**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, DC  20549**

 

**FORM10-KSB/A**

 

(Amendment No. 1)
| **ý** |   | **ANNUAL  REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934****FOR THE FISCAL YEAR ENDED APRIL 30, 2003** |
|------------|--------|---------------------------------------------------------------------------------------------------------------------------------|
|       |   |                                                                                                                            |
| **o**      |   | **TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934**                                         |

 

**Commission File Number 000-33295**

 

**MedicalCV, Inc.**

(Nameof Small Business Issuer in Its Charter)

 

 
| **Minnesota**                                                  |   | **41-1717208**                       |
|----------------------------------------------------------------|--------|--------------------------------------|
| (State or Other Jurisdiction of Incorporation or Organization) |   | (I.R.S. Employer Identification No.) |

 

|                                                                 |
|----------------------------------------------------------------------|
| **9725 South Robert Trail, Inver Grove Heights,  Minnesota 55077**   |
| (Address of Principal Executive Offices, including Zip Code)         |
|                                                                 |
| **(651) 452-3000**                                                   |
| (Issuer’s Telephone Number, including Area Code)                |
|                                                                 |
| Securities registered pursuant to Section 12(b) of the Exchange Act: |
| **None**                                                             |
|                                                                 |
| Securities registered pursuant to Section 12(g) of the Exchange Act: |

**Units (each consisting of oneshare of Common Stock, $0.01 par value, and one redeemable Class A Warrantto purchase one share of Common Stock), Common Stock ($0.01 par value) andredeemable Class A Warrants to purchase Common Stock**

(Title of Class)

 

Check whether theissuer:  (1) filed all reports requiredto be filed by Section 13 or 15(d) of the Exchange Act during the past 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.  Yes ý  No o

 

Check if there is nodisclosure of delinquent filers in response to Item 405 of Regulation S-B containedin this form, and no disclosure will be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-KSB or any amendment to this Form 10-KSB.   o

 

The issuer’s revenues for itsmost recent fiscal year were $2,578,063.

 

The aggregate market value ofthe common equity held by non-affiliates of the issuer as of July 15, 2003, was approximately $8,132,706, based upon the sale priceof one unit on such date.

 

As of July 15, 2003 theissuer had outstanding 7,843,834 shares of common stock.  This number includes 1,500,000 units, eachconsisting of one share of common stock and one redeemable Class A Warrant soldin the issuer’s initial public offering.

 

**DOCUMENTS INCORPORATED BY REFERENCE**

 

Informationrequired by Part III of this document is incorporated by reference to specifiedportions of the registrant’s definitive proxy statement for the 2003 AnnualMeeting of Shareholders.

 

 

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**Explanatory Note**

 

MedicalCV,Inc. (the “Company”) is filing this Amendment No. 1 to its Annual Report onForm 10-KSB for the fiscal year ended April 30, 2003, originally filed July 29,2003 (the “Form 10-KSB”), solely to amend specific items of the Form 10-KSB toreflect changes in classification of certain items in the Company’s statementof operations for each of the two years in the period ended April 30, 2003.

 

The Companychanged the classification of certain expenditures previously classified assales and marketing expenses, to a reduction in net sales.  These expenditures consist of payments madeto international distributors for assistance in marketing the Company'sproducts that are required to be reported as a reduction in net sales pursuantto application of the Consensus for EITF Issue 01-9, “Accounting forConsideration Given by a Vendor to a Customer (Including a Reseller of theVendor’s Products)”.  The revisionresulted in a reduction in net sales and sales and marketing expense, and acorresponding reduction in gross profit and total operating expense.

 

The Company also changed the classification of income from inventoriesreturned from two former international distributors, which had previously beenreported as a reduction of cost of goods sold rather than as a reduction of generaland administrative expenses for the year ended April 30, 2003.  The revision resulted in an increase to costof goods sold, a reduction in gross profit and a reduction in general andadministrative expenses for the year ended April 30, 2003.

 

  The financial statements for the fiscalyears ended April 30, 2003 and 2002, have been restated to give effect to thesechanges in classification.  See note 17of the Notes to Consolidated Financial Statements.  The changes in classification had no effect on the Company’s lossfrom operations or net loss, nor any effect on the consolidated balance sheet,statement of shareholders’ equity (deficit) or statement of cash flows.  This Amendment No. 1 amends only portions ofthe Form 10-KSB; the remainder of the Form 10-KSB is unchanged and is notreproduced in this Amendment No. 1. This Amendment No. 1 does not reflect events occurring after theoriginal filing of the Form 10-KSB.

 

This AmendmentNo. 1 contains changes to the following disclosures:

 
| Part II –  Item 6.  | Management’s  Discussion and Analysis or Plan of Operation |
|--------------------------|-----------------------------------------------------------------|
|                     |                                                            |
| Part II –  Item 7.  | Financial  Statements                                           |
|                     |                                                            |
| Part II –  Item 8A. | Controls and  Procedures                                        |

 

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**TABLE OF CONTENTS**

 
| PART II            |    |
|--------------------|---------|
|               |    |   |   |
|               | ITEM 6  | Management’s Discussion and Analysis or  Plan of Operation |   |
|               |    |   |   |
|               | ITEM 7  | Financial Statements |   |
|               |    |   |   |
|               | ITEM 8A | Controls and Procedures |   |
|               |    |   |   |
| SIGNATURES         |    |   |
|               |    |   |   |
| INDEX  TO EXHIBITS |    |

 

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**ITEM6             MANAGEMENT’S DISCUSSION ANDANALYSIS OR PLAN OF OPERATION**

 

*The following discussion contains variousforward-looking statements within the meaning of Section 21E of the ExchangeAct.  Although we believe that, inmaking any such statement, our expectations are based on reasonableassumptions, any such statement may be influenced by factors that could causeactual outcomes and results to be materially different from thoseprojected.  When used in the followingdiscussion, the words**“anticipates,”“believes,”“expects,”“intends,”“plans,”“estimates” and similar expressions, as they relateto us or our management, are intended to identify such forward-lookingstatements.  These forward-lookingstatements are subject to numerous risks and uncertainties that could causeactual results to differ materially from those anticipated.  Factors that could cause actual results todiffer materially from those anticipated, certain of which are beyond ourcontrol, include those discussed in our Cautionary Statement as well as thosediscussed elsewhere in this Form 10-KSB.*

 

*Our actual results, performance or achievementscould differ materially from those expressed in, or implied by, forward-lookingstatements.  Accordingly, we cannot becertain that any of the events anticipated by forward-looking statements willoccur or, if any of them do occur, what impact they will have on us.  We caution you to keep in mind the cautionsand risks described our Cautionary Statement as well as those discussedelsewhere in this Form 10-KSB and to refrain from attributing undue certaintyto any forward-looking statements, which speak only as of the date of thedocument in which they appear.*

 

**Overview**

 

We area cardiothoracic surgery device company. Our primary products are mechanicalheart valves known as the Omnicarbon® Series 3000 and Series 4000, which wemanufacture and market.  Our heart valves are used to treat heartfailure caused by the aging process, heart diseases, prosthetic heart valvefailure and congenital defects.  Todate, we have distributed the Omnicarbon 3000 and 4000 heart valves primarilyin Europe, South Asia, the Middle East and the Far East.  In fiscal year 2003, we derived 62 percent of our net sales fromEurope.  As an innovator of heart valvetechnology, we have more than 33 years of experience in developing, manufacturing andmarketing five generations of heart valves, and we have sold approximately140,000 heart valves worldwide.

 

On July 26, 2001, the FDA gave us notice of premarketapproval to sell our Omnicarbon 3000 heart valve in the U.S., the largestgeographic market for mechanical heart valves. In anticipation of FDA premarket approval, we invested in our sales andmarketing infrastructure, including adding sales management to our staff andrecruiting field sales representatives to call on domestic surgery centers inthe U.S.  Based upon our Omnicarbonheart valve’s 18 years of implants in patients in Europe, we believe thatwe can establish a competitive position in the mechanical heart valve industryin the U.S. and leverage this position into other critical areas ofcardiothoracic surgery.  We also expectthat our ability to market the Omnicarbon 3000 heart valve in the U.S. willfavorably affect our international sales, as many cardiovascular surgeons andothers who make purchasing decisions are aware of the FDA’s rigorous premarket approval process andconsider it to be a validation of the safety and efficacy of medicaldevices.  Our company had its firstimplant of the Omnicarbon 3000 heart valve in the U.S. in December 2001.

 

The worldwide heart valve market is dynamic and highlycompetitive.  In addition, technologyand competitive offerings, such as new tissue heart valves, place increasedpressure on us as we seek to increase our market share and revenue.  For more information regarding these risks,you should review our Cautionary Statement.

 

**Critical AccountingPolicies**

 

*The preparation of our financial statements inconformity with generally accepted accounting principles requires management tomake estimates and assumptions that affect the amounts reported in theconsolidated financial statements and accompanying notes.  We believe our estimates and assumptions arereasonable; however, actual results and the timing of the recognition of suchamounts could differ from those estimates. We have identified the following critical accounting policies andestimates utilized by management in the preparation of our financialstatements: revenue recognition, deferred income tax assets, account**s receivableallowance,  and inventory obsolescence.  Actual amounts could differ significantlyfrom management’sestimates.*

 

***RevenueRecognition*****. **We recognizerevenue using guidance from SEC Staff Accounting Bulletin No. 101 “RevenueRecognition in Financial Statements.”  Revenue from thesale of our mechanical heart valves is recognized provided that we havereceived a purchase order, the price is fixed, title has transferred,collection of the resulting receivable is probableand

 

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there are no remaining obligations.  Transfer of title occurs for substantially all sales uponshipment.  Our products are not subjectto any customer acceptance process. There are no rights of return unless the product does not performaccording to specifications.

 

***DeferredIncome Tax Assets*****. **In assessingthe realizability of our deferred tax assets, management considers whether itis more likely than not that our deferred income tax assets will berealized.  The ultimate realization ofdeferred income tax assets is dependent on the generation of future taxableincome, which must occur prior to the expiration of our net operating loss andcredit carryforwards, which comprise the majority of the deferred tax assets.  As of April 30, 2003, we haveestablished a valuation allowance of $6,618,352 to fully offset our deferred tax assets due to uncertaintyabout predicting thesufficiency of future taxable income necessary to realize these deferred taxassets, particularly in light of our recent history of significant operatinglosses.  In addition, future utilizationof available net operating loss carryforwards may be limited under InternalRevenue Code 382 as a result of future changes in ownership.

 

***AccountsReceivable Allowance*. **In determining the adequacy of ourallowance for doubtful accounts, management considers a number of factors,including the aging of our receivable portfolio, customer payment trends, thefinancial condition of our customers and economic conditions in our customers’ countries.  Our analysis in determining the allowance for doubtful accountsis performed by management on a customer-by-customer basis.  Although our recorded allowance includes ourbest estimates, we cannot predict the resolution of these matters withcertainty.  As of April30, 2003, our allowance for doubtful accounts was $113,295.

 

***Inventory Obsolescence*. **In determining the appropriate carryingvalue of our inventories, management considers a number of factors, includingthe aging of our inventory, recent sales trends, industry market conditions andeconomic conditions.  Our analysisrequires us to estimate revenues by type of mechanical heart valve.  For example, we have expected a decline inOmniscience heart valves, which has been a consideration in the valuation ofthese items in our inventory.  Althoughadjustments to the carrying value of our inventories reflect our bestestimates, the estimates require a large degree of judgment.  During the fiscal year ended April 30, 2003,we recorded a provision for inventory obsolescence of $105,422.

 

**Selected Financial Data**

 
|                                                                     |   | **Years ended April 30,**  |       |
|--------------------------------------------------------------------------|--------|----------------------------|------------|
|                                                                     |   | **200****3  Restated (1)** |       | **200****2  Restated (1)** |   |
| **Statement  of Operations Data:**                                       |   |                       |       |   |   |
| Net sales                                                                |   | $                          | 2,578,063  |   | $ | 2,536,868 |   |
| Cost of goods sold                                                       |   | 1,807,402                  |       | 2,109,453 |   |
| Gross profit                                                             |   | 770,661                    |       | 427,415 |   |
| Total operating expenses                                                 |   | 5,018,873                  |       | 4,017,780 |   |
| Net loss                                                                 |   | (4,667,709                 | )          | (4,297,665 | ) |
| Basic and diluted net  loss per share                                    |   | (.60                       | )          | (.62 | ) |
| Weighted average number  of shares outstanding                           |   | 7,843,834                  |       | 6,980,820 |   |
|                                                                     |   |                       |       |   |   |
| **Balance  Sheet Data:**                                                 |   |                       |       |   |   |
| Total current assets                                                     |   | $                          | 4,623,691  |   | $ | 6,441,819 |   |
| Total current  liabilities                                               |   | 2,968,189                  |       | 3,683,594 |   |
| Working capital                                                          |   | 1,655,502                  |       | 2,758,225 |   |
| Total assets                                                             |   | 6,054,920                  |       | 8,091,226 |   |
| Long-term debt and capital lease  obligations, including current portion |   | 3,788,573                  |       | 2,983,906 |   |
| Total shareholders’ equity (deficit)                                |   | (385,930                   | )          | 4,026,040 |   |
|                                                                     |   |                       |       |   |   |
| **Statement  of Cash Flows Data:**                                       |   |                       |       |   |   |
| Net cash used in  operating activities                                   |   | $                          | (4,309,507 | ) | $ | (3,186,805 | ) |
| Cash and cash  equivalents at end of year                                |   | 184,227                    |       | 2,781,675 |   |
|                                                                     |   |                       |       |   |   |
| **General  Data and Ratio:**                                             |   |                       |       |   |   |
| Current ratio                                                            |   | 1.6                        |       | 1.7 |   |
| Gross profit margin on  net sales                                        |   | 29.9                       | %          | 16.9 | % |

** **

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**(1****)**As described in Note17 to the Consolidated Financial Statements, we restated our financialstatements to change the classification of certain expenditures previouslyclassified as sales and marketing expenses to a reduction in net sales and tochange the classification of income from inventories returned from two formerinternational distributors previously classified as a reduction of cost ofgoods sold to a reduction ingeneral and administrative expenses.

 

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**Results of Operations**

 

***Restatement. ***We haverestated our financial statements  toreflect changes in classification of certain items in the Company’s Statementof Operations for each of the two years in the period ended April 30, 2003.

 

We havechanged the classification of certain expenditures previously classified assales and marketing expenses to a reduction in net sales. These expendituresconsist of payments made to international distributors for assistance inmarketing our products that are required to be reported as a reduction in netsales pursuant to application of the Consensus for EITF Issue 01-9 “Accountingfor Consideration Given by a Vendor to a Customer (Including a Reseller of theVendor’s Products)”. The financial statements for the years ended April 30,2003 and 2002, have been restated to give effect to this change inclassification.  The changes in theseclassifications decreased net sales, gross profit, sales and marketing expenseand total operating expenses by corresponding amounts.

 

We have also changed the classification of income from inventories returnedfrom two former international distributors, which had previously been reportedas a reduction of cost of goods sold rather than as a reduction of general andadministrative expenses for year ended April 30, 2003.  The financial statements for the year endedApril 30, 2003 have been restated to give effect to the change inclassification.  The change inclassification increased cost of goods sold, decreased gross profit anddecreased general and administrative expenses by $92,000 for the year endedApril 30, 2003.

 

The changes inclassifications had no effect on our loss from operations or net loss, nor anyeffect on the consolidated balance sheet, statement of shareholders’ equity(deficit) or cash flows.  See Note 17 tothe Consolidated Financial Statements.

 

 

**Results of Operations for the Fiscal YearsEnded April 30, 200****3 and 2002**

 

*Net Sales*.  Net sales in the year ended April 30, 2003,increased 1.6 percentto $2,578,063 from$2,536,868 in the prioryear.  The increase was attributable tohigher Omnicarbon unit sales in the U.S. and Middle East marketsdue to the increased sales focus and successful expansion of clinical sites inthose markets.

 

In fiscal years 2003 and 2002, the vast majority of our sales weredenominated in U.S. dollars. Fluctuations in foreign currency exchange rates have not resulted insignificant losses or gains on outstanding trade accounts receivable.  All of our distributors are required to payfor products in U.S. dollars, other than our Japanese distributor, which paysin Japanese yen,and two European customers, which pay in euros.   We recognize thata strong U.S. dollar can adversely affect unit sales payable in currenciesother than U.S. dollars for our foreign distributors.

 

*Gross Profit.*  Gross profit as a percentage of net sales increased to 29.9 percent in the year ended April 30, 2003, from 16.9 percent in the prior year.  The improvement in fiscal year 2003 grossprofit margins was attributable primarily to reductions in Omnicarbon 4000product costs combined with favorable mix due to unit sales growth in the U.S.market. Wehave expended considerable resources in developing our new carbon manufacturingprocess technologies utilized in manufacturing the Omnicarbon 4000 heart valve,which is currently sold outside theU.S. market.  Gross profit margins inthe prior year wereunfavorably impacted by non-recurring costs associated with these developmentactivities.  Our strategy is to obtainFDA approval of our proprietary pyrolytic carbon manufacturing process in order to market theOmnicarbon 4000 in the U.S.  Due to itslower manufacturing cost, we believe the Omnicarbon 4000 will generatesignificantly higher gross profit margins when sold in the U.S. than theOmnicarbon 3000 heart valve.

 

*Sales and Marketing*.  Sales and marketing expenses in the yearended April 30, 2003, were $2,307,769 or 89.5 percent of net sales compared to $1,643,774 or 64.8 percent of net sales in the prior year.  The increase in spending in fiscal year 2003 related to expanded Omnicarbon marketingefforts in the U.S.,and to a lesser extent, international markets. Our overallstrategy is to promote the clinical results of the Omnicarbon heart valve andthe technical strengths of our company in designing and manufacturingmechanical heart valves.

 

*General and Administrative*.  General and administrative expenses for theyear ended April 30, 2003, were $1,834,418 or 71.2 percent of net sales compared to $1,594,968 or 62.9 percent of net sales in the prior year.  The increase was primarily attributable toincreased expensesassociated with operating as a public company and salary and related expenses associatedwith strengthening the executive management staff.

