpricing on maintenance related services. The increase in training revenue andinstallation revenue was due to an increase in the number of Vitrea licensessold each year.

 

Hardware revenuedecreased 15% to $2.2 million in 2005 compared to $2.5 million in 2004. Hardware revenue increased 23% to $2.5million in 2004 compared to $2.1 million in 2003. We sell hardware as aconvenience to our customers, and fluctuations are driven by individualcustomer purchasing preferences. Sales of hardware systems are not core to ourstrategy and will fluctuate from period to period depending upon the needs ofour customers.

 

**Cost of revenue**

 

Gross profit increased 56%to $40.2 million in 2005 compared to $25.7 million in 2004. Gross profitincreased 27% to $25.7 million in 2004 compared to $20.2 million in 2003. Grossmargin percentage increased to 78% in 2005 compared to 71% in 2004, which was adecrease from 74% in 2003.

 

A comparison of grossprofit and gross margin by revenue category is as follows:

 

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| ** **                | ** ** | **For the years ended December 31,** | ** ** |
|---------------------------|------------|-------------------------------------------|------------|
| ** **                | ** ** | **2005**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
|                      |       |                                      |       |   |   |   |   |
| Gross profit:             | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| License  fees             |       | $                                         | 30,546,173 |   | $ | 20,060,269 |   | $ | 16,570,441 |   |
| Maintenance  and services |       | 8,764,627                                 |       | 4,864,358 |   | 3,070,676 |   |
| Hardware                  |       | 846,364                                   |       | 750,339 |   | 587,540 |   |
| Total  gross profit       |       | $                                         | 40,157,164 |   | $ | 25,674,966 |   | $ | 20,228,657 |   |
|                      |       |                                      |       |   |   |   |   |
| Gross margin:             | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| License  fees             |       | 87                                        | %          | 83 | % | 90 | % |
| Maintenance  and services |       | 61                                        | %          | 51 | % | 45 | % |
| Hardware                  |       | 39                                        | %          | 30 | % | 28 | % |
| Total  gross margin       |       | 78                                        | %          | 71 | % | 74 | % |

 

License fee gross marginsincreased to 87% in 2005 compared to 83% in 2004. The increase in 2005 was dueto an increase in average revenue per Vitrea license sold due to an increase inthe sales price and an increase in the percentage of license revenue generatedoutside of our Toshiba relationship, as sales through Toshiba have loweraverage revenue per transaction; an increase in total Vitrea option revenue,which has lower associated costs; and a decrease in the sales of third-partysoftware options, which carry a lower margin than software that has beendeveloped internally. License fee gross margins decreased to 83% in 2004compared to 90% in 2003. The decrease in 2004 was due to an increase in thecost of third-party software, which was up $1.1 million over 2003, and anincrease of $976,000 in amortization expense related to acquired HInnovationintangible assets. In addition, royalties paid to third parties who supply technology that is embedded in ourproducts was $2.3 million, $1.6 million and $1.5 million in 2005, 2004 and2003, respectively. The increase in royalty expense is a direct result ofselling more Vitrea licenses. Amortization charged to cost of revenue relatedto the HInnovation acquisition was $1.1 million, $976,000 and $0 in 2005, 2004and 2003, respectively. As revenue continues to increase, amortizationexpense as a percentage of license revenue will decrease. As a result of third partysoftware sales and revenue mix, license fee gross margin will continue tofluctuate based on these factors.

 

Maintenance and servicesgross margin increased to 61% in 2005 compared to 51% in 2004. Margins onmaintenance and services increased to 51% in 2004 from 45% in 2003. The increasesin both 2005 and 2004 were due to increased pricing on maintenance services andincreased revenue from a growing installed base, without an increase in costsat a similar rate. Wewill continue to invest in our training, installation, professional servicesand customer support areas in the future to adequately support our growinginstalled base of customers, as well as to evaluate maintenance and servicespricing as our cost structure increases, which could have an impact onmaintenance and services gross margins in the future.

 

Hardware gross marginincreased to 39% in 2005 compared to 30% in 2004. Hardware gross marginincreased to 30% in 2004 from 28% in 2003. Hardware gross margin washistorically volatile but has stabilized in 2005 as pricing has increased and hasbecome more consistent.

 

**Sales and marketing**

 

Sales and marketingexpenses increased 39% to $16.9 million in 2005 compared to $12.2 million in2004. Sales and marketing expenses increased 31% to $12.2 million in 2004compared to $9.3 million in 2003. Sales and marketing expenses as a percentageof revenue were 33%, 34% and 34% in 2005, 2004 and 2003, respectively.

 

The increases in expensesfor all periods were due to increases in compensation costs as a result ofadditional personnel, higher sales commission expenses from significantlyincreased revenue and higher costs related to supporting our presence at anincreased number of industry tradeshows. Salaries, benefits and bonus-relatedexpenses, excluding commissions, increased $878,000 to $5.5 million in 2005compared with $4.6 million in 2004, and increased $1.1 million to $4.6 millionin 2004 compared to $3.5 million in 2003, with the increases being drivenprimarily by additional personnel required to drive and support our rapidgrowth. We had 50, 45 and 38 sales and marketing personnel as of December 31,2005, 2004 and 2003, respectively. Commissions expense increased $1.3 million to$4.2 million in 2005 compared with $2.9 million 2004, and increased $682,000 to$2.9 million in 2004 compared to $2.3 million in 2003, as commissions expensehas a direct correlation to increased revenue. Also, as a result of increasedpersonnel, travel and entertainment related expenses increased $168,000 to $1.7million in 2005 compared with $1.5 million in 2004, and increased $440,000 to$1.5 million in 2004 compared to $1.1 million in 2003. In addition, we havesignificantly increased our presence at industry tradeshows, and 

 

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tradeshow, advertisingand marketing collateral related expenses increased $861,000 million to $1.9million in 2005 compared with $1.0 million in 2004, and increased $387,000 to$1.0 million in 2004 compared to $652,000 in 2003. In the fourth quarter of2005, we recorded a $410,000 loss on contract relating our agreement with R2Technology, Inc., see “Critical accounting policies and estimates – Agreementwith R2 Technology, Inc.” for further discussion.

 

We expect sales andmarketing expenses to continue to increase in future periods primarily as aresult of the need to support additional growth through the hiring of sales andmarketing personnel.

 

**Research and development**

 

Research and developmentexpenses increased 29% to $8.1 million in 2005 compared to $6.3 million in 2004.Research and development expenses increased 22% to $6.3 million in 2004compared to $5.2 million in 2003. Research and development expenses as apercentage of revenue were 16%, 18% and 19% in 2005, 2004 and 2003,respectively.

 

The increases in expensesfor all periods were due in part to increases in compensation costs as aresult of additional personnel. Salaries, benefits and bonus-related expensesincreased $964,000 to $5.4 million in 2005 compared with $4.4 million in 2004,and increased $651,000 to $4.4 million in 2004 compared to $3.7 million in 2003.The increases were caused primarily by the costs of additional personnel tocontinue expanding our product development efforts. We had 62, 50 and 38 researchand development personnel as of December 31, 2005, 2004 and 2003,respectively.  In addition, contract andconsulting costs increased $442,000 to $646,000 in 2005 compared to $204,000 in2004, and increased $162,000 to $204,000 in 2004 compared to $42,000 in 2003,as we continue to require additional temporary assistance in completing certainresearch and development activities, specifically in the area of softwaretesting and validation.

 

We expect research anddevelopment expenses to continue to increase in future periods primarily as aresult of additional personnel required to support the expansion of our productdevelopment activities so that we can maintain our status as an industry leaderin advanced visualization.

 

**General and administrative**

 

General and administrativeexpenses increased 25% to $7.0 million in 2005 compared to $5.6 million in 2004.General and administrative expenses increased 48% to $5.6 million in 2004compared to $3.8 million in 2003. General and administrative expenses as apercentage of revenue were 14%, 16% and 14% in 2005, 2004 and 2003,respectively.

 

The increases in allperiods were due in part to increases in compensation costs as a result ofadditional personnel and increasing regulatory, legal and consulting relatedexpenses. Salaries, benefits and bonus related expenses increased $1.5 million to$3.6 million in 2005 compared with $2.1 million in 2004, and increased $345,000to $2.1 million in 2004 compared to $1.8 million in 2003. The increases werecaused primarily by the costs of additional personnel to support increasinginfrastructure and other administrative needs of a growing business. There were30, 23 and 20 general and administrative personnel as of December 31,2005, 2004 and 2003, respectively.  Inaddition, because of increasing regulatory requirements, includingSarbanes-Oxley, fees related to audit and legal services and contract andtemporary workers increased $730,000 to $1.7 million in 2005, compared with $949,000in 2004 and increased $307,000 in 2004 compared with 2003. The 2005 increaseswere offset in part by a net $786,000 fluctuation in bad debt expenserelated to the recovery of previously reserved-for receivables. In 2004, baddebt expense increased by $580,000 as a result of the establishment of reservesfor specific past due accounts.

 

We expect general andadministrative expenses to continue to increase in future periods primarily asa result of additional personnel required to support increasing regulatoryrequirements, and as the costs of being a public company continue to rise.

 

**Other items**

 

Loss on operating lease –In March 2004, we signed a non-cancelable operating lease for a new officefacility in Minnetonka, Minnesota. The new lease term started in February 2005and expires in January 2012. We moved into the Minnetonka location andmoved out of the Plymouth, Minnesota location in February 2005. Our leasefor the office facility in Plymouth expired on July 31, 2005, with theexception of a small portion of the space that is under lease until May 31,2006. Under the terms of the Minnetonka lease, since February 2005, thelessor is to pay the monthly base rent payments and taxes and operating costrent obligation payments for our former office in Plymouth.  In the first quarter of 2005, we recorded alease loss of $493,000 related to the abandonment of the Plymouth office. Theestimated lease payments to be made by the Minnetonka landlord to the Plymouthlandlord are considered a lease incentive and recorded as an immediate chargeand deferred rent, which is amortized as a reduction of rent expense throughthe term of the lease.

 

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Acquired in-processresearch and development – Results for the first quarter of 2004 included a$1.0 million write-off of in-process research and development costs related tothe HInnovation acquisition.

 

**Interest income**

 

We generated $1.1 millionof interest income in 2005, compared with $368,000 in 2004 and $214,000 in 2003.The increases were primarily due to increases in cash, cash equivalents andmarketable securities, which were generated from increased cash flows in allperiods, and an increase in interest rates.

 

**Income taxes**

 

Ourmethodology for determining the realizability of our deferred tax assetsinvolves estimates of future taxable income from our core business, theestimated impact of future tax deductions from the exercise of stock optionsoutstanding as of each balance sheet date, and the expiration dates and amountsof net operating loss carryforwards and other tax credits. These estimates areprojected through the life of the related deferred tax assets based onassumptions which we believe to be reasonable and consistent with currentoperating results.

 

Althoughwe had cumulative pre-tax income for financial reporting purposes for the threeyears ended December 31, 2005, we did not pay any significant income taxesfor that period due to tax deductions from the exercise of stock options aswell as our utilization of net operating losses. In assessing the realizabilityof our deferred tax assets as of each balance sheet date, we consideredevidence regarding our ability to generate sufficient future taxable income torealize our deferred tax assets. The primary evidence considered included thecumulative pre-tax income for financial reporting purposes for the past threeyears; the estimated impact of future tax deductions from the exercise of stockoptions outstanding as of December 31, 2005; and the estimated futuretaxable income based on historical operating results.

 

Aftergiving consideration to these factors, we concluded that it was more likelythan not that tax loss carryforwards will be realized prior to expiration andother tax credits that expire prior to 2010 will not be utilized due to theestimated future tax deductions from the exercise of stock options outstandingas of December 31, 2005 as well as utilization of tax loss carryforwards. Asa result, we have a valuation allowance of $242,000 as of December 31,2005 relating to tax credits that expire prior to 2010.

 

Wealso concluded that it was more likely than not that the net deferred taxassets of $9.7 million as of December 31, 2005 and the estimated futuretax deductions from the exercise of stock options outstanding as of December 31,2005 would be utilized prior to expiring. Based on this conclusion, we willrequire approximately $55.6 million in cumulative future taxable income to begenerated at various times over the next 20 years to realize the related netdeferred tax assets of $9.7 million as of December 31, 2005 as well as theestimated future tax deductions from the exercise of stock options outstandingand in-the-money as of December 31, 2005.

 

If we adjust either ourestimates of future taxable income or tax deductions from the exercise of stockoptions down, or our stock price increases significantly without an increase intaxable income, causing us to believe that our deferred tax assets will not beutilized, we may need to establish additional valuation allowances on ourdeferred tax assets, which could materially impact our financial position andresults of operations.

 

During2003, we concluded that it is more likely than not that substantially all of ournet deferred tax assets would be realized, and we reversed substantially all ofour valuation allowance for net deferred tax assets, which resulted in therecording of a net tax benefit in 2003. The reversal of the deferred tax assetsvaluation allowance was based upon our historical operating performance andmanagement’s expectation that we would generate taxable income of at least $25million in future periods to allow us to realize the deferred tax assetsresulting from the tax benefits associated with our net operating losscarryforwards and a significant portion of our research and development taxcredit carryforwards, as well as certain other tax benefits related to book andtax income timing differences. The reversal of the valuation allowance resultedin a tax benefit of $7.2 million. This reversal, net of other current yearstate and federal income taxes, resulted in a net tax benefit of $6.5 millionin 2003.

 

Our effective income taxrate was 33%, 67%, and (294%) in 2005, 2004 and 2003, respectively. As notedabove, we recorded a net tax benefit in 2003 relating to the reversal of our valuationallowance, which resulted in abnormal effective tax rate of (294%). Oureffective tax rate of 67% in 2004 was impacted by the mix between our U.S.operating results, for which we record income taxes, and our foreign operatingresults, for which we did not record an income tax benefit due to theuncertainty of realizing these tax benefits in future years in our foreignjurisdictions. During 2005, we completed a transfer 

 

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pricing study for ourforeign operations in China, which resulted in a more normalized tax rate of33%. Based on current estimates, we anticipate an effective income tax rate ofapproximately 37% to 38% in 2006. The increase in the estimated effective taxrate is due to the expiration of the research and development (“R&D”) taxcredit on December 31, 2005; the R&D tax credit reduced our 2005effective tax rate by four percentage points. There is current legislation inCongress that would extend the R&D tax credit and, if approved, we wouldexpect an effective tax rate between 33% and 36% in 2006. We do not anticipatepaying any significant income taxes for the next three to six years due to theutilization of net operating losses and tax deductions from the exercise ofstock options.

 

**Liquidityand capital resources**

 

As of December 31,2005, we had $20.8 million in cash and cash equivalents, $29.0 million inmarketable securities, working capital of $45.6 million and no borrowings, ascompared to $24.1 million in cash and cash equivalents, $11.5 million inmarketable securities, working capital of $31.0 million and no borrowings as ofDecember 31, 2004.

 

*Operating activities*

 

During 2005, cashprovided by operations was $13.7 million, which consisted of a decrease of$101,000 from changes in working capital accounts, an increase of $1.2 millionin deferred rent relating to payments and estimated payments to be made by ourMinnetonka landlord for our benefit, and an increase of $12.6 million fromother operating activities. Changes in working capital accounts primarilyrelated to an increase in accounts receivable of $6.1 million and an increasein deferred revenue of $3.5 million due to increased sales and an increasedcustomer base. Days’ sales outstanding as of December 31, 2005 increasedto 101 days, compared to 82 days as of December 31, 2004, which increasedas a result of a significant portion of sales occurring in the third month ofthe fourth quarter of 2005. Our aging remains relatively current with less than2% of receivables greater than 90 days past due as of December 31, 2005and 2004. We use days’ sales outstanding as an activity measure which placesemphasis and focus on accounts receivable, but the measure used by us isnot defined under U.S. generally accepted accounting principles, and similarlytitled measures may not be computed the same by other companies. Otherchanges in working capital accounts included a decrease in prepaid and othercurrent assets of $135,000; an increase of $740,000 in accounts payable due toincreased operating costs and general timing of payments to vendors; and anincrease of $1.9 million related to accruals for bonuses and royalty payments.

 

During 2004, cashprovided by operations was $7.6 million, which consisted of an increase of $1.8million in working capital accounts and $5.8 million in cash flow from otheroperating activities. The increase in accounts receivable was due to oursignificant overall revenue increase in the fourth quarter of 2004 versus thesame period in 2003. The increase in deferred revenue was due to the increasein maintenance and services on a year-over-year basis and an overall increasein customer base to which these services are sold. The increase in accruedexpenses and other current liabilities was primarily due to an overall increasein operations and the general timing of cash disbursements in the fourthquarter of 2004. Cash flows from other operating activities in 2004 consistedprimarily of non-cash expenses related to the amortization from identifiedintangibles and an in-process research and development charge related to the February 2004HInnovation acquisition, an increased provision for doubtful accounts relatedto the establishment of reserves for specific customer accounts, depreciationand amortization of property and equipment, and a tax benefit related to theexercise of stock options. Days’ sales outstanding as of December 31, 2004increased to 82 days compared to 65 days as of December 31, 2003.

 

Cash provided byoperations was $4.4 million in 2003, which consisted of an increase in workingcapital accounts of $760,000 in 2003 and cash flow from other operatingactivities of $3.6 million in 2003.

 

*Investing activities*

 

We used $21.7 million, $15.7million and $3.4 million of cash in investing activities in 2005, 2004 and 2003,respectively.

