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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549



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FORM 10-K



(Mark One)

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



For the fiscal year ended December 31, 2002



or



| ̈ |  | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THESECURITIES EXCHANGE ACT OF 1934
|- |  | ---------------------------------------------------------------------------------------



Commission File Number 000-49804



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Kyphon Inc.

(Exact name of Registrant as
specified in its charter)



|Delaware                 |  | 77-0366069                          
|------------------------ |  | ------------------------------------
|(State of incorporation) |  | (I.R.S. Employer Identification No.)



1350
Bordeaux Drive

Sunnyvale, California, 94089

(Address of principal executive offices, including Zip Code)



(408) 548-6500

(Registrants telephone number, including area code)



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



|Title of each class: |  | Name of each exchange on which registered:
|-------------------- |  | ------------------------------------------
|None                 |  | N/A                                       



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

Common Stock, $0.001 par value

(Title of Class)



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



Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the Registrants knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any amendment to this  Form 10-K.  x



Indicate by check mark whether Registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).  Yes  x  No ̈



The aggregate market value of the voting stock held by non-affiliates of the registrant, based upon the
closing sale price of the Common Stock on June 28, 2002 (which is the last business day of registrants most recently completed second fiscal quarter), as reported on the NASDAQ National Market was approximately $189.1 million. Shares of Common
Stock held by each executive officer and director and by each person who owns 5% or more of the outstanding Common Stock have been excluded in that such persons may be deemed affiliates. This determination of affiliate status is not necessarily a
conclusive determination for other purposes.



At
March 14, 2003, the Registrant had 37,822,642 shares of Common Stock outstanding.



DOCUMENTS INCORPORATED BY REFERENCE



Items 10, 11, 12 and 13 of Part III of this Form 10-K incorporates information by reference from the registrants definitive proxy statement to be filed with the Securities and Exchange Commission
within 120 days after the close of the fiscal year.



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KYPHON INC.



FISCAL YEAR 2002 FORM 10K ANNUAL REPORT

TABLE OF CONTENTS



|               |  |                                                                                       |  | Page
|-------------- |  | ------------------------------------------------------------------------------------- |  | ----
|PART I         |  |                                                                                       |  |     
|Item 1         |  | Business                                                                              |  | 3   
|Item 2         |  | Properties                                                                            |  | 24  
|Item 3         |  | Legal Proceedings                                                                     |  | 24  
|Item 4         |  | Submission of Matters to a Vote of Security Holders                                   |  | 24  
|              
|PART II        |  |                                                                                       |  |     
|Item 5         |  | Market for the Registrants Common Equity and Related Stockholder Matters             |  | 25  
|Item 6         |  | Selected Consolidated Financial Data                                                  |  | 26  
|Item 7         |  | Managements Discussion and Analysis of Financial Condition and Results of Operations |  | 27  
|Item 7A        |  | Quantitative and Qualitative Disclosures about Market Risk                            |  | 34  
|Item 8         |  | Consolidated Financial Statements and Supplementary Data                              |  | 35  
|Item 9         |  | Changes in and Disagreements with Accountants on Accounting and Financial Disclosure  |  | 60  
|              
|PART III       |  |                                                                                       |  |     
|Item 10        |  | Directors and Executive Officers of the Registrant                                    |  | 60  
|Item 11        |  | Executive Compensation                                                                |  | 60  
|Item 12        |  | Security Ownership of Certain Beneficial Owners and Management                        |  | 60  
|Item 13        |  | Certain Relationships and Related Transactions                                        |  | 60  
|Item 14        |  | Controls and Procedures                                                               |  | 60  
|              
|PART IV        |  |                                                                                       |  |     
|Item 15        |  | Exhibits, Financial Statement Schedules and Reports on Form 8-K                       |  | 61  
|              
|Signatures     |  | 62                                                                                   
|Certifications |  | 63                                                                                   



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PART 1



This Annual Report on Form 10-K contains
forward-looking statements within the meaning of the federal securities laws. These statements include those concerning the following: our intentions, beliefs and expectations regarding our future success and results; the timing and success of our
clinical trials and regulatory submissions; our belief that our cash and cash equivalents will be sufficient to satisfy our anticipated cash requirements; our operating results; our expectations regarding our revenues and customers; and our
distributors and territorial expansion efforts. These statements are subject to risks and uncertainties that could cause actual results and events to differ materially. For a detailed discussion of these risks and uncertainties, see the
Business section of this Form 10-K.



Kyphon undertakes no obligation to update forward-looking statements to reflect events or circumstances occurring after the date of this Form 10-K.



ITEM 1.    
BUSINESS



Overview



We develop medical devices to restore
spinal anatomy using minimally invasive technology. Our initial marketing focus is on surgeons who repair spine fractures caused by osteoporosis. Our first commercial products, comprising our KyphX instruments, utilize our proprietary balloon
technology. Surgeons use those tools to help repair fractures during minimally-invasive spine surgeries. Alternative spine fracture treatments are either highly invasive or are pain-management therapies that do not repair the fracture.



Each year, there are approximately 700,000 clinically
diagnosed spine fractures due to osteoporosis in the United States and Europe in approximately 550,000 patients. Osteoporosis is a disease that primarily affects women over the age of 50 and that is characterized by bone deterioration, leading to an
increased susceptibility to spine fractures. These fractures can result in an increased risk of death, significant pain, reduced respiratory function and impaired quality of life.



As of December 31, 2002, we had trained more than 2,700 physicians in the United States, Europe and South
Korea in the use of our KyphX instruments, and these physicians had used our instruments in over 28,000 spine surgeries. Based on our experience to date and supported by published peer-reviewed physician journal articles, we believe that use of our
KyphX instruments during minimally-invasive spine surgery leads to significant patient benefits, including the ability to reverse the collapse of the bone caused by the spine fracture. Reversal of collapsed bone in the spine can potentially reduce
spine deformity, thereby increasing mobility and improving respiratory function in patients. Risks of procedures using our instruments include the same risks common to performing surgery using anesthesia and to performing surgery on older patients.
In addition, like other spine surgeries, these procedures using our instruments may result in serious complications, including bleeding, nerve injury, paralysis and death.



In May 2000, we commenced full commercial introduction of our KyphX instruments in the United States. We
devote significant resources to supporting our sales and marketing team, training and educating physicians and supporting reimbursement and clinical activities related to our products. As of December 31, 2002, we had 16 U.S. issued patents, 14
issued foreign patents, 34 pending U.S. patent applications, 111 pending foreign applications and 23 licensed patents.



In August 2002, we acquired the rights to 23 patents owned by Bonutti Research covering the use of inflatable devices for use in and
around soft tissue in the spine. In February 2003, we acquired Sanatis GmbH, a privately-held developer and manufacturer of orthopedic biomaterials based in Rosbach, Germany. We intend to pursue the development and commercialization of spine
products arising from these acquisitions to complement our existing KyphX instruments and leverage our spine sales force. The commercialization of products from these acquisitions will require research, development, and regulatory approvals and/or
clearances, and may require clinical studies prior to market launch.



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Anatomy of the Spine



The spinal column contains 24 bones called
vertebrae. Each vertebra consists of a large block of bone, called the vertebral body, that helps maintain upright posture. The soft tissue between each vertebrae is generally referred to as a spinal disc. The vertebral body consists of soft inner,
or cancellous, bone surrounded by a thin outer shell of hard bone. Each vertebra also has bone segments that extend out from the vertebral body, called the posterior elements, that surround and protect the spinal cord.