 

*Engineering and Regulatory*.  Engineering and regulatory expenses for theyear ended April 30, 2003, were $876,686 or 34.0 percent of net sales compared to $779,038 or 30.7 percent of net sales in the prior year.  The increase in fiscal year 2003 spending was primarily attributable to expenses associated with thepurchase and development of the Northrup Universal

 

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HeartValve Repair SystemTM and the IMA AccessTM Retractor device combined with costsrelated to the pursuit of FDA approval for our proprietary pyrolytic carbonmanufacturing process in order to market the Omnicarbon 4000 heart valve in theU.S.

 

*Other (Expense) Income*.  Interest expense totaled $467,315 in the year ended April 30, 2003, compared to $463,388 in the prior year.  Interest expense reflectedamortization of deferred financing costs for both years.  Lossfrom the early extinguishment of convertible subordinated bridge notes of$335,410 was reflected in fiscal year 2002.

 

*Income Tax Provision*.  In light of our recent history of operatinglosses, we recorded a valuation allowance to fully offset our deferred taxassets in fiscal year 2000.  We have continuedto provide a full valuation allowance through fiscal year 2003due to the inherent uncertainty about the sufficiency of future taxable income necessary torealize our deferred tax assets.

 

*Loss from Operations*.  As of April 30, 2003,we had an accumulated deficit of  $17,073,095.  We have incurred losses in each of the last seven fiscal years.  Since 1994, we have invested in developing a bileaflet heartvalve, a proprietary pyrolytic carbon coating process and obtaining premarketapproval from the FDA to market our Omnicarbon 3000 heart valve in theU.S.  Our strategy has been to invest intechnology to better position ourselves competitively once FDA premarketapproval was obtained.  We expectcumulative net losses to continue at least through fiscal year 2004 because of anticipated spendingnecessary to market the Omnicarbon 3000 heart valve in the U.S. and toestablish and maintain a strong marketing organization for domestic and foreignmarkets.

 

**Liquidityand Capital Resources**

 

Cash and cash equivalents decreased to $184,227 at April 30, 2003, from $2,781,675 at April 30, 2002. The decreasein cash and cash equivalents of $2,597,448 from the prior yearwas due to the following:

 
| Net cash used in operating activities     |   | $         | (4,309,507 | ) |
|-------------------------------------------|--------|-----------|------------|---|
| Net cash used in investing activities     |   | (128,960  | )          |
| Net cash provided by financing activities |   | 1,841,019 |       |
| Net decrease                              |   | $         | (2,597,448 | ) |

 

Net cash used in operating activitiesincreased $1,122,702 from $3,186,805 in the prior year to $4,309,507 in the fiscal year ended April 30, 2003.  The increase was due principally to funding higher operating losses in fiscal year 2003 as we increased ourmarketing efforts in the U.S.  Inaddition, increases in accounts receivable, inventories and prepaid assets werepartially offset by increases in accounts payable and accrued expenses.  Inventories increased $368,078 in fiscal year 2003 and $188,084 in fiscal year 2002.  The increases in inventories in fiscal years 2003 and 2002 were related to carrying additional inventory tosupport the launch of the Omnicarbon3000 heart valve inthe U.S. market and anticipatedgrowth ininternational sales.

 

Net cash used in investing activities was $128,960 and $465,024 for the fiscal years ended April 30, 2003 and 2002, respectively.  Weinvested $128,960 inproperty, plant, and equipment in the year ended April 30, 2003, compared to $384,024 in the prior year.  Our investment in property, plant, and equipment in fiscalyear 2002 related primarily to thedevelopment of our proprietary pyrolytic carbon manufacturing process.  As described in Commitments and ContingentLiabilities, we loaned $81,000 to UROPACE during fiscal year 2002.

 

Net cash provided by financing activities was$1,841,019 inthe fiscal year endedApril 30, 2003, and consisted primarily of borrowings fromrelated parties of $1,303,333 combined with net proceeds from the related partysale-leaseback transaction of $1,000,000; partially offset by principalpayments of $462,314.  We completed our initialpublic offering early in the thirdquarter of fiscal year 2002, which generated net proceeds of $5,396,485.  Other sources of cash from financingactivities in fiscal year 2002 were our increased borrowings of $1,570,000 on our line ofcredit and the net proceeds of $438,885 from the sale of $500,000principal amount of convertible subordinatedbridge notes.  We used $975,000 of funds generated through our offering to repay the bridge notes in the fourthquarter of fiscal year 2002 and to make principal payments on our bank line of credit.

 

Throughout fiscal year 2003 and subsequent to April 30, 2003, weentered into a number of financing transactions to provide funds necessary tomeet our working capital and capital expenditure needs and to meet otherobligations.  These financing activitiesconsisted of the following:

 

•                                          In December2002, we received a $60,000 unsecured advance from an executive officer.  Principal and interest on this advance wasrepaid in April 2003.

 

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•                                          In January2003, we established a line of credit with PKM Properties, LLC (“PKM”), anentity controlled by Paul K. Miller. Mr. Miller is a member of our board of directors and is our largestbeneficial owner of securities.  Theline of credit bears interest at the higher of 7 percent or 1 percent above abank reference rate (7 percent is the rate in effect as of April 30,2003).  The line of credit is currentlycollateralized by a security interest in substantially all of our assets.  This line of credit matures on September 17,2003.  In connection with the line ofcredit, we also issued a warrant to PKM with a five-year term to purchase350,000 shares of our common stock at an exercise price of $0.596 per share.  The allocated fair value of the warrants was$128,995.  This discount was completelyamortized to interest expense as of April 30, 2003.  The amount outstanding under this short-term debt with relatedparty at April 30, 2003 was $943,333.

 

•                                          On April 4,2003, we sold our corporate headquarters, manufacturing facility andsurrounding land in Inver Grove Heights, Minnesota to PKM.  In connection with the transaction, wereceived total consideration of $3.84 million consisting of (1) $1.0 million incash, (ii) PKM’s assumption of our $2.5 million outstanding indebtedness toAssociated Bank which eliminated our indebtedness to Associated Bank, and (iii)PKM’s assumption of our promissory note with Dakota Electric Association andland special assessments payable to Dakota County aggregating $336,105.  We relied on a fair market value appraisalof the property in determining the amount of such consideration.   Also in connection with the transaction, weissued to PKM a five-year warrant for the purchase of 350,000 shares of ourcommon stock at an exercise price of $0.625 per share.   These warrants had an allocated fair valueof $89,602.

 

Of the net cashproceeds, $300,000 plus interest was applied to our indebtedness to PKMpursuant to the line of credit agreement described above.

 

Simultaneous withthe sale of the facility, we entered into a lease with PKM to lease back thefacility and a portion of the land.  Thelease has a ten-year initial term with options for us to extend the lease up toten additional years.  Under certainconditions, we also have an option to purchase the building at the end of theinitial ten-year term at the fair value at that time.

 

Due to ourcontinued involvement with the property, including the ability to buy back theproperty at a future date, the transaction is accounted for as a financing ofthe property sold and leased back. Accordingly, the net book value of the facility and land sold to PKMwith a net book value of $759,146 continues to be presented as part of ourproperty, plant and equipment balance. The related party lease obligation of $3,779,100 at April 30, 2003,represents the minimum amounts due PKM for the initial ten-year term discountedat 4.4 percent and additional payments to be paid to PKM for the DakotaElectric Association and Dakota County obligations assumed by PKM.

 

•                                          On July 8,2003, we completed a $2.0 million bridge financing transaction, resulting innet proceeds of approximately $1.87 million.

 

Under the terms of thefinancing, we established a one-year $1.0 million discretionary line of creditwith PKM.  The line, which requires thepayment of interest at a rate of 10 percent per year, matures on May 27, 2004,and is secured by substantially all of our assets.   As additional consideration for the financing, we agreed toissue PKM ten-year warrants for the purchase of up to 380,357 shares of ourcommon stock at an exercise price of $0.70 per share with terms and conditionsthat include weighted-average anti-dilution rights.  We also agreed to modify certain terms of the warrants issued toPKM in connection with a credit facility extended by PKM in January 2003, toconform to the terms of the warrants issued as part of this bridge debtfinancing.

 

In a simultaneoustransaction, we entered into a loan agreement and borrowed $1.0 million fromPeter L. Hauser pursuant to a one-year subordinated note with an interest rateof 10 percent per year. Pursuant to an intercreditor agreement with PKM, theloan is secured by substantially all of our assets.  The lender was issued ten-year warrants for the purchase of380,357 shares of our common stock on terms comparable to the PKM warrantsdescribed above.  Following thetransaction, Mr. Hauser became the beneficial owner of approximately 10.3percent of our securities.

 

We expect that our operating losses andnegative operating cash flow will continue at leastthroughfiscal year 2004 as we expand our manufacturing capabilities, continueincreasing our corporate staff to support the U.S. roll-out of our Omnicarbon3000 heart valve, andadd marketing programs domestically and internationally to build awareness ofand create demand for our Omnicarbon heart valves.   Weanticipate that our sales and marketing and general and administrative expenses

 

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willcontinue to constitute a material use of our cash resources.  The actual amounts and timing of our capitalexpenditures will vary significantly depending upon the speed at which we are able to expandour distribution capability in domestic and international markets and the availabilityof financing.

 

Our capital requirementsmay vary depending upon the timing and the success of the implementation of ourbusiness plan, regulatory, technological and competitive developments, or if:

 

•                                          increasedsales levels of our core products and new products are not achieved;

 

•                                          operatinglosses exceed our projections;

 

•                                          our manufacturing and development costsor estimates prove tobe inaccurate;

 

•                                          we determine to acquire, license or develop additionaltechnologies;

 

•                                          we experience substantialdifficulty in gaining U.S. market acceptance or delays in obtaining FDA clearance of our proprietarycarbon coating process for heart valves sold in the U.S. market; or

 

•                                          we make acquisitions.

 

Our ability to continue as a going concern dependsupon our ability to obtain additional debt and/or equity financing in thesecond quarter of fiscal year 2004.  Weare currently seeking additional financing to fund our operations and workingcapital requirements.  We cannot provideany assurance, however, that such additional financing will be available onterms acceptable to us or at all.  Wewill need to obtain additional capital prior to the maturity date of ourrevolving line of credit with PKM on September 17, 2003, or otherwise extend orrestructure this debt to continue operations.

 

Weanticipate that we will need to raisebetween $4,000,000and $6,000,000 ofadditional equity or debt financing to fund operations and working capitalrequirements beginning in September 2003.  We previously anticipated that these fundswould need to be raised by mid to late calendar year 2004. We expect to face substantial difficultyin raising funds in the current market environment and we have no commitmentsat this time to provide the required financing.  If weobtainthe foregoing financing, we believe we willhavesufficient capital resources to operate and fund the growth of our businessfor the remainder of fiscal year 2004 and into fiscal year 2005.

 

We cannot assure you that we willbe able to raise sufficient additionalcapital on terms that we consideracceptable, or at all.  Theterms of any equity financing are expected to be highly dilutive to ourexisting security holders.  Thedelisting of our securities from the Nasdaq SmallCap Market that occurred inMarch 2003 will negatively affect our ability to raise capital.  Ifwe are unable to obtain adequate financing on acceptable terms, we will be unable tocontinue operations.

 

Until such time as the level of U.S. market acceptanceof our heart valves increases and the FDA approves our pyrolytic carbonprocess, we anticipate that we will continue to depend upon cash provided byfinancing activities to address our working capital requirements.  By broadening our portfolio of cardiothoracicsurgery products, we hope to reduce our dependence on sales of heart valves andreduce our reliance upon financing transactions, which may not be available tous.  We cannot, however, assure you thatour efforts to diversify our product offerings will:

 

•                                          beattainable;

 

•                                          be profitable;

 

•                                          reduce ourreliance upon financing transactions; or

 

•                                          enable us tocontinue operations.

** **

**Commitmentsand Contingent Liabilities**

 

*Snia S.p.A. Carbomedics (formerly Sulzer Carbomedics).* In July 1998, weentered into a three-year supply agreement with Snia S.p.A.Carbomedics, the source of certainraw material components used in the manufacture of our Omnicarbon 3000 heartvalves.  The supply agreement wasextended for an additional two years in March 2001.  The agreement provides that we purchase a minimum number of rawmaterial units each calendar year through December 2003. Under the terms of the agreement, we are required to compensate SniaS.p.A. Carbomedics for any purchaseshortfalls up to a maximum of $200,000

 

9

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per year. We have not met the minimum purchase requirements for the past threecalendar years.  In addition, we do notbelieve we will meet the minimum purchase requirement for calendar year 2003. As a result, we expensed $138,738 in fiscalyear 2003, and $148,991in fiscal year 2002 related to these purchase shortfalls.  Thesecharges were reflected in cost of goods sold. Future purchase shortfalls could adversely affect our ongoingrelationship with Snia S.p.A. Carbomedics.

 

*UROPACE*.  In July 1995, we established a whollyowned subsidiary, UROPACE, Inc., tocommercialize technology for treating female urinary incontinence.  On November 1, 2000, we completed thespin-off of UROPACE to our existing shareholders.  The separation was effected by transferring from our company toUROPACE all assets, tangible and intangible, relating to the development offemale urinary incontinence technology. Our shareholders of record on September 15, 2000 received one share ofcommon stock of UROPACE for each 6.882 shares of our common stock they held onthat date.  The assets transferred toUROPACE had no book value at November 1, 2000, and the operations of UROPACEbefore the spin-off had no revenues and minimal expenses during fiscal year2000 and fiscal year 2001.  As a part ofthis spin-off, we agreed to loan UROPACE up to $356,250 at a variable interestrate.  Principal and interest on thenote will be payable in installments equal to 5 percent of UROPACE’s future annual net sales until the noteand interest is paid in full.  At April30, 2003, we had loaned UROPACE $235,000,none of which had been repaid.  Due to the development stage of UROPACE andthe uncertainty associated with the collection of these borrowings, we haverecorded an allowance for the entire balance of the loan, with thecorresponding expense included in other (expense) income in the ConsolidatedStatement of Operations.

 

*Related Party Lease Obligation. *On April 4, 2003, we sold our corporateheadquarters, manufacturing facility and surrounding land in Inver GroveHeights, Minnesota to PKM.  Inconnection with the transaction, we received total consideration of $3.84million consisting of (1) $1.0 million in cash, (ii) PKM’s assumption of our $2.5million outstanding indebtedness to Associated Bank which eliminated ourindebtedness to Associated Bank, and (iii) PKM’s assumption of our promissorynote with Dakota Electric Association and land special assessments payable toDakota County aggregating $336,105.

 

We simultaneously leased back our facility pursuant toa ten-year lease, with options to renew and an option to repurchase thefacility.  We will continue to utilizethe facility as we did prior to the sale-leaseback transaction, with no changein operations.

 

*Capital Leases*. We lease certain manufacturing equipment under various capital leases.  The capital lease terms extendinto fiscal year 2004 with implicit interest rates rangingfrom 6.9 to 16.2 percent.  The capitalleases are collaterized by the underlying equipment with a total original costof $322,733.

 

*Clinical Studies. *We entered into an agreement with several large non-U.S.hospitals to conduct clinical studies regarding certain aspects of ourOmnicarbon heart valve’sclinical performance.  The agreementruns through fiscal year 2006.  Ingeneral, recipients of clinical study payments are required to purchase ourproducts in order tocomplete their studies.

 

*Consulting*.  In November 2001, we entered into aseparation agreement and release with Adel A. Mikhail, Ph.D., who was ourfounder and served as our President and Chief Executive Officer from March 1992until June 15, 2001, when he retired. Dr. Mikhail continues to serve as Chairman of our Board of Directors.  As part of the agreement, we agreed toretain Dr. Mikhail as an independent consultant for a period of two years.  Dr. Mikhail receives a $6,000 per monthretainer.  The agreement expires in June2003.  We also entered into anemployment separation agreement with an officer in late 2002, which providesfor consulting services through calendar 2003.

 

*Short-Term Debt with Related Party.*  We established a line of credit in January2003 with PKM.  As noted above, PKM isan entity controlled by a principal shareholder, who also serves on our boardof directors.  This line matures onSeptember 17, 2003.

 

10

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|                                   |   | **Payments Due By Period** |      |
|----------------------------------------|--------|----------------------------|-----------|
| **Summary of Contractual Obligations** |   | **TOTAL**                  |      | **Less than One****Year** |   | **Two to Three****Years** |   | **Four or More****Years** |   |
| Snia S.p.A.  Carbomedics               |   | $                          | 200,000   |   | $ | 200,000 |   | $ |   |   | $ |   |   |
| UROPACE Loan                           |   | 121,250                    |      | 121,250 |   |   |   |   |   |
| Related Party Lease Obligation(1)      |   | 4,214,006                  |      | 454,944 |   | 835,528 |   | 2,903,634 |   |
| Capital Leases(1)                      |   | 42,069                     |      | 42,069 |   |   |   |   |   |
| Clinical Studies                       |   | 410,380                    |      | 137,762 |   | 192,247 |   | 80,371 |   |
| Consulting                             |   | 98,872                     |      | 98,872 |   |   |   |   |   |
| Short-Term Debt with Related Party     |   | 943,333                    |      | 943,333 |   |   |   |   |   |
| TOTAL CONTRACTUAL  OBLIGATIONS         |   | $                          | 6,030,010 |   | $ | 1,998,230 |   | $ | 1,047,775 |   | $ | 2,984,005 |   |

 

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(1)           Future payments include interest due.

 

**Recent AccountingPronouncements**

 

In June 2002, the FASB issuedSFAS No. 146, “Accounting for Exit or Disposal Activities.”  The new statement addresses the accountingfor costs associated with exit or disposal activities.  The provisions of the statement wereeffective for disposal activities initiated after December 31, 2002.  The adoption of SFAS No. 146 did not have animpact on our financial position or results of operations.  The new standard principally affects thetiming of when charges are recorded as opposed to the amount of the ultimatecharge.  There have been no exit ordisposal activities subsequent to December 31, 2002.

 

We adopted the provisions of FASBInterpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements forGuarantees, Including Indirect Guarantees of Indebtedness of Others” in thethird quarter of fiscal year 2003.  Thedisclosure provisions of the interpretation are effective for our financialstatements for the third quarter of fiscal year 2003.  The provisions for initial recognition and measurement areeffective on a prospective basis for guarantees that are issued or modifiedafter December 31, 2002.  Theimplementation of this accounting pronouncement did not have a material effecton our results of operations, financial position or cash flows.