 

We used $4.3 million, $1.6 million and $1.9 million for purchases ofproperty and equipment in 2005, 2004 and 2003, respectively. The purchases for all periods were principally toupgrade computer equipment and to purchase computer equipment for new personnel.In addition, we purchased furniture and fixtures and leasehold improvementsrelated to our move to our Minnetonka headquarters in the first quarter of 2005and expansions of our former facilities in 2004 and 2003. We anticipate that wewill continue to purchase property and equipment necessary in the normal courseof business. The amount and timing of these purchases and the related cashoutflows in future periods are difficult to predict and depend on a number offactors, including the hiring of employees and the rate of change of computerhardware.

 

Weused $38.8 million, $30.4 million and $6.8 million to purchase investments in marketablesecurities during 2005, 2004 and 2003, respectively. We realized $21.4 million, $22.5 million and $5.2million of proceeds from sales of marketable 

 

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securitiesduring 2005, 2004 and 2003,respectively. The marketable securities consist of U.S. government obligations,U.S. government agency obligations, corporate commercial obligations andcertificates of deposits.

 

During the first quarterof 2004, the Company completed the acquisition of HInnovation, Inc. inaccordance with the terms and conditions of an Acquisition Agreement and Planof Reorganization dated as of January 8, 2004, using $6.1 million of cash.See Note 3 to the Consolidated Financial Statements for additional informationon the acquisition.

 

*Financing activities*

 

Cashprovided by financing activities totaled $4.7 million, $2.2 million, and $21.1million for 2005, 2004 and 2003, respectively. The cash provided by financing activities in 2005 and2004 resulted primarily from the exercise of stock options granted under ourstock plans and upon the exercise of warrants. Of the cash provided byfinancing activities during 2003, $19.0 million consisted of net proceeds,after deducting offering costs of $1.3 million, from our private placement in June 2003of 1.5 million shares of common stock at $13.50 per share. A registrationstatement covering the resale of these shares was declared effective on September 29,2003 by the Securities and Exchange Commission. Effective March 1, 2006,we de-registered the resale of these shares not already sold.

 

We have never paid or declaredany cash dividends and do not intend to pay dividends in the near future.

 

The following summarizesour contractual obligations, including purchase commitments, at December 31,2005 and the effect such obligations are expected to have on our liquidity andcash flow in future periods.

 
| ** **           | ** ** | **Total** | ** ** | **1 Year or Less** | ** ** | **1 to 3 Years** | ** ** | **3 to 5 Years** | ** ** | **More than 5  Years** | ** ** |
|----------------------|------------|-----------|------------|--------------------|------------|------------------|------------|------------------|------------|------------------------|------------|
|                 |       |      |       |               |       |             |       |             |       |                   |       |
| Operating leases (1) |       | $         | 4,279,000  |               | $          | 511,000          |       | $                | 1,423,000  |                   | $          | 1,504,000 |   | $ | 841,000 |   |
|                      |            |           |            |                    |            |                  |            |                  |            |                        |            |  |  |  |  |  |

 

----

(1)          We currently lease ouroffice facilities in Minnetonka, Minnesota under a lease that expires in January 2012.In March 2004, we signed a non-cancelable operating lease for this newoffice space. The new lease term started in February 2005 and expires in January 2012.Under the terms of the new lease, the lessor for the Minnetonka office beganmaking the minimum lease payments for our former facilities located in Plymouth,Minnesota in February 2005. As part of the new lease, we are alsorequired to pay a portion of the lessor’s operating costs for the newfacilities. The minimum lease payments listed include both the Plymouth andMinnetonka office locations. See Note 5 to the Consolidated FinancialStatements for additional information on the new lease.

 

Off-balance-sheetarrangements

 

We did not have anyoff-balance sheet arrangements as of December 31, 2005 or 2004.

 

Contingent considerationrelated to acquisition

 

We have a contingentconsideration agreement related to our acquisition of HInnovation, Inc. inFebruary 2004. The maximum potential contingent consideration wasinitially $6.0 million. No contingent consideration has been earned, and, as ofDecember 31, 2005, the potential maximum contingent consideration is $1.5million, which consists solely of cash.

 

The remaining milestone uponwhich contingent consideration may be earned is related to porting ourbase software to HInnovation’s Web-based platform and the commerciallaunch thereof. A second milestone, based upon achieving certain revenuetargets for the HInnovation products by March 2005, was not met andexpired. A third milestone, based on the licensing of products based on patentsheld by HInnovation by February 2006, was not met and expired. Anycontingent payments made by us will result in an equivalent increase ingoodwill.

 

Agreement with R2Technology, Inc.

 

In the fourth quarter of2005, we recorded a $410,000 loss on contract relating to our agreement with R2Technology, Inc. See “Critical accounting policies and estimates – Agreementwith R2 Technology, Inc.” for further discussion. As of December 31,2005, the remaining potential aggregate Applicable Minimums range from aminimum of approximately $414,000 to a maximum of approximately $4.1 million.

 

33

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Other purchase commitments

 

We had no significantoutstanding purchase orders as of December, 31 2005. We have entered into anumber of technology licensing agreements that provide for the payment ofroyalties when we sell Vitrea. Except for the R2 purchase commitment describedabove, we are not obligated for any minimum payments under such agreements.

 

Other matters

 

If our operationsprogress as anticipated, of which there can be no assurance, we believe thatour cash and cash equivalents on hand and generated from operations should besufficient to satisfy our cash requirements, including commitments, for atleast the next 12 months. The timing of our future capital requirements,however, will depend on a number of factors, including the ability andwillingness of physicians to use advanced visualization and analysis softwarein clinical analysis, surgical planning, patient screening and other analysisand treatment protocols; our ability to successfully market our products; our abilityto differentiate our volume rendering software from competing productsemploying surface rendering or other technologies; our ability to build andmaintain an effective sales and distribution channel; the impact of competitionin the medical visualization business; our ability to obtain any necessaryregulatory approvals; and our ability to enhance existing products and developnew products on a timely basis. To the extent that our operations do notprogress as anticipated, additional capital may be required. There can beno assurance that any required additional capital will be available onacceptable terms or at all, and the failure to obtain any such capital wouldhave a material adverse effect on the business.

 

**Foreign currency transactions**

 

Substantially all of ourforeign transactions are negotiated, invoiced and paid in U.S. dollars.

 

**Inflation**

 

We believe inflation hasnot had a material effect on our operations or financial condition.

 

**Recent accounting pronouncement**

 

In December 2004,the FASB issued SFAS No. 123 (revised 2004), “Share-Based Payment.” SFAS No. 123Rsupersedes APB Opinion No. 25, which requires recognition of an expensewhen goods or services are provided. SFAS No. 123R requires thedetermination of the fair value of the share-based compensation at the grantdate and the recognition of the related expense over the period in which theshare-based compensation vests. SFAS No. 123R permits a prospective or twomodified versions of retrospective application under which financial statementsfor prior periods are adjusted on a basis consistent with the pro formadisclosures required for those periods by the original SFAS No. 123. In April 2005,the SEC adopted a new rule that amends the compliance dates for SFAS No. 123R.We are required to adopt the provisions of SFAS No. 123R effective January 1,2006, at which time we will begin recognizing an expense for unvestedshare-based compensation that has been issued or will be issued after that date.We have determined that we will adopt SFAS No. 123R using the modifiedprospective application method under which we will apply SFAS No. 123R tonew awards granted after the adoption of SFAS No. 123R and any portion ofexisting awards that were granted after December 15, 1994 and have notvested by the date we adopt SFAS No. 123R. We expect the impact of theadoption of SFAS No. 123R to be material to our consolidated financialstatements. We estimate that equity-based compensation charges in 2006 will beapproximately $4.1 million to $5.0 million after tax, depending on the stockprice when new options are granted and the volume and timing of incentive stockoption exercises, all of which are difficult to predict. These factors can alsoaffect our effective tax rate. Future stock-based compensation will differ frompro forma amounts (see Note 2 schedule labeled “Stock-based compensation”).

 

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

 

Market risk refers to therisk that a change in the level of one or more market prices, interest rates,indices, volatilities, correlations or other market factors such as liquiditywill result in losses for a certain financial instrument or group of financialinstruments. We do not hold or issue financial instruments for tradingpurposes, and we do not enter into forward financial instruments to manage andreduce the impact of changes in foreign currency rates because, as disclosedabove, substantially all of our foreign transactions are negotiated, invoicedand paid in U.S. dollars. Based on the controls in place and the relative sizeof the financial instruments entered into, we believe the risks associated withnot using these instruments would not have a material adverse effect on ourconsolidated financial position or results of operations.

 

34

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

 

In the normal course ofbusiness, we are exposed to market risks, including changes in interest ratesand price changes, that could affect our operating results. As of December 31,2005, fluctuations in interest rates, exchange rates and price changes wouldnot have had a material effect on our financial position or operating results.

 

**Interestrate risk**

 

We place our cash, cashequivalents and marketable securities, which generally have a term of less thanone year, with a high-quality financial institution and have investmentguidelines relative to diversification and maturities designed to maintainsafety and liquidity. As of December 31, 2005, we had cash, cashequivalents and marketable securities totaling $49.8 million. If, during 2005,average short-term interest rates decreased by 1.0% from 2005 average rates, basedon our quarterly average balance of cash, cash equivalents and marketablesecurities, our projected interest income from short-term investments would havedecreased by approximately $425,000.

 

**Foreign currencyrisk**

 

Substantially all of ourforeign transactions are negotiated, invoiced and paid in U.S. dollars. Therefore,fluctuations in the value of the dollar as compared to other foreign currencieshave not had an effect on our results of operations or financial condition.

 

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

 

Our financial statements,supplemental schedule and Report of Independent Registered PublicAccounting Firm thereon, all of which are included in this Annual Report on Form 10-K,are listed in Item 15(a)(1) of this Form 10-K.

 

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

 

Not applicable.

 

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

 

**Evaluation of disclosure controls and procedures**

 

We maintain disclosure controls and procedures thatare designed to ensure that information required to be disclosed in the reportsthat we file or submit under the Securities Exchange Act of 1934, as amended (“ExchangeAct”), are recorded, processed, summarized, and reported within the timeperiods specified in the rules and forms of the Securities and ExchangeCommission, and that such information is accumulated and communicated to ourmanagement, including our Chief Executive Officer and Chief Financial Officer,as appropriate, to allow timely decisions regarding required disclosure.  Our management, under the supervision of andwith the participation of our Chief Executive Officer and Chief FinancialOfficer, has evaluated the effectiveness of our disclosure controls andprocedures, as defined in Rules 13a-15(e) and 15d-15(e) underthe Exchange Act, as of the end of the period covered by this report. Based onsuch evaluation, our Chief Executive Officer and Chief Financial Officer haveconcluded that our disclosure controls and procedures were effective as of December 31,2005.

 

We maintain a disclosurecommittee to assist our Chief Executive Officer and Chief Financial Officer inperforming the evaluation discussed above. The members of this committeeinclude certain of our executive officers, senior members of our finance andaccounting staff, our general counsel and our outside legal counsel.

 

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

 

Management is responsiblefor establishing and maintaining adequate internal control over financialreporting, as defined in Exchange Act Rules 13a-15(f) and 15d-15(f). Ourinternal control over financial reporting is a process designed to providereasonable assurance regarding the reliability of financial reporting and thepreparation of financial statements for external purposes in accordance withgenerally accepted accounting principles. Because of its inherent limitations,internal control over financial reporting may not prevent or detectmisstatements. Also, projections of any evaluation of effectiveness to futureperiods are subject to the risk that controls may become inadequatebecause of changes in conditions or that the degree 

 

35

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of compliance with the policiesor procedures may deteriorate.

 

Our management, under thesupervision of and with the participation of our Chief Executive Officer andChief Financial Officer, has evaluated the effectiveness of our internalcontrol over financial reporting as of December 31, 2005 based on thecriteria established in *Internal Control –Integrated Framework* issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO). Based on the results of thisevaluation, we concluded that our internal control over financial reporting waseffective as of December 31, 2005.

 

Our assessment of the effectiveness of the Company’s internalcontrol over financial reporting as of December 31, 2005 has been auditedby PricewaterhouseCoopers LLP, an independent registered accounting firm, asstated in their report which is included in Item 15(a)(1) of this Annual Reporton Form 10-K.

 

**Changes in internal control overfinancial reporting**

 

As disclosed in our AmendmentNo. 2 on Form 10-K/A filed on May 4, 2005, we reported that asof December 31, 2004, we had material weaknesses in internal controlrelated to (i) the accuracy and completeness of maintenance and servicesrevenues and deferred revenues; (ii) verifying the existence of propertyand equipment; and (iii) the period-end financial reporting process. As ofDecember 31, 2005, we have concluded that we have eliminated the materialweaknesses. Specifically, we have taken the following remedial actions:

 

•          Theprocess of recognizing revenue related to maintenance and services has beenredesigned to ensure more timely receipt of information from operational areasto ensure revenue is recognized in the appropriate period.

•          Newprocedures have been established to address the tagging and tracking of fixedassets to ensure that property and equipment can be adequately accounted for.

•          Controlsrelated to the quarterly financial reporting process are being closelymonitored to ensure they are operating as designed. This material weakness wasrelated to the third quarter of 2004.

 

In addition, over thepast six fiscal quarters, we have added a number of additional personnel to ourfinance and accounting staff. The additional personnel include a new ChiefOperating Officer/Chief Financial Officer, a new Senior Director of Finance, anew Controller, a new Manager of Financial Reporting and a Senior StaffAccountant, all of whom have strong public accounting and/or public companyexperience.

 

The changes in our internalcontrol over financial reporting during our fiscal quarter ended December 31,2005 that have materially affected, or are reasonably likely to materiallyaffect, our internal control over financial reporting, are described above.

 

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

 

None.

 

36

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**Part III**

 

Certaininformation required by Part III is omitted from this Annual Report on Form 10-Kbecause we will file a definitive Proxy Statement relating to our 2006 AnnualMeeting of Stockholders pursuant to Schedule 14A (the “Proxy Statement”)not later than 120 days after the end of the fiscal year covered by this AnnualReport on Form 10-K, and certain information included therein isincorporated herein by reference as indicated below.

 

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

 

The information requiredby this Item 10 will be included under the captions “Election of Directors”and “Information Concerning Directors, Nominees and Executive Officers” in our2006 Proxy Statement. Information concerning the compliance of our officers,directors and 10% shareholders with Section 16(a) of the SecuritiesExchange Act of 1934 is incorporated by reference to the information to becontained in the 2006 Proxy Statement under the caption “Information ConcerningDirectors Nominees and Executive Officers – Section 16(a) BeneficialOwnership Reporting Compliance.”  Theinformation regarding Audit Committee members and “audit committee financialexperts” is incorporated by reference to the information to be contained in the2006 Proxy Statement under the caption “Information Concerning DirectorsNominees and Executive Officers – Board Committees.”  The information regarding our Code ofBusiness Ethics is incorporated by reference to the information to be containedin the 2006 Proxy Statement under the heading “Information Concerning DirectorsNominees and Executive Officers – Code of Business Conduct and Ethics.”

 

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

 

The information under thecaptions “Information Concerning Directors Nominees and Executive Officers – ExecutiveCompensation” and “Information Concerning Directors Nominees and ExecutiveOfficers – Director Compensation” to be contained in the 2006 Proxy Statementis incorporated herein by reference.

 

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

 

The information under thecaptions “Beneficial Ownership of Common Stock” and “Information ConcerningDirectors, Nominees and Executive Officers – Securities Authorized for Issuers UnderEquity Compensation Plans” to be contained in the 2006 Proxy Statement isincorporated herein by reference.

 

**Item 13.****                            CertainRelationships and Related Transactions**

 

Not applicable.

 

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

 

The information under thecaption “Ratification of Appointment of PricewaterhouseCoopers LLP as IndependentRegistered Public Accounting Firm” to be contained in the 2006 Proxy Statementis incorporated herein by reference.

 

37

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**Part IV**

 

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

 

(a)          The followingconsolidated financial statements of Vital Images, Inc. and Report ofIndependent Registered Public Accounting Firm thereon are included herein:

 

(1)          Financial Statements

 
| Report of Independent  Registered Public Accounting Firm                                                                                        |
|-------------------------------------------------------------------------------------------------------------------------------------------------|
| Consolidated Balance Sheets as of December 31,  2005 and 2004                                                                              |
| Consolidated Statement of Operations  for the years ended December 31, 2005, 2004 and 2003                                                 |
| Consolidated Statements of Stockholders’  Equity and Other Comprehensive Income for the years ended December 31,  2005, 2004 and 2003 |
| Consolidated Statements of Cash Flows for the years  ended December 31, 2005, 2004 and 2003                                                |
| Notes to Consolidated Financial Statements                                                                                                      |

 

(2)          All other schedules tothe consolidated financial statements required by Article 12 of RegulationS-X are not required under the related instructions or are inapplicable andtherefore have been omitted.

 

(3)          Listing of Exhibits

 

The Exhibits required tobe a part of this Report are listed in the Index to Exhibits.

 

(b)     Exhibits

 

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

 

38

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**Signatures**

 

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the Registrant has duly caused this Report to be signed on its behalf bythe undersigned, thereunto duly authorized, in Minneapolis, Minnesota, on the16th day of March, 2006.