Consequences of Spine Fractures



When the spine is structurally weakened, routine downward
pressure can cause a vertebral body to collapse and fracture. These fractures are referred to as vertebral body compression fractures. The vertebral body generally fractures at the front, which can subsequently cause the spine to tilt forward. Over
time, these fractures can result in a curved deformity of the spine and a forward stooped posture called kyphosis. Vertebral compression fractures are caused primarily by deterioration of the inner cancellous bone due to osteoporosis. Other causes
of spine fractures include trauma, tumors and infection.



Unrepaired spine fractures can result in serious physical and emotional consequences, including:



| |  |  | Increased Risk of Mortality.    In a 2000 study of 6,459 women with osteoporosis followed for 3.8 years, those women who sustained a spine
fracture during the study were 8.7 times more likely to die than those women who did not experience a fracture.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Acute and Chronic Pain.    About one-third of the spine fractures caused by osteoporosis are accompanied by severe acute back pain. In
addition, the spine deformity caused by these fractures can change the position of muscles and ligaments, leading to chronic pain. In a 1998 study of 7,223 women over the age of 65, those who had a single unrepaired spine fracture that had set in
its collapsed position were two times more likely to suffer back pain than equivalently-aged women without spine deformity.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Health Effects Resulting from Organ Compression.    Fractured and collapsed vertebrae shorten and curve the spine, moving the ribs down
toward the pelvis and compressing the chest and stomach. Compression of the lungs can create new, or worsen already existing, respiratory disorders, including lung disease and pneumonia. A German and a Canadian study published in the 1990s,
involving a total of 108 participants, demonstrated that patients with spine fractures showed a statistically significant decrease in lung capacity that correlated with spine deformity. In addition, kyphosis can lead to compression of the stomach
and a resultant reduced appetite and weight loss.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Functional Limitation.    Spine fractures can cause prolonged or permanent disability, reducing mobility and impairing other physical
functions. Patients with spine fractures can require significant assistance, including the use of walkers or other aids, during normal physical activities. In a 2001 study of 1,395 post-menopausal women, patients with one or more unrepaired spine
fractures scored significantly lower on a standardized test for physical function than those who had no fractures. The loss in quality of life increased with additional fractures.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Increased Risk of Additional Fractures.    The change in alignment of the spine can shift a patients center of balance, increasing
the risk of falls and additional fractures, particularly of the spine and the hip. In a 1991 study of 1,098 post-menopausal women followed for 4.7 years, the presence of one spine fracture increased the risk of subsequent spine fractures by five
times. The presence of two or more spine fractures increased the risk of additional spine fractures by 12 times in the same timeframe. In addition, a 2001 study prospectively following 6,788 women over the age of 50 for the incidence of osteoporotic
fractures found that one or more spine fractures increased the risk of hip fracture by 4.5 times, while the presence of two or more spine fractures increased the risk of hip fracture by 7.2 times.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| |  |  | Emotional Effects.    Studies have demonstrated that the physical deformity caused by spine fractures, and the resulting fear of falling,
can create patient anxiety and clinical depression, leading to a reduction in normal daily and social activities.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Market Opportunity for the Treatment of Spine Fractures



We believe an estimated 700,000 clinically diagnosed spine fractures due to osteoporosis occur in the United States and Europe each year.
In the U.S. alone, we believe there are an additional 440,000 fractures that go undiagnosed or untreated. The majority of the diagnosed fractures are managed in the hospital or at home predominantly with conservative treatment options such as bed
rest, pain medication and back braces. Approximately 150,000 people in the United States are hospitalized due to pain associated with spine fractures, resulting in costs estimated to be in excess of $1.6 billion annually. The number of fractures
caused by osteoporosis is increasing primarily due to the aging of the population.



Alternative Means for the Treatment of Spine Fractures



When treating a patient with a spine fracture, an orthopedic surgeons primary objective, as with any fracture, is to reduce the fracture, that is, to return the bone to its pre-fracture position.
While surgeons can use conventional orthopedic surgical techniques to reduce and otherwise repair spine fractures, these procedures are highly invasive and especially risky for elderly patients. As a result, physicians rarely refer their patients
for surgical procedures to repair spine fractures, but instead prescribe therapies and treatments designed to simply manage the pain.



Conventional Spine Surgery



Spine surgery is complex and risky due to the proximity of the surgical site to the spinal cord and major organs. Conventional spine
surgery can repair fractured vertebrae and restore height, but is highly invasive and involves significant risks. These surgeries involve making long incisions in the patients chest so that large stainless steel instruments can move the
fractured bones back into their normal position. However, the instruments used in these surgeries are not optimally designed to manipulate deteriorated bone. The fractured bones are then held in place by metal implants, which, in the case of elderly
patients with osteoporosis, can fail to hold due to the softness of the inner cancellous bone to which they are attached. As a result, this surgery is performed in very limited circumstances. The invasiveness of conventional spine surgery may lead
to death, spinal cord injury, extensive post-operative hospital stays and prolonged bed rest for recovery. Additional complications may include bowel, lung and nerve damage, pain, bleeding, infection and blood clots.



Pain Management Therapies



Due to the limitations of conventional orthopedic surgery for
patients with spine fractures, the majority of these patients are treated with conservative pain management therapies. These methods do not involve surgical intervention and do not repair the fractured spine. These pain management therapies can
comprise many techniques, alone or in combination, including:



| |  |  | bed rest, in the hospital or at home;
| | - |  | -------------------------------------



| |  |  | prescription and over-the-counter pain medication;
| | - |  | --------------------------------------------------



| |  |  | back braces;
| | - |  | ------------



| |  |  | home health care;
| | - |  | -----------------



| |  |  | physical therapy;
| | - |  | -----------------



| |  |  | exercise; and
| | - |  | -------------



| |  |  | chiropractic care.
| | - |  | ------------------



These therapies are designed to provide pain relief while the fractured vertebra slowly sets in its collapsed form. Periods of treatment
can be lengthy, resulting in expensive hospital stays and follow-up. These therapies



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can also worsen the underlying problem. For example, bed rest is known to cause bone and muscle loss, making recovery more difficult in
elderly patients, and potentially leading to additional fractures. In addition, doctors report that patient compliance with these therapies is low because of the:



| |  |  | prolonged nature of treatment;
| | - |  | ------------------------------



| |  |  | patients reluctance to wear back braces;
| | - |  | -----------------------------------------



| |  |  | difficulty and pain associated with exercise and physical therapy; and
| | - |  | ----------------------------------------------------------------------



| |  |  | inadequate pain reduction.
| | - |  | --------------------------



In addition, physicians may stabilize the fractured area by a treatment that has become known as vertebroplasty. Vertebroplasty does not
repair the spine fracture, but simply reduces the associated pain. Because vertebroplasty freezes the vertebral body in its collapsed position, patients may continue to suffer the physical, emotional and quality of life problems associated with
unrepaired spine fractures.