 

In December 2002, the FASB issued SFAS No. 148,“Accounting for Stock-Based Compensation - Transition and Disclosure — anamendment of FAS 123.” SFAS No. 148 provides alternative methods of transitionfor a voluntary change to the fair value based method of accounting forstock-based employee compensation and amends certain disclosure requirements ofSFAS No. 123.  The transition provisionsof this statement are effective for fiscal years ending after December 15,2002, and the disclosure requirements of this statement are effective forinterim periods beginning after December 15, 2002.  We currently plan to continue to apply the intrinsic-value basedmethod to account for stock options.  Weimplemented the year-end disclosure provisionsincluded in Note 2 as of April 30, 2003 and will implement the interim perioddisclosure provisions in the quarter ending July 31, 2003.

 

In January 2003, the FASB issued FIN No. 46,“Consolidation of Variable Interest Entities, an interpretation of AccountingResearch Bulletin No. 51.”  FIN No. 46requires certain variable interest entities (“VIEs”), to be consolidated by theprimary beneficiary of the entity if the equity investors in the entity do nothave the characteristics of a controlling financial interest or do not havesufficient equity at risk for the entity to finance its activities withoutadditional subordinated financial support from other parties.  FIN No. 46 is effective for all VIEs createdor acquired after January 31, 2003.  ForVIEs created or acquired prior to February 1, 2003, the provisions of FIN No.46 must be applied for the first interim or annual period beginning after June15, 2003.  We currently have nocontractual relationship or other business relationship with a VIE andtherefore the adoption of FIN No. 46 did not have a material effect on ourconsolidated financial position, results of operations or cash flows.  However, should we enter into any sucharrangement with a VIE in the future, our consolidated financial position orresults of operations may be adversely effected.

 

**Qualitative andQuantitative Disclosures about Market Risk**

 

We develop our products in the U.S. and market our productsglobally.  Because we continue to deriveour revenue primarily from sources outside of the U.S., our financial resultscould be affected by many factors, such as changes in currency exchange ratesor weak economic conditions in foreign markets.  Substantially all of our sales are denominated in U.S. dollars.  A strengthening of the U.S. dollar couldmake our products less competitive in foreign markets.  We do not currently participate in anycurrency hedging activities to mitigate this risk.  We intend to assess the need to use financial instruments tohedge our exchange rate exposure on an ongoing basis.  Our interest income and expenses aresensitive to changes in the general level of U.S. interest rates, particularlysince our investments are in short-term instruments and our short-term debt require interest paymentscalculated at variable rates.  Based onthe current nature and levels of our investments and debt, however, we believethat we currently have no material market risk exposure.

 

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Our general investing policy is to limit market and creditrisk and the risk of principal loss. All liquid investments with original maturities of three months or lessare considered to be cash equivalents.

 

**CautionaryStatement**

 

*MedicalCV, Inc., or persons acting on ourbehalf, or outside reviewers retained by us making statements on our behalf, orunderwriters of our securities, from time to time, may make, in writing ororally, “forward-looking statements” as defined under the Private SecuritiesLitigation Reform Act of 1995.  ThisCautionary Statement, when used in conjunction with an identifiedforward-looking statement, is for the purpose of qualifying for the “safeharbor” provisions of the Litigation Reform Act and is intended to be a readilyavailable written document that contains factors which could cause results todiffer materially from such forward-looking statements.  These factors are in addition to any othercautionary statements, written or oral, which may be made, or referred to, inconnection with any such forward-looking statement.*

 

*The following matters, among others, may havea material adverse effect on our business, financial condition, liquidity,results of operations or prospects, financial or otherwise.  Reference to this Cautionary Statement inthe context of a forward-looking statement or statements shall be deemed to bea statement that any one or more of the following factors may cause actualresults to differ materially from those in such forward-looking statement orstatements.*

 

***Risksrelated to our business***

 

**If we are unable to fund our significant capitalneeds, we may be required to cease operations.**  Our ability to continue as a going concerndepends upon our ability to obtain additional debt and/or equity financing inthe second quarter of fiscal year 2004. We are currently seeking additional financing to fund our operations andworking capital requirements.  We cannotprovide any assurance, however, that such additional financing will beavailable on terms acceptable to us or at all. We will need to obtain additional capital prior to the maturity date ofour revolving line of credit with PKM Properties, LLC (“PKM”) on September 17,2003, or otherwise extend or restructure this debt to continue operations.

 

Based on our current rate of expenditures,anticipated net sales and current sales and marketing plans, we estimate thatwe will need toraise between $4,000,000 and $6,000,000 of additional equity or debtfinancing to fund operations and working capital requirements beginningin September 2003.  We expect to face substantial difficulty inraising funds in the current market environment and we have no commitments atthis time to provide the required financing.  The timing and amount of our future capital requirements willdepend on a number of factors, including:

 

•                                          the extent to which our Omnicarbon 3000heart valve gains market acceptance in the U.S.;

 

•                                          costs of manufacturing and marketing;

 

•                                          potential reductions in heart valvepricing by our competitors;

 

•                                          costs of developing, licensing and acquiring new products andtechnologies;

 

•                                          time and costs involved in obtainingregulatory clearance for our pyrolytic carbon coating process for sales in theU.S. of our Omnicarbon 4000 heart valve and other unanticipated regulatorycosts;

 

•                                          costs involved in filing, prosecuting andenforcing patents or defending against any patent infringementclaims;

 

•                                          competing technological and marketdevelopments; and

 

•                                          progress and cost of clinical trials fornew products.

 

We will require additional capital to supportouroperations, to complete the development of products and to manufacture andmarket any products resulting from current development projects.  We cannot assure you that such additionalfinancing will be available on acceptable terms, or at all.  If funds are raised by issuing additionalequity securities, our then existing shareholders will experience furtherdilution.  If we are unable to obtainadditional funds as needed, we may not be able to:

 

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•                                          develop or enhance our products;

 

•                                          gain market share in the U.S.;

 

•                                          respond to competitive pressures orunanticipated requirements; or

 

•                                          continueoperations.

 

**Substantially all ofour assets are pledged to lenders and subject to risk of loss.**  In connection with bridge loan transactionsin January and July 2003, substantially all of our assets were pledged tosecure our indebtedness to PKM, an entity controlled by Paul K. Miller, one ofour directors and our largest beneficial owner of securities, and to Peter L.Hauser, who following the transaction in which he participated, became thebeneficial owner of approximately 10.3 percent of our securities.  As of July 29, 2003, we were indebted tothese lenders in the principal amount of $2,708,070.  We will be required to obtain substantial additional debt orequity financing beginning in September 2003 to repay this indebtedness atmaturity and to fund ongoing operations. We cannot assure you that we will be able to obtain any additionalfinancing, or that any financing obtained will be on terms favorable tous.  If we default under the terms ofour agreements with the lenders, or if we are unable to repay our indebtednessto them when it becomes due, the lenders may elect to exercise their rights assecured creditors, which may include foreclosing upon and causing the sale ofour assets.  If such event should occur,it would likely result in the termination of all of our business operations.

 

**We anticipate futurelosses and negative cash flows, which may limit or delay our ability to becomeprofitable.**  Wehave incurred losses in each of the last seven fiscal years.  We had net losses of $4,667,709 for the fiscal year ended April30, 2003 and $4,297,665 for the fiscal year ended April 30, 2002.  As of April 30, 2003, we had an accumulateddeficit of $17,073,095.  If we fail to obtain additional financingwhen required, we may not be able to develop or enhance our products, gainmarket share in the U.S. or respond to competitive pressures or unanticipatedrequirements, which could seriously harm our business, financial position andresults of operations.  We expect toincur additional net losses until we are able to generate and sustainsubstantially higher revenues while maintaining reasonable expense levels, bothof which involve uncertainty.  We alsomust continue to make significant expenditures on sales and marketing inconnection with our heart valves.  Wecannot assure you that our revenues will grow in future periods or that we willever become profitable.  If we doachieve profitability, we cannot assure you that we would be able to sustain orincrease profitability on a quarterly or annual basis in the future. In addition, the reports of our independent accountants for fiscal years 2003 and 2002 include explanatory paragraphs expressing doubt about our ability tocontinue as a going concern.

 

**We rely upon sales ofour Omnicarbon heart valves for substantially all of our revenue.**  Our results of operations materially dependon the success of the Omnicarbon 3000 and 4000 heart valves, which accountedfor substantially all of our operating revenue for the fiscal years ended April30, 2003, and April 30, 2002.  Asignificant reduction in sales of Omnicarbon heart valves for any reason,including the introduction of additional competing products, would have amaterial adverse effect on us.  If wedevelop additional products, we would need to obtain regulatory approval beforewe could sell them.  Given the time-consumingnature of the regulatory clearance process, we do not expect to be able to sellsuch additional products in the foreseeable future.  We also anticipate that research and development and clinical andregulatory expenses will continue to rise in future periods.

 

**We cannot assure youthat our heart valves will gain physician acceptance.** A limited number of cardiovascular surgeonsand cardiologists can influence medical device selection and purchase decisionsfor a large portion of the target cardiovascular surgery patient population.  We cannot assure you that our Omnicarbonheart valves, or any of the products that we may develop, will gain anysignificant degree of physician acceptance, or that users will accept theseproducts as preferable to alternative products or methods of treatment.  Physician acceptance of our Omnicarbon heartvalves will depend upon our ability to demonstrate the clinical advantages oflower complication rates and cost-effectiveness of Omnicarbon heart valves whencompared to other prosthetic heart valves. Negative publicity involving Omnicarbon heart valves or other prostheticheart valves could adversely affect the overall acceptance of Omnicarbon heartvalves.  Further, because Omnicarbonheart valves are monoleaflet heart valves, we must overcome a market preferencefor bileaflet heart valves, which are marketed by most major manufacturers ofmechanical heart valves.  Any of theforegoing factors, among others, could limit or detract from physicianacceptance of our Omnicarbon heart valves and have a negative effect on ourbusiness, financial condition, operating results and cash flows.

 

**We cannot assure youthat our efforts to introduce new products will be successful.**  We are continuously seeking to develop,acquire or license new technologies to broaden our product offerings to thecardiothoracic surgery market.  Weintroduced one such product in December 2002 and, subject to necessaryregulatory approval, intend to introduce one or more such products in fiscalyear 2004.  We cannot assure you that wewill succeed in introducing such products, that such products

 

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will gain market acceptance, orthat such products will significantly contribute to profitability; nor can weassure you that we will be able to recover the cost of investing in thedevelopment and introduction of such products.

 

**Because we do nothave FDA clearance to market our Omnicarbon heart valves manufactured with ourproprietary pyrolytic carbon process for sale in the U.S., we depend upon athird party supplier for critical components.**  We market our Omnicarbon 3000 heart valves,which we have now begun to sell in the U.S. and Japan, with pyrolytic carboncomponents produced by Snia S.p.A. Carbomedics, a third party supplier whichsells competing heart valves.  We have asupply contract that requires us to purchase such components for use in theOmnicarbon 3000 heart valve solely from Snia S.p.A. Carbomedics until December2003.  Given the absence of FDA-clearedalternative sources for pyrolytic carbon components for our Omnicarbon 3000 heartvalves, any disruption or termination of our supply contract, or our failure toextend it, if necessary, would have a material adverse effect on our continuedability to sell Omnicarbon 3000 heart valves. Future purchase shortfalls could adversely affect our ongoingrelationship with Snia S.p.A. Carbomedics. Further, we cannot assure you that we will be able to obtain FDAclearance to manufacture Omnicarbon heart valves for sale in the U.S. using ourown pyrolytic carbon process.  Ourfuture success will depend, in part, on obtaining FDA clearance to manufacturecarbon components for heart valves for sale in the U.S.

 

**We may need to fundmultiple research studies throughout the lifecycle of each of our products,providing statistically significant scientific data to regulatory agencies andcost effectiveness data to third party payers.**  The FDA, foreign regulatory agencies andthird party health care payers may require scientific clinical outcomes dataand cost effectiveness data.  We willneed to provide this data throughout our products’ lifecycles.  Payers and governmental agencies may changethe frequency and breadth of clinical research required, potentiallysignificantly increasing our costs. Without adequate positive outcomes data that demonstrate advantages fromthe use of our Omnicarbon heart valves, we may not achieve any significantmarket penetration.  We cannot assureyou that our outcomes data will be adequate to meet present or future medicaldevice utility requirements.  If ouroutcomes data does not meet such requirements, we may be unable to sell ourproducts or obtain third party reimbursement for the costs of our products.

 

**Intense competitionin the prosthetic heart valve industry could prevent us from successfullymarketing our products or render our products obsolete.**  We compete in mature, highly competitivemarkets in which many of our competitors have well-known and establishedproducts.  To compete successfully inthese markets, we must maintain competitive pricing and demonstrate theadvantages of our Omnicarbon heart valves in terms of post-surgicalcomplications.  Several companies arecurrently pursuing new mechanical heart valve designs, blood compatiblecoatings for mechanical heart valves, longer lasting tissue heart valves andsurgical alternatives to implanting prosthetic heart valves.  It is possible that technological advancesby our competitors, or advances in surgical procedures that delay the need forreplacing heart valves, could render our Omnicarbon heart valves noncompetitiveor obsolete.

 

Our primarycompetitors, St. Jude Medical, Inc., Medtronic, Inc. and Snia S.p.A.Carbomedics, dominate the market and control most of the mechanical heart valvemarket worldwide.  Our competitors haveextensive clinical data demonstrating the performance of their heart valves andinternal carbon manufacturing capabilities. The companies with which we compete have many additional competitiveadvantages over us, including:

 

•                                          greater namerecognition and product market acceptance;

 

•                                          moreestablished physician relationships;

 

•                                          broaderproduct lines;

 

•                                          greaterdistribution capabilities;

 

•                                          greaterregulatory compliance capabilities;

 

•                                          largermarketing, research and development staffs and facilities; and

 

•                                          greaterfinancial resources.

 

We cannotassure you that we will be able to compete against such competitors or theirproducts.

 

**Our future resultsdepend upon the strength of the mechanical heart valve market.**  Our business could suffer if the use ofmechanical heart valves declines.  Inrecent years, there has been an increase in the number of tissue heart valvesused.  We believe that improvements intissue heart valve longevity and an increase in the average age of heart valvepatients

 

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have contributed to the recentincrease in the use of tissue heart valves. If the use of mechanical heart valves declines, it could materiallyadversely affect our business, financial condition, operating results and cashflows.

 

**Thesmall number of distributors operating in foreign markets that currentlygenerate substantially all of our revenues pose a concentration of credit riskand could leave us at any time, impairing our business.**  Substantially all of our sales originatefrom a small number of distributors who market our Omnicarbon 4000 heart valvesin Europe, South Asia, the Middle East and the Far East.  Because we do not control the amount ortiming of the resources such parties allocate to sales of our product, anyrevenues we derive from such relationships depend upon the efforts of suchdistributors.  If we could not locate areplacement on a timely basis, the loss of an international distributor couldadversely affect us.

 

One of oursignificant international distributors, MercéV. Electromedicina, S.L., is an affiliate of our company.  During our fiscal year ended April 30, 2003,such affiliate made net purchases of product from our company equal toapproximately 29.6 percentof our net sales. ** **Sales to thisdistributor accounted for approximately 30.0 percent of our accounts receivableat April 30, 2003.  During ourfiscal year ended April 30, 2002, affiliates made net purchases of product fromour company equal to approximately 47.0 percent of our net sales.  Obligations to us from our distributors areunsecured.  Distributors could fail topay receivables or cease distributing our products at any time, therebymaterially and adversely affecting our business, financial condition, operatingresults and cash flows.

 

**We depend upon salesoutside the U.S., which are subject to a number of risks that could harm ourability to successfully commercialize our product and could harm our business.**  We face several risks as a result of doingbusiness in foreign markets, including:

 

•                                          unforeseenchanges in regulatory requirements and government health programs;

 

•                                          potentiallyadverse tax consequences;

 

•                                          political andeconomic instability; and

 

•                                          greaterdifficulty in collecting payments from product sales.

 

In addition,the value of the U.S. dollar in relation to other currencies may also harm oursales to customers outside the U.S. because we require substantially all of ourcustomers to pay for our products in U.S. currency.

 

**Substantialgovernment regulation in the U.S. and abroad may restrict our ability to sellour heart valves.** The FDA and comparable regulatory authorities in foreign countriesextensively and rigorously regulate our products, product developmentactivities and manufacturing processes. In the U.S., the FDA regulates the introduction of medical devices aswell as the manufacturing, labeling and record-keeping procedures for suchproducts.  We are required to:

 

•                                          obtainclearance before we can market and sell medical devices;

 

•                                          satisfycontent requirements applicable to our labeling, sales and promotionalmaterials;

 

•                                          comply withmanufacturing and reporting requirements; and

 

•                                          undergorigorous inspections.

 

The process ofobtaining marketing clearance for new medical devices from the FDA can becostly and time consuming.  For example,the premarket clearance process, which our heart valves and other medicaldevices must undergo, can require numerous years to complete.  Although we have obtained FDA clearance forour Omnicarbon 3000 heart valve, we cannot assure you that our future productswill obtain FDA clearance on a timely basis, or at all.  Our products must also comply with laws andregulations of foreign countries in which we market such products.  In general, the extent and complexity ofmedical device regulation is increasing worldwide.  This trend may continue, and the cost and time required to obtainmarketing clearance in any given country may increase as a result.  We cannot assure you that our products willobtain any necessary foreign clearances on a timely basis, or at all.

 

**Once medical devicesare cleared for sale, regulatory authorities may still limit the use of suchproducts, restrict sales to certain models or sizes, prevent the sale ormanufacture of such products or require a recall or withdrawal of such productsfrom the marketplace.** Following initial clearance from regulatory authorities, we continue tobe subject to extensive regulatory requirements.  Government authorities can withdraw marketing clearance due toour failure

 

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to comply with regulatorystandards or due to the occurrence of unforeseen problems following initialclearance.  Ongoing regulatoryrequirements are wide-ranging and govern, among other things:

 

•                                          annualinspections to retain CE mark for sale of products in the European Union;

 

•                                          productmanufacturing;

 

•                                          annualinspections to retain ISO certification of our quality system;

 

•                                          suppliersubstitution;

 

•                                          productchanges;

 

•                                          processmodifications;

 

•                                          medicaldevice reporting; and

 

•                                          product salesand distribution.