 

 
|   |   |   | Vital Images, Inc.                                                                                                 |
|--------|--------|--------|-------------------------------------------------------------------------------------------------------------------------|
|   |   |   |                                                                                                                    |   |
|   |   | By:    | /s/Michael H. Carrel                                                                                                    |   |
|   |   |   | Michael H. Carrel                                                                                                       |
|   |   |   | Chief  Operating Officer and

Chief Financial  Officer  (Principal Financial Officer and Principal  Accounting Officer) |

 

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

 

 
| **Signature**                | ** ** | **Title**                                                         | ** **                                           | **Date** |
|------------------------------|------------|-------------------------------------------------------------------|------------------------------------------------------|----------|
|                         |       |                                                              |                                                 |     |
| /s/Jay D. Miller             |       |                                                              | President, Chief  Executive Officer and Director     |     | March 16, 2006 |
| Jay D. Miller                |       | (Principal  Executive Officer)                                    |                                                 |     |
|                         |       |                                                              |                                                 |     |
| /s/Michael H. Carrel         |       |                                                              | Chief Operating Officer  and Chief Financial Officer |     | March 16, 2006 |
| Michael H. Carrel            |       | Treasurer  and Secretary                                          |                                                 |     |
|                         |       | (Principal  Financial Officer and Principal   Accounting Officer) |                                                 |     |
|                         |       |                                                              |                                                 |     |
| /s/Douglas M. Pihl           |       |                                                              | Chairman of the Board  and Director                  |     | March 16, 2006 |
| Douglas M. Pihl              |       |                                                              |                                                 |     |
|                         |       |                                                              |                                                 |     |
| /s/Vincent J. Argiro         |       |                                                              | Chief Technology  Officer, Founder and Director      |     | March 16, 2006 |
| Vincent J. Argiro            |       |                                                              |                                                 |     |
|                         |       |                                                              |                                                 |     |
| /s/James B. Hickey, Jr. |       |                                                              | Director                                             |     | March 16, 2006 |
| James B. Hickey, Jr.    |       |                                                              |                                                 |     |
|                         |       |                                                              |                                                 |     |
| /s/Richard W. Perkins        |       |                                                              | Director                                             |     | March 16, 2006 |
| Richard W. Perkins           |       |                                                              |                                                 |     |
|                         |       |                                                              |                                                 |     |
| /s/Michael W. Vannier        |       |                                                              | Director                                             |     | March 16, 2006 |
| Michael W. Vannier           |       |                                                              |                                                 |     |
|                         |       |                                                              |                                                 |     |
| /s/Sven A. Wehrwein          |       |                                                              | Director                                             |     | March 16, 2006 |
| Sven A. Wehrwein             |       |                                                              |                                                 |     |
|                         |       |                                                              |                                                 |     |
| /s/Gregory J. Peet           |       |                                                              | Director                                             |     | March 16, 2006 |
| Gregory J. Peet              |       |                                                              |                                                 |     |

 

39

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**Report of Independent Registered Public Accounting Firm**

 

To****theBoard of Directors and Stockholders of Vital Images, Inc.:

 

We have completed integrated audits of Vital ImagesInc.’s 2005 and 2004 consolidated financial statements and of its internalcontrol over financial reporting as of December 31, 2005, and an audit ofits 2003 consolidated financial statements in accordance with the standards ofthe Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, arepresented below.

 

Consolidated financial statements

 

In our opinion, the consolidated financial statements listed inthe index appearing under Item 15(a)(1) present fairly, in allmaterial respects, the financial position of Vital Images, Inc. and itssubsidiary at December 31, 2005 and 2004, and the results of theiroperations and their cash flows for each of the three years in the period endedDecember 31, 2005****in conformitywith accounting principles generally accepted in the United States of America. Thesefinancial statements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these financial statements based onour audits. We conducted our audits of these statements in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit of financial statements includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financialstatements, assessing the accounting principles used and significant estimatesmade by management, and evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

 

Internal control overfinancial reporting

 

Also, in our opinion,management’s assessment, included in Management’s report on internal controlover financial reporting appearing under Item 9A, that the Company maintainedeffective internal control over financial reporting as of December 31,2005 based on criteria established in *Internal Control - IntegratedFramework* issued by the Committee of Sponsoring Organizations of theTreadway Commission (COSO), is fairly stated, in all material respects, basedon those criteria. Furthermore, in our opinion, the Company maintained, in allmaterial respects, effective internal control over financial reporting as of December 31,2005, based on criteria established in *Internal Control -Integrated Framework* issued by the COSO. The Company’s management isresponsible for maintaining effective internal control over financial reportingand for its assessment of the effectiveness of internal control over financialreporting. Our responsibility is to express opinions on management’s assessmentand on the effectiveness of the Company’s internal control over financialreporting based on our audit. We conducted our audit of internal control overfinancial reporting in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that weplan and perform the audit to obtain reasonable assurance about whethereffective internal control over financial reporting was maintained in allmaterial respects. An audit of internal control over financial reportingincludes obtaining an understanding of internal control over financialreporting, evaluating management’s assessment, testing and evaluating thedesign and operating effectiveness of internal control, and performing suchother procedures as we consider necessary in the circumstances. We believe thatour audit provides a reasonable basis for our opinions.

 

A company’s internalcontrol over financial reporting is a process designed to provide reasonableassurance regarding the reliability of financial reporting and the preparationof financial statements for external purposes in accordance with generallyaccepted accounting principles. A company’s internal control over financialreporting includes those policies and procedures that (i) pertain to themaintenance of records that, in reasonable detail, accurately and fairly reflectthe transactions and dispositions of the assets of the company; (ii) providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with generally acceptedaccounting principles, and that receipts and expenditures of the company arebeing made only in accordance with authorizations of management and directorsof the company; and (iii) provide reasonable assurance regardingprevention or timely detection of unauthorized acquisition, use, or dispositionof the company’s assets that could have a material effect on the financialstatements.

 

Because of its inherentlimitations, internal control over financial reporting may not prevent ordetect misstatements. Also, projections of any evaluation of effectiveness tofuture periods are subject to the risk that controls may become inadequatebecause of changes in conditions, or that the degree of compliance with thepolicies or procedures may deteriorate.

 

 

PricewaterhouseCoopersLLP

Minneapolis, Minnesota

March 15, 2006

 

40

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

 
| ** **                                                                                                                                                                                         | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                         | ** ** | **2005**              | ** ** | **2004** | ** ** |
| ** **                                                                                                                                                                                         | ** ** | ** **            | ** ** | ** ** | ** ** |
| **Assets**                                                                                                                                                                                         | ** ** | ** **            | ** ** | ** ** | ** ** |
| Current  assets:                                                                                                                                                                                   | ** ** | ** **            | ** ** | ** ** | ** ** |
| Cash  and cash equivalents                                                                                                                                                                         |       | $                     | 20,844,640 |   | $ | 24,119,157 |   |
| Marketable  securities                                                                                                                                                                             |       | 28,965,329            |       | 11,546,140 |   |
| Accounts  receivable, net                                                                                                                                                                          |       | 14,330,087            |       | 8,090,359 |   |
| Deferred  income taxes                                                                                                                                                                             |       | 717,000               |       | 600,000 |   |
| Prepaid  expenses and other current assets                                                                                                                                                         |       | 1,227,586             |       | 1,092,495 |   |
| Total  current assets                                                                                                                                                                              |       | 66,084,642            |       | 45,448,151 |   |
| Property  and equipment, net                                                                                                                                                                       |       | 5,361,319             |       | 3,222,367 |   |
| Deferred  income taxes                                                                                                                                                                             |       | 8,949,000             |       | 8,454,000 |   |
| Licensed  technology, net                                                                                                                                                                          |       | 210,000               |       | 330,000 |   |
| Other  intangible assets, net                                                                                                                                                                      |       | 4,493,000             |       | 5,777,000 |   |
| Goodwill                                                                                                                                                                                           |       | 6,052,744             |       | 6,052,744 |   |
| Total  assets                                                                                                                                                                                      |       | $                     | 91,150,705 |   | $ | 69,284,262 |   |
|                                                                                                                                                                                               |       |                  |       |   |   |
| **Liabilities and Stockholders’ Equity**                                                                                                                                                      |       |                  |       |   |   |
| Current  liabilities:                                                                                                                                                                              |       |                  |       |   |   |
| Accounts  payable                                                                                                                                                                                  |       | $                     | 2,639,608  |   | $ | 1,892,657 |   |
| Accrued  compensation                                                                                                                                                                              |       | 3,687,866             |       | 3,175,354 |   |
| Accrued  royalties                                                                                                                                                                                 |       | 1,347,660             |       | 573,985 |   |
| Other  current liabilities                                                                                                                                                                         |       | 1,575,215             |       | 673,131 |   |
| Deferred  revenue                                                                                                                                                                                  |       | 11,230,578            |       | 8,136,844 |   |
| Total  current liabilities                                                                                                                                                                         |       | 20,480,927            |       | 14,451,971 |   |
| Deferred  revenue                                                                                                                                                                                  |       | 645,230               |       | 277,568 |   |
| Deferred  rent                                                                                                                                                                                     |       | 1,235,051             |       | — |   |
| Total  liabilities                                                                                                                                                                                 |       | 22,361,208            |       | 14,729,539 |   |
|                                                                                                                                                                                               |       |                  |       |   |   |
| Commitments  and contingencies (Notes 3 and 5)                                                                                                                                                     |       |                  |       |   |   |
|                                                                                                                                                                                               |       |                  |       |   |   |
| Stockholders’  equity:                                                                                                                                                                        |       |                  |       |   |   |
| Preferred  stock: $0.01 par value; 5,000,000 shares authorized; none issued or outstanding                                                                                                         |       | —                |       | — |   |
| Common  stock: $0.01 par value; 20,000,000 shares authorized; 12,847,744 issued and  outstanding as of December 31, 2005; and 12,007,160 issued and  outstanding as of December 31, 2004 |       | 128,478               |       | 120,072 |   |
| Additional  paid-in capital                                                                                                                                                                        |       | 75,918,201            |       | 65,813,282 |   |
| Deferred  stock-based compensation                                                                                                                                                                 |       | (1,707,013            | )          | — |   |
| Accumulated  deficit                                                                                                                                                                               |       | (5,530,236            | )          | (11,330,766 | ) |
| Accumulated  other comprehensive loss                                                                                                                                                              |       | (19,933               | )          | (47,865 | ) |
| Total  stockholders’ equity                                                                                                                                                                   |       | 68,789,497            |       | 54,554,723 |   |
| Total  liabilities and stockholders’ equity                                                                                                                                                   |       | $                     | 91,150,705 |   | $ | 69,284,262 |   |

 

The accompanyingnotes are an integral part of the consolidated financial statements.

 

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**Vital Images, Inc.Consolidated Statements ofOperations**

 
| ** **                                            | ** ** | **For the Year Ended December 31,** | ** ** |
|-------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                            | ** ** | **2005**                                 | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                  |       |                                     |       |   |   |   |   |
| Revenue:                                              | ** ** | ** **                               | ** ** | ** ** | ** ** | ** ** | ** ** |
| License  fees                                         |       | $                                        | 35,227,630 |   | $ | 24,054,251 |   | $ | 18,388,794 |   |
| Maintenance  and services                             |       | 14,324,034                               |       | 9,524,791 |   | 6,844,470 |   |
| Hardware                                              |       | 2,165,375                                |       | 2,543,005 |   | 2,066,454 |   |
| Total  revenue                                        |       | 51,717,039                               |       | 36,122,047 |   | 27,299,718 |   |
|                                                  |       |                                     |       |   |   |   |   |
| Cost of revenue:                                      |       |                                     |       |   |   |   |   |
| License  fees                                         |       | 4,681,457                                |       | 3,993,982 |   | 1,818,353 |   |
| Maintenance  and services                             |       | 5,559,407                                |       | 4,660,433 |   | 3,773,794 |   |
| Hardware                                              |       | 1,319,011                                |       | 1,792,666 |   | 1,478,914 |   |
| Total  cost of revenue                                |       | 11,559,875                               |       | 10,447,081 |   | 7,071,061 |   |
|                                                  |       |                                     |       |   |   |   |   |
| Gross  profit                                         |       | 40,157,164                               |       | 25,674,966 |   | 20,228,657 |   |
|                                                  |       |                                     |       |   |   |   |   |
| Operating expenses:                                   |       |                                     |       |   |   |   |   |
| Sales  and marketing                                  |       | 16,931,854                               |       | 12,204,574 |   | 9,317,766 |   |
| Research  and development                             |       | 8,148,071                                |       | 6,329,190 |   | 5,168,695 |   |
| General  and administrative                           |       | 7,019,180                                |       | 5,626,719 |   | 3,806,914 |   |
| Loss  on operating lease                              |       | 493,000                                  |       | — |   | — |   |
| Acquired  in-process research and development         |       | —                                   |       | 1,000,000 |   | — |   |
| Total  operating expenses                             |       | 32,592,105                               |       | 25,160,483 |   | 18,293,375 |   |
|                                                  |       |                                     |       |   |   |   |   |
| Operating  income                                     |       | 7,565,059                                |       | 514,483 |   | 1,935,282 |   |
|                                                  |       |                                     |       |   |   |   |   |
| Interest income                                       |       | 1,066,471                                |       | 368,080 |   | 213,859 |   |
| Income before income  taxes                           |       | 8,631,530                                |       | 882,563 |   | 2,149,141 |   |
|                                                  |       |                                     |       |   |   |   |   |
| Provision (benefit) for  income taxes, net            |       | 2,831,000                                |       | 587,000 |   | (6,313,000 | ) |
| Net income                                            |       | $                                        | 5,800,530  |   | $ | 295,563 |   | $ | 8,462,141 |   |
|                                                  |       |                                     |       |   |   |   |   |
| Net income per share -  basic                         |       | $                                        | 0.47       |   | $ | 0.03 |   | $ | 0.83 |   |
|                                                  |       |                                     |       |   |   |   |   |
| Weighted average common  shares outstanding - basic   |       | 12,378,815                               |       | 11,632,351 |   | 10,189,114 |   |
|                                                  |       |                                     |       |   |   |   |   |
| Net income per share -  diluted                       |       | $                                        | 0.44       |   | $ | 0.02 |   | $ | 0.71 |   |
|                                                  |       |                                     |       |   |   |   |   |
| Weighted average common  shares outstanding - diluted |       | 13,283,441                               |       | 12,535,670 |   | 11,848,268 |   |

 

The accompanyingnotes are an integral part of the consolidated financial statements.

 