In vertebroplasty, a
physician, typically an interventional radiologist, places one or two large needles into the fractured vertebra, and injects bone filler material into the collapsed vertebral body. The bone filler most commonly used in vertebroplasty is bone cement,
which the FDA has not specifically approved for use as a bone filler in the spine. Because the vertebral body is in a collapsed position, this procedure requires the use of thin bone filler material that is injected under high pressure in order to
effectively penetrate the inner spaces of the deteriorated bone. Once injected, the bone filler material hardens and fixes the bone in its collapsed position.



Our Products



Kyphon provides surgeons with tools to help repair fractures during minimally-invasive spine surgery. Our instruments have also been used
in open surgical procedures. We generally refer to our products as the KyphX instruments.



Minimally-invasive spine fracture surgeries using our KyphX instruments involve the insertion of two of our disposable proprietary balloon devices into the fractured bone. The surgeon inflates our
balloons to compact and move the deteriorated bone. As a result of the inflation of the balloons, the collapse caused by the fracture may be reversed. This reversal will be more difficult if the bone has previously healed in its fractured position.
The balloons are then removed, and the newly-created cavity is stabilized by filling it with the surgeons choice of bone filler material, which can include bone cement, a plastic polymer that hardens in place. We believe that surgeons
typically use a relatively thick bone cement at low pressure and under manual control. Although bone cement may be used by surgeons if they feel it is in the best interest of the patient, we may not promote bone cement for use in the spine without
additional regulatory approval. Currently, there is no bone filler that has specifically been approved for use with the KyphX instruments to repair spine fractures.



We have trained more than 2,700 physicians, including 500 in Europe and 50 in other international sites
primarily South Korea, in the use of our KyphX instruments. These physicians have used our instruments in over 28,000 surgeries involving spine fractures.



Based upon published reports of clinical results, discussions with surgeons who have used our instruments, and our own research, we
believe that the use of our KyphX instruments during minimally-invasive spine surgery may lead to significant clinical outcomes, including the following:



| |  |  | restoration of collapsed vertebrae;
| | - |  | -----------------------------------



| |  |  | reduction of spinal deformities;
| | - |  | --------------------------------



| |  |  | reduction of pain; and
| | - |  | ----------------------



| |  |  | enhanced quality of life.
| | - |  | -------------------------



Currently, our FDA clearance permits us to promote in the United States our KyphX Inflatable Bone Tamp, a device used to move and compact
bone, for use as a conventional bone tamp for the reduction of fractures and/



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or the creation of a void in cancellous bone in the spine, hand, tibia (a leg bone), radius (an arm bone) and calcaneus (the heel bone).
Before we can promote and market in the United States the use of our KyphX instruments in any specific procedure, or claim any treatment benefits from any procedure, we may need to conduct clinical studies to document the benefits, if any, and
receive FDA approval.



We are discussing
alternatives to clinical trials, or least burdensome pathways, with the FDA to support FDA approval for the use of bone cement as a bone filler material in conjunction with our cleared KyphX instruments in a specific minimally-invasive spine
procedure and to determine the benefits resulting from that procedure. We cannot assure you that we will achieve consensus on such a pathway. If we do not achieve consensus, we will instead be seeking regulatory approval to initiate clinical
studies. We cannot assure you that our studies, if completed, will demonstrate to the FDAs satisfaction any treatment benefits from spine fracture repair procedures using the KyphX Inflatable Bone Tamp or that the FDA will approve any
treatment benefit claims in a timely fashion, if at all. If we fail to obtain additional FDA approvals that will allow us to promote the treatment benefits of the KyphX Inflatable Bone Tamp, our ability to expand the commercialization of our
products may be impaired.



Risks of spine
fracture surgery performed with our KyphX instruments include the same risks common to performing surgery using anesthesia and performing surgery on elderly patients. In addition, as with other spine surgeries, surgeries using our instruments may
result in serious complications, including chronic pain; follow-up surgery; infection; unintended damage to the bone or tissue; bleeding; bowel, lung or nerve injury; paralysis; and death. Use of bone filler material by surgeons to fill the void
created using our KyphX Inflatable Bone Tamp may also lead to these complications, as a result of leakage of the bone filler material into the spinal canal or surrounding tissue.



The Use of KyphX Instruments During Minimally-Invasive Spine Surgery



Spine fracture surgeries using our KyphX instruments are
minimally invasive and are generally performed by spine-focused orthopedic surgeons and neurosurgeons. A surgeon first creates a working channel through the patients back into the fractured vertebral body using our KyphX Bone Access System.



The surgeon then inserts two of our proprietary
disposable KyphX Inflatable Bone Tamps into the fractured bone and carefully inflates them with fluid using X-ray images to monitor the procedure. Surgeons can control inflation volume and pressure using our KyphX Inflation Syringe. Inflation of the
balloons compacts the soft inner bone creating a cavity. When possible, this inflation also pushes the hard outer bone up toward its natural position, reducing the fracture.



The KyphX Inflatable Bone Tamps are then removed, and the surgeon chooses a bone filler material to insert
into the void. Using the KyphX Bone Filler Device, the surgeon delivers the chosen bone filler material into the void under manual control and low pressure to minimize the risk of material leaks.



Once the procedure is complete, the incisions are closed
typically with a small number of stitches. These procedures are usually performed in the operating room, but may also be performed in an outpatient setting. Surgeons choose local or general anesthesia based on patient health and preference and the
number of fractures to be treated. The entire surgical procedure is usually performed in about one hour per fracture treated. Because the patients are often older, they are usually admitted for observation in an overnight hospital stay.



Business Strategy



Our goal is to become the recognized leader in restoring
spinal function through minimally invasive therapies. In particular, the key elements of our strategy are to:



| |  |  | Establish Minimally-Invasive Surgery Using our KyphX Instruments as the Standard of Care for Spine Fracture Repair.    We intend to
support clinical efforts to establish that treating spine fractures with a
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| | specific minimally-invasive surgical procedure using our KyphX instruments provides significantly better patient outcomes than the pain
management focused therapies typically prescribed by physicians today.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Continue to Penetrate the Spine Market Using a Direct Sales Force.    Our instruments are sold in the United States directly to hospitals
by our experienced sales team, comprised of 70 sales consultants, 35 sales associates, 12 regional sales managers, two area directors, and a vice president. By leveraging their extensive medical device experience, our sales people are able to
identify key physicians within these hospitals and provide effective customer assistance to accelerate market adoption of our instruments.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Educate Referring Physicians.    Patients with spine fractures often are not referred to spine surgeons for treatment, but are prescribed
pain management therapies. Our objective is to educate primary care physicians and other medical advisers on the use of our KyphX instruments as an alternative to conventional spine fracture treatment. We have initiated a pilot program whereby
selected sales representatives will call on primary care physicians to educate them about our instruments.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Expand Marketing Claims.    Our marketing and promotional claims currently are not permitted to include reference to bone cement, the
material commonly used in the spine by surgeons when they perform spine fracture repair. We have initiated discussions with the FDA to explore least burdensome approaches to allow us to support FDA approval for the promotion of bone cement as a bone
filler material in conjunction with our KyphX instruments in a specific minimally-invasive spine procedure and to determine the benefits resulting from that procedure. In Europe, we have initiated a post-marketing clinical study comparing
Kyphoplasty to conventional treatments of bed rest, pain medication and bracing. We believe the results of this and other studies, if successful, will allow us to expand our marketing and third-party reimbursement efforts.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Establish Appropriate Levels of Physician Reimbursement.    In all 50 states and in the District of Columbia, Medicare reimburses
physicians for their services when they perform procedures using our instruments. We intend to use peer-reviewed physician journal articles and support from leading physicians who are familiar with the KyphX instruments to continue establishing
appropriate levels of physician reimbursement.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Continue Revenue Growth Through New Product Acquisition and Development.    Our sales force is an important asset with the capacity to
sell new products that complement our KyphX Instruments including KyphX product line extensions as well as new technologies that we develop or acquire from others. In August 2002, we acquired the rights to 23 patents owned by Bonutti Research
covering the use of inflatable devices for use in and around soft tissue in the spine. In February 2003, we acquired Sanatis GmbH, a privately-held developer and manufacturer of orthopedic biomaterials based in Rosbach, Germany. We intend to pursue
the development and commercialization of spine products arising from these acquisitions to complement our existing KyphX instruments and leverage our spine sales force. The commercialization of products from these acquisitions as well as our own
internal efforts will require research, development, and regulatory approvals and/or clearances, and may require clinical studies prior to market launch. We intend to pursue other external business development opportunities as well to help us
achieve our goals.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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Products