 

The FDA andvarious government agencies inspect our facilities from time to time todetermine whether we are in compliance with applicable laws andregulations.  If we fail to comply ormaintain compliance with medical device laws or regulations, regulatoryauthorities may fine us and bar us from selling our products.  If the FDA believes we are not in compliancewith such laws or regulations, it can:

 

•                                          seize ourproducts;

 

•                                          require arecall;

 

•                                          withdrawpreviously granted market clearances;

 

•                                          implementprocedures to stop future violations; and/or

 

•                                          seek civiland criminal penalties against us.

 

**The uncertainty ofthird party reimbursements and possible health care reforms may adverselyaffect us. **Ourability to market products successfully in the U.S. will depend in part on theextent to which reimbursement for the cost of such products and relatedtreatment will be available from government health administration authorities,private health insurers, health maintenance organizations and other third partypayers.  Payers increasingly challengethe need for, and prices of, medical products and services.  Payers may deny reimbursement for proceduresthat they deem experimental or for devices used in ways other than as clearedby the FDA or stated in their indications for use.  With respect to our products, some payers could deny coverageuntil the devices become generally accepted by the medical profession.  The inability of hospitals and otherproviders to obtain reimbursement from third party payers for our productswould have a material adverse impact on our business, financial condition,operating results and cash flows.

 

Health carereform may also impact sales of new products in the U.S.  Reforms may include:

 

•                                          mandatedbasic health care benefits;

 

•                                          controls onhealth care spending through limiting the growth of private health insurancepremiums and Medicare and Medicaid spending; and

 

•                                          fundamentalchanges to the health care delivery system.

 

We anticipatethat Congress and state legislatures will continue to review and assessalternative health care delivery systems and payment methodologies, and thatpublic debate of these issues will likely continue in the future.  Due to uncertainties regarding the ultimatefeatures of reform initiatives and their enactment and implementation, wecannot predict which, if any, of such reform proposals will be adopted, whenthey may be adopted or what impact they may have on our

 

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ability to market our currentand future products.  Laws resultingfrom such reform initiatives could adversely impact our business, financialcondition, operating results and cash flows.

 

**Despite our effortsto protect our proprietary rights, unauthorized parties may attempt to useinformation that we regard as proprietary. We also run the risk of infringing the proprietary rights of thirdparties.**  We donot have patent protection for the design of our Omnicarbon heart valves.  We rely upon a combination of trade secrets,know-how and confidentiality agreements to protect the proprietary aspects ofour technology, including aspects of manufacturing.  We have patent applications filed for the pyrolytic carbon coatingprocess used in our Omnicarbon 4000 heart valve.  We have patents for our bileaflet mechanical heart valvedevelopment project which is currently on hold.  We expect to seek patent protection for additional products inthe future.  Our success will depend, inpart, on our ability to protect our products and to manufacture and sell themwithout infringing the rights of third parties.  The validity and breadth of claims covered in medical technologypatents involve complex legal and factual questions and, therefore, are highlyuncertain.  In addition, the laws ofmany countries do not protect our proprietary rights to as great an extent asdo the laws of the U.S.  We cannotassure you that:

 

•                                          any pendingpatent applications or any future patent applications will result in theissuance of patents;

 

•                                          the scope ofany patent protection will be effective to exclude competitors or to providecompetitive advantages to us;

 

•                                          we will beable to commercially exploit any issued patents before they expire;

 

•                                          any of ourpatents will be held valid if subsequently challenged;

 

•                                          others willnot claim rights in, or ownership of, the patents and other proprietary rightswe hold;

 

•                                          our productsand processes will not infringe, or be alleged to infringe, the proprietaryrights of others; or

 

•                                          we will beable to protect meaningful rights in proprietary technology over which we donot hold patents.

 

Furthermore,we cannot assure you that others have not developed or will not developproducts which may duplicate any of our products or manufacturing processes, orthat others will not design around our patents.  Other parties may independently develop or otherwise acquiresubstantially equivalent techniques, gain access to our proprietary technologyor disclose such technology.  Inaddition, whether or not we obtain additional patents, others may hold orreceive patents covering components of products we independently develop in thefuture.  We cannot assure you that thirdparties will not claim infringement by us, and seek substantial damages, withrespect to current or future products. If we were to become involved in a dispute regarding intellectualproperty, whether ours or that of another company, we may be involved in legalproceedings.  Any such claims, with orwithout merit, could be time-consuming, result in costly litigation, causeproduct shipment delays and require us to:

 

•                                          ceasemanufacturing and selling the product in question, which could seriously harmus;

 

•                                          enter intoroyalty or licensing agreements; or

 

•                                          designcommercially acceptable non-infringing alternative products.

 

We cannotassure you that we would be able to obtain royalty or licensing agreements, ifrequired, on terms acceptable to us or at all, or that we would be able todevelop commercially acceptable non-infringing alternative products.  Our failure to do so could have a materialadverse effect upon our business, financial condition, operating results andcash flows.

 

**If patients allegethat the use of Omnicarbon heart valves adversely affected them, we may facesubstantial product liability claims.**  Substantial product liability litigationexists within the medical device industry. Mechanical heart valves are life-sustaining devices, and their failuremay result in patient death.  We havehad product liability claims in the past, which have been resolved withoutmaterial financial cost to us.  Wecannot assure you, however, that future product liability claims will notexceed the limits of our insurance coverage or that such insurance will continueto be available on commercially reasonable terms, or at all.  Consequently, a product liability claim orother claim with respect to uninsured liabilities, or in excess of insuredliabilities, could have a material adverse effect on our business, financialcondition, operating results and cash flows. In addition, adverse publicity resulting from product liabilitylitigation may materially adversely affect

 

17

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us regardless of whether theclaims are valid or whether we are liable. These claims may divert our financial and management resources thatwould otherwise be used to benefit the future performance of our operations.

 

**Key employees couldleave our company at any time, impairing our development and profitability**.  We depend heavily on the technical knowledgeand industry expertise of our management team. The development and execution of our business plan depends upon theseindividuals.   We do not have employmentagreements with most of our key employees. The departure of key people could adversely affect our business,financial condition, operating results and cash flows.

 

**We may be unable torecruit, motivate and retain qualified employees.**  Our success depends upon our ability toattract, motivate and retain a sufficient number of qualified employees,including those who concentrate in research and development, sales, marketingand manufacturing, to keep pace with our product development schedules.  Even though we have not experiencedshortages of qualified people to date, qualified individuals needed to fillthese positions could be in short supply in our market.  Our inability to recruit, motivate andretain such individuals may delay the planned launch of new products or resultin high employee turnover, either of which could have a material adverse effecton our business, financial condition, operating results and cash flows.  Additionally, competition for qualifiedemployees could require us to pay higher wages and provide additional benefitsto attract sufficient employees.

 

**We may be unable tocollect on our loan to UROPACE, Inc. **InJuly 1995, we established a wholly-owned subsidiary called UROPACE, Inc.  On November 1, 2000, we completed a spin-offof UROPACE to our existing shareholders. As part of this spin-off, we agreed to loan UROPACE up to $356,250 at avariable interest rate.  As of April 30,2003, we had loaned UROPACE $235,000.** **Principaland interest on the note is payable in installments equal to 5 percent of UROPACE’sfuture annual net sales until the note is paid in full.  Due to the development stage of UROPACE, itis uncertain whether we will be able to collect on this loan.  For financial reporting purposes, we haverecorded an allowance for the entire balance of the loan at April 30, 2003.

 

***Risks related to oursecurities***

 

**Fluctuations in ouroperating results may result in decreases in the price of our securities.**  Our operating results have and will continueto fluctuate significantly because of several factors, including the timing ofFDA clearance, government policies regarding payment for our products and newtechnology.  Consequently, our operatingresults may fall below the expectations of public market analysts andinvestors.  In that event, the price ofour securities would likely decrease.

 

**No public market existsfor our common stock or Class A Warrants, and an active market may not developfor our units. **Wecannot assure you that a public market for our common stock or Class A Warrantswill develop in the future or that an active market for our units will develop.  Before our initial public offering, therewas no public market for our units.  Asa result, we arbitrarily established the offering price for the units and theexercise price of the Class A Warrants through negotiations with ourunderwriter.  Such prices were not basedupon our assets, earnings history or book value.

 

**You may have difficulty reselling your securities.**  Our securities are subject to certain rulesof the SEC relating to “penny stocks.” Such rules require broker-dealers to make a suitability determinationfor purchasers and to receive the purchaser’s prior written consent for apurchase transaction, thus restricting the ability to purchase or sell oursecurities in the open market.  Inaddition, trading in our securities is conducted in the over-the-counter marketon the OTC Bulletin Board, which was established for securities that do notmeet Nasdaq listing requirements. Selling our securities may be difficult because of the quantity ofsecurities that may be bought and sold, the possibility that transactions maybe delayed, and the low level of security analyst and news media coverage givento over-the-counter stocks.  Thesefactors could contribute to lower prices and larger spreads in the bid and askprices for our securities.

 

**Our existingshareholders have significant control, which could reduce your ability toreceive a premium for your securities through a change in control.**  Officers and directors of our companybeneficially own approximately 46 percent of our common stock.** **Asa result, they may be able to control our company and direct our affairs,including the election of directors and approval of significant corporatetransactions.  This concentration ofownership could also delay, defer or prevent a change in control of ourcompany, and make some transactions more difficult or impossible without theirsupport.  These transactions mightinclude proxy contests, tender offers, open market purchase programs or othershare purchases that could give our shareholders the opportunity to realize apremium over the then prevailing market price of our securities.  As a result, this concentration of ownershipcould depress the price of our securities.

 

**Minnesota law and ourability to issue preferred stock could deter a take-over or acquisition of ourcompany**.  Ourarticles of incorporation authorize the issuance of shares of preferredstock.  Our board of directors, withoutany action by our shareholders, is authorized to designate and issue thepreferred stock in such classes or series as it deems appropriate and

 

18

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establish the rights andprivileges of such shares, including liquidation and voting rights.  Our ability to designate and issue preferredstock having preferential rights over our common stock could adversely affectthe voting power and other rights of holders of common stock, should wedetermine to issue preferred stock.  Weare also subject to the Minnesota Business Corporation Act, which includesprovisions that limit the voting rights of persons acquiring specifiedpercentages of shares of an issuing public corporation in a “control shareacquisition” and restrict “business combinations” between issuing publiccorporations and specified persons acquiring their securities.  Our ability to issue preferred stock and theapplication of the provisions of Minnesota law discussed above could impede ordeter another company from making a tender offer or other proposal to take usover.

 

**We may redeem theClass A Warrants at a nominal price. **Wemay redeem the Class A Warrants at $0.01 per warrant at any time, upon tenbusiness days’ notice, if the closing price of our common stock or unitsexceeds $8.50, subject to customary anti-dilution adjustments, for any tenconsecutive trading days before such notice. If we redeem the Class A Warrants, you will lose your right to exercisethe Class A Warrants except during the ten business day notice period.  Our redemption of the Class A Warrants couldforce you to exercise the Class A Warrants at a time when it may bedisadvantageous for you to do so, to sell the Class A Warrants at the thencurrent market price or to accept the redemption price, which could besubstantially less than the market value of the Class A Warrants at the time ofredemption.

 

**If we do not maintainan effective prospectus, you will be unable to exercise your Class A Warrants.**  You will be able to exercise the Class AWarrants, and we will be able to issue shares to you upon such exercise, onlyif a current prospectus relating to the shares underlying the Class A Warrantsis then in effect and only if such securities are qualified for sale or exemptfrom qualification under the applicable securities laws of the state in whichyou reside.

 

19

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**ITEM7             FINANCIAL STATEMENTS**

 

**INDEX TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**MedicalCV, Inc.**
| Report of Independent Auditors                                             |   |
|----------------------------------------------------------------------------|--------|
| Consolidated  Financial Statements                                         |   |
| Consolidated Balance Sheet                                                 |   |
| Consolidated Statement of Operations                                       |   |
| Consolidated Statements of Changes in  Shareholders’ Equity (Deficit) |   |
| Consolidated Statement of Cash Flows                                       |   |
| Notes to Consolidated Financial Statements                                 |   |

 

20

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**Report of Independent A****uditors**

 

To the Board of Directors and Shareholders of MedicalCV, Inc.

 

In our opinion, the accompanying consolidated balance sheets and therelated consolidated statements of operations, of changes in shareholders’ equity (deficit) and of cash flows present fairly, in all materialrespects, the financial position of MedicalCV, Inc. at April 30, 2003 and 2002, and the results of its operations and its cash flows forthe years then ended in conformity with accounting principles generallyaccepted in the United States of America. These financial statements are the responsibility of the Company’s management; our responsibility is toexpress an opinion on these financial statements based on our audits.  We conducted our audits of these statementsin accordance with auditing standards generally accepted in the United Statesof America, which require that we plan and perform the audit to obtainreasonable assurance about whether the financial statements are free ofmaterial misstatement.  An auditincludes examining, on a test basis, evidence supporting the amounts anddisclosures in the financial statements, assessing the accounting principlesused and significant estimates made by management, and evaluating the overallfinancial statement presentation.  Webelieve that our audits provide a reasonable basis for our opinion.

 

As discussed innote 17 of the notes to consolidated financial statements, the Company hasrestated its consolidated statement of operations for each of the two years inthe period ended April 30, 2003, to reflect a change in classification ofcertain marketing expenditures and to reflect a change in classification ofincome from inventories returned from two former international distributors.

 

The accompanyingfinancial statements have been prepared assuming that the Company will continueas a going concern.  As discussed inNote 1 to the financial statements, the Company has sustained losses andnegative cash flows from operations in recent years and has insufficient fundsto finance its working capital and capital expenditure needs, which raisessubstantial doubt about the Company’s ability to continue as agoing concern.  Management’s plans in regard to these matters arealso described in Note 1.  The financialstatements do not include any adjustments that might result from the outcome ofthis uncertainty.

 
| /s/ PricewaterhouseCoopers  LLP                                         |   |
|-------------------------------------------------------------------------|--------|
| PricewaterhouseCoopers  LLP                                             |
| Minneapolis,  Minnesota                                                 |
| June 6, 2003,  except as to Note 16 for which the date is July 8, 2003, |
| and  except as to Notes 4 and 17 for which the date is March 19, 2004   |

 

21

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**MEDICALCV, INC.**

 

**Consolidated BalanceSheet**

 
|                                                                                                 |   | **April 30,** |      |
|------------------------------------------------------------------------------------------------------|--------|---------------|-----------|
|                                                                                                 |   | **2003**      |      | **2002** |   |
| **ASSETS**                                                                                           |   |          |      |   |   |
| Current assets:                                                                                      |   |          |      |   |   |
| Cash and cash equivalents                                                                            |   | $             | 184,227   |   | $ | 2,781,675 |   |
| Trade accounts receivable, net                                                                       |   | 1,472,995     |      | 1,258,616 |   |
| Inventories                                                                                          |   | 2,782,613     |      | 2,322,535 |   |
| Prepaid expenses and other current assets                                                            |   | 183,856       |      | 78,993 |   |
| Total current assets                                                                                 |   | 4,623,691     |      | 6,441,819 |   |
|                                                                                                 |   |          |      |   |   |
| Property, plant and equipment, net                                                                   |   | 1,368,240     |      | 1,575,153 |   |
| Deferred financing costs                                                                             |   | 62,989        |      | 72,860 |   |
| Other assets                                                                                         |   | —        |      | 1,394 |   |
| Total assets                                                                                         |   | $             | 6,054,920 |   | $ | 8,091,226 |   |
|                                                                                                 |   |          |      |   |   |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY (DEFICIT)**                                              |   |          |      |   |   |
| Current liabilities:                                                                                 |   |          |      |   |   |
| Accounts payable                                                                                     |   | $             | 895,405   |   | $ | 589,520 |   |
| Short-term debt with related party                                                                   |   | 943,333       |      | — |   |
| Current portion of related party lease  obligation                                                   |   | 273,843       |      | — |   |
| Current portion of long-term debt                                                                    |   | —        |      | 2,542,460 |   |
| Current portion of capital lease  obligations                                                        |   | 42,069        |      | 59,854 |   |
| Accrued expenses                                                                                     |   | 813,539       |      | 491,760 |   |
| Total current liabilities                                                                            |   | 2,968,189     |      | 3,683,594 |   |
|                                                                                                 |   |          |      |   |   |
| Long-term debt, less current portion                                                                 |   | —        |      | 339,523 |   |
| Capital lease obligations, less current  portion                                                     |   | —        |      | 42,069 |   |
| Related party lease obligation, less  current portion                                                |   | 3,472,661     |      | — |   |
| Total liabilities                                                                                    |   | 6,440,850     |      | 4,065,186 |   |
|                                                                                                 |   |          |      |   |   |
| Shareholders’ equity (deficit):                                                                 |   |          |      |   |   |
| Preferred stock, $.01 par value; 5,000,000  shares authorized; no shares issued and outstanding      |   | —        |      | — |   |
| Common stock; $.01 par value; 95,000,000  shares authorized; 7,843,834 shares issued and outstanding |   | 78,438        |      | 78,438 |   |
| Additional paid-in capital                                                                           |   | 16,613,337    |      | 16,362,050 |   |
| Deferred stock-based compensation                                                                    |   | (4,610        | )         | (9,062 | ) |
| Accumulated deficit                                                                                  |   | (17,073,095   | )         | (12,405,386 | ) |
| Total shareholders’ equity (deficit)                                                            |   | (385,930      | )         | 4,026,040 |   |
| Total liabilities and shareholders’ equity  (deficit)                                           |   | $             | 6,054,920 |   | $ | 8,091,226 |   |

 

The accompanying notes are an integral partof these financial statements.