42

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

 
| ** **                                                                            | ** ** | ** **        | ** ** | ** **  | ** ** | ** **     | ** ** | ** **       | ** ** | ** **        | ** ** | **Accumulated**        | ** ** | ** **        | ** ** | ** ** | ** ** |
|---------------------------------------------------------------------------------------|------------|-------------------|------------|-------------|------------|----------------|------------|------------------|------------|-------------------|------------|------------------------|------------|-------------------|------------|------------|------------|
| ** **                                                                            | ** ** | ** **        | ** ** | ** **  | ** ** | **Additional** | ** ** | ** **       | ** ** | ** **        | ** ** | **Other**              | ** ** | **Total**         | ** ** | ** ** | ** ** |
| ** **                                                                            | ** ** | **Common  Stock** | ** ** | **Paid-In** | ** ** | **Deferred**   | ** ** | **Accumulated**  | ** ** | **Comprehensive** | ** ** | **Stockholders’** | ** ** | **Comprehensive** | ** ** |
| ** **                                                                            | ** ** | **Shares**        | ** ** | **Amount**  | ** ** | **Capital**    | ** ** | **Compensation** | ** ** | **Deficit**       | ** ** | **Loss**               | ** ** | **Equity**        | ** ** | **Income** | ** ** |
|                                                                                  |       |              |       |        |       |           |       |             |       |              |       |                   |       |              |       |       |       |
| Balances  as of December 31, 2002                                                |       | 8,987,009         |       | $           | 89,870     |           | $          | 31,719,371       |       | $                 | —     |                   | $          | (20,088,470       | )          | $          | —     |   | $ | 11,720,771 |   |   |   |
|                                                                                  |       |              |       |        | ** ** | ** **     |       |             | ** ** | ** **        |       |                   |       |              |       |       |       |
| Issuance  of common stock upon exercise of stock options                              |       | 559,006           |       | 5,590       |       | 1,690,005      | ** ** | ** **       |       |              | ** ** | ** **             |       | 1,695,595         |       |       |       |
| Tax  benefit related to exercise of stock options                                     |       |              |       |        |       | 3,189,000      | ** ** | ** **       |       |              | ** ** | ** **             |       | 3,189,000         |       |       |       |
| Issuance  of common stock under employee stock purchase plan                          |       | 12,995            |       | 130         |       | 150,437        | ** ** | ** **       |       |              | ** ** | ** **             |       | 150,567           |       |       |       |
| Issuance  of common stock upon exercise of stock warrants                             |       | 81,370            |       | 814         |       | 246,777        | ** ** | ** **       |       |              | ** ** | ** **             |       | 247,591           |       |       |       |
| Issuance  of common stock in connection with private placement, net of offering costs |       | 1,500,000         |       | 15,000      |       | 18,975,515     | ** ** | ** **       |       |              | ** ** | ** **             |       | 18,990,515        |       |       |       |
| Stock-based  compensation                                                             |       |              |       |        |       | 137,485        | ** ** | ** **       |       |              | ** ** | ** **             |       | 137,485           |       |       |       |
| Net  income                                                                           | ** ** | ** **        |       |        |       |           |       |             |       | 8,462,141         |       |                   |       | 8,462,141         |       | $          | 8,462,141  |   |
| Balances  as of December 31, 2003                                                |       | 11,140,380        |       | 111,404     |       | 56,108,590     |       | —           |       | (11,626,329       | )          | —                 |       | 44,593,665        |       | $          | 8,462,141  |   |
|                                                                                  |       |              |       |        | ** ** | ** **     |       |             | ** ** | ** **        |       |                   |       |              |       |       |       |
| Issuance  of common stock upon exercise of stock options                              |       | 456,380           |       | 4,564       |       | 1,967,064      | ** ** | ** **       |       |              | ** ** | ** **             |       | 1,971,628         |       |       |       |
| Tax  benefit related to exercise of stock options                                     |       |              |       |        |       | 1,430,000      | ** ** | ** **       |       |              | ** ** | ** **             |       | 1,430,000         |       |       |       |
| Issuance  of common stock under employee stock purchase plan                          |       | 18,344            |       | 183         |       | 171,648        | ** ** | ** **       |       |              | ** ** | ** **             |       | 171,831           |       |       |       |
| Issuance  of common stock upon exercise of stock warrants                             |       | 15,794            |       | 158         |       | 18,682         | ** ** | ** **       |       |              | ** ** | ** **             |       | 18,840            |       |       |       |
| Stock-based  compensation                                                             |       |              |       |        |       | 11,507         | ** ** | ** **       |       |              | ** ** | ** **             |       | 11,507            |       |       |       |
| Acquistion  of HInnovation                                                            |       | 376,262           |       | 3,763       |       | 6,105,791      | ** ** | ** **       |       |              | ** ** | ** **             |       | 6,109,554         |       |       |       |
| Unrealized  loss on investments                                                       |       |              |       |        |       |           |       |             |       |              |       | (47,865                | )          | (47,865           | )          | $          | (47,865    | ) |
| Net  income                                                                           | ** ** | ** **        |       |        |       |           |       |             |       | 295,563           |       |                   |       | 295,563           |       | 295,563    |       |
| Balances  as of December 31, 2004                                                |       | 12,007,160        |       | 120,072     |       | 65,813,282     |       | —           |       | (11,330,766       | )          | (47,865                | )          | 54,554,723        |       | $          | 247,698    |   |
|                                                                                  |       |              |       |        | ** ** | ** **     |       |             | ** ** | ** **        |       |                   |       |              |       |       |       |
| Issuance  of common stock upon exercise of stock options                              |       | 711,288           |       | 7,113       |       | 4,495,581      |       |             |       |              | ** ** | ** **             |       | 4,502,694         |       |       |       |
| Tax  benefit related to exercise of stock options                                     |       |              |       |        |       | 3,359,000      |       |             |       |              | ** ** | ** **             |       | 3,359,000         |       |       |       |
| Issuance  of common stock under employee stock purchase plan                          |       | 14,526            |       | 145         |       | 209,738        |       |             |       |              | ** ** | ** **             |       | 209,883           |       |       |       |
| Grant  of restricted stock to employees, net                                          |       | 114,770           |       | 1,148       |       | 2,019,461      |       | (2,020,609       | )          |              | ** ** | ** **             |       | —            |       |       |       |
| Stock-based  compensation                                                             |       |              |       |        |       | 21,139         |       | 313,596          |       |              | ** ** | ** **             |       | 334,735           |       |       |       |
| Change  in unrealized loss on investments, net of tax                                 |       |              |       |        |       |           |       |             |       |              |       | 27,932                 |       | 27,932            |       | $          | 27,932     |   |
| Net  income                                                                           |       |              |       |        |       |           |       |             |       | 5,800,530         |       |                   |       | 5,800,530         |       | 5,800,530  |       |
| Balances  as of December 31, 2005                                                |       | 12,847,744        |       | $           | 128,478    |           | $          | 75,918,201       |       | $                 | (1,707,013 | )                      | $          | (5,530,236        | )          | $          | (19,933    | ) | $ | 68,789,497 |   | $ | 5,828,462 |   |

 

The accompanyingnotes are an integral part of the consolidated financial statements.

 

43

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**VitalImages, Inc.**

**Consolidated Statements of Cash Flows**

 
| ** **                                                                         | ** ** | **For the Year Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                         | ** ** | **2005**                                 | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                               |       |                                     |       |   |   |   |   |
| Cash flows from  operating activities:                                             |       |                                     |       |   |   |   |   |
| Net  income                                                                        |       | $                                        | 5,800,530  |   | $ | 295,563 |   | $ | 8,462,141 |   |
| Adjustments  to reconcile net income to net cash provided by operating activities: |       |                                     |       |   |   |   |   |
| Depreciation  and amortization of property and equipment                           |       | 2,143,459                                |       | 1,569,390 |   | 1,220,468 |   |
| Amortization  of identified intangible assets                                      |       | 1,404,000                                |       | 1,243,000 |   | 120,000 |   |
| Acquired  in-process research and development                                      |       | —                                   |       | 1,000,000 |   | — |   |
| Provision  for (recovery of) doubtful accounts, net                                |       | (159,395                                 | )          | 626,800 |   | 46,000 |   |
| Deferred  income taxes                                                             |       | (600,000                                 | )          | (878,000 | ) | (9,581,000 | ) |
| Tax  benefit from stock option transactions                                        |       | 3,359,000                                |       | 1,430,000 |   | 3,189,000 |   |
| Amortization  of discount and accretion of premium on marketable securities        |       | 24,181                                   |       | 463,192 |   | — |   |
| Employee  stock-based compensation                                                 |       | 313,596                                  |       |   |   |   |   |
| Non-employee  stock-based compensation                                             |       | 21,139                                   |       | 11,507 |   | 137,485 |   |
| Loss  on operating lease                                                           |       | 493,000                                  |       | — |   | — |   |
| Amortization  of deferred rent                                                     |       | (163,123                                 | )          | — |   | — |   |
| Changes  in operating assets and liabilities, net of effect from acquisition:      |       |                                     |       |   |   |   |   |
| Accounts  receivable                                                               |       | (6,080,333                               | )          | (3,839,283 | ) | 47,203 |   |
| Prepaid  expenses and other assets                                                 |       | (135,091                                 | )          | (168,864 | ) | (422,212 | ) |
| Accounts  payable                                                                  |       | 739,653                                  |       | 301,200 |   | 499,981 |   |
| Accrued  and other liabilities                                                     |       | 1,913,091                                |       | 1,892,334 |   | (63,204 | ) |
| Deferred  revenue                                                                  |       | 3,461,396                                |       | 3,611,889 |   | 698,527 |   |
| Deferred  rent                                                                     |       | 1,180,354                                |       | — |   | — |   |
| Net  cash provided by operating activities                                         |       | 13,715,457                               |       | 7,558,728 |   | 4,354,389 |   |
|                                                                               |       |                                     |       |   |   |   |   |
| Cash flows from  investing activities:                                             |       |                                     |       |   |   |   |   |
| Purchases  of property and equipment                                               |       | (4,275,113                               | )          | (1,626,777 | ) | (1,879,117 | ) |
| Purchases  of marketable securities                                                |       | (38,844,438                              | )          | (30,433,525 | ) | (6,775,592 | ) |
| Sales  of marketable securities                                                    |       | 21,417,000                               |       | 22,454,915 |   | 5,205,118 |   |
| Acquisition  of HInnovation, Inc., net of cash acquired                       |       | —                                   |       | (6,108,096 | ) | — |   |
| Net  cash used in investing activities                                             |       | (21,702,551                              | )          | (15,713,483 | ) | (3,449,591 | ) |
|                                                                               |       |                                     |       |   |   |   |   |
| Cash flows from  financing activities:                                             |       |                                     |       |   |   |   |   |
| Proceeds  from sale of common stock under stock plans                              |       | 4,712,577                                |       | 2,143,459 |   | 1,846,162 |   |
| Proceeds  from sale of common stock under stock warrants                           |       | —                                   |       | 18,840 |   | 247,591 |   |
| Proceeds  from sale of common stock, net of offering costs                         |       | —                                   |       | — |   | 18,990,515 |   |
| Net  cash provided by financing activities                                         |       | 4,712,577                                |       | 2,162,299 |   | 21,084,268 |   |
|                                                                               |       |                                     |       |   |   |   |   |
| Net (decrease) increase  in cash and cash equivalents                              |       | (3,274,517                               | )          | (5,992,456 | ) | 21,989,066 |   |
|                                                                               |       |                                     |       |   |   |   |   |
| Cash and cash  equivalents, beginning of year                                      |       | 24,119,157                               |       | 30,111,613 |   | 8,122,547 |   |
| Cash and cash  equivalents, end of year                                            |       | $                                        | 20,844,640 |   | $ | 24,119,157 |   | $ | 30,111,613 |   |
|                                                                               |       |                                     |       |   |   |   |   |
| Supplemental cash flow  information:                                               |       |                                     |       |   |   |   |   |
| Purchases  of property and equipment with accounts payable                         |       | $                                        | 308,053    |   | $ | 300,755 |   | $ | 227,755 |   |
| Non-cash investing and  financing activities:                                      |       |                                     |       |   |   |   |   |
| Common  stock issued for acquisition of HInnovation, Inc.                     |       | $                                        | —     |   | $ | 6,109,554 |   | $ | — |   |

 

The accompanyingnotes are an integral part of the consolidated financial statements.

 

44

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**VitalImages, Inc.**

**Notes toConsolidated Financial Statements**

 

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

 

Vital Images, Inc.(the “Company”) develops, markets and supports enterprise-wide advanced visualizationsoftware for use primarily in clinical analysis and therapy planning. TheCompany’s software applies proprietary computer graphics and image processingtechnologies to a wide variety of data supplied by computed tomography (“CT”),magnetic resonance (“MR”) and positron emission tomography (“PET”) scanners. TheCompany’s products allow clinicians to create 2D, 3D and 4D views of humananatomy and to non-invasively navigate within these images to better visualizeand understand internal structures and pathologies. The Company believes thatits high-speed visualization technology and customized protocolscost-effectively bring 3D visualization and analysis into the routine,day-to-day practice of medicine.

 

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

 

The Company is subject torisks and uncertainties, including dependence on information technologyspending by customers, well-established competitors, concentration of clientsin a limited number of industries, fluctuations of quarterly results, a lengthyand variable sales cycle, dependence on principal products and third-partytechnology, rapid technological change, its ability to develop products thatgain market acceptance and international expansion.

 

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

 

**Basis of presentation**

 

The consolidatedfinancial statements include the accounts of the Company and its wholly-ownedsubsidiary, HInnovation, Inc. All intercompany accounts and transactionshave been eliminated.

 

**Use of estimates**

 

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

 

**Fair value of financialinstruments**

 

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

 

**Cash and cash equivalents**

 

Cash and cash equivalentsconsist of cash and temporary investments with maturities of 90 days or lesswhen purchased. The carrying amount of cash equivalents approximates fair valuedue to the short maturity of these instruments.

 

**Marketable securities**

 

Management determines theappropriate classification of marketable securities at the time of purchase andreevaluates such designation as of each balance sheet date. Currently, allmarketable securities held by the Company are classified as available-for-sale.Available-for-sale securities are carried at fair value as determined by quotedmarket prices, with unrealized gains and losses, net of tax, reported as aseparate component of stockholders’ equity. If an unrealized loss for anyinvestment is considered to be other-than-temporary, the loss will berecognized in the consolidated statements of operations in the period thedetermination is made. The cost basis of securities sold is determined usingthe specific identification method. The cost of marketable securities isadjusted for amortization of premiums and accretion of discounts to maturity. Suchamortization and accretion is included in interest income. Interest anddividends on securities classified as available-for-sale

 

45

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are included in interestincome. As of December 31, 2005, all investments mature within one year.

 

As of December 31,2005 and 2004, the Company’s marketable securities were as follows:

 
| ** **              | ** ** | **December 31, 2005** | ** ** | **December 31, 2004** | ** ** |
|-------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **              | ** ** | **Cost**                   | ** ** | **Aggregate**              | ** ** | **Net Unrealized** | ** ** | **Cost** | ** ** | **Aggregate** | ** ** | **Net Unrealized** | ** ** |
| ** **              | ** ** | **Basis**                  | ** ** | **Fair Value**             | ** ** | **Losses** | ** ** | **Basis** | ** ** | **Fair Value** | ** ** | **Losses** | ** ** |
| Corporate debt          |       | $                          | 27,998,057 |                       | $          | 27,970,349 |   | $ | (27,708 | ) | $ | 10,596,591 |   | $ | 10,553,290 |   | $ | (43,301 | ) |
| Certificates of deposit |       | 999,401                    |       | 994,980                    |       | (4,421 | ) | 997,414 |   | 992,850 |   | (4,564 | ) |
|                    |       | $                          | 28,997,458 |                       | $          | 28,965,329 |   | $ | (32,129 | ) | $ | 11,594,005 |   | $ | 11,546,140 |   | $ | (47,865 | ) |

 

**Accounts receivable and allowancefor doubtful accounts**

 

Accounts receivable are initially recorded at aselling price, which approximates fair value upon the sale of goods or servicesto customers. The Company maintains an allowance for doubtful accounts toreflect accounts receivable at net realizable value. In judging the adequacy ofthe allowance for doubtful accounts, the Company considers multiple factors,including historical bad debt experience, the general economic environment, theneed for specific client reserves and the aging of the Company’s receivables. Thisprovision is included in general and administrative expense in the consolidatedstatements of operations. A considerable amount of judgment is required inassessing these factors. If the factors utilized in determining the allowancedo not reflect future performance, then a change in the allowance for doubtfulaccounts would be necessary in the period such determination has been made,which would impact future results of operations.

 

**Concentration of credit risk**

 

Financial instrumentsthat potentially subject the Company to concentrations of credit risk consistprimarily of cash and cash equivalents and trade accounts receivable. Depositswith the Company’s bank may exceed the amount of insurance provided onsuch 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 corporate debt and certificates ofdeposit. The Company’s investment policy, approved by the Board of Directors,limits the amount the Company may invest in any one type of investment,thereby reducing credit risk concentrations. The Company’s customer base isgenerally concentrated with a small number of customers. The Company reviewsthe creditworthiness of its customers prior to product shipment and generallydoes not require collateral.

 

**Property and equipment**

 

Property and equipmentare recorded at cost. Depreciation is computed using the straight-line methodover the related asset’s estimated useful life, generally three to seven years.Leasehold improvements are amortized over the shorter of their estimated usefullives or the remaining terms of the related leases. The asset cost and relatedaccumulated depreciation or amortization are adjusted for asset retirement ordisposal with the resulting gain or loss, if any, credited or charged toresults of operations.

 

**Long-lived assets**

 

The Company reviewslong-lived assets for impairment whenever events or changes in circumstancesindicate the carrying amount may not be recoverable, in accordance withStatement of Financial Accounting Standards (“SFAS”) No. 144, “Accountingfor the Impairment or Disposal of Long-Lived Assets.”  Events or changes in circumstances thatindicate the carrying amount may not be recoverable include, but are notlimited to, a significant decrease in the market value of the business or assetacquired, a significant adverse change in the extent or manner in which thebusiness or asset acquired is used, or a significant adverse change in thebusiness climate. If such events or changes in circumstances are present, theundiscounted cash flows method is used to determine whether the asset isimpaired. Cash flows would include the estimated terminal value of the assetand exclude any interest charges. To the extent the carrying value of the assetexceeds the undiscounted cash flows over the estimated remaining life of theasset, the impairment is measured using the discounted cash flows. The discountrate utilized would be based on management’s best estimate of the related risksand return at the time the impairment assessment is made.

 

46

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**Goodwill**

 

The Company accounts forgoodwill in accordance with the provisions of SFAS No. 142, “Goodwill andOther Intangible Assets”. Under SFAS No. 142, goodwill and intangibleassets with indefinite lives are reviewed for impairment annually or morefrequently if events or changes in circumstances indicate that the asset mightbe impaired. The first step of the goodwill impairment test, used to identifypotential impairment, compares the fair value of a reporting unit with itscarrying amount, including goodwill. The Company operates as one reporting unitand therefore compares the book value to the market value (marketcapitalization plus a control premium). If the market value exceeds the bookvalue, goodwill is considered not impaired, and thus the second step of theimpairment test is not necessary. If the Company’s book value exceeds themarket value, the second step of the goodwill impairment test is performed tomeasure the amount of impairment loss, if any. The second step of the goodwillimpairment test, used to measure the amount of impairment loss, compares theimplied fair value of the goodwill with the book value of the goodwill. If thecarrying value of the goodwill exceeds the implied fair value of the goodwill,an impairment loss would be recognized in an amount equal to the excess. Anyloss recognized cannot exceed the carrying amount of goodwill. After a goodwillimpairment loss is recognized, the adjusted carrying amount of goodwill is itsnew accounting basis. Subsequent reversal of a previously recognized goodwillimpairment loss is prohibited once the measurement of that loss is completed. TheCompany completed the annual goodwill impairment assessment as of December 31,2005, in which no impairment was recorded.

 

**Revenue recognition**

 

The Company recognizesrevenue in accordance with American Institute of Certified Public Accountants (“AICPA”)Statement of Position (“SOP”) 97-2, Software Revenue Recognition, as amended bySOP 98-4 and SOP 98-9, as well as Technical Practice Aids issued from time totime by the AICPA, and SEC Staff Accounting Bulletin No. 104. The Companyrecognizes revenue when it is realized or realizable and earned. The Companyconsiders revenue realized or realizable and earned when it has persuasiveevidence of an arrangement, the product has been shipped or the services havebeen provided to the customer, the sales price is fixed or determinable, andcollectability is probable. Provided all other revenue recognition criteria aremet, license revenue from Resellers is recognized on a sell-in or sell-throughbasis depending on the arrangement with the Reseller. The Company recognizesrevenue from Resellers on a sell-in basis provided the Reseller i) assumes allrisk of the purchase, ii) has the ability and obligation to pay regardless ofreceiving payment from the end user, and iii) has a history of timely payments.