We currently sell the following instruments for use in spine
fracture procedures:



|Product Category     |  | Description                                                         |  | Function                                           
|-------------------- |  | ------------------------------------------------------------------- |  | ---------------------------------------------------
|Bone Access Systems  |  | Set of small disposable tools                                       |  | Create working channel into fractured bone         
|                    
|Inflatable Bone Tamp |  | Disposable balloon catheter                                         |  | Compact soft inner bone and push up hard outer bone
|                    
|Inflation Syringe    |  | Disposable syringe with rotating handle and pressure gauge          |  | Inflate the KyphX Xpander Inflatable Bone Tamp     
|                    
|Bone Filler Device   |  | Disposable stainless steel nozzle with inner rod and plastic handle |  | Deliver bone filler material into bone cavity      
|                    
|Bone Biopsy Device   |  | Disposable stainless steel tube and rod                             |  | Take sample of soft bone for evaluation purposes   



Bone
Access Systems.    Bone Access Systems are sterile sets of small disposable surgical tools used to access and create a working channel into the fractured bone. One version contains a long guide pin, an instrument used to
separate tissue and a small hand drill. In addition, it contains two small tubes through which other tools are passed and a proprietary handle that can be used with multiple KyphX tools. A second version combines the instrument used to separate
tissue, the small tube through which other tools are passed and the proprietary handle into one tool. Alternative versions of this one tool can either be pushed or twisted into and through bone. All versions of the Bone Access System contain a
sterile needle used to penetrate hard bone.



Inflatable Bone Tamp.    Our proprietary KyphX Xpander Inflatable Bone Tamps are disposable sterile devices that combine the functionality of a metal bone tamp with the engineering principles of medical
balloon technologies. Unlike other medical balloons, however, our balloons are specially designed to be used in bone. Other currently available medical balloons are not used in bone because they are not appropriate in size, shape or durability, or
are not designed to provide lifting force.



Conventional bone tamps are rigid stainless steel instruments that move fractured hard bone and compact soft bone using indirect mechanical force. While it is the goal of orthopedic surgeons to move a fractured area all at once,
conventional bone tamps cannot do this without a large incision and without significant tissue and bone disruption. Unlike other bone tamps, the KyphX Xpander Inflatable Bone Tamp contains a balloon that can be placed inside a fractured bone through
a narrow working channel and expanded to move fractured bone all at once. Once inside, the balloon portion of the KyphX Xpander Inflatable Bone Tamp is carefully inflated under X-ray monitoring. This inflation applies direct mechanical force to
compact the soft inner bone and push up the broken hard outer bone.



Inflation Syringe.    Our KyphX Xpander Inflation Syringe is a disposable sterile device with a rotating handle and a built-in pressure gauge that precisely controls the inflation of our KyphX
Xpander Inflatable Bone Tamp. The rotating handle allows the surgeon to deliver a measured volume of the fluid that inflates the balloon.



Bone Filler Device.    The KyphX Bone Filler Device is a disposable stainless steel nozzle with an inner rod
and a plastic handle. Bone filler can be loaded into the nozzle and pushed into the void with the inner rod under low pressure and fine manual control.



Bone Biopsy Device.    Our KyphX Bone Biopsy Device is a disposable, stainless steel tube and rod that can be
used to take biopsy samples of soft bone for further evaluation.



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Clinical Studies



We have initiated a clinical study in
Europe and may conduct a clinical study in the United States. Although the two studies may have several common clinical assessments and clinical end points, they are intended to serve different purposes.



The U.S. clinical study, if needed, would generate additional
clinical safety and effectiveness data to support FDA approval or market clearance for a bone cement as a bone filler material that would be used in conjunction with our KyphX instruments in a specific minimally-invasive surgery for the treatment of
spine fractures. This approval or market clearance would allow us to promote a specific procedure using our KyphX instruments, and allow us to expand marketing claims to include treatment benefits, depending on whether the study results are
accepted. We have begun to work with the FDA to evaluate potential alternatives to a clinical trial, or least burdensome alternatives, that would form the basis for approval or clearance of bone cement. The filing of an Investigational Device
Exemption, or IDE is contingent upon the outcome of our discussions with the FDA. If an IDE is required and if it is approved and the clinical study initiated, we anticipate that the study patients will be enrolled over a period of time and
subsequently followed for a period of up to two years. There is no assurance that we will reach agreement with FDA on an alternate risk-based regulatory strategy and may have to seek regulatory approval to initiate clinical studies.



The primary purpose for conducting the European study is to
gather local clinical data to support our sales and marketing efforts as well as to support reimbursement of our KyphX instruments in various European countries. Clinical endpoints for the European clinical study may be similar to those of the U.S.
clinical study if the U.S. study is initiated. We have initiated the European study and expect to continue patient enrollment throughout 2003. We will continue to monitor these patients with the goal of using local data to support our European
marketing and reimbursement efforts.



In addition
to the two clinical studies referenced above, Kyphon may conduct additional IDE and/or non-significant risk clinical studies to demonstrate specific clinical outcomes related to the treatment of patients with KyphX instruments and/or alternative
bone fillers.



Reimbursement



Establishing reimbursement for any new medical technology is
a challenge in the current environment of cost containment, managed care and Medicare. To successfully establish reimbursement coverage, we must prove that our technology improves health outcomes, such as quality of life or functional ability, and
does so in a cost-effective manner.



Payment for
patient care in the United States is generally made by private insurers. These insurers act on their own behalf or under contract with the U.S. government to administer the Medicare program. Medicare covers most of the medical care expenses of
individuals over the age of 64. Approximately 90% of patients with spine fractures caused by osteoporosis are covered by Medicare, while the rest are covered by private insurers. Even when patients are not covered by Medicare, private insurers often
follow the coverage and payment policies of Medicare.