 

22

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**MedicalCV, Inc.**

**Consolidated Statement of Operations**

 
|                                                                     |   | **Year ended  April 30,**     |       |
|--------------------------------------------------------------------------|--------|-------------------------------|------------|
|                                                                     |   | **2003  Restated  (Note 17)** |       | **2002  Restated  (Note 17)** |   |
|                                                                     |   |                          |       |   |   |
| Net sales                                                                |   | $                             | 2,578,063  |   | $ | 2,536,868 |   |
| Cost of goods sold                                                       |   | 1,807,402                     |       | 2,109,453 |   |
|                                                                     |   |                          |       |   |   |
| Gross profit                                                             |   | 770,661                       |       | 427,415 |   |
|                                                                     |   |                          |       |   |   |
| Operating expenses:                                                      |   |                          |       |   |   |
| Sales and marketing                                                      |   | 2,307,769                     |       | 1,643,774 |   |
| General and administrative                                               |   | 1,834,418                     |       | 1,594,968 |   |
| Engineering and regulatory                                               |   | 876,686                       |       | 779,038 |   |
|                                                                     |   |                          |       |   |   |
| Total operating expenses                                                 |   | 5,018,873                     |       | 4,017,780 |   |
|                                                                     |   |                          |       |   |   |
| Loss from operations                                                     |   | (4,248,212                    | )          | (3,590,365 | ) |
|                                                                     |   |                          |       |   |   |
| Other (expense) income:                                                  |   |                          |       |   |   |
| Interest expense                                                         |   | (467,315                      | )          | (463,388 | ) |
| Interest income                                                          |   | 12,705                        |       | 47,414 |   |
| Loss from early extinguishment of  convertible subordinated bridge notes |   | —                        |       | (335,410 | ) |
| Other income, net                                                        |   | 35,113                        |       | 44,084 |   |
|                                                                     |   |                          |       |   |   |
| Total other expense                                                      |   | (419,497                      | )          | (707,300 | ) |
|                                                                     |   |                          |       |   |   |
| Net loss                                                                 |   | $                             | (4,667,709 | ) | $ | (4,297,665 | ) |
|                                                                     |   |                          |       |   |   |
| Basic and diluted net loss per share                                     |   | $                             | (.60       | ) | $ | (.62 | ) |
|                                                                     |   |                          |       |   |   |
| Shares used in computing basic and diluted  net loss per share           |   | 7,843,834                     |       | 6,980,820 |   |

 

The accompanying notes are an integral partof these financial statements.

 

23

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**MedicalCV,Inc.**

**ConsolidatedStatements of Changes in Shareholders’ Equity (Deficit)**

 
|                                                                                                             |   | **Common Stock** |   | **Additional****Paid-inCapital** |   | **Deferred****Stock-BasedCompensation** |   | **(Accumulated****Deficit)** |   | **Total**   |    |
|------------------------------------------------------------------------------------------------------------------|--------|------------------|--------|----------------------------------|--------|-----------------------------------------|--------|------------------------------|--------|-------------|---------|
| **Shares**                                                                                                       |   | **Amount**       |
|                                                                                                             |   |             |   |                             |   |                                    |   |                         |   |        |    |   |   |
| **Total,  April 30, 2001**                                                                                       |   | 6,343,834        |   | $                                | 63,438 |                                    | $      | 10,490,378                   |   | $           | (16,824 | ) | $ | (8,107,721 | ) | $ | 2,429,271 |   |
| Net loss                                                                                                         |   |             |   |                             |   |                                    |   |                         |   | (4,297,665  | )       | (4,297,665 | ) |
| Common stock issued,  net of issuance costs of $1,353,515                                                        |   | 1,500,000        |   | 15,000                           |   | 5,381,485                               |   |                         |   |        |    | 5,396,485 |   |
| Warrants issued in  connectionwith  issuance of commonstock                                                      |   |             |   |                             |   | 50                                      |   |                         |   |        |    | 50 |   |
| Amortization of stock-basedcompensation                                                                          |   |             |   |                             |   |                                    |   | 7,762                        |   |        |    | 7,762 |   |
| Stock options issued to  non-employees                                                                           |   |             |   |                             |   | 69,844                                  |   |                         |   |        |    | 69,844 |   |
| Discount on convertiblesubordinated bridge notes                                                                 |   |             |   |                             |   | 497,125                                 |   |                         |   |        |    | 497,125 |   |
| Warrants issued in  connectionwith  convertiblesubordinated  bridge notes                                        |   |             |   |                             |   | 500                                     |   |                         |   |        |    | 500 |   |
| Repurchase of beneficialconversion feature relatedto early extinguishment ofconvertible subordinatedbridge notes |   |             |   |                             |   | (77,332                                 | )      |                         |   |        |    | (77,332 | ) |
| **Total,  April 30, 2002**                                                                                       |   | 7,843,834        |   | 78,438                           |   | 16,362,050                              |   | (9,062                       | )      | (12,405,386 | )       | 4,026,040 |   |
| Net loss                                                                                                         |   |             |   |                             |   |                                    |   |                         |   | (4,667,709  | )       | (4,667,709 | ) |
| Amortization of stock-basedcompensation                                                                          |   |             |   |                             |   |                                    |   | 4,452                        |   |        |    | 4,452 |   |
| Stock options issued to  non-employees                                                                           |   |             |   |                             |   | 20,329                                  |   |                         |   |        |    | 20,329 |   |
| Warrants issued in connection with  sale-leaseback transaction                                                   |   |             |   |                             |   | 89,602                                  |   |                         |   |        |    | 89,602 |   |
| Warrants issued in connection with  short-term debt with related party                                           |   |             |   |                             |   | 128,995                                 |   |                         |   |        |    | 128,995 |   |
| Warrants issued in connection with  technology purchase                                                          |   |             |   |                             |   | 12,361                                  |   |                         |   |        |    | 12,361 |   |
|                                                                                                             |   |             |   |                             |   |                                    |   |                         |   |        |    |   |   |
| **Total,  April 30, 2003**                                                                                       |   | 7,843,834        |   | $                                | 78,438 |                                    | $      | 16,613,337                   |   | $           | (4,610  | ) | $ | (17,073,095 | ) | $ | (385,930 | ) |

 

The accompanying notes are an integral partof these financial statements.

 

24

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**MedicalCV,Inc.**

**ConsolidatedStatement of Cash Flows**

 
|                                                                                                                  |   | **Year ended  April 30,** |       |
|-----------------------------------------------------------------------------------------------------------------------|--------|---------------------------|------------|
|                                                                                                                  |   | **2003**                  |       | **2002** |   |
| Cash flows from operating activities:                                                                                 |   |                      |       |   |   |
| Net loss                                                                                                              |   | $                         | (4,667,709 | ) | $ | (4,297,665 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities:                                          |   |                      |       |   |   |
| Loss on early extinguishment of convertible  subordinated bridge notes                                                |   | —                    |       | 335,410 |   |
| Depreciation                                                                                                          |   | 335,873                   |       | 290,049 |   |
| Amortization of discount on convertible  subordinated bridge notes                                                    |   | —                    |       | 84,383 |   |
| Provision for  doubtful accounts, excluding return of inventory in 2003                                          |   | 47,132                    |       | 133,360 |   |
| Return of inventory                                                                                                   |   | (92,000                   | )          |   |   |
| Provision for inventory obsolescence                                                                                  |   | —                    |       | 37,584 |   |
| Stock-based compensation                                                                                              |   | 24,780                    |       | 77,606 |   |
| Warrants issued in connection with  technology purchase                                                               |   | 12,361                    |       | — |   |
| Interest expense associated with warrant  grants and other costs                                                      |   | 201,855                   |       | 222,191 |   |
| Changes in assets and liabilities:                                                                                    |   |                      |       |   |   |
| Accounts receivable                                                                                                   |   | (261,511                  | )          | (185,416 | ) |
| Inventories                                                                                                           |   | (368,078                  | )          | (188,084 | ) |
| Prepaid expenses and other assets                                                                                     |   | (169,875                  | )          | 48,361 |   |
| Accounts payable                                                                                                      |   | 305,885                   |       | 78,180 |   |
| Accrued expenses                                                                                                      |   | 321,779                   |       | 177,236 |   |
|                                                                                                                  |   |                      |       |   |   |
| Net cash used in operating activities                                                                                 |   | (4,309,507                | )          | (3,186,805 | ) |
|                                                                                                                  |   |                      |       |   |   |
| Cash flows from investing activities:                                                                                 |   |                      |       |   |   |
| Purchase of property, plant and equipment                                                                             |   | (128,960                  | )          | (384,024 | ) |
| Loan to UROPACE                                                                                                       |   | —                    |       | (81,000 | ) |
|                                                                                                                  |   |                      |       |   |   |
| Net cash used in investing activities                                                                                 |   | (128,960                  | )          | (465,024 | ) |
|                                                                                                                  |   |                      |       |   |   |
| Cash flows from financing activities:                                                                                 |   |                      |       |   |   |
| Borrowings on line of credit with related  party                                                                      |   | 1,243,333                 |       | 1,570,000 |   |
| Borrowings on short-term debt with related  party                                                                     |   | 60,000                    |       | — |   |
| Principal payments on short-term debt with  related party                                                             |   | (360,000                  | )          |   |   |
| Principal payments on bank line of credit                                                                             |   | —                    |       | (475,000 | ) |
| Principal payments on other long-term debt                                                                            |   | (42,460                   | )          | (42,464 | ) |
| Proceeds from sale-leaseback transaction  with related party, net                                                     |   | 1,000,000                 |       | — |   |
| Borrowings on bridge loans, net                                                                                       |   | —                    |       | 438,885 |   |
| Principal payments on bridge loans                                                                                    |   | —                    |       | (500,000 | ) |
| Principal payments under capital lease  obligations                                                                   |   | (59,854                   | )          | (66,929 | ) |
| Issuance of common stock, net of issuance  costs                                                                      |   | —                    |       | 5,396,485 |   |
| Issuance of warrants                                                                                                  |   | —                    |       | 550 |   |
|                                                                                                                  |   |                      |       |   |   |
| Net cash provided by financing activities                                                                             |   | 1,841,019                 |       | 6,321,527 |   |
|                                                                                                                  |   |                      |       |   |   |
| Net increase (decrease) in cash and cash  equivalents                                                                 |   | (2,597,448                | )          | 2,669,698 |   |
|                                                                                                                  |   |                      |       |   |   |
| Cash and cash equivalents at beginning of  year                                                                       |   | 2,781,675                 |       | 111,977 |   |
|                                                                                                                  |   |                      |       |   |   |
| Cash and cash equivalents at end of year                                                                              |   | $                         | 184,227    |   | $ | 2,781,675 |   |
|                                                                                                                  |   |                      |       |   |   |
| Supplemental disclosure of cash flow  information:                                                                    |   |                      |       |   |   |
| Cash paid during the year for:                                                                                        |   |                      |       |   |   |
| Interest                                                                                                              |   | $                         | 265,460    |   | $ | 241,197 |   |
| Income taxes                                                                                                          |   | 250                       |       | 1,256 |   |
|                                                                                                                  |   |                      |       |   |   |
| Non-cash investing and financing  activities:                                                                         |   |                      |       |   |   |
| Capital lease obligations incurred for the  purchase of property, plant, and equipment                                |   | —                    |       | 34,796 |   |
| Discount on convertible subordinated bridge  notes related to warrants and beneficial conversion feature              |   | —                    |       | 497,125 |   |
| Repurchase of beneficial conversion feature  related to early extinguishment of convertible subordinated bridge notes |   | —                    |       | 77,332 |   |
| Warrants issued in connection with  sale-leaseback transaction with related party                                     |   | 89,602                    |       | — |   |
| Payments/assumptions of debt made in connection with the related party  lease (See note 6):                           |   |                      |       |   |   |
| Assumption of line of credit obligation by purchaser                                                                  |   | 2,500,000                 |       | — |   |
| Assumption of Dakota Electric and Dakota County debt by purchaser                                                     |   | 336,105                   |       | — |   |

 

The accompanying notes are an integral partof these financial statements.

 

25

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**MedicalCV, Inc.**

**Notesto Consolidated Financial Statements**

 

**1.****                             ****Business Description**

 

MedicalCV,Inc. (the Company) is a corporation engaged in the manufacture and marketing ofcardiothoracic surgery devices primarily in Europe, SouthAsia, the Middle East and the Far East.  The primary product of the Company is amechanical heart valve.

 

The Company’s consolidatedfinancial statements for the year ended April 30, 2003, have been prepared on agoing concern basis, which contemplates the realization of assets andsettlement of liabilities and commitments in the normal course ofbusiness.  The Company has sustainedlosses and negative cash flows from operations in recent years and expectsthese conditions to continue for the foreseeable future.  At April 30, 2003, the Company had anaccumulated deficit of $17,073,095, and had insufficient funds to meet therequirements of its short-term debt, and finance its working capital andcapital expenditure needs.  Accordingly,these matters raise substantial doubt about the Company’s ability to continueas a going concern.  The Company iscurrently pursuing the refinancing of its short-term debt and seeking otherfinancing to fund its operations and working capital requirements.  If the Company is unable to refinance its short-termdebt and obtain funds beginning in September 2003, it will be required tosignificantly revise its business plans and drastically reduce operatingexpenditures such that it may not be able to develop or enhance its products,gain market share in the United States or respond to competitive pressures orunanticipated requirements, which could seriously harm its business, financialposition and results of operations.

 

The Company issubject to risks and uncertainties common to medical technology-basedcompanies, including rapid technological change, dependence on one principalproduct, new product development and acceptance, actions of competitors,dependence on key personnel and United States market penetration.

 

**2.****                              Summaryof Significant Accounting Policies**

 

**Principles of Consolidation**

 

The Company’sconsolidated financial statements include the accounts of MedicalCV, Inc. andits wholly-owned subsidiaries, CV Holdings, Inc., which was liquidated infiscal year 2002, and CVD International, Inc., which was liquidated in fiscalyear 2003 with no material impact to the financial statements.  All significant intercompany transactionsand balances have been eliminated in consolidation.

 

**Use of Estimates**

 

Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the United States 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 coulddiffer from those estimates.

 

**Fair Value of Financial Instruments**

 

The Company’sfinancial instruments consist primarily of cash and cash equivalents, tradeaccounts receivable and accounts payable for which the current carrying amountsapproximate fair value.  Additionally,the borrowing rates currently available to the Company approximate current ratesfor debt agreements with similar terms and average maturities.

 

**Cash and Cash Equivalents**

 

Cash and cashequivalents consist of checking accounts and a money market account, all ofwhich are held in two depository institutions. The Company considers all highly-liquid investments with original maturities ofthree months or less to be cash equivalents. The carrying value of cash equivalents approximates fair value becauseof the short maturity of these instruments.  The majority of the Company’s cash and cash equivalents are held intwo financial institutions.  Deposits inthese institutionsmay exceed the amount of federal insurance provided on such deposits.

 

26

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**Inventories**

 

Inventoriesconsist of various mechanical heart valves and other medical items that arestated at the lower of cost or market, with cost determined utilizing standardcosts, which approximate the first-in, first-out method of inventory valuation.

 

**Property, Plant and Equipment**

 

Property,plant and equipment is stated at cost. Depreciation and amortization is computed using the straight-line methodover the estimated useful lives of the related assets.  The building is depreciated over a 30-yearlife.  Machinery and equipment,furniture and fixtures, and tooling and software are depreciated over five-yearlives.  Maintenance and repairs arecharged to current operations when incurred. The cost and related accumulated depreciation or amortization of assetsdisposed of are removed from the related accounts and any resulting gains orlosses are recorded to the statement of operations.

 

**Long-Lived Assets**

 

The Companyperiodically evaluates the carrying value of long-lived assets to be held andused, including but not limited to, capital assets and intangible assets, whenevents and circumstances warrant such a review.  The carrying value of a long-lived asset is considered impairedwhen the anticipated undiscounted cash flow from such asset is separatelyidentifiable and is less than its carrying value.  In that event, a loss is recognized based on the amount by whichthe carrying value exceeds the fair value of the long-lived asset.  Fair value is determined primarily using theanticipated cash flows discounted at a rate commensurate with the riskinvolved.  Losses on long-lived assetsto be disposed of are determined in a similar manner, except that fair valuesare reduced for the cost to dispose.  Nolosses from impairment have been recognized in the financial statements.

 

**Revenue Recognition**

 

The Companyrecognizes revenues from the sale ofits mechanical heart valves provided that the Company has received a purchaseorder, the price is fixed, title has transferred, collection of the resultingreceivable is probable, and there are no remaining obligations.  Transfer of title occurs for substantiallyall sales upon shipment.  The Company’sproducts are not subject to any customer acceptance process.  There are no rights of return unless theproduct does not perform according to specifications.

 

**Research and Development**

 

Research anddevelopment costs are expensed as incurred.

 

**Stock-Based Compensation**

 

The Companyaccounts for stock-based employee compensation arrangements in accordance withthe provisions of Accounting Principles Board Opinion No. 25, “Accountingfor Stock Issued to Employees,” and complies with the disclosure provisions ofSFAS No. 123, “Accounting for Stock-Based Compensation” and SFAS No. 148“Accounting for Stock-Based Compensation-Transition and Disclosure, anamendment of FASB Statement No. 123.”

 

The Companyhas adopted the disclosure-only provisions of SFAS No. 123.  For purposes of the pro forma disclosuresbelow, the estimated fair value of the options is amortized to expense over theoptions’ vesting period.  Hadcompensation cost for the Company’s stock options been recognized based on thefair value at the grant date consistent with the provisions of SFASNo. 123, the Company’s net loss would have been adjusted to the pro formaamounts indicated below:

 

27

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|                                                                                                |   | **For the  Years Ended  April 30,** |       |
|-----------------------------------------------------------------------------------------------------|--------|------------------------------------------|------------|
|                                                                                                |   | **2003**                                 |       | **2002** |   |
| Net loss reported                                                                                   |   | $                                        | (4,667,709 | ) | $ | (4,297,665 | ) |
| Less:   stock-based employee compensation benefit included in operating  results, as reported: |   | —                                   |       | — |   |
| Less:   Pro forma stock based employee compensation (cost) benefit                             |   | (294,142                                 | )          | (951,779 | ) |
|                                                                                                |   |                                     |       |   |   |
| Net loss - pro forma                                                                                |   | (4,961,851                               | )          | (5,249,444 | ) |
|                                                                                                |   |                                     |       |   |   |
| Net loss per common share – basic and  diluted                                                 |   |                                     |       |   |   |
| As reported                                                                                         |   | (.60                                     | )          | (.62 | ) |
| Pro forma                                                                                           |   | (.63                                     | )          | (.75 | ) |
|                                                                                                     |        |                                          |            |  |  |  |  |

 

**Income Taxes**

 

Deferredincome taxes are recorded to reflect the tax consequences on future years ofdifferences between the tax bases of assets and liabilities and their financialreporting amounts at each year-end, based on enacted tax laws and statutory taxrates applicable to the periods in which the differences are expected to affecttaxable income.  Deferred tax assets arereduced by a valuation allowance when, in the opinion of management, it is morelikely than not that some portion or all of the deferred tax asset will not berealized.  Income tax expense or benefitis the tax payable or refundable for the year and the change during the year indeferred tax assets and liabilities.