 

License fees revenue isderived from the licensing of computer software. Hardware revenue is derivedfrom the sale of system hardware, including peripheral equipment. Maintenanceand service revenue is derived from software maintenance and from telephonesupport, installation, training and consulting services. The Company’s softwarelicenses are always sold as part of an arrangement that includesmaintenance and support and often installation and training services.

 

The Company licenses itssoftware and sells products and services to end-users and also indirectlythrough original equipment manufacturers (“OEMs”) and independent distributors(collectively, “Resellers”). Terms offered by the Company do not generallydiffer based on whether the customer is an OEM, an end-user or a Reseller. TheCompany generally offers terms that require payment within 30 to 90 days afterproduct delivery. In rare situations where the Company offers terms thatrequire payment beyond 90 days after product delivery, revenue is deferreduntil the payment becomes due. The Company does not generally offer rights ofreturn, acceptance clauses or price protection to its customers. In raresituations where the Company provides rights of return or acceptance clauses,revenue is deferred until the clause expires. The Company evaluates the creditworthiness of all customers. In circumstances in which  the Company does not have experience sellingto a customer and lacks adequate credit information to conclude that collectionis probable, revenue is deferred until the arrangement fees are collected andall other revenue recognition criteria in the arrangement have been met. Additionally:

 

•                  Softwareand Hardware – Revenue from license fees and hardware is recognized whenshipment of the product has occurred, no significant Company obligations withregard to implementation remain and the Company’s services are not consideredessential to the functionality of other elements of the arrangement.

 

•                  Services– Revenue from maintenance and support arrangements is deferred and recognizedratably over the term of the maintenance and support arrangements. Revenue fromtraining, installation and consulting services is recognized as the servicesare provided to customers.

 

•                  Multiple-ElementArrangements – The Company enters into arrangements with customers that includea combination of software products, system hardware, specified upgrades,maintenance and support, or installation and training services. For sucharrangements, the Company recognizes revenue using the residual value method. TheCompany allocates the total arrangement fee among the various elements of thearrangement based on the relative fair value of each of the undeliveredelements determined by vendor-specific objective evidence. The fair 

 

47

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value of maintenance andsupport services is based upon the renewal rate for continued servicearrangements. The fair value of installation and training services isestablished based upon sold separately pricing for the services. In softwarearrangements for which the Company does not have vendor-specific objectiveevidence of fair value for all elements, revenue is deferred until the earlierof when vendor-specific objective evidence is determined for the undeliveredelements (residual method) or when all elements for which the Company does nothave vendor-specific objective evidence of fair value have been delivered.

 

**Stock-based compensation**

 

The Company hasstock-based employee and director compensation plans, which are described morefully in Note 6. The Company accounts for stock-based employee compensationarrangements in accordance with the provisions of Accounting Principles BoardOpinion No. 25, “Accounting for Stock Issued to Employees”, and complieswith the disclosure provisions of SFAS No. 123, “Accounting forStock-Based Compensation” and SFAS No. 148, “Accounting for Stock-BasedCompensation-Transition and Disclosure-an amendment of Financial AccountingStandards Board (“FASB”) Statement No. 123.”

 

The Company has adoptedthe disclosure-only provisions of SFAS No. 123. For purposes of the proforma disclosures below, the estimated fair value of the options and restrictedstock is amortized to expense over the vesting period. Shares used in the proforma diluted earnings per share computation use the calculation methodologyprescribed by SFAS No. 123, which is different from the shares used forthe reported diluted earnings per share computation. Had compensation cost forthe Company’s stock options and restricted stock awards been recognized basedon the fair value at the grant date consistent with the provisions of SFAS No. 123,the Company’s net income would have been adjusted to the pro forma amountsindicated below:

 
| ** **                                                                                                                              | ** ** | **For the Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                                                                              | ** ** | **2005**                                 | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                                                                              | ** ** | ** **                               | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net  income, as reported                                                                                                                |       | $                                        | 5,800,530  |   | $ | 295,563 |   | $ | 8,462,141 |   |
|                                                                                                                                    |       |                                     |       |   |   |   |   |
| Add:  Stock-based employee compensation expense included in reported net income, net  of related tax effects                            |       | 199,133                                  |       | — |   | — |   |
|                                                                                                                                    |       |                                     |       |   |   |   |   |
| Deduct:  Total stock-based employee compensation expense determined under fair value  method for all awards, net of related tax effects |       | (2,077,953                               | )          | (2,155,282 | ) | (1,387,174 | ) |
|                                                                                                                                    |       |                                     |       |   |   |   |   |
| Pro  forma net income (loss)                                                                                                            |       | $                                        | 3,921,710  |   | $ | (1,859,719 | ) | $ | 7,074,967 |   |
|                                                                                                                                    |       |                                     |       |   |   |   |   |
| Net  income (loss) per share - basic                                                                                                    |       |                                     |       |   |   |   |   |
| As  reported                                                                                                                            |       | $                                        | 0.47       |   | $ | 0.03 |   | $ | 0.83 |   |
| Pro  forma                                                                                                                              |       | $                                        | 0.32       |   | $ | (0.16 | ) | $ | 0.69 |   |
|                                                                                                                                    |       |                                     |       |   |   |   |   |
| Net  income (loss) per share - diluted                                                                                                  |       |                                     |       |   |   |   |   |
| As  reported                                                                                                                            |       | $                                        | 0.44       |   | $ | 0.02 |   | $ | 0.71 |   |
| Pro  forma                                                                                                                              |       | $                                        | 0.30       |   | $ | (0.16 | ) | $ | 0.62 |   |

 

The pro forma effects onnet income for 2005, 2004 and 2003 are not representative of the pro formaeffect that will occur on net income in future periods (see Note 2 schedule labeled“New accounting pronouncement”).

 

**Research and development costs**

 

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

 

48

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**Income taxes**

 

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

 

**Computation of net income pershare**

 

Basic earnings per shareis computed using net income and the weighted average number of common sharesoutstanding. Diluted earnings per share reflect the weighted average number ofcommon shares outstanding plus any potentially dilutive shares outstandingduring the period. Potentially dilutive shares consist of shares issuable uponthe exercise of stock options and warrants, as well as unvested restrictedstock.

 

The computations forbasic and diluted net income per share are as follows:

 
| ** **                                                                  | ** ** | **For the Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                  | ** ** | **2005**                                 | ** ** | **2004** | ** ** | **2003** | ** ** |
| Numerator:                                                                  |       |                                     |       |   |   |   |   |
| Net  income                                                                 |       | $                                        | 5,800,530  |   | $ | 295,563 |   | $ | 8,462,141 |   |
|                                                                        |       |                                     |       |   |   |   |   |
| Denominator:                                                                |       |                                     |       |   |   |   |   |
| Denominator  for weighted average common shares outstanding – basic    |       | 12,378,815                               |       | 11,632,351 |   | 10,189,114 |   |
|                                                                        |       |                                     |       |   |   |   |   |
| Dilution  associated with common stock warrants                             |       | —                                   |       | 5,402 |   | 59,389 |   |
|                                                                        |       |                                     |       |   |   |   |   |
| Dilution  associated with the company’s stock based compensation plans |       | 904,626                                  |       | 897,917 |   | 1,599,765 |   |
|                                                                        |       |                                     |       |   |   |   |   |
| Denominator:                                                                |       |                                     |       |   |   |   |   |
| Denominator  for weighted average common shares outstanding – diluted  |       | 13,283,441                               |       | 12,535,670 |   | 11,848,268 |   |
|                                                                        |       |                                     |       |   |   |   |   |
| Net income per share –  basic                                          |       | $                                        | 0.47       |   | $ | 0.03 |   | $ | 0.83 |   |
| Net income per share –  diluted                                        |       | $                                        | 0.44       |   | $ | 0.02 |   | $ | 0.71 |   |

 

Aggregates of 230,000,545,000, and 172,000 shares of restricted stock and options to purchase sharesof common stock were excluded from the computations of diluted earnings pershare for the years ended December 31, 2005, 2004 and 2003, respectively,because they were anti-dilutive.

 

**Comprehensive income**

 

Comprehensive income asdefined by SFAS No. 130, “Reporting Comprehensive Income,” includes netincome and items defined as other comprehensive income. SFAS No. 130requires that items defined as other comprehensive income, such as foreigncurrency translation adjustments and unrealized gains and losses on certainmarketable securities, be separately classified in the financial statements. Suchitems are reported in the consolidated statements of stockholders’ equity ascomprehensive income.

 

**New accounting pronouncement**

 

In December 2004,the FASB issued SFAS No. 123 (revised 2004), “Share-Based Payment.” SFAS No. 123Rsupersedes APB Opinion No. 25, which requires recognition of an expensewhen goods or services are provided. SFAS No. 123R 

 

49

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requires thedetermination of the fair value of the share-based compensation at the grantdate and the recognition of the related expense over the period in which theshare-based compensation vests. SFAS No. 123R permits a prospective or twomodified versions of retrospective application under which financial statementsfor prior periods are adjusted on a basis consistent with the pro formadisclosures required for those periods by the original SFAS No. 123. In April 2005,the Securities and Exchange Commission adopted a new rule that amends thecompliance dates for SFAS No. 123R. The Company is required to adopt theprovisions of SFAS No. 123R effective January 1, 2006, at which timethe Company will begin recognizing an expense for unvested share-basedcompensation that has been issued or will be issued after that date. TheCompany has determined that it will adopt SFAS No. 123R using the modifiedprospective application method under which the Company will apply SFAS No. 123Rto new awards granted after the adoption of SFAS No. 123R and any portionof existing awards that were granted after December 15, 1994 and have notvested by the date the Company adopts SFAS No. 123R. The Company expectsthe impact of the adoption of SFAS No. 123R to be material to itsconsolidated financial statements. The Company estimates that equity-basedcompensation charges in 2006 will be approximately $4.1 million to $5.0 millionafter tax, depending on the stock price when new options are granted and thevolume and timing of incentive stock option exercises, all of which aredifficult to predict. These factors also affect the Company’s effective taxrate. Future stock-based compensation will differ from pro forma amounts (seeNote 2 schedule labeled “Stock-based compensation”).

 

**3.****              Acquisition**

 

The following acquisitionwas accounted for under the purchase method of accounting under SFAS No. 141,“Business Combinations,” and accordingly, the assets and liabilities acquiredwere recorded at their estimated fair values at the effective date of theacquisition, and the results of operations have been included in theconsolidated statements of operations since the acquisition date. In accordancewith SFAS No. 142, “Goodwill and Other Intangible Assets,” goodwillrecorded as a result of the acquisition is subject to an annual impairmenttest.

 

**HInnovation, Inc.**

 

On February 18,2004, the Company completed the acquisition of HInnovation, Inc. (“HInnovation”)in accordance with the terms and conditions of an Acquisition Agreement andPlan of Reorganization (the “Acquisition Agreement”) dated as of January 8,2004. HInnovation is a provider of software solutions that allow physicians touse PCs or notebook computers to access 2D, 3D and 4D medical imagingapplications securely over the Internet. The acquisition of HInnovation wasmade to acquire products and technology that will enable the Company to moreeffectively compete in the distributed computing market for 2D/3D/4Dvisualization and analysis software.

 

The total purchase priceof the HInnovation acquisition was approximately $12.6 million. The Companyacquired all of the outstanding common stock of HInnovation in exchange for$5.8 million in cash paid and 376,262 newly issued shares of common stockissued to the stockholders of HInnovation. The common stock was valued at $6.1million for accounting purposes. Vital Images’ stock was valued at $16.2375 pershare, which was equal to the average of the closing sale prices of one shareof Vital Images’ stock as reported on the Nasdaq National Market (now known asthe Nasdaq Global Market) for the two consecutive trading days occurring beforethe first public announcement of the signing of the Acquisition Agreement andthe two consecutive trading days occurring immediately after such publicannouncement date. The Company incurred $360,000 in direct costs of theacquisition and assumed $382,000 of liabilities. The Company did not assume anystock options or warrants.

 

The Company has acontingent consideration agreement related to the acquisition. The maximumpotential contingent consideration was initially $6.0 million. No contingentconsideration has been earned, and as of December 31, 2005, the remainingpotential maximum contingent consideration was $1.5 million in cash, which may beearned upon porting the Company’s base software to HInnovation’s Web-based platform andthe commercial launch thereof. A second milestone, based upon achieving revenuetargets for the HInnovation products by March 2005, was not met andexpired. A third milestone, based on licensing products based on patents heldby HInnovation by February 2006, was not met and expired. Any contingentpayments made by the Company will result in an equivalent increase in goodwill.

 

The purchase price wasallocated to the identified assets of HInnovation. A third-party appraisal firmassisted the Company with the valuation of the identified intangible assets. Thevaluation resulted in the allocation of $6.9 million to identifiable intangibleassets, which will be amortized over periods ranging from three to seven years.The valuation also resulted in the identification of $1.0 million of acquired in-processresearch and development (“IPR&D”) costs, which were immediately expensedon the closing date and represent a non-deductible charge for income taxpurposes.

 

At the time ofacquisition, HInnovation had development projects in process, including thecollaboration module of its Web-based product (the “Collaboration ModuleProject”). The Collaboration Module Project involves the design and development

 

50

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of innovative featuresfor Web-based consultation meetings with interactive and synchronized viewingof full-quality images, annotation and mouse movement. The Collaboration ModuleProject includes significant and innovative advancements to the HInnovationsoftware platform in the areas of network synchronization of high qualityimages and user privilege management for online collaboration. The design,verification and other processes involved in the Collaboration Module Projectrequire tools and skills that are new to HInnovation. The appraisal referencedabove estimated that $1.0 million of the purchase price represents the fairvalue of purchased IPR&D related to the Collaboration Module Project, thatit has not yet reached technological feasibility and that it has no alternativefuture uses. This amount was expensed as a non-recurring, non-tax-deductiblecharge upon consummation of the acquisition.

 

The appraisal firmapplied the income valuation approach to assist the Company in determining theestimated fair value of the purchased IPR&D. These estimates were based onthe following assumptions:

 

•                  Theestimated revenue was based upon HInnovation’s estimate of revenue growth overthe next seven years from the revenue growth of primarily the CollaborationModule.

 

•                  Theestimated gross margin of 65% to 78% was based upon gross margin for comparableproducts.

 

•                  Theestimated selling, general and administrative expenses were based on a considerationof historical operating expenses as a percentage of revenue and HInnovation’sprojected operating expenses.

 

•                  Thecost to complete each project was based on estimated remaining labor hours anda fully-burdened labor cost and other direct expenses.

 

•                  Thediscount rate used in the alternative income valuation approach was based onthe weighted average cost of capital (“WACC”). The WACC calculation producesthe average required rate of return of an investment in an operating enterprisebased on various required rates of return from investments in various areas ofthat enterprise. The discount rate used in the alternative valuation approachwas 35%. Premiums were added to the WACC to account for the inherent risks inthe development of the products, the risks of the products being completed onschedule, and the risk of the eventual sales of the product meeting theexpectations of HInnovation.

 

The first phase of theCollaboration Module was released in the third quarter of 2004. The first phaseprovided basic collaboration between users, allowing one user to present toanother user. The second phase of the Collaboration Module provided two-waycollaboration between users, allowing both users to interact with the data, andwas released in the third quarter of 2005.

 

The total purchase priceis as follows:

 
| Fair  value of common stock issued (376,262 shares) |   | $         | 6,109,554  |   |
|-----------------------------------------------------|--------|-----------|------------|--------|
| Cash paid to  HInnovation shareholders              |   | 5,752,626 |       |
| Direct acquisition  costs                           |   | 360,259   |       |
| Liabilities assumed                                 |   | 381,562   |       |
|                                                |   | $         | 12,604,001 |   |

 

The allocation of thetotal purchase price is as follows:

 
| Existing  software technology, subject to amortization - 5 year life       |   | $          | 3,400,000  |   |
|----------------------------------------------------------------------------|--------|------------|------------|--------|
| Patent and patent  applications, subject to amortization - 7 year life     |   | 3,000,000  |       |
| Non-compete/employement  agreements, subject to amortization - 3 year life |   | 500,000    |       |
| Goodwill                                                                   |   | 6,052,744  |       |
| In-process research and  development costs                                 |   | 1,000,000  |       |
| Deferred tax  liabilities, net                                             |   | (1,405,000 | )          |
| Fair value of assets  acquired                                             |   | 51,468     |       |
| Fair value of cash  acquired                                               |   | 4,789      |       |
|                                                                       |   | $          | 12,604,001 |   |

 

The following factors contributed to a purchase price that resulted inthe recognition of goodwill:

 

51

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•                  HInnovationhad the first Web-based product in the Company’s market.

 

•                  HInnovationhad a patent and patent applications that cover certain important aspects ofthe underlying technology.

 

•                  HInnovationalso had unique technology under development that was included as part ofthe acquired IPR&D.