For inpatient fracture reduction procedures, Medicare pays the hospital a prospectively determined amount based primarily on the patients diagnosis and the nature of the care provided during the hospital stay. We receive
payment from the hospital for our instruments, and Medicare reimburses the hospital under this reimbursement system for its costs of admitting and treating the patient, including the purchase of our instruments, under existing applicable codes. The
surgeon who performs the procedure is reimbursed under a different system that is based on procedure codes, called current procedural terminology, or CPT, codes. Currently, Medicare reimburses physicians who use our KyphX instruments on a state by
state basis. This form of reimbursement is not uniform across all states because there is no CPT code or associated national payment



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rate relating to procedures using our instruments. As a result, unless a state has a published policy regarding reimbursement, physicians
must report procedures using our instruments under an unlisted CPT code, submit their bills for review and request payment based on the time, work and risk involved in the procedure. We intend to continue to use the results of future clinical
studies, peer-reviewed physician journal articles, and support from leading physicians who are familiar with our KyphX instruments to further support physician reimbursement for procedures using our instruments. In addition, it is possible that
medical societies familiar with the Kyphoplasty procedure will apply for the establishment of a national payment rate through a CPT code. Based on our understanding of this process, it is not anticipated that a national CPT could be established
prior to 2005, if at all.



Sales and Marketing



We market and sell our KyphX instruments
through a direct sales force in the United States. Our target customer base includes the approximately 3,500 physicians who perform spine surgery, including orthopedic spine surgeons and neurosurgeons.



Our U.S. sales organization is currently comprised of 77 sales
territories. Each territory is managed by a spine consultant who acts as the primary customer contact. These spine consultants have extensive experience selling medical devices, generally focusing on emerging technologies. Several of the larger
territories are managed with the assistance of a spine associate. The associate provides case coverage support and participates in the education of primary care physicians. Our 105 U.S. sales professionals are led by 12 regional sales managers, two
area directors and a vice president of sales. We expect we will need to continue to increase the size of our sales organization in order to increase sales and market penetration and to provide the significant, ongoing level of customer support
required by our sales strategy. We have initiated a pilot program whereby selected representatives will call on primary care physicians to educate them about our instruments.



Our European operations are headquartered in Belgium with direct sales organizations in a few major European
countries. We anticipate continuing to build direct sales organizations in the major European countries while establishing distributor or agency arrangements in smaller ones. We intend to follow a similar model in Europe to the one established in
the United States, working with internationally recognized physicians initially as we expand our training, reimbursement and selling activities.



We have initiated the sales process in selected Asia-Pacific markets. We have selected a distributor in South Korea and have begun product
introduction there. During 2003, we plan to formulate our clinical and regulatory plans for Japan. In addition, we plan to consider Canada and other selected South American and Asia-Pacific countries regarding potential product registration and
selling activities.



Our sales and marketing
programs focus on working with leading spine surgeons to champion and educate other surgeons on the use of our instruments. Additionally, we have implemented an ongoing educational process for primary care physicians to explain the applicability and
use of our instruments.



Manufacturing



We inspect, assemble, test, package and sterilize components
that have been manufactured by us or to our specifications by outside contractors. We inspect each lot of components and finished instruments to determine compliance with our specifications.



We believe our manufacturing operations are in compliance with
regulations mandated by the FDA and the European Union. We have been an FDA-registered and California-licensed medical device manufacturer since 1998. We obtained our CE Mark in February 2000, and our facility is ISO 9001/EN 46001/ISO 13485
certified. We are subject to unannounced inspections by the FDA and the Food and Drug Branch of the California Department of Health Services, or CDHS, and these inspections may include the manufacturing facilities of our



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subcontractors. We have been inspected by the CDHS, the FDA and European auditors. There have been no significant audit findings as a result
of these inspections. We cannot assure you that we comply with all applicable manufacturing regulations.



Most purchased components for our instruments are available from more than one supplier. There are no contractual obligations by suppliers
to continue to supply to us, nor are we contractually obligated to purchase from a particular supplier. We have identified and qualified alternate suppliers for materials in our KyphX Inflatable Bone Tamp. For some of our other products,
identification and qualification of alternate suppliers may take time.



We are currently increasing our manufacturing capabilities as we increase commercialization efforts. Manufacturers often experience difficulties in scaling up production, including problems with production yields and quality
control and assurance. If we are unable to manufacture our instruments to keep up with demand, we would not meet expectations for growth of our business.



Research and Development



As of December 31, 2002, we had 14 employees dedicated to research and development. Through the recent acquisition of Sanatis GmbH, we
have added two employees to our research and development team, whose efforts will primarily be focused on developing biomaterials for use with our instruments. The research and development group develops new products to address unmet market needs
with the goal of enhancing revenue. The major focus of the group is to explore new technologies for use in orthopedic applications, including treatment of spine fractures. In addition, we intend to further develop balloon technology to treat various
other bone disorders arising from trauma or cancer. We are currently developing the following products:



| |  |  | additional instruments to facilitate the use of our products in fractures that are particularly difficult to repair;
| | - |  | --------------------------------------------------------------------------------------------------------------------



| |  |  | optimized delivery systems for bone void fillers;
| | - |  | -------------------------------------------------



| |  |  | Kyphon-branded acrylic cement or biomaterial for use as a bone void filler;
| | - |  | ---------------------------------------------------------------------------



| |  |  | instruments targeted to facilitate repair in smaller vertebral bodies; and
| | - |  | --------------------------------------------------------------------------



| |  |  | balloon designs and instruments that cause a balloon to inflate differentially.
| | - |  | -------------------------------------------------------------------------------



Unless an exemption is available, we will need approval or clearance from the FDA to promote or market any of
these products in the United States. We cannot be certain that we will be able to obtain approval or clearance for these products.



Training



We devote significant resources to training and educating physicians in the use of our KyphX instruments. We limit our training and
education of physicians to the specialized skills involved in the proper use of our instruments, because the FDA has taken the position that we may not train physicians about specific procedures in the spine. Specific procedures in which our
instruments are used commonly involve bone cement to fill the void created by our instruments. Although physicians may use our instruments with bone filler material of their choice, including bone cement, the FDA has taken the position that we
cannot promote the use of bone cement, or train surgeons to use bone cement, with our instruments unless bone cement is specifically approved for use in the spine. We instruct our trainers, both physician faculty consultants and employees, not to
discuss the use of any bone filler material, including bone cement, with our instruments. However, if questions are posed by surgeons during training, we inform surgeons of the regulatory status of bone cement and its use with our products. Although
we believe our training methods are proper, if the FDA determines that our training constitutes promotion of an unapproved use, they could request that we modify our training or subject us to regulatory enforcement actions, including the issuance of
a warning letter, injunction, seizure, civil fine and criminal penalty.



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Competition



We compete with providers of non-surgical
treatments, drugs to reduce pain, drugs to prevent osteoporosis, open surgical procedures and instruments for vertebroplasty. We believe the primary competitive factors that affect our instruments are cost, reimbursement status, efficacy and safety.



Osteoporosis drugs marketed and in development
today generally reduce the risk of fracture by up to 70%. These drugs are made by large pharmaceutical companies such as Merck, Eli Lilly, Wyeth, Procter & Gamble, Novartis AG and Aventis Pharmaceuticals. These drugs and future drugs may further
reduce the incidence of spine fractures.



We are
aware of a number of major medical device companies that have developed or plan to develop instruments marketed for use with bone filler material to treat spine fractures. Competition among these companies is likely to increase the awareness and
frequency of vertebroplasty and other alternative procedures.