 

**Comprehensive Income (Loss)**

 

Comprehensiveincome (loss) includes net income (loss) and items defined as othercomprehensive income (loss).  Itemsdefined as other comprehensive income (loss) include items such as foreigncurrency translation adjustments and unrealized gains and losses on certainmarketable securities.  For the yearsended April 30, 2003 and 2002, there were no adjustments to net loss to arriveat comprehensive loss.

 

**Concentration of Credit Risk**

 

At April 30,2003 and 2002, approximately 38percent and 54percent, respectively, of the Company’s accounts receivable weredue from one distributor that individually accounted for 10 percent or more of the Company’s tradeaccounts receivable in each respective fiscal year (see Note 13).  The Company generally requires no collateralfrom its customers with respect to trade accounts receivable.  The Company maintains an allowance fordoubtful accounts based upon its historical experience and the expectedcollectibility of all accounts receivable.

 

**Net Income (Loss) Per Share**

 

Net income(loss) per share is computed under the provisions of SFAS No. 128, “EarningsPer Share.”  Basic net income (loss) percommon share is computed using net income (loss) and the weighted-averagenumber of shares of common stock outstanding. Diluted earnings per share reflect the potential dilution of securitiesthat could share in the earnings of an entity. Diluted net loss per common share does not differ from basic net lossper common share in the years ended April 30, 2003 and 2002 since 4,300,940 and 3,551,390,respectively, of potential dilutive shares of common stock from the exercise ofstock options and warrants were excluded from the computation because they areanti-dilutive.

 

**Reclassifications**

 

Certain amounts previously reported have beenreclassified to conform to the fiscal year 2003 presentation.  These reclassifications had no effect on net loss, cash flows or shareholders’ equity (deficit) as previously reported.

 

**New Accounting Pronouncements**

 

In June 2002, the FASB issuedSFAS No. 146, “Accounting for Exit or Disposal Activities.”  The new statement addresses the accountingfor costs associated with exit or disposal activities.  The provisions of the statement wereeffective for disposal activities initiated after December 31, 2002.  The adoption of SFAS No. 146 did not have animpact on the Company’s financial position or results of operations.  The new standard principally affects theCompany’s timing of when charges are

 

28

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recorded as opposed to the amount of theultimate charge.  There have been noexit or disposal activities subsequent to December 31, 2002.

 

The Company adopted the provisions of FASBInterpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements forGuarantees, Including Indirect Guarantees of Indebtedness of Others” in the thirdquarter of fiscal year 2003.  Thedisclosure provisions of the interpretation are effective for the Company’sfinancial statements for the third quarter of fiscal year 2003.  The provisions for initial recognition andmeasurement are effective on a prospective basis for guarantees that are issuedor modified after December 31, 2002. The implementation of this accounting pronouncement did not have amaterial effect on the Company’s results of operations, financial position orcash flows.

 

In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation -Transition and Disclosure — an amendment of FAS 123.” SFAS No. 148 provides alternative methods of transitionfor a voluntary change to the fair value based method of accounting forstock-based employee compensation and amends certain disclosure requirements ofSFAS No. 123.  The transition provisions of this statement are effective for fiscal yearsending after December 15, 2002, and the disclosure requirements of thisstatement are effective for interim periods beginning afterDecember 15, 2002.  The Company currently plans to continueto apply the intrinsic-value based method to account for stock options.  TheCompany implemented the year-end disclosure provisions included in Note 2 as ofApril 30, 2003 and will implement the interim period disclosure provisions inthe quarter ending July 31, 2003.

 

In January 2003, the FASB issued FIN No. 46,“Consolidation of Variable Interest Entities, an interpretation of AccountingResearch Bulletin No. 51.” FIN No. 46 requires certain variable interestentities (VIEs), to be consolidated by the primary beneficiary of the entity ifthe equity investors in the entity do not have the characteristics of acontrolling financial interest or do not have sufficient equity at risk for theentity to finance its activities without additional subordinated financialsupport from other parties.  FIN No. 46is effective for all VIEs created or acquired after January 31, 2003.  For VIEs created or acquired prior toFebruary 1, 2003, the provisions of FIN No. 46 must be applied for the firstinterim or annual period beginning after June 15, 2003.  The Company currently has no contractualrelationship or other business relationship with a VIE and therefore the adoptionof FIN No. 46 did not have a material effect on its consolidated financialposition, results of operations or cash flows. However, should the Company enter into any such arrangement with a VIEin the future, its consolidated financial position or results of operations maybe adversely effected

 

**3.****                                      SupplementalFinancial Statement Information**

 

Certain balance sheetcomponents consist of the following at April 30:

 

| **Trade Accounts Receivable, Net** |   | **2003**  |      | **2002** |   |
|------------------------------------|--------|-----------|-----------|----------|--------|
|                               |   |      |      |     |   |
| Related parties                    |   | $         | 557,899   |     | $      | 700,581 |   |
| Other                              |   | 1,028,391 |      | 756,692  |   |
| Allowance for doubtful accounts    |   | (113,295  | )         | (198,657 | )      |
|                               |   |      |      |     |   |
|                               |   | $         | 1,472,995 |     | $      | 1,258,616 |   |

 

| **Inventories** |   | **2003**  |      | **2002**  |   |
|-----------------|--------|-----------|-----------|-----------|--------|
|            |   |      |      |      |   |
| Raw materials   |   | $         | 377,961   |      | $      | 436,855 |   |
| Work-in-process |   | 529,668   |      | 551,561   |   |
| Finished goods  |   | 1,874,984 |      | 1,334,119 |   |
|            |   |      |      |      |   |
|            |   | $         | 2,782,613 |      | $      | 2,322,535 |   |

 

29

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| **Property, Plant and Equipment, Net**    |   | **2003**   |      | **2002**   |   |
|-------------------------------------------|--------|------------|-----------|------------|--------|
|                                      |   |       |      |       |   |
| Land                                      |   | $          | 182,000   |       | $      | 182,000 |   |
| Building                                  |   | 1,251,601  |      | 1,225,190  |   |
| Machinery and equipment                   |   | 1,558,442  |      | 1,512,611  |   |
| Furniture and fixtures                    |   | 182,243    |      | 177,513    |   |
| Tooling                                   |   | 116,363    |      | 100,263    |   |
| Software                                  |   | 146,159    |      | 112,271    |   |
|                                      |   |       |      |       |   |
|                                      |   | 3,438,808  |      | 3,309,848  |   |
|                                      |   |       |      |       |   |
| Accumulated depreciation and amortization |   | (2,070,568 | )         | (1,734,695 | )      |
|                                      |   |       |      |       |   |
|                                      |   | $          | 1,368,240 |       | $      | 1,575,153 |   |

 

**4.****                                      Returnof Inventory**

 

During the quarter ended July31, 2002, the Company obtained inventories from two former internationaldistributors.  The heart valves weresold to these customers during fiscal year 2000 and the first half of fiscalyear 2001.  Due to financialdifficulties experienced by these distributors, the Company provided allowancesfor the remaining uncollected accounts receivable balances in fiscal years 2001and 2002.  The Company did not anticipatethe return of these products at the time the uncollectible accounts wereestablished.  Upon obtaining title tothe heart valves from these former distributors during the quarter ended July31, 2002, the Company increased its inventories and recorded a recovery of  its prior provision for doubtful accountswhich reduced its general and administrative costs for the year ended April 30,2003 by $92,000 representing the cost of the returned inventories. As describedin Note 17, the Company had previously reported the return of inventory as areduction of cost of goods sold and has restated its financial statements forthe year ended April 30, 2003 to change the classification to a reduction ofgeneral and administrative expenses.

 

**5.****                                      Short-termDebt with Related Party**

 

In January 2003, the Company established adiscretionary line of credit with PKM Properties, LLC (PKM), an entitycontrolled by Paul K. Miller.  Mr.Miller serves on the Company’s Board of Directors and is its largestshareholder.  This line of creditinitially matured on  April 17,2003.  On April 15, 2003, the maturitydate was extended to September 17, 2003. As of April 30, 2003, the Company hadborrowed $943,333 under the line of credit.  Inaddition, the Company incurred direct financing costs of $67,828, which wereamortized to interest expense over the original three-month life of the line ofcredit.  The line of credit bearsinterest at the higher of 7 percent or 1 percent above a bank reference rate (7percent is the rate in effect as of April 30, 2003).  PKM was issued a second mortgage on the Company’s real estate anda security interest in all remaining assets.

 

In connection with the line of credit, theCompany also issued a warrant to PKM with a five-year term to purchase 350,000shares of the Company’s common stock at an exercise price of $0.596 pershare.  The allocated fair value of thewarrants was $128,995 using the Black-Scholes valuation model and usingassumptions consistent with those disclosed in Note 10 and was accountedfor as a discount on the borrowings under the line of credit.  This discount was amortized to interestexpense over the original three-month life of the line of credit.  As of April 30, 2003, the discount was fullyamortized.

 

The Company also received a $60,000 unsecuredadvance in December 2002 from an executive officer to fund working capitalrequirements.  This loan was repaid infull in early April 2003.

 

**6.****                                      RelatedParty Lease Obligation**

 

On April 4,2003, the Company sold its corporate headquarters and manufacturing facilityand surrounding land in Inver Grove Heights, Minnesota, to PKM (see Note 5 foradditional information on PKM).

 

In connectionwith the transaction, the Company received total consideration of $3.84 millionconsisting of (1) $1.0 million in cash, (ii) PKM’s assumption of the Company’s$2.5 million outstanding indebtedness to Associated Bank (see Note 6), and(iii) PKM’s assumption of the Company’s promissory note with Dakota ElectricAssociation and land special assessments payable to Dakota County aggregating$336,105.   Also in connection with thetransaction, the Company issued to PKM a five-year warrant for the purchase of350,000 shares of the Company’s common stock at an exercise price of $0.625 per

 

30

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share.   These warrants had an allocated fair valueof $89,602 using the Black-Scholes valuation model and using assumptionsconsistent with those disclosed in Note 10.

 

Simultaneouswith the sale of the facility, the Company entered into a lease with PKM tolease back the facility and a portion of the land.  The lease has a ten-year initial term with options for theCompany to extend the lease up to ten additional years.  Under certain conditions, the Company alsohas an option to purchase the building at the end of the initial ten-year termat the fair value at that time.

 

Due to theCompany’s continued involvement with the property including the ability to buyback the property at a future date, the transaction is accounted for as afinancing of the property sold and leased back.  Accordingly, the net book value of the facility and land sold toPKM with a net book value of $759,146 (gross value of $1,433,601 net ofaccumulated depreciation of $674,455) continues to be presented as part of theCompany’s property, plant and equipment balance (see Note 3).  The related party lease obligation of$3,779,100 represents the minimum amounts due PKM for the initial ten year termdiscounted at 4.4 percent and additional payments to be paid to PKM for theDakota Electric Association and Dakota County obligations assumed by PKM.

 

Scheduledmaturities of the related party lease obligation is as follows:

** **
| **Year Ending April 30,** |   | **Amount** |      |
|---------------------------|--------|------------|-----------|
|                      |   |       |      |
| 2004                      |   | $          | 273,843   |   |
| 2005                      |   | 285,154    |      |
| 2006                      |   | 307,675    |      |
| 2007                      |   | 320,327    |      |
| 2008                      |   | 333,473    |      |
| Thereafter                |   | 2,226,032  |      |
|                      |   |       |      |
|                      |   | $          | 3,746,504 |   |

 

**7.****                                      Long-Term Debt and Convertible Subordinated BridgeNotes**

 

Long-term debtsconsist of the following at April 30:

 
|                                                                                                                                                                                                                                    |   | **2003** |   | **2002**   |   |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------|--------|------------|--------|
|                                                                                                                                                                                                                                    |   |     |   |       |   |
| Revolving credit line with Associated Bank,  interest payable monthly with the principal due November 2002, collateralized  by the Company’s real estate and other business assets excluding accounts  receivable                  |   | $        | — |       | $      | 2,500,000 |   |
|                                                                                                                                                                                                                                    |   |     |   |       |   |
| Promissory note with Dakota Electric  Association, principal and interest due in monthly installments through May  2009, interest at 5.75%, collateralized by the Company’s lighting equipment  and rooftop air-conditioning units |   | —   |   | 165,983    |   |
|                                                                                                                                                                                                                                    |   |     |   |       |   |
| Land special assessments payable to Dakota  County, principal and interest due in semi-annual installments through May  2010, interest at 8%                                                                                            |   | —   |   | 216,000    |   |
|                                                                                                                                                                                                                                    |   |     |   |       |   |
|                                                                                                                                                                                                                                    |   | —   |   | 2,881,983  |   |
|                                                                                                                                                                                                                                    |   |     |   |       |   |
| Less current maturities                                                                                                                                                                                                                 |   | —   |   | (2,542,460 | )      |
|                                                                                                                                                                                                                                    |   |     |   |       |   |
|                                                                                                                                                                                                                                    |   | $        | — |       | $      | 339,523 |   |

 

On November23, 1999, the Company obtained a $2,500,000revolving credit line with Associated Bank. The line of credit was due November 23, 2002, and was collateralized bythe Company’s real estate and other business assets, excluding accounts receivable.  In addition, a shareholder and a member of the Board of Directors ofthe Company provided a $2,000,000personal guarantee and pledged marketable securities with a guaranteed value of$1,100,000 to supportrepayment of borrowings on the credit line. Interest was required to be paid monthly and accrued at the Wall StreetJournal Prime Rate.  The interest rateat April 30, 2002 was 4.75 percent.  As part of the credit agreement, the Companywas formerly required to maintain a minimumtangible net worth of not less than $3,000,000 on a quarterly basis.  On April 4, 2003, the Company’s

 

31

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outstanding obligation underthis credit line was assumed by the buyer in connection with the sale of theCompany’s headquarters and manufacturing facility (see Note 6).  Accordingly, as of April 30, 2003, the lineof credit was repaid in full and closed.

 

In connectionwith the sale of the Company’s corporate headquarters and manufacturingfacility (see Note 6) the promissory note with Dakota Electric and the landspecial assessments payable to Dakota County were assumed by the purchaser ofthe property.

 

**ConvertibleSubordinated Bridge Notes**

 

On August 21, 2001, the Company sold units of convertiblesubordinated bridge notes with an aggregate principal amount of $500,000 andredeemable warrants to purchase an aggregate of 500,000 shares of the Company’scommon stock for total proceeds of $500,500. Each unit consisted of a $25,000 principal amount 10 percent convertiblesubordinated bridge note and redeemable warrants to purchase 25,000 shares ofthe Company’s commonstock at a price of $6.50 per share. The notes wereunsecured and were due in August 2002. The Company had the option to prepay the notes without premium orpenalty.

 

The allocated fair value of the warrants of $308,236 and the valueof the beneficial conversion feature of $188,889 as of August 21, 2001 wasaccounted for as a discount on the convertible subordinated bridge notes.  This discount, which was presented as a reduction of the facevalue of the Notes on the consolidated balance sheet, wasfully amortized as part of interest expense over the one-yearlife of the Notes using the effective interest method.

 

During the fourth quarter of 2002, the Company early extinguishedthe convertible subordinated bridge notes. On the date ofextinguishment, $77,332 of the remaining discount, representing the repurchaseof the beneficial conversion feature, was treated as a reduction of AdditionalPaid-in Capital with the balance of the discount of $335,410 being charged toother expense.

 

**8.****                                      Leases**

 

**Operating Leases**

 

The Companyleased certain manufacturing equipment under various operating lease agreementswhich expired at various dates in fiscal year 2003.  At the end of the lease terms, the Company has the option torenew the leases, purchase the equipment at fair value, or return theequipment.

 

Rental expenseunder operating leases was $21,935 and $66,874 in fiscal years 2003 and 2002,respectively.

 

**Capital Leases**

 

The Companyleases certain manufacturing equipment under various capital leases.  The equipment is leased under agreementsexpiring through fiscal year 2004 with implicit interest rates ranging from 8.9 percent to 10.0 percent.  The Company may elect to purchase theequipment under bargain purchase options at the end of the lease terms.  The leases are collateralized by theunderlying equipment with a total cost of $181,420 and accumulated amortizationof $125,998 and$89,714 at April 30, 2003 and 2002, respectively.

 

As of April30, 2003, remaining scheduled lease payments under capital lease obligationscontinue into fiscal year 2004 and aggregate $42,069 (net of interest portionof $1,799).

 

32

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**9.****                              Income Taxes**

 

The components of deferredincome tax assets at April 30 are as follows:

 
|                                               |   | **2003**   |      | **2002**   |   |
|----------------------------------------------------|--------|------------|-----------|------------|--------|
|                                               |   |       |      |       |   |
| Federal net operating loss carryforwards           |   | $          | 4,706,100 |       | $      | 3,863,200 |   |
| Research and experimentation credit  carryforwards |   | 524,200    |      | 524,200    |   |
| State net operating loss carryforwards             |   | 243,400    |      | 245,800    |   |
| Other carryforwards                                |   | 76,700     |      | 78,800     |   |
| Inventories                                        |   | 57,200     |      | 86,000     |   |
| Allowance for uncollectible accounts               |   | 118,400    |      | 147,400    |   |
| Property, plant and equipment                      |   | 80,600     |      | 44,900     |   |
| Accrued expenses and other                         |   | 15,300     |      | 37,400     |   |
|                                               |   |       |      |       |   |
| Total deferred tax assets                          |   | 5,821,900  |      | 5,027,700  |   |
|                                               |   |       |      |       |   |
| Valuation allowance                                |   | (5,821,900 | )         | (5,027,700 | )      |
|                                               |   |       |      |       |   |
| Net deferred tax asset                             |   | $          | —    |       | $      | — |   |

 

The Company has establishedvaluation allowances to fullyoffset tax assets due to the inherent uncertainty of predictingthe sufficiency of future taxable income necessary to realize these deferredtax assets, particularly in light of the Company’s recent history ofsignificant operating losses.  Inaddition, future utilization of available net operating loss carryforwards maybe limited under Internal Revenue Code 382 as a result of future changes inownership.