 

The following unauditedpro forma condensed consolidated results of operations have been prepared as ifthe acquisition of HInnovation had occurred as of the beginning of the periodspresented. Pro forma adjustments relate to amortization of identifiedintangible assets, acquired IPR&D and income taxes. The unaudited pro formacondensed consolidated results of operations are for comparative purposes onlyand are not necessarily indicative of results that would have occurred had theacquisition occurred as of the beginning of the periods presented, nor are theynecessarily indicative of future results.

 
| ** **                      | ** ** | **For the Year Ended December 31,** | ** ** |
|---------------------------------|------------|------------------------------------------|------------|
| ** **                      | ** ** | **2004**                                 | ** ** | **2003** | ** ** |
| ** **                      | ** ** | ** **                               | ** ** | ** ** | ** ** |
| Revenue                         |       | $                                        | 36,150,047 |   | $ | 27,322,218 |   |
|                            |       |                                     |       |   |   |
| Net income                      |       | $                                        | 1,172,570  |   | $ | 6,517,277 |   |
| Net income per share -  diluted |       | $                                        | 0.09       |   | $ | 0.53 |   |

 

**4.****              Financial statementcomponents**

 

**Allowance for doubtful accounts**

 

The allowance fordoubtful accounts activity was as follows:

 
| ** **        | ** ** | **For the Year Ended December 31,** | ** ** |
|-------------------|------------|------------------------------------------|------------|
| ** **        | ** ** | **2005**                                 | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **        | ** ** | ** **                               | ** ** | ** ** | ** ** | ** ** | ** ** |
| Beginning balance |       | $                                        | 767,000    |   | $ | 235,000 |   | $ | 240,000 |   |
| Provision         |       | 43,000                                   |       | 626,800 |   | 46,000 |   |
| Write-offs        |       | (287,185                                 | )          | (94,800 | ) | (51,000 | ) |
| Recoveries        |       | (202,395                                 | )          | — |   | — |   |
| Ending balance    |       | $                                        | 320,420    |   | $ | 767,000 |   | $ | 235,000 |   |

 

The recovery in 2005 wasdue to the payment of a receivable for which the Company had previouslyestablished a specific allowance.

 

**Property and equipment, net**

 

The components of propertyand equipment were as follows:

 
| ** **                                      | ** ** | **December 31,** | ** ** |
|-------------------------------------------------|------------|-----------------------|------------|
| ** **                                      | ** ** | **2005**              | ** ** | **2004** | ** ** |
|                                            |       |                  |       |   |   |
| Equipment                                       |       | $                     | 7,496,476  |   | $ | 5,247,471 |   |
| Furniture and fixtures                          |       | 2,172,969             |       | 1,516,497 |   |
| Computer software                               |       | 1,104,836             |       | 765,870 |   |
| Leasehold improvements                          |       | 1,311,892             |       | 273,924 |   |
| Total  property and equipment                   |       | 12,086,173            |       | 7,803,762 |   |
| Less accumulated  depreciation and amortization |       | (6,724,854            | )          | (4,581,395 | ) |
| Property  and equipment, net                    |       | $                     | 5,361,319  |   | $ | 3,222,367 |   |

 

Depreciation expense was$2.1 million, $1.6 million and $1.2 million for the years ended December 31,2005, 2004 and 2003, respectively.

 

52

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**Licensed technology, net**

 

In July 2001, theCompany entered into an agreement to license technology from a third party. TheCompany paid an aggregate of $750,000 to the licensor in 2001. The Companyrecorded this $750,000 purchase as licensed technology and is amortizing itover the estimated useful life of the technology of 75 months. Thisamortization expense is reported as cost of revenue for license fees. As part ofthis agreement, the Company is also obligated to pay the licensor royalties onthe sales of certain products as defined in the agreement. During 2005, 2004and 2003, $1.4 million, $1.0 million and $772,000, respectively, of suchroyalties were incurred and were reported as cost of revenue for license fees.

 
| ** **                     | ** ** | **December 31,** | ** ** |
|--------------------------------|------------|-----------------------|------------|
| ** **                     | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Licensed technology            |       | $                     | 750,000    |   | $ | 750,000 |   |
| Less accumulated  amortization |       | (540,000              | )          | (420,000 | ) |
| Licensed technology,  net      |       | $                     | 210,000    |   | $ | 330,000 |   |

 

 

Amortization expense was$120,000 for each of the years ended December 31, 2005, 2004 and 2003.

 

**Other intangible assets, net**

 

Acquired intangibleassets subject to amortization were as follows:

 
| ** **                                       | ** ** | **December 31,  2005** | ** ** | **December 31,  2004**   | ** ** |
|--------------------------------------------------|------------|-----------------------------|------------|-------------------------------|------------|
| ** **                                       | ** ** | **Gross  Carrying  Value**  | ** ** | **Accumulated  Amortization** | ** ** | **Net  Carrying  Value** | ** ** | **Gross  Carrying  Value** | ** ** | **Accumulated  Amorization** | ** ** | **Net  Carrying  Value** | ** ** |
| ** **                                       | ** ** | ** **                  | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Existing  software technology                    |       | $                           | 3,400,000  |                          | $          | (1,282,000 | ) | $ | 2,118,000 |   | $ | 3,400,000 |   | $ | (598,000 | ) | $ | 2,802,000 |   |
| Patents  and patent applications                 |       | 3,000,000                   |       | (810,000                      | )          | 2,190,000 |   | 3,000,000 |   | (378,000 | ) | 2,622,000 |   |
| Non-compete/employment  agreements               |       | 500,000                     |       | (315,000                      | )          | 185,000 |   | 500,000 |   | (147,000 | ) | 353,000 |   |
| Total  intangible assets subject to amortization |       | $                           | 6,900,000  |                          | $          | (2,407,000 | ) | $ | 4,493,000 |   | $ | 6,900,000 |   | $ | (1,123,000 | ) | $ | 5,777,000 |   |

 

Intangible assets subjectto amortization are amortized on a straight-line basis over the estimatedperiod of benefit. Amortization expense was $1.3 million and $1.1 million forthe years ended December 31, 2005 and 2004, respectively.  The estimated future annual amortizationexpense for identified intangible assets is as follows:

 
| 2006       |   | $         | 1,284,000 |   |
|------------|--------|-----------|-----------|--------|
| 2007       |   | 1,133,000 |      |
| 2008       |   | 1,116,000 |      |
| 2009       |   | 498,000   |      |
| 2010       |   | 432,000   |      |
| Thereafter |   | 30,000    |      |
|       |   | $         | 4,493,000 |   |

 

The preceding expectedamortization expense is an estimate. Actual amortization expense may differfrom estimates due to additional intangible asset acquisitions, impairment ofintangible assets, accelerated amortization of intangible assets, and otherevents.

 

**Goodwill**

 

The changes in thecarrying amount of goodwill for the year ended December 31, 2005 are asfollows:

 

53

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| Beginning balance                  |   | $      | 6,052,744 |   |
|------------------------------------|--------|--------|-----------|--------|
| Goodwill  acquired during the year |   | — |      |
| Ending balance                     |   | $      | 6,052,744 |   |

 

**Deferred revenue**

 

The components ofdeferred revenue were as follows:

 
| ** **                             | ** ** | **December 31,** | ** ** |
|----------------------------------------|------------|-----------------------|------------|
| ** **                             | ** ** | **2005**              | ** ** | **2004** | ** ** |
|                                   |       |                  |       |   |   |
| Maintenance and support                |       | $                     | 7,136,577  |   | $ | 4,734,764 |   |
| Training                               |       | 3,528,738             |       | 2,697,892 |   |
| Installation                           |       | 224,550               |       | 309,200 |   |
| Software                               |       | 592,353               |       | 454,108 |   |
| Hardware and other                     |       | 393,590               |       | 218,448 |   |
| Total  deferred revenue                |       | 11,875,808            |       | 8,414,412 |   |
| Less  current portion                  |       | (11,230,578           | )          | (8,136,844 | ) |
| Long-term  portion of deferred revenue |       | $                     | 645,230    |   | $ | 277,568 |   |

 

**5.****              Commitments andcontingencies**

 

**Operating lease commitments**

 

The Company rents officespace and certain office equipment under operating leases. In addition tominimum lease payments, the office leases require payment of a proportionateshare of real estate taxes and building operating expenses. Total rent expense,including an allocation of the lessor’s operating costs, was $635,000, $715,000and $678,000 for the years ended December 31, 2005, 2004 and 2003,respectively.

 

In March 2004, theCompany signed a non-cancelable operating lease for a new office facility inMinnetonka, Minnesota. The new lease term started in February 2005 andexpires in January 2012. The Company moved into the Minnetonka locationand moved out of its Plymouth, Minnesota location in February 2005. TheCompany’s office facility in Plymouth expired on July 31, 2005 with theexception of a small portion of the space that is under lease until May 31,2006. Under the terms of the new lease, the Minnetonka lessor will pay themonthly base rent payments and taxes and operating cost rent obligationpayments for the Company’s former office facility in Plymouth beginning February 2005.

 

The Company recordeddeferred rent of $1.6 million in the first quarter of 2005 relating toestimated payments by the Minnetonka lessor for the benefit of the Company. Suchpayments are considered lease incentives under FASB Technical Bulletin (“FTB”)88-1, “Issues Relating to Accounting for Leases,” and are amortized as a reductionof rent expense over the term of the Minnetonka lease. The deferred rentbalance as of December 31, 2005 was $1.4 million, of which $187,000 wasclassified as current. Payments by the Minnetonka lessor for the benefit of theCompany consist of the following:

 

•                  $405,000relating to lease payments to be made by the Minnetonka lessor to the Plymouthlessor; under FTB 88-1, such payments must be recorded as a lease loss by theCompany in the first quarter of 2005. Additionally, the Company recorded $88,000of other costs relating to the Plymouth lease, resulting in a total loss onoperating lease of $493,000.

•                  $205,000relating to moving costs reimbursed to the Company by the Minnetonka lessor;moving costs were expensed as incurred during the first quarter of 2005.

•                  $975,000relating to leasehold improvements paid for by the Minnetonka lessor; under FTB88-1, such leasehold improvements must be recorded as an asset by the Companyand amortized over the shorter of their estimated useful lives or the remainingterms of the related leases.

 

The minimum leasepayments, excluding estimated taxes and operating cost rent obligations, areapproximately:

 

54

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| 2006       |   | $       | 511,000   |   |
|------------|--------|---------|-----------|--------|
| 2007       |   | 695,000 |      |
| 2008       |   | 728,000 |      |
| 2009       |   | 744,000 |      |
| 2010       |   | 760,000 |      |
| Thereafter |   | 841,000 |      |
| Total      |   | $       | 4,279,000 |   |

 

**Purchase commitments**

 

In April 2005, theCompany entered into an agreement with R2 Technology, Inc. (“R2”) tomarket R2’s lung nodule CAD software product to the Company’s customers. The April 2005agreement replaced the Company’s November 2002 agreement with R2. Underthe April 2005 agreement, all previous commitments were cancelled andreplaced with a new commitment which began in the third quarter of 2005. Thenew commitment provides R2 with certain minimum quarterly revenues (“ApplicableMinimums”) from the sale of certain R2 lung CAD related products and services (“R2Lung CAD Products”) over a 12-quarter period ending June 30, 2008. TheCompany will receive a commission based on sales of R2 Lung CAD Products to theCompany’s customers. This agreement states that to the extent the quarterlyApplicable Minimum is not met, the Company will pay R2 the difference betweenthe Applicable Minimum and the actual R2 Lung CAD Product revenue achieved.

 

The Applicable Minimumsfor the quarters ending September 30, 2005, December 31, 2005 and March 31,2006 are $414,000 per quarter. However, beginning in the quarter ending June 30,2006 and for each subsequent quarter thereafter, the Applicable Minimum will bereduced to the lowest of:

 

i)                                         theApplicable Minimum in the preceding quarter;

ii)                                      theApplicable Minimum of the preceding quarter multiplied by the percent by whichthe R2 Lung CAD Product revenue in the preceding quarter fell below thatquarter’s Applicable Minimum, up to a maximum decline of twenty-three percent(23%); or

iii)                                   twotimes the R2 Lung CAD Product revenue generated by R2 during the precedingquarter through all other sales, marketing and distribution channels, excludingR2 Lung CAD Product revenue generated from Customers under the agreement.

 

If at any time during theremainder of the R2 agreement the Applicable Minimum is less than $414,000 andR2 Lung CAD Product revenue for a quarter exceeds $414,000, the Applicable Minimumfor the next quarter will be $414,000. Thereafter, the Applicable Minimums willbe subject to the above adjustment. Additionally, at the end of every fourthquarter under the April 2005 R2 agreement, if the aggregate revenuegenerated under the agreement in the previous four quarters exceeded$1,665,000, the remaining Applicable Minimum per quarter shall be reduced bythe amount of excess divided by the number of quarters remaining under theagreement.

 

The Applicable Minimumfor the quarter ended December 31, 2005 was not met by approximately$314,000 and, based on current estimates, management believes it is probablethat the estimated aggregate Applicable Minimums will not be met for thequarter ending March 31, 2006. Additionally, management estimates that theApplicable Minimum will be $0 after March 31, 2006, as, based oninformation available to us, R2 has not generated any R2 Lung CAD Productrevenue through any other sales, marketing and distribution channels, otherthan R2 Lung CAD Product revenue generated from Customers under this agreement.Based on these results and future estimates, the Company recorded a $410,000net loss to sales and marketing expense in the quarter ended December 31,2005 relating to this agreement to cover estimated losses through March 31,2006. The $410,000 net loss is based on the fourth quarter of 2005 shortfall of$314,000 and first quarter of 2006 Applicable Minimum of $414,000 offset by theestimated forecasted revenues of $140,000, by the deferred commission fees onsales as of December 31, 2005 of $142,000 and estimated deferredcommission fee on forecasted revenues of $36,000. However, the estimatedaggregate Applicable Minimums is a subjective determination, and any changes toestimates and actual results could have an adverse impact on the Company’sfinancial position and results of operations. As of December 31, 2005, theremaining potential aggregate Applicable Minimums range from a minimum ofapproximately $414,000 to a maximum of approximately $4.1 million. Any futurelosses will be recorded under SFAS No. 5, “Accounting for Contingencies,”,which requires the amount to be probable and estimable.

 

The Company has notrecognized any commission revenue relating to this agreement, as it was notconsidered to be fixed or determinable due to the potential for payments by theCompany to R2 relating to the Applicable Minimums.

 

55

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**Other items**

 

Under general contractterms, the Company includes an indemnification clause in its software licensingagreement that indemnifies the licensee against liability and damages arisingfrom any claims of patent, copyright, trademark or trade secret infringement bythe Company’s software. The Company has incurred insignificant costs as aresult of this type of indemnification clause, and the Company does notmaintain a product warranty liability related to such indemnification clauses.

 

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

 

**6.****              Stockholders’ equity**

 

**Background**

 

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

 

**Privateplacement**

 

InJune 2003, the Company completed a private placement of 1.5 million sharesof common stock at $13.50 per share for total gross proceeds of $20.3 million. Afterdeducting offering costs of $1.3 million, the Company received net proceeds of$19.0 million. A registration statement covering the resale of these shares wasdeclared effective on September 29, 2003 by the Securities and ExchangeCommission. Effective March 1, 2006, we de-registered the resale of theseshares not already sold.

 

**Stockoption 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 theplan, the Board of Directors may grant options and other stock-basedawards to key employees to purchase shares of the Company’s common stock at anoption exercise price equal to or greater than 85% of the fair market value onthe date of grant. The options are exercisable at such times, in installmentsor otherwise, as the Board of Directors may determine. Generally, theseoptions have 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. The totalnumber of shares of common stock that may be issued or awarded under theStock Option Plan is 4.1 million. As of December 31, 2005, there were 715,181shares available for the grant of awards under the Stock Option Plan.

 

Also in May 1997,Bio-Vascular, as the sole shareholder of the Company, approved and adopted theVital Images, Inc. 1997 Director Stock Option Plan (the “Director Plan”)(together with the Stock Option Plan, the “1997 Plans”), which became effectiveon the Distribution Date. The Director Plan provides non-employee directorswith automatic grants of stock options and allows the Board of Directors tomake additional discretionary option grants to any or all directors. Optionsthat are granted under the Director Plan are granted with an option price equalto the fair market value on the date of grant, with a term of eight years, arenon-qualified options and become exercisable in three equal annual installmentsbeginning on the first occurring December 31 after the date of grant. Thetotal number of shares of common stock that may be issued or awarded underthe Director Plan is 500,000. As of December 31, 2005, there were 207,000shares available for the grant of awards under the Director Plan.

 

The Company had optionsto purchase 194,000, 199,000 and 205,012 shares outside of the above plans outstandingas of December 31, 2005, 2004 and 2003, respectively. No non-plan optionswere granted during the years ended December 31, 2005, 2004 or 2003.

 

56

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**Non-employeeoptions**

 

In December 2000,the Company granted options to purchase 10,000 shares to a non-employeeconsultant. Options to purchase 5,000 shares vest over a four-year period, andthe remaining options vested immediately when a specified milestone wasachieved, which occurred in May 2003. The options to purchase 5,000 sharesthat vested in May 2003 were exercised in June 2003. In December 2001,the Company granted options to purchase a total of 4,000 shares to twonon-employee consultants and, in December 2002, the Company grantedoptions to purchase an additional 4,000 shares to two non-employee consultants.These options vest over a four-year period. All of the non-plan options have aterm of eight years and were granted at exercise prices at least equal to fairmarket value of the Company’s common stock on the date of grant. The Companyrecords compensation expense related to these arrangements based upon the fairvalues of the options during the periods the consultants provide services. Suchfair values are measured using the Black-Scholes option-pricing model. TheCompany recorded $21,000, $12,000 and $137,000 of compensation expense relatedto these options for each of the years ended December 31, 2005, 2004 and2003, respectively.