Any products that we commercialize will be subject to intense competition. Many of our competitors and potential competitors in these markets have substantially greater financial, technical and marketing resources than we do, and
they may succeed in developing products that would render our instruments obsolete or noncompetitive. In addition, many of these competitors have significantly greater experience and reputations than we do in their respective fields. Our ability to
compete successfully will depend on our ability to develop proprietary instruments that reach the market in a timely manner, receive adequate reimbursement and are safer, less invasive and less expensive than alternatives available for the same
condition. Current or future competitors may develop technologies and products that are more effective than ours. Because of the size of the potential market, we anticipate that companies will dedicate significant resources to developing competing
procedures. Our technologies and instruments may be rendered obsolete or uneconomical by technological advances or entirely different approaches developed by one or more of our competitors.



Patents and Proprietary Technology



We believe that in order to have a competitive advantage, we
must develop and maintain the proprietary aspects of our technologies. As of December 31, 2002, we had 16 issued U.S. patents, 14 issued foreign patents, 34 pending U.S. patent applications, 111 pending foreign patent applications, and 23 licensed
patents.



In August 2002, we entered into a
patent sublicense agreement with Bonutti Research Inc. for the exclusive right to 23 U.S. patents issued to Dr. Peter Bonutti. Under the terms of the agreement, we acquired the exclusive right to develop minimally-invasive balloons and related
products for use within joints, ligaments, tendons, or cartilage in the spine and the co-exclusive right to develop minimally-invasive balloons and related products for use in orthopedic applications in joints, ligaments, cartilage, nerves or
tendons outside of the spine.



In February 2003,
we acquired Sanatis GmbH, a privately-held developer and manufacturer of orthopedic biomaterials based in Rosbach, Germany. Sanatis has filed four patent applications covering inventions relating to calcium cement formulations and a cement delivery
technology.



We require our employees,
consultants and advisors to execute confidentiality agreements in connection with their employment, consulting or advisory relationships with us. We also require our employees, consultants and advisors who we expect to work on our products to agree
to disclose and assign to us all inventions conceived during the work day, using our property or which relate to our business. Despite any measures taken to protect our intellectual property, unauthorized parties may attempt to copy aspects of our
products or to obtain and use information that we regard as proprietary. Finally, our competitors may independently develop similar technologies. Because of the importance of our patent portfolio to our business, we may lose market share to our
competitors if we fail to protect our intellectual property rights.



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The medical
device industry is characterized by the existence of a large number of patents and frequent litigation based on allegations of patent infringement. As the number of entrants into our market increases, the possibility of a patent infringement claim
against us grows. While we make an effort to ensure that our products do not infringe other parties patents and proprietary rights, our products and methods may be covered by U.S. patents held by our competitors. In addition, our competitors
may assert that future products we may market infringe their patents.



Government Regulation



Our products are medical devices subject to extensive regulation by the FDA under the Federal Food, Drug and Cosmetic Act. FDA regulations govern, among other things, the following activities that we will perform:



| |  |  | product design and development;
| | - |  | -------------------------------



| |  |  | product testing;
| | - |  | ----------------



| |  |  | product manufacturing;
| | - |  | ----------------------



| |  |  | product labeling;
| | - |  | -----------------



| |  |  | product storage;
| | - |  | ----------------



| |  |  | premarket clearance or approval;
| | - |  | --------------------------------



| |  |  | advertising and promotion; and
| | - |  | ------------------------------



| |  |  | product sales and distribution.
| | - |  | -------------------------------



Each medical device that we wish to commercially distribute in the United States requires either 510(k) clearance or premarket approval
from the FDA prior to marketing. Devices deemed to pose relatively less risk are placed in either class I or II, which requires the manufacturer to submit a premarket notification requesting permission for commercial distribution; this is known as
510(k) clearance. Some low-risk devices are exempted from this requirement. Devices deemed by the FDA to pose the greatest risk, such as life-sustaining, life-supporting or implantable devices, or devices deemed not substantially equivalent to a
previously 510(k)-cleared device, are placed in class III requiring premarket approval.



510(k) Clearance Pathway.    To obtain 510(k) clearance, we must submit a premarket notification demonstrating that the proposed device is substantially equivalent in
intended use and in safety and effectiveness to a previously 510(k)-cleared device or a device that was in commercial distribution before May 28, 1976 for which the FDA has not yet called for submission of premarket applications, or is a device that
has been reclassified from class III to class II or I. The FDAs 510(k) clearance pathway usually takes from three to 12 months, but it can last significantly longer.



After a device receives 510(k) clearance, any modification that could significantly affect its safety or
effectiveness, or that would constitute a major change in its intended use, requires a new 510(k) clearance or could require premarket approval. The FDA requires each manufacturer to make this determination in the first instance, but the FDA can
review any manufacturers decision. If the FDA disagrees with a manufacturers decision not to seek a new 510(k) clearance, the agency may retroactively require the manufacturer to seek 510(k) clearance or premarket approval. The FDA can
also require the manufacturer to cease marketing and/or recall the modified device until 510(k) clearance or premarket approval is obtained.



Our KyphX Inflatable Bone Tamp currently has 510(k) clearance for use as a conventional bone tamp for the reduction of fractures and/or
the creation of a void in cancellous bone in the spine, hand, tibia, radius and calcaneus. The KyphX Xpander Inflatable Bone Tamp is marketed pursuant to the 510(k) clearance for the KyphX Inflatable Bone Tamp. The KyphX Inflation Syringe and 11
Gauge Bone Access Needle are 510(k)-



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cleared products that we currently obtain from contract suppliers. We believe our KyphX Introducer Tool Kit, Osteo Introducer System,
Advanced Osteo Introducer, Advanced Osteo Introducer System, Bone Biopsy Device, and KyphX Bone Filler Device, when sold as manual orthopedic surgical instruments, are exempt from clearance or approval requirements. Our products are not cleared for
any specific surgical procedure or for use with bone cement in the spine. Our current 510(k) clearance does not permit us to promote any particular benefits obtained by using our instruments in surgery. Before we can promote the use of bone cement
in the spine or promote benefits experienced by patients following procedures in which our instruments are used, we need to reach agreement with FDA on the data required and the regulatory pathway to follow. That agreement may result in the need to
conduct one or more clinical studies to support any or all of the marketing applications.



In October 2000, we received a warning letter from the FDA challenging our promotional claims that we were making for our KyphX instruments. In that letter and subsequently, the FDA took the position
that our initial 510(k) clearance for the KyphX Inflatable Bone Tamp did not permit us to promote the product for use in any specific sites in the body or for any specific surgical procedures. The FDA also maintained we could not promote any
clinical benefits for our products until we submitted and obtained additional regulatory approvals.



After discussions and correspondence with the FDA, we agreed to abide by these restrictions and revised our promotional campaign
accordingly. Subsequently, we obtained our current 510(k) clearance to promote the KyphX Inflatable Bone Tamp as a conventional bone tamp in the reduction of fracture and/or creation of a void in cancellous bone in the spine, hand, tibia, and
calcaneus. Therefore, at the present time, we do not promote any treatment benefit of, or promote, or train physicians in, any specific surgical procedures involving the use of our instruments or the use of our instruments with bone cement in the
spine. In order to do so, we must reach agreement with FDA on whether further marketing applications are needed, and whether additional clinical data must be generated to support such applications. We have no basis on which to assume that an
agreement will be reached without the need to do a study and/or file an IDE application, and we do not know whether such an IDE application if required will be approved in a reasonable time, if at all. The failure to obtain FDA approval of treatment
benefits using our cleared products in specific procedures may significantly impair our ability to promote our products.