 

The Company’sfederal net operating loss carryforwards of approximately $11,362,327 and statenet operating loss carryforwards of $4,190,389 expire in fiscal years 2013through 2023.  Available research andexperimentation credits at April 30, 2003 represent federal and state amountsof $354,603 and $111,930,respectively, with expiration dates in fiscal years 2010 through 2021.

 

Thereconciliation of the U.S. statutory federal income tax rate with the effectiverate for the years ended April 30, 2003 and 2002, is as follows:

 
|                                                               |   | **2003** |       | **2002**  |   |
|--------------------------------------------------------------------|--------|----------|------------|-----------|--------|
|                                                               |   |     |       |      |   |
| Tax benefit at statutory rate                                      |   | $        | (1,475,500 | )         | $      | (1,355,000 | ) |
|                                                               |   |     |       |      |   |
| Research and experimentation tax credits                           |   | —   |       | (55,200   | )      |
| State taxes, net of federal benefit                                |   | (50,200  | )          | (76,300   | )      |
| Nondeductible expenses                                             |   | 24,200   |       | (97,700   | )      |
| Gain on sale of corporate headquarters and  manufacturing facility |   | 718,800  |       | —    |   |
| Other                                                              |   | (11,500  | )          | (12,600   | )      |
| Change in valuation allowance                                      |   | 794,200  |       | 1,596,800 |   |
|                                                               |   |     |       |      |   |
| Total income tax (benefit) provision                               |   | $        | —     |      | $      | — |   |

 

**10.****                               Shareholders’Equity****(Deficit)**

 

**Common Stock**

 

On January 25,2001, the Company gave a stock bonus of 15,000 shares of the Company’s commonstock to an officer of the Company.  Theestimated fair value of the shares of $42,000 was recorded as a general andadministrative expense.

 

On November 27, 2001, the Company closed onits initial public offering.  Inconnection with the initial public offering, the Company issued 1,500,000 units at aprice of $4.50 per unit for gross proceeds of $6,750,000.  After offering costs, the Company receivednet proceeds of $5,396,485.  Each unitconsisted of one share of common stock and one redeemable Class A Warrant.  Each Class A Warrant became exercisable and separablefrom the common stock on May 20,2003.  The holder of each Class A Warrant is entitled to purchase, at any time until November20, 2004, one share of common

 

33

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stockat an exercise price of $6.50 per share, subject to customary anti-dilutionadjustments.  The Company may redeem theClass A Warrants for $0.01 per warrant at any time, upon ten business days’ written notice, if the closing price of the Company’s common stock or units exceeds $8.50,subject to customary anti-dilution adjustments, for any ten consecutive tradingdays before such notice.

 

**Stock Options**

 

The Companyhas authorized the issuance of stock options for the aggregate purchase of2,653,034 shares of common stock under various plans covering certainemployees, members of the Board of Directors and certain independentcontractors approved by the Board of Directors.  Options are typically granted at prices not less than fair marketvalue at the date of grant.  Optionsgenerally become exercisable between one to three years after grant date andhave a maximum term of three to ten years depending on the plan.

 

The followingis a summary of stock option activity with respect to the Company’s variousplans and includes option activity for employees, directors and non-employees:

 

|                        |   | **Options** |   | **Weighted  Average  Exercise Price  Per Share** |   |
|-----------------------------|--------|-------------|--------|--------------------------------------------------|--------|
|                        |   |        |   |                                             |   |
| Outstanding, April 30, 2001 |   | 455,140     |   | $                                                | 3.03   |   |
|                        |   |        |   |                                             |   |
| Granted                     |   | 591,250     |   | 3.79                                             |   |
| Expired                     |   | (5,000      | )      | 5.00                                             |   |
|                        |   |        |   |                                             |   |
| Outstanding, April 30, 2002 |   | 1,041,390   |   | $                                                | 3.46   |   |
|                        |   |        |   |                                             |   |
| Granted                     |   | 179,500     |   | .75                                              |   |
| Expired                     |   | (134,950    | )      | 3.89                                             |   |
|                        |   |        |   |                                             |   |
| Outstanding, April 30, 2003 |   | 1,085,940   |   | $                                                | 2.98   |   |

 

At April 30,2003 and 2002,603,034 and 655,534 options, respectively, were availablefor grant under the Company’s stock option plans. On August 9, 2001, the Company’s shareholders approved the 2001 Equity Incentive Plan(2001 Plan) and reserved 500,000 shares of common stock for issuance uponexercise of stock options to be granted under the 2001 Plan to employees,officers, consultants, advisors, employee and non-employee directors andemployees of certain related entities. The number of shares reserved for issuance under the 2001 Plan increaseson January 1 of each year by the greater of 50,000 shares or 3.5 percent of theoutstanding shares of the Company’s common stock on such date, unless the Board of Directorssets the increase at a lower number of shares. On January 1, 2003, the number of shares available under the 2001 Plan increased by 274,534shares pursuant to the foregoing provision.

 

The followingtable summarizes information about stock options outstanding and exercisable atApril 30, 2003:

 
|                          |               | **Options  Outstanding** |    | **Options  Exercisable**                                    |   |
|-------------------------------|--------------------|--------------------------|---------|-------------------------------------------------------------|--------|
| **Range of  Exercise Prices** |               | **Number  Outstanding**  |    | **Weighted  Average  Remaining  Contractual  Life (Years)** |   | **Weighted  Average  Exercise  Price** |   | **Number  Exercisable** |   | **Weighted  Average  Exercise  Price** |   |
|                          |               |                     |    |                                                        |   |   |   |   |   |   |   |
|                          | $0.51 – $0.98 |                     | 179,500 |                                                        | 7.45   |   | $ | 0.74 |   | 67,500 |   | $ | 0.78 |   |
|                          | $2.36 – $5.00 |                     | 906,440 |                                                        | 3.69   |   | $ | 3.43 |   | 649,144 |   | $ | 3.74 |   |
|                          |               | 1,085,940                |    |                                                        |   |   |   | 716,644 |   |   |   |

 

During the yearsended April 30, 2003 and 2002, the Company issued fully vested, four and five-yearoptions to purchase an aggregate of 42,500 and 37,500 shares of the Company’s common stock at exercise prices of $0.51 to $0.87 and $2.53 to $4.50 per share, respectively, to certain non-employees whoprovided technical advisory services to the Company.  The aggregate fair value of the options using the Black-Scholesvaluation model was $20,329 and $69,844 and were fully expensed in fiscal years 2003 and 2002. The following assumptionswere used to value the options for the years ended

April 30, 2003and 2002:

 

34

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|                    |   | **200****3**  |   | **200****2**  |   |
|-------------------------|--------|---------------|--------|---------------|--------|
| Dividend  yield rate    |   | 0 percent     |   | 0 percent     |   |
| Risk free interest rate |   | 3.26 percent  |   | 4.71 percent  |   |
| Expected life           |   | 4 to 10 years |   | 4 to 10 years |   |
| Volatility              |   | 85 percent    |   | 85 percent    |   |

 

Deferred compensation relating to stockoptions granted with exercise prices below fair value during the year ended April 30, 2001 was$20,075.  Such deferred compensationwill be amortized over the vesting periods of the related stock options, whichgenerally range from three to five years. This compensation is recognized on an accelerated basis in accordancewith FASB Interpretation (FIN) No. 28. Compensation expense relating to stock options granted below fair marketvalue of $4,452 and $7,762 was recognized during the years endedApril 30, 2003 and2002.

 

During the yearended April 30, 2003, for purposes of determining fair valueusing the Black-Scholes option pricing model as prescribed by SFAS No. 123, theCompany used the contractual life of the options as the expected holding periodfor employees and the life of the options for directors.  Therisk-free interest rate for 2003 was 3.26 percent, the dividend yield used was 0 percent and thevolatility factor was 85 percent.

 

During the yearended April 30, 2002, for purposes of determining fair value using theBlack-Scholes option pricing model as prescribed by SFAS No. 123, the Companyused the contractual life of the options as the expected holding period foremployees and the life of the options for directors.  The risk-free interest rate for 2002 was4.71 percent, the dividend yield used was 0 percent and the volatility factorwas 85 percent.

 

**Stock Warrants**

 

At April 30, 2003and 2002, the Companyhad outstanding and exercisable warrants to purchase 3,215,000 and 2,510,000 shares, respectively, of the Company’s common stock at prices ranging from $0.60 to $6.75 per share.  Thewarrants expire at various dates through April 4, 2008. At April 30, 2003 and 2002, theweighted average remaining contractual life of the warrants was 1.68 and 3.14 years and the weighted average exercise price of thewarrants was $4.58and $5.91,respectively.

 

In January2003, the Company entered into a discretionary credit line with PKM (see Note 5for additional information on PKM).  Inconnection with this discretionary credit line, the Company issued fully vestedfive-year warrants to purchase a total of 350,000 shares of common stockexercisable at $0.596 per share.  TheCompany also completed a refinancing transaction in which its headquartersfacility was sold in a sale-leaseback transaction to this same entity in April2003.  As part of the transaction theCompany issued an additional five-year warrant to purchase 350,000 shares ofcommon stock at $0.625 per share.

 

The fair valueof the warrants was calculated using the Black-Scholes valuation model and$218,597 was capitalized as deferred financing costs in fiscal year 2003.  The deferred financing costs are beingamortized to interest expense over the life of the discretionary credit lineand property lease, respectively.  Thefollowing assumptions were used to value the warrants:  dividend yield 0 percent, risk free interestrate of 3.03 percent, expected life equal to the contractual term of five yearsand volatility of 85 percent.  As ofApril 30, 2003, the remaining balance of deferred financing costs was $89,602.

 

In November1999 and December 2000, the Company issued fully vested four-year warrants topurchase an aggregate of 100,000 shares of common stock exercisable at $2.00per share to a board member in connection with a bank line of creditguarantee.  The fair value of thewarrants was calculated using the Black-Scholes valuation model and $76,622 wascapitalized as deferred financing costs in fiscal year 2001.  The deferred financing costs are beingamortized to interest expense on a straight-line basis over the life of theguarantee.  The following assumptionswere used to value the warrants: dividend yield of 0 percent,risk-free interest rate of 5.69percent, expected life equal to the contractual life of fouryears and volatility of 69 percent. At April 30, 2003, the balance was fully amortized.

 

**11.****                       Research and Development Costs**

 

Research and Development costs principally consistof engineering costs, included as part of engineering andregulatory in the Consolidated Statement of Operations, totaled $558,141 and$491,278for the fiscal years ended April 30, 2003and 2002, respectively.  Research and Development costs relateprimarily to product and process development initiatives.

 

35

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**12.****                               SupplyAgreement**

 

In July 1998,the Company entered into a three-year supply agreement with Snia S.p.A.Carbomedics, Inc. (Carbomedics), the source of certain raw material componentsassociated with the manufacture of certain of the Company’s heart valves.  The supply agreement was extended for anadditional two years in March 2001, and expires December 31, 2003.

 

This agreementprovides that the Company purchase a minimum number of raw material units eachcalendar year through 2003.  Under theterms of the agreement, the Company is required to compensate Carbomedics forany purchase shortfalls up to a maximum of $200,000 per year.  The Company has not met the minimum purchase requirement for the last three calendar yearsand does not believe it will meet the minimum purchase requirement for calendaryear 2003.  As a result, the Companyexpensed $138,738 and $148,991 relatedto these purchase shortfalls to cost of goods sold in fiscalyears 2003 and 2002, respectively.

 

**13.****                       Segment and Related Party Information**

 

The Companyviews its operations and manages its business as one segment, the manufacturingand marketing of cardiothoracic surgery devices.  Factors used to identify the Company’s single operating segmentinclude the organizational structure of the Company and the financialinformation available for evaluation by the chief operating decision maker. The following tablesummarizes net sales by geographic area:

 

|        |   | **For the  Years Ended  April 30,** |      |
|-------------|--------|-------------------------------------|-----------|
|        |   | **2003  Restated  (Note 17)**       |      | **2002  Restated  (Note 17)** |   |
|        |   |                                |      |   |   |
| Europe      |   | $                                   | 1,471,015 |   | $ | 1,538,970 |   |
| South Asia  |   | 414,455                             |      | 488,940 |   |
| Middle East |   | 342,585                             |      | 165,993 |   |
| Far East    |   | 60,348                              |      | 306,735 |   |
| Other       |   | 289,660                             |      | 36,230 |   |
|        |   |                                |      |   |   |
| Total       |   | $                                   | 2,578,063 |   | $ | 2,536,868 |   |

 

At April 30, 2003 and 2002,substantially all of the Company’s operations and assets are based in theUnited States.

 

The Companydistributes its products primarily through distributor organizations that, inturn, market the product directly to medical institutions.  One of these distributors is a shareholderof the Company with an ownership interest of approximately 6.6 percent.  Anaffiliate of this shareholder distributor is also a member of theCompany’s Board of Directors.  Sales todistributors that individually account for 10 percent or more of the Company’s net salesin each respective fiscal year are as follows:

 

|                           |   | **2003  Restated  (Note 17)** |    | **2002  Restated  (Note 17)** |   |
|--------------------------------|--------|-------------------------------|---------|-------------------------------|--------|
|                           |   |                          |    |                          |   |
| Distributor #1 (related party) |   | $                             | 762,842 |                          | $      | 1,194,960 |   |
| Distributor #2                 |   | 319,985                       |    | 408,147                       |   |
| Distributor #3                 |   | 347,085                       |    | 265,210                       |   |
| Distributor #4                 |   | 319,000                       |    | 101,372                       |   |
|                                |        |                               |         |                               |        |  |  |

 

Accounts receivable from theabove related party distributor at April 30, 2003 and 2002totaled $557,899 and $685,365, respectively.

 

**14.****                       Spin-off ofUROPACE**

 

On November 1,2000, the Company completed the spin-off of UROPACE, Inc. (UROPACE), asubsidiary of the Company, to the existing shareholders of the Company.  The separation was effected by transferringfrom the Company to UROPACE all assets, tangible and intangible, relating tothe development of female urinary incontinence technology.

 

36

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Shareholders of record onSeptember 15, 2000, received one share of common stock of UROPACE for each6.882 shares of the Company’s common stock held on that date.

 

The assetstransferred to UROPACE had no book value at November 1, 2000 and the operationsof UROPACE prior to the spin-off had no revenues and minimal expenses duringthe fiscal year ended April 30, 2001. As a part of this spin-off, the Company agreed to loan UROPACE up to$356,250 at a variable interest rate. Principal and interest on the note will be payable in installments equalto 5 percent ofUROPACE’s future annual net sales until the note and interest is paid infull.  The Company had loaned UROPACE$235,000 and $154,000at April 30, 2003 and 2002.  Due to thedevelopment stage of UROPACE and the uncertainty associated with the collectionof this amount, the Company has recorded an allowance for the entire balance ofthe loan at April 30, 2003 and 2002, with the corresponding expense included inother income (expense) in the Consolidated Statement of Operations.

 

**15.****                               Savingsand Retirement Plan**

 

The Companysponsors a 401(k) savings and retirement plan (the Plan) which is available toall eligible employees.  Under the Plan,the Company may make a discretionary contribution to the Plan upon approval bythe Company’s Board of Directors. Employees are fully vested in their own contributions and earningsthereon and become fully vested in the Company’s contributions and earningsthereon after three years of service. The Company made contributions to the Plan of $21,504 and $16,475 in fiscal years2003 and 2002, respectively.

 

**16.****                               SubsequentEvent-Bridge Debt Financing**

 

On July 8, 2003, the Company completed a $2.0million bridge financing transaction with private investors, resulting in netproceeds of approximately $1.87 million.

 

Underthe terms of the financing, the Company established a one-year $1.0 milliondiscretionary line of credit with PKM (see Note 5 for additional information on PKM),a related party.  Theline, which requires the payment of interest at a rate of 10 percent per year,matures on May 27, 2004, and is secured by substantially all assets of theCompany.  As additional considerationfor the financing, the Company agreed to issue PKM ten-year warrants for thepurchase of up to 380,357 shares of the Company’s common stock at an exerciseprice of $0.70 per share with terms and conditions that includeweighted-average anti-dilution rights. The Company also agreed to modify certain terms of the warrants issuedto PKM in connection with a credit facility extended by PKM in January 2003(See Note 5), to conform to the terms of the warrants issued as part of thisbridge debt financing.

 

Ina simultaneous transaction, the Company entered into a loan agreement andborrowed $1.0 million from an individual who following the transaction becamethe beneficial owner of approximately 10.3 percent of the Company’s securities,pursuant to a one-year subordinated note with an interest rate of 10 percentper year.  Pursuant to an intercreditoragreement with PKM, the loan is secured by substantially all assets of theCompany.  The lender was issued ten-yearwarrants for the purchase of 380,357 shares of common stock on terms comparableto the PKM warrants described above.

 

**17.****                              ****Restatement of ConsolidatedStatement of Operations**

 

The Company has restated its financial statements to change theclassification of marketing support expenditures, which had previously beenreported as sales and marketing expense rather than a reduction in net salespursuant to application of the Consensus for Emerging Issues Task Force No.01-09, “Accounting for Consideration Given by a Vendor to a Customer (Includinga Reseller of the Vendor’s Products).” The Company has made the appropriate modifications to the consolidatedstatement of operations to give effect to the change in classification ofmarketing support expenditures.  Theeffect of this change in classification is to decrease net sales, gross profitand sales and marketing expenses by corresponding amounts for all periodspresented.

 

The Company has also restated its financial statements for the yearended April 30, 2003, to change the classification of income from inventoriesreturned from two former international distributors, which had previously beenreported as a reduction of cost of goods sold rather than as a reduction ofgeneral and administrative expenses (see Note 4).  The Company has made the appropriate modifications to theconsolidated statement of operations for the year ended April 30, 2003 to giveeffect to the change in classification of the value of the inventories returnedfrom the two former international distributors.  The effect of this change in classification is to increase costof goods sold, decrease gross profit and decrease general and administrativeexpenses by $92,000 for the year ended April 30, 2003.