 

The following tablesummarizes stock option activity for 2005, 2004 and 2003:

 
| ** **                                      | ** ** | **Shares Underlying   Options** | ** ** | **Weighted-Average   Exercise Price Per   Share** | ** ** |
|-------------------------------------------------|------------|---------------------------------|------------|---------------------------------------------------|------------|
|                                            |       |                            |       |                                              |       |
| Total outstanding as of  December 31, 2002 |       | 2,461,844                       |       | $                                                 | 4.98       |   |
|                                            |       |                            |       |                                              |       |
| Options  granted                                |       | 618,750                         |       | $                                                 | 12.04      |   |
| Options  exercised                              |       | (574,381                        | )          | $                                                 | 3.55       |   |
| Options  cancelled                              |       | (65,241                         | )          | $                                                 | 7.31       |   |
|                                            |       |                            |       |                                              |       |
| Total outstanding as of  December 31, 2003 |       | 2,440,972                       |       | $                                                 | 7.05       |   |
|                                            |       |                            |       |                                              |       |
| Options  granted                                |       | 514,100                         |       | $                                                 | 12.29      |   |
| Options  exercised                              |       | (456,380                        | )          | $                                                 | 4.32       |   |
| Options  cancelled                              |       | (172,017                        | )          | $                                                 | 9.80       |   |
|                                            |       |                            |       |                                              |       |
| Total outstanding as of  December 31, 2004 |       | 2,326,675                       |       | $                                                 | 8.54       |   |
|                                            |       |                            |       |                                              |       |
| Options  granted                                |       | 509,315                         |       | $                                                 | 17.60      |   |
| Options  exercised                              |       | (711,288                        | )          | $                                                 | 6.33       |   |
| Options  cancelled                              |       | (127,427                        | )          | $                                                 | 11.45      |   |
|                                            |       |                            |       |                                              |       |
| Total outstanding as of  December 31, 2005 |       | 1,997,275                       |       | $                                                 | 11.45      |   |
|                                            |       |                            |       |                                              |       |
| Options  exercisable as of:                     |       |                            |       |                                              |       |
| December 31,  2003                         |       | 1,407,347                       |       | $                                                 | 5.09       |   |
| December 31,  2004                         |       | 1,409,650                       |       | $                                                 | 6.74       |   |
| December 31,  2005                         |       | 1,185,463                       |       | $                                                 | 9.03       |   |

 

Various price ranges andweighted average information for options outstanding and exercisable as of December 31,2005 are as follows:

 
| ** **                    | ** ** | **Options  Outstanding** | ** ** | **Options  Exercisable**                           | ** ** |
|-------------------------------|------------|--------------------------|------------|----------------------------------------------------|------------|
| **Range of  Exercise Prices** | ** ** | **Number  Outstanding**  | ** ** | **Weighted  Average  Remaining  Contractual Life** | ** ** | **Weighted  Average Exercise  Price** | ** ** | **Number  Exercisable** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|                          |       |                     |       |                                               |       |   |   |   |   |   |   |
| $2.31                    | -          | $7.00                    |       |                                               | 278,779    |   | 2.28 years |   | $ | 4.62 |   | 274,139 |   | $ | 4.60 |   |
| $7.25                         | -          | $7.25                    |       |                                               | 350,119    |   | 4.19 years |   | $ | 7.25 |   | 323,914 |   | $ | 7.25 |   |
| $7.34                    | -          | $9.60                    |       |                                               | 346,844    |   | 4.16 years |   | $ | 8.80 |   | 271,510 |   | $ | 8.61 |   |
| $9.94                    | -          | $12.60                   |       |                                               | 340,983    |   | 6.09 years |   | $ | 11.93 |   | 153,555 |   | $ | 11.81 |   |
| $13.01                        | -          | $16.98                   |       |                                               | 385,415    |   | 6.95 years |   | $ | 16.08 |   | 61,900 |   | $ | 16.66 |   |
| $17.75                   | -          | $26.75                   |       |                                               | 295,135    |   | 7.10 years |   | $ | 19.37 |   | 100,445 |   | $ | 19.09 |   |
|                          |       | 1,997,275                |       | 5.21 years                                         |       | $ | 11.45 |   | 1,185,463 |   | $ | 9.03 |   |

 

57

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**Employeestock purchase plan**

 

The 1997 Employee StockPurchase Plan (the “ESPP”) was approved and adopted by Bio-Vascular, as thesole shareholder of the Company, in May 1997. The ESPP, which becameeffective on July 1, 1997, enables eligible employees to purchase theCompany’s common stock at a price equal to 85% of the fair market value of thestock on the date an offering period commences or on the date an offeringperiod terminates, whichever is lower. The ESPP covers an aggregate of up to250,000 shares of common stock that can be issued and sold to participatingemployees of the Company through a series of three-month offering periods,beginning July 1, 1997. The ESPP covers substantially all employees,subject to certain limitations. Each employee may elect to have up to 10%of his or her base pay withheld and applied toward the purchase of shares ineach such offering period. Purchases under the ESPP for 2005 were 14,526shares, generating proceeds to the Company of $210,000 at an average purchaseprice of $14.45; for 2004 were 18,344 shares, generating proceeds to theCompany of $172,000 at an average purchase price of $9.37; and for 2003 were12,995 shares, generating proceeds to the Company of $151,000 at an averagepurchase price of $11.59. As of December 31, 2005, there were 68,583shares of common stock reserved for future purchases under the ESPP.

 

**Stock-basedcompensation**

 

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

 
| ** **                     | ** ** | **For the  Years Ended December 31,** | ** ** |
|--------------------------------|------------|--------------------------------------------|------------|
| ** **                     | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Options  under the 1997 Plans  |       | $                                          | 10.31      |   | $ | 8.30 |   | $ | 8.20 |   |
| Discount  on shares under ESPP |       | $                                          | 4.81       |   | $ | 3.47 |   | $ | 3.65 |   |

 

The weighted average fairvalues for the 1997 Plans and the non-plan options were based on the fairvalues on the dates of grant.   The fairvalues for the 1997 Plans and the non-plan employee options were calculatedusing the Black-Scholes option-pricing model with the following weighted-averageassumptions:

 
| ** **                  | ** ** | **For the  Years Ended December 31,** | ** ** |
|-----------------------------|------------|--------------------------------------------|------------|
| ** **                  | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Expected  option life       |       | 5.0 years                                  |       | 5.0 years |   | 5.0 years |   |
| Expected  volatility factor |       | 67                                         | %          | 83 | % | 85 | % |
| Expected  dividend yield    |       | 0                                          | %          | 0 | % | 0 | % |
| Risk-free  interest rate    |       | 3.90                                       | %          | 3.41 | % | 3.07 | % |

 

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

 
| ** **                  | ** ** | **For the  Years Ended December 31,** | ** ** |
|-----------------------------|------------|--------------------------------------------|------------|
| ** **                  | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Expected  option life       |       | 4.38 years                                 |       | 5.38 years |   | 5.9 years |   |
| Expected  volatility factor |       | 68                                         | %          | 79 | % | 85 | % |
| Expected  dividend yield    |       | 0                                          | %          | 0 | % | 0 | % |
| Risk-free  interest rate    |       | 4.07                                       | %          | 3.50 | % | 2.66 | % |

 

The weighted-average fairvalues of shares under the ESPP were based on the 15% purchase discount.

 

**Deferred stock-based compensation**

 

The Company grantsnonvested shares of common stock (“restricted stock”) to certain employeesunder the Stock Option Plan. The restricted stock vests 25% annually beginningone year after the grant date. The Company records deferred stock-basedcompensation equal to the fair market value of the common stock on the date ofgrant and amortizes the deferred stock-based compensation ratably over thevesting term of the grant.

 

The following tablesummarizes the activity in deferred stock-based compensation for 2005:

 

58

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| ** **                                         | ** ** | **For the Year Ended   December 31,** | ** ** |
|----------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                         | ** ** | **2005**                                   | ** ** |
| Beginning balance                                  |       | $                                          | —     |   |
| Restricted  stock awards, net of cancellations     |       | 2,020,609                                  |       |
| Amortization  of deferred stock-based compensation |       | (313,596                                   | )          |
| Ending balance                                     |       | $                                          | 1,707,013  |   |

 

No restricted stockawards were granted in 2004 or 2003.

 

**Warrants**

 

In December 1999,the Company completed a private placement of 1.65 million units at $3.25 perunit. Each unit consisted of one share of the Company’s common stock and aredeemable, five-year warrant to purchase an additional share of common stockat $3.75 per share. The warrants were immediately exercisable with anexpiration date in December 2004. The warrants could be redeemed by theCompany at any time before December 2004 at a redemption price of $.01 perwarrant, upon notice of such redemption, provided that (i) the closing bidprice of the Company’s common stock exceeded $5.75 per share for any 30consecutive trading days prior to such notice and (ii) a registrationstatement covering the resale of the warrant shares had been filed by theCompany with the Securities and Exchange Commission and was effective as of thedate of such notice. The Company satisfied the conditions for redemption of thewarrants on December 7, 2000. In December 2001, the Company calledfor redemption of all outstanding warrants. As of December 31, 2003, all 1.65million warrants had been exercised.

 

The Company also issuedwarrants to the selling agent for the December 1999 private placement topurchase 163,651 shares of the Company’s common stock at $3.25 per share. Thewarrants were immediately exercisable and expired in December 2004. During2004 and 2003, warrants to purchase 19,156 and 83,063, respectively, wereexercised. These warrant exercises generated proceeds to the Company of $18,800and $248,000 for the years ended December 31, 2004 and 2003, respectively.In conjunction with these exercises, during 2004 and 2003, 3,362 and 1,693shares, respectively, were forfeited as part of cashless exercises. As of December 31,2005, none of these warrants remained outstanding.

 

**Rightsplan**

 

In April 1997, theCompany declared a dividend distribution of one Preferred Stock Purchase Rightfor each outstanding share of the Company’s common stock (the “Rights”). Withcertain exceptions, the Rights become exercisable only if one of the followingevents occurs: (i) an acquiring party accumulates 15% or more of theCompany’s common stock, (ii) a party announces an offer to acquire 15% ormore of the Company’s common stock, or (iii) the acquisition of asubstantial amount of the Company’s common stock by a person whom the Board ofDirectors has determined is an “Adverse Person” as defined in the underlyingRights Agreement. Each Right entitles the holder to purchase one-thousandth ofa share of the Company’s Series A Junior Preferred Stock at a price of$20.00 (the “Exercise Price”). If a person or group becomes the beneficialowner of 15% or more of the Company’s common stock or the Board of Directorsdetermines that a person is an Adverse Person, each holder of a Right shallthereafter have the right to receive preferred stock having a fair market valueequal to two times the Exercise Price. Upon the occurrence of certain mergers,combinations or acquisitions 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 toredeem the Right at $.001 per Right at any time until 10 days following theacquisition of 15% or more of the Company’s common stock or 10 days after thepoint at which the Company’s Board of Directors determines that a person is anAdverse Person, as defined by the Rights Agreement. The Rights expire on April 30,2007 if not previously redeemed or exercised.

 

**7.****              Income taxes**

 

The income tax provision(benefit) for the years ended December 31, 2005, 2004 and 2003 include thefollowing components:

 

59

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| ** **                            | ** ** | **For the Year Ended December 31,** | ** ** |
|---------------------------------------|------------|------------------------------------------|------------|
| ** **                            | ** ** | **2005**                                 | ** ** | **2004** | ** ** | **2003** | ** ** |
| Current income taxes:                 |       |                                     |       |   |   |   |   |
| Federal                               |       | $                                        | 48,000     |   | $ | 25,000 |   | $ | — |   |
| State                                 |       | 36,000                                   |       | 5,000 |   | 79,000 |   |
|                                  |       | 84,000                                   |       | 30,000 |   | 79,000 |   |
| Deferred income taxes:                |       |                                     |       |   |   |   |   |
| Federal                               |       | 2,613,000                                |       | 513,000 |   | (7,657,000 | ) |
| State                                 |       | 159,000                                  |       | 44,000 |   | 1,265,000 |   |
| Foreign                               |       | (25,000                                  | )          | — |   | — |   |
|                                  |       | 2,747,000                                |       | 557,000 |   | (6,392,000 | ) |
| Provision (benefit) for  income taxes |       | $                                        | 2,831,000  |   | $ | 587,000 |   | $ | (6,313,000 | ) |

 

A reconciliation of theCompany’s income tax provision (benefit) computed using the federal statutoryrate to the tax provision reported in the Company’s statements of operations isas follows:

 
| ** **                                            | ** ** | **For the Year Ended December 31,** | ** ** |
|-------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                            | ** ** | **2005**                                 | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                            | ** ** | ** **                               | ** ** | ** ** | ** ** | ** ** | ** ** |
| Tax provision computed  at the federal statutory rate |       | $                                        | 2,935,000  |   | $ | 300,000 |   | $ | 726,000 |   |
| State taxes, net of  federal benefit                  |       | 299,000                                  |       | 94,000 |   | 116,000 |   |
| Increase (decrease) in  tax from:                     |       |                                     |       |   |   |   |   |
| Research  and development tax credits                 |       | (362,000                                 | )          | (319,000 | ) | (85,000 | ) |
| Business  meals and entertainment                     |       | 41,000                                   |       | 46,000 |   | 34,000 |   |
| Extraterritorial  income exclusion                    |       | (27,000                                  | )          | — |   | — |   |
| Foreign  tax rate differential                        |       | (5,000                                   | )          | — |   | — |   |
| Acquired  in-process research and development         |       | —                                   |       | 340,000 |   | — |   |
| Change  in state tax rate                             |       | (104,000                                 | )          | (54,000 | ) | — |   |
| Change  in valuation allowance                        |       | 47,000                                   |       | 226,000 |   | (7,171,000 | ) |
| Other,  net                                           |       | 7,000                                    |       | (46,000 | ) | 67,000 |   |
| Provision (benefit) for  income taxes                 |       | $                                        | 2,831,000  |   | $ | 587,000 |   | $ | (6,313,000 | ) |

 

The significantcomponents of the Company’s tax-effected net deferred tax assets are as follows:

 
| ** **                                          | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------|------------|-----------------------|------------|
| ** **                                          | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Current:                                            | ** ** | ** **            | ** ** | ** ** | ** ** |
| Accrued  expenses and allowances                    |       | $                     | 717,000    |   | $ | 600,000 |   |
| Total  current                                      |       | $                     | 717,000    |   | $ | 600,000 |   |
|                                                |       |                  |       |   |   |
| Noncurrent:                                         |       |                  |       |   |   |
| Net  operating loss carryforwards                   |       | $                     | 7,760,000  |   | $ | 8,880,000 |   |
| Research  and development tax credit carryforwards  |       | 2,365,000             |       | 1,570,000 |   |
| Depreciation  and amortization                      |       | 516,000               |       | 434,000 |   |
| Deferred  revenue                                   |       | 235,000               |       | 105,000 |   |
| Identified  intangible assets                       |       | (1,641,000            | )          | (2,193,000 | ) |
| Other,  net                                         |       | 3,000                 |       | 31,000 |   |
| Net  deferred tax assets before valuation allowance |       | 9,238,000             |       | 8,827,000 |   |
| Less  valuation allowance                           |       | (289,000              | )          | (373,000 | ) |
| Total  noncurrent                                   |       | $                     | 8,949,000  |   | $ | 8,454,000 |   |

 

**Net operating loss carryforwardsand other tax credit carryforwards as of December 31, 2005**

 

TheCompany had federal tax loss carryforwards of approximately $21.7 million,representing a $7.4 million deferred tax 

 

60

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assetas of December 31, 2005. Of the total federal tax loss carryforward, $10.0million was generated through the exercise of stock options. The federal taxloss carryforwards will expire in 2010 through 2023 if not utilized. TheCompany estimates that it is more likely than not that this deferred tax assetwill be realized prior to expiration.

 

TheCompany had state tax loss carryforwards of approximately $6.3 million,representing a $354,000 deferred tax asset as of December 31, 2005. Thestate tax loss carryforwards will expire at various dates through 2023 if notutilized. The Company recorded a $47,000 valuation allowance related to thisdeferred tax asset as of December 31, 2005 due to the uncertainty in realizationprior to expiration. The Company wrote off $131,000 to the valuationallowance relating to state deferred tax assets for net operating losses nolonger available to the Company.

 

TheCompany had foreign tax loss carryforwards of approximately $83,000,representing a $25,000 deferred tax asset as of December 31, 2005. TheCompany estimates that it is more likely than not that this deferred tax assetwill be realized prior to expiration.

 

TheCompany had other federal and state tax credits and carryforwards ofapproximately $2.4 million, representing a $2.1 million deferred tax asset asof December 31, 2005. The federal and state credits and carryforwards willexpire in 2006 through 2025 if not utilized. The Company had a $242,000valuation allowance related to this deferred tax asset as of December 31,2005 due to the uncertainty in realization prior to expiration.

 

**Activityduring the year ended December 31, 2005**

 

TheCompany’s methodology for determining the realizability of its deferred taxassets involves estimates of future taxable income from its core business, theestimated impact of future tax deductions from the exercise of stock optionsoutstanding as of December 31, 2005, and the expiration dates and amountsof net operating loss carryforwards and other tax credits. These estimates areprojected through the life of the related deferred tax assets based onassumptions which management believes to be reasonable and consistent withcurrent operating results.