The FDA recently published a Public Health Web Notification entitled Complications Related to the Use of Bone Cement in
Vertebroplasty and Kyphoplasty Procedures. The notification described complications relating to the use of bone cement in those procedures and indicated that the FDA was working with appropriate professional organizations and manufacturers of
orthopedic devices to consider the regulatory options available to evaluate the long-term safety and effectiveness of bone cement in vertebroplasty and kyphoplasty procedures. Our discussions with FDA on the least burdensome alternatives have
focused on those options.



Premarket
Approval.    A premarket approval application, or PMA, must be submitted if the device cannot be cleared through the 510(k) process. A PMA must normally be supported by extensive data including, but not limited to, technical,
preclinical, clinical studies, manufacturing and labeling to demonstrate to the FDAs satisfaction the safety and effectiveness of the device.



After a PMA is filed, the FDA begins an in-depth review of the submitted information, which generally takes between one and three years,
but may take significantly longer. During this review period, the FDA may request additional information or clarification of the information already provided. Also, in many cases, an advisory panel of experts from outside the FDA will be convened to
review and evaluate the application and provide recommendations to the FDA as to the approvability of the device. In addition, the FDA will conduct a preapproval inspection of the manufacturing facility to ensure compliance with quality system
regulations. New PMAs or PMA supplements are required for significant modifications to the manufacturing process, labeling and design of a device that is approved through the premarket approval process. PMA supplements in certain circumstances
require submission of the same type of information as that contained in an original PMA, but limited in scope to the changes from the device covered by the original premarket approval. PMA supplements



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may not require extensive clinical data or review of the application by an advisory panel. We expect that any clinical benefit claims we wish
to make about the KyphX instruments may require the submission and approval of a PMA by the FDA before we can make any such claims. We also believe that a premarket approval may be necessary before we can promote the use of bone cement or other bone
filler material in conjunction with our KyphX instruments in any surgical procedure. The present discussion regarding alternative risk-based regulatory requirements reflecting the least burdensome concept could alter the need for a PMA, but we can
provide no assurance that our discussions with the FDA will provide that result.



We cannot assure you that any future premarket approval submissions will be approved by the FDA in a timely fashion, if at all.



Clinical Studies. Clinical studies are almost always required to support a premarket application and
are sometimes required for a 510(k) premarket notification. These studies may require submission of an application for an Investigational Device Exemption, or IDE. The IDE application must be supported by appropriate data, such as animal and
laboratory testing results, showing that it is safe to test the device in humans and that the testing protocol is scientifically sound. The IDE must be approved in advance by the FDA for a specific number of patients unless the product is deemed a
nonsignificant risk device eligible for more abbreviated IDE requirements. Clinical studies for significant risk devices may begin once the IDE application is approved by the FDA and the appropriate institutional review boards at the clinical trial
sites.



Any clinical studies we sponsor must be
conducted in accordance with FDA regulations. These clinical studies will require that we submit, and obtain FDA approval of, an IDE prior to commencing clinical studies. The results of any clinical studies we do conduct may not be sufficient for us
to obtain any additional clearances or approvals or to support additional marketing claims for our KyphX instruments.



Postmarket.    After a device is placed on the market, numerous regulatory requirements apply. These include:



| |  |  | the Quality System regulations, which require manufacturers to follow elaborate testing, control, documentation and other quality assurance procedures during the
manufacturing process;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the Medical Device Reporting regulation, which requires that manufacturers report to the FDA instances where their device may have caused or contributed to a death
or serious injury or malfunctioned in a way that would likely cause or contribute to a death or serious injury if the malfunction were to recur; and
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | FDA regulations that prohibit the promotion of medical devices for unapproved or off-label uses.
| | - |  | --------------------------------------------------------------------------------------------------



We are subject to inspection and marketing surveillance by the
FDA to determine our compliance with regulatory requirements. If the FDA finds that we have failed to comply, it can institute a wide variety of enforcement actions, ranging from a public warning letter to more severe sanctions including:



| |  |  | fines, injunctions, and civil penalties;
| | - |  | ----------------------------------------



| |  |  | recall or seizure of our products;
| | - |  | ----------------------------------



| |  |  | operating restrictions, partial suspension or total shutdown of production;
| | - |  | ---------------------------------------------------------------------------



| |  |  | refusing our requests for 510(k) clearance or premarket approval of new products;
| | - |  | ---------------------------------------------------------------------------------



| |  |  | withdrawing 510(k) clearance or premarket approvals already granted; and
| | - |  | ------------------------------------------------------------------------



| |  |  | criminal prosecution.
| | - |  | ---------------------



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The FDA also
has the authority to require us to repair, replace or refund the cost of any medical device that we have manufactured or distributed in certain circumstances.



International.    International sales of medical devices are subject to foreign government regulations, which
vary substantially from country to country. The time required to obtain approval by a foreign country may be longer or shorter than that required for FDA approval, and the requirements may differ. The primary regulatory authority in Europe is that
of the European Union, or EU, which consists of 15 countries encompassing most of the major countries in Europe. Other countries, such as Switzerland, have voluntarily adopted laws and regulations that mirror those of the EU with respect to medical
devices. The EU has adopted numerous directives and standards regulating the design, manufacture, clinical trial, labeling and adverse event reporting for medical devices. Devices that comply with the requirements of a relevant directive will be
entitled to bear CE conformity marking, indicating that the device conforms with the essential requirements of the applicable directives and, accordingly, can be commercially distributed throughout Europe. The method of assessing conformity varies
depending on the class of the product, but normally involves a combination of self-assessment by the manufacturer and a third-party assessment by a Notified Body. This third-party assessment may consist of an audit of the
manufacturers quality system and specific testing of the manufacturers product. An assessment by a Notified Body in one country within the EU is required in order for a manufacturer to commercially distribute the product throughout the
EU. During this process, we must demonstrate compliance with designated manufacturing and quality requirements known as the ISO requirements.



We have obtained CE Marking permitting us to commercialize our current products in Europe. We are in the process of obtaining CE Marking
with regard to a calcium phosphate biomaterial that we acquired with the acquisition of Sanatis GmbH. We have certification of our manufacturing facilities to ISO 9001/EN46001 quality system requirements. We had our annual inspection in February
2003 with no non-compliance reports issued, continuing our facility as ISO 9001/EN46001 certified. While no additional premarket approvals in individual EU countries are required, prior to marketing of a device bearing the CE Mark, practical
complications with respect to market introduction may occur. For example, differences among countries have arisen with regard to labeling requirements.



Employees



As of December 31, 2002, we had a total of 305 employees, with 58 people in operations, 14 people in research and development, 148 people
in sales and sales administration, 33 people in general and administrative, 22 people in clinical and regulatory, 23 people in marketing and professional education, and 7 people in reimbursement. None of our employees is represented by a labor
union, and we believe our employee relations are good.



Available Information



We
are subject to the reporting requirements under the Securities Exchange Act of 1934. Consequently, we are required to file reports and information with the Securities and Exchange Commission (SEC), including reports on the following forms: annual
report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934. These reports and other information
concerning the company may be accessed through the SECs website at http://www.sec.gov.