 

37

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The changes in classifications described in the above two paragraphshad no effect on the Company’s loss from operations or net loss, nor any effecton the Company’s consolidated balance sheet, statement of changes instockholders’ equity (deficit) or statement of cash flows.  The table below summarizes the aggregateeffect of theses changes in classifications.

 
|                       |   | **Fiscal  Year Ended April 30,** |      |
|----------------------------|--------|----------------------------------|-----------|
|                       |   | **2003**                         |      | **2002** |   |
|                       |   | **As  reported**                 |      | **As  restated** |   | **As  reported** |   | **As  restated** |   |
|                       |   |                             |      |   |   |   |   |   |   |
| Net sales                  |   | $                                | 3,135,041 |   | $ | 2,578,063 |   | $ | 2,982,198 |   | $ | 2,536,868 |   |
| Cost of goods sold         |   | 1,715,402                        |      | 1,807,402 |   | n/a |   | n/a |   |
| Gross profit               |   | 1,419,639                        |      | 770,661 |   | 872,745 |   | 427,415 |   |
|                       |   |                             |      |   |   |   |   |   |   |
| Operating expenses:        |   |                             |      |   |   |   |   |   |   |
| Sales and marketing        |   | 2,864,747                        |      | 2,307,769 |   | 2,089,104 |   | 1,643,774 |   |
| General and administrative |   | 1,926,418                        |      | 1,834,418 |   | n/a |   | n/a |   |
| Total operating expenses   |   | 5,667,851                        |      | 5,018,873 |   | 4,463,110 |   | 4,017,780 |   |
|                            |        |                                  |           |  |  |  |  |  |  |  |  |  |  |

 

----

n/a – not applicable

 

38

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**ITEM 8A****                                               CONTROLSAND PROCEDURES**

 

We maintain a system of disclosure controlsand procedures that is designed to provide reasonable assurance thatinformation, which is required to be disclosed, is accumulated and communicatedto management timely.  As of the end ofthe period covered by this report, we carried out an evaluation under thesupervision and with the participation of our management, including our ChiefExecutive Officer and Chief Financial Officer, of the effectiveness of thedesign and operation of our disclosure controls and procedures pursuant toExchange Act Rule 13a-15.  In connectionwith its review of our financial statements for the quarter ended January 31,2004, PricewaterhouseCoopers LLP informed our audit committee that there was amaterial weakness in our internal controls. Specifically, PricewaterhouseCoopers LLP identified a significantdeficiency in the design and operation of internal controls relating todocumenting and reporting international distribution marketing expenditures andrelated reimbursement.  We initiatedprocedures and reporting to document and support customer marketing expenses toremedy this deficiency in the future. Except for that deficiency, based upon that evaluation, our ChiefExecutive Officer and Chief Financial Officer concluded that our disclosurecontrols and procedures are effective in timely alerting them to materialinformation relating to our company required to be disclosed in our periodicfilings with the SEC.

 

Duringour most recent fiscal quarter, there has been no change in our internalcontrol over financial reporting (as defined in Rule 13a-15(f) or 15d-15(f)under the Exchange Act) that has materially affected, or is reasonably likelyto materially affect, our internal control over financial reporting.

 

39

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**SIGNATURES**

 

In accordance with Section 13 or 15(d)of the Exchange Act, the registrant has duly caused this report to be signed onits behalf by the undersigned, thereunto duly authorized, in the City of InverGrove Heights, State of Minnesota, on March 22, 2004.

 

 
|   | MedicalCV, Inc. |
|--------|-----------------|
|   |            |   |
|   |            |   |
|   | By              | /s/ Blair P. Mowery |
|   |            | Blair P. Mowery |
|   |            | President, Chief Executive Officer  and Director  (Principal Executive Officer) |

 

In accordance with the Exchange Act,this report has been signed below by the following persons on behalf of theregistrant, and in the capacities and on the date indicated.

 
| **Signature**                     |   | **Title**                                            |   | **Date**       |
|-----------------------------------|--------|------------------------------------------------------|--------|----------------|
|                              |   |                                                 |   |           |
| /s/ Blair P. Mowery               |   | President, Chief Executive Officer  and              |   | March 22, 2004 |
| Blair P. Mowery                   |   | Director (Principal Executive  Officer)              |   |           |
|                              |   |                                                 |   |           |
|                              |   |                                                 |   |           |
| /s/ John H. Jungbauer             |   | Chief Financial Officer (Principal                   |   | March 22, 2004 |
| John H. Jungbauer                 |   | Accounting Officer and Principal  Financial Officer) |   |           |
|                              |   |                                                 |   |           |
|                              |   |                                                 |   |           |
| /s/ Lawrence L. Horsch            |   | Chairman of the Board                                |   | March 22, 2004 |
| Lawrence L. Horsch                |   |                                                 |   |           |
|                              |   |                                                 |   |           |
|                              |   |                                                 |   |           |
| *                                 |   | Director                                             |   |           |
| Susan L. Critzer                  |   |                                                 |   |           |
|                              |   |                                                 |   |           |
|                              |   |                                                 |   |           |
| *                                 |   | Director                                             |   |           |
| David B. Kaysen                   |   |                                                 |   |           |
|                              |   |                                                 |   |           |
|                              |   |                                                 |   |           |
| *                                 |   | Director                                             |   |           |
| Salvador Mercé Cervelló |   |                                                 |   |           |

 

40

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| *                                                 |   | Director |   |           |
|---------------------------------------------------|--------|----------|--------|----------------|
| Adel A. Mikhail, Ph.D.                            |   |     |   |           |
|                                              |   |     |   |           |
|                                              |   |     |   |           |
| *                                                 |   | Director |   |           |
| Paul K. Miller                                    |   |     |   |           |
|                                              |   |     |   |           |
|                                              |   |     |   |           |
| *   By    /s/ Blair P. Mowery |   |     |   | March 22, 2004 |
| Blair P. Mowery                                   |   |     |   |           |
| Attorney-In-Fact                                  |   |     |   |           |

 

41

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**INDEX TO EXHIBITS**

 
| **Exhibit  Number** |   | **Description**                                                                                                                                                                                                                                                                                                      |
|---------------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1                 |   | Restated Articles of Incorporation  of the Registrant (incorporated by reference to our Registration Statement on  Form SB-2, filed on August 31, 2001 (File No. 333-68884)).                                                                                                                                        |
| 3.2                 |   | Bylaws of the Registrant  (incorporated by reference to our Registration Statement on Form SB-2, filed  on August 31, 2001 (File No. 333-68884)).                                                                                                                                                          |
| 4.1                 |   | Reference is made to Exhibits 3.1  and 3.2.                                                                                                                                                                                                                                                                          |
| 4.2                 |   | Specimen common stock certificate  (incorporated by reference to our Registration Statement on Form SB-2, filed  on August 31, 2001 (File No. 333-68884)).                                                                                                                                                           |
| 4.3                 |   | Form of Warrant Agreement (including  specimen Class A Warrant certificate) (incorporated by reference to our  Registration Statement on Form SB-2, filed on August 31, 2001 (File No.  333-68884)).                                                                                                                 |
| 4.4                 |   | Specimen unit certificate  (incorporated by reference to our Registration Statement on Form SB-2, filed  on August 31, 2001 (File No. 333-68884)).                                                                                                                                                         |
| 10.1                |   | Separation Agreement and Release by  and between the Registrant and Adel A. Mikhail, effective November 1, 2000  (incorporated by reference to our Registration Statement on Form SB-2, filed  on August 31, 2001 (File No. 333-68884)).                                                                             |
| 10.2                |   | 1992 Stock Option Plan (incorporated  by reference to our Registration Statement on Form SB-2, filed on  August 31, 2001 (File No. 333-68884)).                                                                                                                                                            |
| 10.3                |   | 1993 Director Stock Option Plan  (incorporated by reference to our Registration Statement on Form SB-2, filed  on August 31, 2001 (File No. 333-68884)).                                                                                                                                                        |
| 10.4                |   | 1997 Stock Option Plan (incorporated  by reference to our Registration Statement on Form SB-2, filed on  August 31, 2001 (File No. 333-68884)).                                                                                                                                                            |
| 10.5                |   | 2001 Equity Incentive Plan  (incorporated by reference to our Registration Statement on Form SB-2, filed  on August 31, 2001 (File No. 333-68884)).                                                                                                                                                        |
| 10.6                |   | Warrant Agreement by and between the  Registrant and Paul K. Miller, dated November 22, 1999 (incorporated by  reference to our Registration Statement on Form SB-2, filed on August 31,  2001 (File No. 333-68884)).                                                                                                |
| 10.7                |   | Warrant Agreement by and between the  Registrant and Adel A. Mikhail, dated February 2, 2001 (incorporated by  reference to our Registration Statement on Form SB-2, filed on August 31,  2001 (File No. 333-68884)).                                                                                                |
| 10.8                |   | Warrant Agreement by and between the  Registrant and Paul K. Miller, dated December 6, 2000 (incorporated by  reference to our Registration Statement on Form SB-2, filed on August 31,  2001 (File No. 333-68884)).                                                                                                 |
| 10.9                |   | Form of Escrow Agreement by and  between the Registrant, Paul K. Miller, Adel A. Mikhail, Ph.D., Salvador  Mercé Vives, Mercé V. Electromedicina S.L., Richard A. DeWall, M.D., Blair P.  Mowery, Salvador Mercé Cervelló, Allan R. Seck, Norman Dann, Ronald M.  Bosrock, George M. Wettstaedt, |

 

42

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|   |   | Gene E. Stobbs, Shelley Johnson,  Associated Trust Company National Association and the Commissioner of  Commerce for the State of Minnesota (incorporated by reference to our  Registration Statement on Form SB-2, filed on August 31, 2001 (File No. 333-68884)).                                                   |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.10  |   | O.E.M. Supply Contract by and  between the Registrant and Snia S.p.A. Carbomedics, Inc. (f/k/a Sulzer  Carbomedics, Inc.), effective July 24, 1998 (incorporated by reference to our  Registration Statement on Form SB-2, filed on August 31, 2001 (File  No. 333-68884)).                                  |
| 10.11  |   | First Amendment to Supply Agreement  by and between the Registrant and Snia S.p.A. Carbomedics, Inc. (f/k/a Sulzer  Carbomedics, Inc.), effective March 6, 2001 (incorporated by reference to our  Registration Statement on Form SB-2, filed on August 31, 2001 (File No.  333-68884)).                               |
| 10.12  |   | Promissory Note in the principal  amount of $2,500,000, issued by the Registrant, maker, to Associated Bank  Minnesota, payee, dated November 23, 1999 (incorporated by reference to our  Registration Statement on Form SB-2, filed on August 31, 2001 (File No.  333-68884)).                                   |
| 10.13  |   | Commitment Letter by and between  Associated Bank Minnesota, lender, and the Registrant, borrower, dated August  26, 1999, pertaining to proposed revised line of credit terms (incorporated  by reference to our Registration Statement on Form SB-2, filed on August 31,  2001 (File No. 333-68884)).                |
| 10.14  |   | Working Capital Line of Credit —  Change in Terms Agreement by and between Associated Bank Minnesota, lender,  and the Registrant, borrower, dated November 23, 2000 (incorporated by  reference to our Registration Statement on Form SB-2, filed on August 31,  2001 (File No. 333-68884)).                     |
| 10.15  |   | Correspondence from Associated Bank  Minnesota to the Registrant, dated December 11, 2000, extending the line of  credit maturity date (incorporated by reference to our Registration Statement  on Form SB-2, filed on August 31, 2001 (File No. 333-68884)).                                                         |
| 10.16  |   | Correspondence to Paul Miller, dated  August 31, 1999, regarding the Registrant’s compensation to Mr. Miller for  his personal guarantee of the Associated Bank Minnesota line of credit  (incorporated by reference to our Registration Statement on Form SB-2, filed  on August 31, 2001 (File No. 333-68884)). |
| 10.17  |   | Amendment to Working Capital Line of  Credit by and between Associated Bank Minnesota, lender, and the Registrant,  borrower, dated August 24, 2001 (incorporated by reference to our  Registration Statement on Form SB-2, filed on August 31, 2001 (File No.  333-68884)).                                           |
| 10.18  |   | Employment Agreement by and between  the Registrant and Blair P. Mowery, effective June 15, 2001 (incorporated by  reference to our Registration Statement on Form SB-2, filed on August 31,  2001 (File No. 333-68884)).                                                                                              |
| 10.19  |   | Letter Agreement by and between the  Registrant and Allan R. Seck, dated May 5, 1999 (incorporated by reference to  our Registration Statement on Form SB-2, filed on August 31, 2001 (File No.  333-68884)).                                                                                                          |
| 10.20  |   | Amendment to Letter Agreement by and  between the Registrant and Allan R. Seck, dated August 30, 2001 (incorporated  by reference to our Registration Statement on Form SB-2, filed on August 31,  2001 (File No. 333-68884)).                                                                                         |
| 10.21  |   | Discretionary Credit Agreement by  and between the Registrant and PKM Properties, LLC, dated January 17, 2003  (incorporated by reference to our Quarterly Report on Form 10-QSB/A, filed on  April 4, 2003 (File No. 000-33295)).                                                                                     |
| 10.22  |   | Discretionary Credit Note in the  principal amount of $943,666, issued by the Registrant, Maker, to PKM                                                                                                                                                                                                                |

 

43

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|   |   | Properties, LLC, Payee, dated  January 17, 2003 (incorporated by reference to our Quarterly Report on Form  10-QSB/A, filed on April 4, 2003 (File No. 000-33295))                                                                                                                   |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.23  |   | Security Agreement by and between  the Registrant, Debtor, and PKM Properties, LLC, Secured Party, dated January  17, 2003 (incorporated by reference to our Quarterly Report on Form 10-QSB/A,  filed on April 4, 2003 (File No. 000-33295)).                                                 |
| 10.24  |   | Second Mortgage by the Registrant  for the benefit of PKM Properties, LLC, dated January 17, 2003 (incorporated  by reference to our Quarterly Report on Form 10-QSB/A, filed on April 4, 2003  (File No. 000-33295)).                                                                         |
| 10.25  |   | Common Stock Purchase Warrant issued  by the Registrant to PKM Properties, LLC, dated January 17, 2003 (incorporated  by reference to our Quarterly Report on Form 10-QSB/A, filed on April 4, 2003  (File No. 000-33295)).                                                                    |
| 10.26  |   | Promissory Note in the principal  amount of $60,000, issued by the Registrant, Maker, to Allan R. Seck, Payee,  dated December 11, 2002 (incorporated by reference to our Quarterly Report on  Form 10-QSB/A, filed on April 4, 2003 (File No. 000-33295)).                                    |
| 10.27  |   | Working Capital Line of Credit —  Change in Terms Agreement by and between Associated Bank Minnesota, Lender,  and the Registrant, Borrower, dated November 23, 2002 (incorporated by  reference to our Quarterly Report on Form 10-QSB/A, filed on April 4, 2003  (File No. 000-33295)). |
| 10.28  |   | Commercial Guaranty from Paul K.  Miller, Guarantor, to Associated Bank Minnesota, Lender, dated November 23,  2002 (incorporated by reference to our Quarterly Report on Form 10-QSB/A,  filed on April 4, 2003 (File No. 000-33295)).                                                        |
| 10.29  |   | Loan Agreement by and between Peter  L. Hauser and the Registrant, dated July 1, 2003 (incorporated by reference  to our Current Report on Form 8-K, filed July 14, 2003 (File No. 000-33295)).                                                                                                |
| 10.30  |   | $1.0 Million Subordinated Note  issued by the Registrant, Maker, to Peter Ludwig Hauser, Payee, dated July 1,  2003 (incorporated by reference to our Current Report on Form 8-K, filed July  14, 2003 (File No. 000-33295)).                                                                  |
| 10.31  |   | Subordination and Intercreditor  Agreement by and between Peter L. Hauser and PKM Properties, LLC, accepted  and acknowledged by the Registrant, dated July 1, 2003 (incorporated by  reference to our Current Report on Form 8-K, filed July 14, 2003 (File No.  000-33295)).                 |
| 10.32  |   | May Security Agreement in favor of  PKM Properties, LLC and Peter L. Hauser, securing property of the Registrant,  dated July 1, 2003 (incorporated by reference to our Current Report on Form  8-K, filed July 14, 2003 (File No. 000-33295)).                                                |
| 10.33  |   | Warrant Agreement to purchase  380,357 shares of common stock issued by the Registrant to Peter Ludwig  Hauser, dated July 1, 2003 (incorporated by reference to our Current Report  on Form 8-K, filed July 14, 2003 (File No. 000-33295)).                                                   |
| 10.34  |   | May Discretionary Credit Agreement  by and between the Registrant and PKM Properties, LLC, dated July 1, 2003  (incorporated by reference to our Current Report on Form 8-K, filed July 14,  2003 (File No. 000-33295)).                                                                       |
| 10.35  |   | May Discretionary Credit Note issued  by the Registrant, Maker, to PKM Properties, LLC, Payee, dated July 1, 2003  (incorporated by reference to our Current Report on Form 8-K, filed July 14,  2003 (File No. 000-33295)).                                                                   |

 

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| 10.36  |   | Amendment to Warrants by and between  the Registrant and PKM Properties, LLC, dated July 1, 2003 (incorporated by  reference to our Current Report on Form 8-K, filed July 14, 2003 (File No.  000-33295)).                                  |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.37  |   | Warrant Agreement to purchase  320,178 shares of common stock issued by the Registrant to PKM Properties,  LLC, dated July 1, 2003 (incorporated by reference to our Current Report on  Form 8-K, filed July 14, 2003 (File No. 000-33295)). |
|   |   |                                                                                                                                                                                                                                         |
| 16     |   | Letter on change in certifying  accountant from Bertram Vallez Kaplan & Talbot Ltd. (incorporated by  reference to our Registration Statement on Form SB-2, filed on August 31,  2001 (File No. 333-68884)).                             |
| 21     |   | Subsidiaries of the Registrant  (incorporated by reference to our Registration Statement on Form SB-2, filed  on August 31, 2001 (File No. 333-68884)).                                                                            |
| 23     |   | Consent of Independent Auditors.                                                                                                                                                                                                             |
| 24     |   | Power of Attorney.*                                                                                                                                                                                                                          |
| 31.1   |   | Chief Executive Officer  Certification pursuant to Rule 13a-14.                                                                                                                                                                              |
| 31.2   |   | Chief Financial Officer Certification  pursuant to Rule 13a-14.                                                                                                                                                                              |
| 32.1   |   | Chief Executive Officer  Certification pursuant to 18 U.S.C. Section 1350.                                                                                                                                                                   |
| 32.2   |   | Chief Financial Officer  Certification pursuant to 18 U.S.C. Section 1350.                                                                                                                                                                   |

 

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*                                         Previously filed.

 

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