 

Althoughthe Company had cumulative pre-tax income for financial reporting purposes forthe three years ended December 31, 2005, the Company did not pay anysignificant income taxes over that period due to tax deductions from theexercise of stock options as well as its utilization of net operating losses. Inassessing the realizability of its deferred tax assets as of December 31,2005, the Company considered evidence regarding its ability to generatesufficient future taxable income to realize its deferred tax assets. Theprimary evidence considered included the cumulative pre-tax income forfinancial reporting purposes for the past three years; the estimated impact offuture tax deductions from the exercise of stock options outstanding as of December 31,2005; and the estimated future taxable income based on historical operatingresults.

 

Aftergiving consideration to these factors, the Company concluded that it was morelikely than not that tax loss carryforwards will be realized prior toexpiration and other tax credits that expire prior to 2010 will not be utilizeddue to the estimated future tax deductions from the exercise of stock optionsoutstanding as of December 31, 2005 as well as utilization of tax losscarryforwards. As a result, the Company had a valuation allowance of $289,000 asof December 31, 2005 relating to net operating losses and tax credits thatexpire prior to 2010.

 

TheCompany also concluded that it was more likely than not that the net deferredtax assets of $9.7 million as of December 31, 2005 and the estimatedfuture tax deductions from the exercise of stock options outstanding as of December 31,2005 would be utilized prior to expiring. Based on this conclusion, the Companywould require approximately $55.6 million in cumulative future taxable incometo be generated at various times over the next 20 years to realize the relatednet deferred tax assets of $9.7 million as of December 31, 2005 as well asthe estimated future tax deductions from the exercise of stock optionsoutstanding and in-the-money as of December 31, 2005.

 

If the Company adjustseither its estimates of future taxable income or tax deductions from theexercise of stock options down, or the Company’s stock price increasessignificantly without an increase in taxable income, causing the Company tobelieve that its deferred tax assets will not be utilized, the Company may needto establish additional valuation allowances on its deferred tax assets, whichcould materially impact its financial position and results of operations.

 

**Activityduring the year ended December 31, 2004**

 

TheCompany concluded that it was more likely than not that tax loss carryforwardsthat expire in 2005 and other tax credits that expire within the next fouryears will not be utilized due to the estimated future tax deductions from theexercise of stock options outstanding as of December 31, 2004. As aresult, the Company recorded a valuation allowance of $183,000 for the yearended December 31, 2004. The Company also recorded a valuation allowanceof $43,000 relating to 2004 foreign net operating losses that are subject touncertainty regarding utilization and, therefore, a full valuation allowancewas recorded.

 

61

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**Activityduring the year ended December 31, 2003**

 

During2003, the Company concluded that it is more likely than not that substantiallyall of its net deferred tax assets would be realized, and the Company reversedsubstantially all of its valuation allowance for net deferred tax assets, whichresulted in the recording of a net tax benefit in 2003. The reversal of thedeferred tax assets valuation allowance was based upon the Company’s historicaloperating performance and management’s expectation that the Company willgenerate taxable income of at least $25 million in future periods to allow itto realize its deferred tax assets resulting from the tax benefits associatedwith its net operating loss carryforwards and a significant portion of itsresearch and development tax credit carryforwards, as well as certain other taxbenefits related to book and tax income timing differences. The reversal of thevaluation allowance resulted in a tax benefit of $7,171,000. This reversal, netof other current year state and federal income taxes, resulted in a net taxbenefit of $6,507,000 in 2003.

 

**Netoperating loss carryforward limitations**

 

UnderSection 382 of the Internal Revenue Code of 1986, certain stocktransactions which significantly change ownership, including the sale of stockand the granting of options to purchase stock, could limit the amount of netoperating loss carryforwards that may be utilized on an annual basis tooffset taxable income in future periods. Future changes in ownership, asdefined by Section 382, could result in additional limitations in theamount of net operating loss carryforwards that may be utilized on anannual basis.

 

**8.****              Employee benefitplan**

 

The Company maintains theVital Images, Inc. Salary Savings Plan (the “Plan”), which is intended toqualify under Section 401(k) of the Internal Revenue Code, as amended. ThePlan covers substantially all employees. Each employee may elect tocontribute to the Plan through payroll deductions up to 25% of his or hersalary, subject to certain limitations. At the discretion of the Board ofDirectors, the Company may make matching contributions equal to apercentage of the salary reduction contributions or other discretionary amounts.The Company paid $103,000 and $44,000 in matching contributions in 2005 and 2004,respectively. There were no contributions to the Plan by the Company in 2003.

 

**9.****              Major customers andgeographic data**

 

Customersaccounting for more than 10% of the Company’s total revenue are as follows:

 

| ** **                           | ** ** | **For the Year Ended December 31,** | ** ** |
|--------------------------------------|------------|------------------------------------------|------------|
| ** **                           | ** ** | **2005**                                 | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                 |       |                                     |       |   |   |   |   |
| Toshiba Medical Systems  Corporation |       | $                                        | 24,307,000 |   | $ | 18,130,000 |   | $ | 11,544,000 |   |
| Percentage of total  revenue         |       | 47                                       | %          | 50 | % | 42 | % |
|                                      |            |                                          |            |  |  |  |  |  |  |  |

 

The Company’s accountsreceivable are generally concentrated with a small base of customers. As of December 31,2005 and 2004, Toshiba accounted for 36% and 23% of the accounts receivablebalance, respectively.

 

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

 

Export revenue accountedfor 16%, 17% and 13% of total revenue for the years ended December 31, 2005,2004 and 2003, respectively. Substantially all of the Company’s export salesare negotiated, invoiced and paid in U.S. dollars.

 

Export sales bygeographic area are summarized as follows:

 
| ** **              | ** ** | **For the Year Ended December 31,** | ** ** |
|-------------------------|------------|------------------------------------------|------------|
| ** **              | ** ** | **2005**                                 | ** ** | **2004** | ** ** | **2003** | ** ** |
|                    |       |                                     |       |   |   |   |   |
| Europe                  |       | $                                        | 4,461,000  |   | $ | 3,692,000 |   | $ | 2,421,000 |   |
| Asia-Pacific            |       | 2,277,000                                |       | 1,320,000 |   | 846,000 |   |
| Other foreign countries |       | 1,427,000                                |       | 1,078,000 |   | 387,000 |   |
|                    |       | $                                        | 8,165,000  |   | $ | 6,090,000 |   | $ | 3,654,000 |   |

 

62

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**10. Selectedquarterly financial data (unaudited)**

 

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

 
| ** **                                    | ** ** | **First Quarter** | ** ** | **Second Quarter** | ** ** | **Third Quarter** | ** ** | **Fourth Quarter** | ** ** |
|-----------------------------------------------|------------|-------------------|------------|--------------------|------------|-------------------|------------|--------------------|------------|
|                                          |       |              |       |               |       |              |       |               |       |
| **2005**                                      |       |              |       |               |       |              |       |               |       |
| Total revenue                                 |       | $                 | 11,325,000 |               | $          | 11,948,000        |       | $                  | 13,160,000 |   | $ | 15,284,000 |   |
| Gross profit                                  |       | $                 | 8,653,000  |               | $          | 8,918,000         |       | $                  | 10,264,000 |   | $ | 12,322,000 |   |
| Net income                                    |       | $                 | 1,023,000  | (1)                | $          | 734,000           |       | $                  | 1,621,000  |   | $ | 2,421,000 |   |
| Earnings per share –  basic (3)          |       | $                 | 0.08       |               | $          | 0.06              |       | $                  | 0.13       |   | $ | 0.19 |   |
| Earnings per share –  diluted (3)        |       | $                 | 0.08       |               | $          | 0.06              |       | $                  | 0.12       |   | $ | 0.18 |   |
|                                          |       |              |       |               |       |              |       |               |       |
| **2004**                                      |       |              |       |               |       |              |       |               |       |
| Total revenue                                 |       | $                 | 7,816,000  |               | $          | 7,960,000         |       | $                  | 9,248,000  |   | $ | 11,098,000 |   |
| Gross profit                                  |       | $                 | 5,479,000  |               | $          | 5,399,000         |       | $                  | 6,643,000  |   | $ | 8,154,000 |   |
| Net income (loss)                             |       | $                 | (1,352,000 | )(2)               | $          | 78,000            |       | $                  | 670,000    |   | $ | 900,000 |   |
| Earnings (loss) per  share – basic (3)   |       | $                 | (0.12      | )                  | $          | 0.01              |       | $                  | 0.06       |   | $ | 0.08 |   |
| Earnings (loss) per  share – diluted (3) |       | $                 | (0.12      | )                  | $          | 0.01              |       | $                  | 0.05       |   | $ | 0.07 |   |

 

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(1)          Includes a loss onoperating lease of $493,000 related to the Company’s facility move in the firstquarter of 2005.

(2)          Includes $1.0 million ofacquired in-process research and development charge relating to the acquisitionof HInnovation, Inc. in February 2004.

(3)          The sum of the quarterly earnings (loss) pershare may not equal the annual earnings per share due to changes inaverage shares outstanding.

 

63

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**Vital Images, Inc.Form 10-K**

 

**Index to Exhibits**

 
| **Item No.** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                           |
|--------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|         |       |                                                                                                                                                                                                                                                                                                                                                      |
| 2.1          |       | Acquisition Agreement and  Plan of Reorganization by and among Vital Images, Inc., HInnovation  Acquisition, Inc., HInnovation, Inc. and Hui Hu and JMS Co. Ltd.  dated as of January 8, 2004, incorporated by reference to  Exhibit 2.1 to the Company’s Current Report on Form 8-K filed on  February 26, 2004. |
|         |       |                                                                                                                                                                                                                                                                                                                                                      |
| 3.1          |       | Articles of Incorporation of the Company,  incorporated by reference to Exhibit 3.1 to the Company’s Registration  Statement on Form 10 dated March 13, 1997 (“Form 10”).                                                                                                                                              |
|         |       |                                                                                                                                                                                                                                                                                                                                                      |
| 3.2          |       | By-laws of the Company, incorporated by reference to  Exhibit 3.2 to the Form 10.                                                                                                                                                                                                                                                               |
|         |       |                                                                                                                                                                                                                                                                                                                                                      |
| 4.1          |       | Form of common stock certificate of the  Company, incorporated by reference to Exhibit 4.3 to the Form 10.                                                                                                                                                                                                                                 |
|         |       |                                                                                                                                                                                                                                                                                                                                                      |
| 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 Form 10.                                                                                        |
|         |       |                                                                                                                                                                                                                                                                                                                                                      |
| 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 Form 10.                                                                                                                                                                           |
|         |       |                                                                                                                                                                                                                                                                                                                                                      |
| 10.1         |       | Employee Stock Purchase  Plan, incorporated by reference to Exhibit 10.10 to the Form 10.*                                                                                                                                                                                                                                                      |
|         |       |                                                                                                                                                                                                                                                                                                                                                      |
| 10.2         |       | 1997 Stock Option and Incentive  Plan, as amended, incorporated by reference to Exhibit 10.11 to the  Form 10 and Exhibit 99.9 to the Company’s Registration Statement on  Form S-8 dated May 23, 2005.*                                                                                                                    |
|         |       |                                                                                                                                                                                                                                                                                                                                                      |
| 10.3         |       | 1997 Director Stock Option  Plan, as amended, incorporated by reference to Exhibit 10.12 to the  Form 10 and Exhibit 99.14 to the Company’s Registration Statement  on Form S-8 dated May 23, 2005.*                                                                                                                        |
|         |       |                                                                                                                                                                                                                                                                                                                                                      |
| 10.4         |       | 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 Quarterly Report on Form 10-Q for the quarter ended  March 31, 2002.**                                                                          |
|         |       |                                                                                                                                                                                                                                                                                                                                                      |
| 10.5         |       | Amendment No. 1 to  Marketing and Distribution Agreement between Vital Images, Inc. and  Toshiba Corporation, Medical Systems Company, incorporated herein by  reference to Exhibit 10.37 to the Company’s Annual Report on  Form 10-K for the year ended December 31, 2002.**                                              |
|         |       |                                                                                                                                                                                                                                                                                                                                                      |
| 10.6         |       | Amendment No. 2 to  Marketing and Distribution Agreement between Vital Images, Inc. and  Toshiba Medical Systems Corporation, incorporated herein by reference to  Exhibit 10.44 to the Company’s Annual Report on Form 10-K for the  year ended December 31, 2003.**                                                       |
|         |       |                                                                                                                                                                                                                                                                                                                                                      |
| 10.7         |       | Amendment No. 3 to  Marketing and Distribution Agreement between Vital Images, Inc. and Toshiba  Medical Systems Corporation, incorporated herein by reference to  Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the  quarter ended March 31, 2005.**                                                     |
|         |       |                                                                                                                                                                                                                                                                                                                                                      |
| 10.8         |       | Value Added Reseller  Agreement between McKesson Information Systems LLC and Vital  Images, Inc. dated June 19, 2003, incorporated herein by reference  to Exhibit 10.43 to the Company’s Annual Report on Form 10-K for  the year ended December 31, 2003.**                                                               |
|         |       |                                                                                                                                                                                                                                                                                                                                                      |
| 10.9         |       | Technology License  Agreement between PointDX, Inc. and Vital Images, Inc.,  incorporated by reference to Exhibit 10.32 to the Company’s Quarterly  Report on Form 10-Q for the quarter ended September 30, 2001.**                                                                                                         |
|         |       |                                                                                                                                                                                                                                                                                                                                                      |
| 10.10        |       | Amended and Restated  Development, Supply, Marketing and Distribution Agreement dated as of  June 1, 2003 by and between Vital Images, Inc. and  E-Z—EM, Inc., incorporated by reference to                                                                                                                                           |

 

64

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| **Item No.** | ** ** | **Description**                                                                                                                                                                                                                                                         |
|--------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|         |       |                                                                                                                                                                                                                                                                    |
|         |       | Exhibit 10.1 to the  Company’s Current Report on Form 8-K filed with the Securities and Exchange  Commission on August 3, 2004.**                                                                                                                   |
|         |       |                                                                                                                                                                                                                                                                    |
| 10.11        |       | 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.**                      |
|         |       |                                                                                                                                                                                                                                                                    |
| 10.12        |       | Employment Agreement dated  February 9, 2002 between Vital Images, Inc. 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.*                |
|         |       |                                                                                                                                                                                                                                                                    |
| 10.13        |       | Form of Change in  Control Agreement between Vital Images, Inc. and Steven P. Canakes 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, 2000.* |
|         |       |                                                                                                                                                                                                                                                                    |
| 10.14        |       | Employment Agreement dated  September 8, 2005 by and between Vital Images, Inc. and  Dr. Susan A. Wood, incorporated by reference to Exhibit 99.4 to the  Company’s Current Report on Form 8-K dated September 12, 2005.*            |
|         |       |                                                                                                                                                                                                                                                                    |
| 10.15        |       | Change in Control  Agreement dated September 8, 2005 by and between Vital Images, Inc.  and Dr. Susan A. Wood, incorporated by reference to Exhibit 99.5 to  the Company’s Current Report on Form 8-K dated September 12, 2005.*     |
|         |       |                                                                                                                                                                                                                                                                    |
| 10.16        |       | Employment Agreement dated  September 8, 2005 by and between Vital Images, Inc. and Philip I.  Smith, incorporated by reference to Exhibit 99.6 to the Company’s  Current Report on Form 8-K dated September 12, 2005.*                   |
|         |       |                                                                                                                                                                                                                                                                    |
| 10.17        |       | Employment Agreement dated  September 8, 2005 by and between Vital Images, Inc. and Steven P.  Canakes, incorporated by reference to Exhibit 99.7 to the Company’s  Current Report on Form 8-K dated September 12, 2005.*                 |
|         |       |                                                                                                                                                                                                                                                                    |
| 10.18        |       | Employment Agreement dated  May 16, 2005 by and between Vital Images, Inc. and Michael H.  Carrel, incorporated by reference to Exhibit 99.2 to the Company’s  Current Report on Form 8-K dated May 19, 2005.*                            |
|         |       |                                                                                                                                                                                                                                                                    |
| 10.19        |       | Change in Control  Agreement dated May 16, 2005, by and between Vital Images, Inc. and  Michael H. Carrel, incorporated by reference to Exhibit 99.4 to the  Company’s Current Report on Form 8-K dated May 19, 2005.*                    |
|         |       |                                                                                                                                                                                                                                                                    |
| 10.20        |       | Agreement dated  February 16, 2006 by and between Vital Images, Inc. and  Dr. Vincent Argiro, incorporated by reference to Exhibit 99.2 to  the Company’s Current Report on Form 8-K dated February 16, 2006.*                       |
|         |       |                                                                                                                                                                                                                                                                    |
| 10.21        |       | Employment Agreement dated  October 24, 2005 by and between Vital Images, Inc. and Jeremy A.  Abbs, filed herewith.*                                                                                                                                          |
|         |       |                                                                                                                                                                                                                                                                    |
| 10.22        |       | Form of Change in  Control Agreement between Vital Images, Inc. and Philip I. Smith and  Jeremy A. Abbs, filed herewith.*                                                                                                                                     |
|         |       |                                                                                                                                                                                                                                                                    |
| 10.23        |       | Schedule of Executive  Officer Compensation, filed herewith.*                                                                                                                                                                                                      |
|         |       |                                                                                                                                                                                                                                                                    |
| 21.1         |       | Subsidiaries of Registrant, filed herewith.                                                                                                                                                                                                                             |
|         |       |                                                                                                                                                                                                                                                                    |
| 23.1         |       | Consent of PricewaterhouseCoopers LLP, filed  herewith.                                                                                                                                                                                                                 |

 

65

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

 

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*                 Indicates a management contract orcompensatory plan or arrangement.

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

 

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