You may also find on our website at http://www.kyphon.com electronic copies of our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those
reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934. Such filings are placed on our website as soon as reasonably possible after they are filed with the SEC.



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Risk Factors Affecting
Operations and Future Results



Risks Related to Our
Business



Unless we obtain additional
FDA approvals, or otherwise reach agreement with the FDA on an alternate risk-based regulatory strategy, we will not be able to promote the use of our instruments in specific surgical procedures or the benefits of any surgical procedures (including
procedures involving bone cement) using our instruments in the United States, and our ability to grow our business could be harmed.



In October 2000, we received a warning letter from the FDA challenging the promotional claims that we were making for our KyphX
instruments. It was the FDAs position that our regulatory clearance for the KyphX Inflatable Bone Tamp did not permit us to promote the product for use in any specific sites in the body, or for any specific surgical procedures. The FDA also
stated that we could not promote any clinical benefits of surgical procedures using our instruments until we obtained additional regulatory approvals related to the benefits. After discussions and correspondence with the FDA, we agreed to abide by
these restrictions and revised our promotional campaign accordingly. Subsequently, we obtained our current 510(k) clearance to promote the KyphX Inflatable Bone Tamp as a conventional bone tamp in the reduction of fracture and/or creation of a void
in cancellous bone in the spine, hand, tibia, and calcaneus. In order to promote the use of our devices in specific sites, for specific procedures and with certain resultant patient benefits, we must reach agreement with the FDA on whether further
market clearances or approvals are needed and whether additional clinical data must be generated to support such clearance or approval. We have no basis on which to assume that an agreement will be reached without the need to conduct a clinical
study and file one or more regulatory applications. If such an application or applications are filed, we can provide no assurance that they will be approved in a timely fashion, if at all. If we fail to obtain these additional necessary regulatory
approvals, our ability to generate revenues may be harmed.



If the FDA finds that bone cement should not be used in the spine, our ability to sell and promote our instruments would be harmed, and our exposure to product liability litigation could increase.



In October 2002, the FDA published a Public Health Web
Notification entitled Complications Related to the Use of Bone Cement in Vertebroplasty and Kyphoplasty Procedures. The notification states that reported complications related to vertebroplasty and kyphoplasty procedures, such as soft
tissue damage and nerve root pain and compression, have resulted from leakage of bone cement, and that other complications include pulmonary embolism, respiratory and cardiac failure and death had been reported. The notification is subject to
potential future revision at the sole discretion of the FDA. The content of a revised notification can not be predicted. The notification indicates that the FDA is working with appropriate professional organizations and manufacturers of orthopedic
devices to consider the regulatory options available to evaluate the long-term safety and effectiveness of bone cement in vertebroplasty and kyphoplasty procedures. The notification requests that the healthcare community follow established
procedures for reporting of deaths or serious injuries resulting from the use of medical devices, including bone cement. The notification, itself, may raise concerns with our customers, potential customers and reimbursement organizations, which
could impact our ability to sell and promote our instrument. An increase in reports of deaths or serious injuries could lead to the FDA issuing safety alerts, health advisories, or FDA-mandated labeling changes restricting use of our instruments,
including new warnings regarding their use or contraindicating their use with bone cement. In addition, increased reporting of adverse events would expose us to product liability litigation, and our current insurance coverage limits may not be
adequate. Product liability insurance is expensive and may not be available to us in the future on acceptable terms, if at all.



In the United States, we are not permitted to promote, or train physicians in, the use of our KyphX instruments with bone cement in
the spine, unless we obtain additional FDA approvals or otherwise reach agreement with FDA on limited training and promotion.



As the FDAs position is that we may not train physicians about specific procedures in the spine, we limit our training and education
of physicians to the specialized skills involved in the proper use of our instruments.



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Although physicians may use our instruments with bone filler material of their choice, including bone cement, the FDA has taken the position
that we cannot promote the use of bone cement, or train surgeons to use bone cement, with our instruments unless bone cement is specifically approved for use in the spine with our instruments. We instruct our trainers, both physician faculty
consultants and employees, not to discuss the use of any bone filler material, including bone cement, with our instruments. However, they may respond to unsolicited questions about bone cement that are raised by physician participants during a
training program. Although we believe our training methods are proper, if the FDA determines that our training constitutes promotion of an unapproved use, they can request that we modify our training or subject us to regulatory enforcement actions,
including the issuance of a warning letter, injunction, seizure, civil fine and criminal penalty.



If we are unable to obtain U.S. regulatory approval to market the use of bone cement for use with our instruments in spine fracture
surgery or to document resulting benefits, or reach agreement with FDA on an alternate risk-based regulatory framework governing such claims, our future competitive position and revenue may be harmed.



We may need to seek regulatory approval to initiate a
clinical study designed to support FDA approval for the use of bone cement as a bone filler material in conjunction with our cleared instruments in a specific minimally-invasive spine procedure. There are many risks associated with conducting the
clinical study, including our ability to:



| |  |  | obtain FDA approval of our study protocol;
| | - |  | ------------------------------------------



| |  |  | enroll patients;
| | - |  | ----------------



| |  |  | avoid adverse patient outcomes; and
| | - |  | -----------------------------------



| |  |  | demonstrate safety and efficacy.
| | - |  | --------------------------------



Any of these factors could delay, limit or prevent our successful completion of a clinical study and our regulatory approval. If we are
unable to obtain FDA approval for the use of bone cement with our KyphX instruments in spine surgery, our future competitive position and revenues may be harmed.



Our failure to obtain or maintain necessary regulatory clearances or approvals could hurt our ability
to commercially distribute and market our KyphX instruments.



Our KyphX instruments are considered medical devices and are subject to extensive regulation in the United States and in foreign countries where we intend to do business. Unless an exemption applies, each medical device that
we wish to market in the United States must first receive either 510(k) clearance or premarket approval from the FDA. The FDAs 510(k) clearance process usually takes from three to 12 months, but may take longer. The premarket approval process
generally takes from one to three years from the time the application is filed with the FDA, but it can be significantly longer and can be significantly more expensive than the 510(k) clearance process. Although we have obtained 510(k) clearance for
the KyphX Inflatable Bone Tamp to help repair fractures in specific sites in the spine, hand, leg, arm and heel, our 510(k) clearance can be revoked if safety or effectiveness problems develop. We also may be required to obtain 510(k) clearance or
premarket approval to market additional instruments or for new indications for our KyphX instruments. Before we can market any bone cement product for use with our instruments in spine surgery, we must first obtain regulatory approval. We cannot be
certain that we would obtain 510(k) clearance or premarket approval in a timely manner or at all. Delays in obtaining clearances or approvals may adversely affect our revenue and future profitability.



Modifications to our marketed devices may require new
510(k) clearances or premarket approvals or may require us to cease marketing or recall the modified devices until clearances are obtained.



Any modification to a 510(k)-cleared device that could significantly affect its safety or effectiveness, or that would constitute a major
change in its intended use, requires a new 510(k) clearance or, possibly, premarket approval. The FDA requires every manufacturer to make this determination in the first instance, but the FDA can



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review any manufacturers decision. We have modified aspects of our KyphX instruments, but we believe that new 510(k) clearances are not
required. The FDA may not agree with any of our decisions not to seek new clearances or approvals. If the FDA requires us to seek 510(k) clearance or premarket approval for any modification to a previously cleared instrument, we may be required to
cease marketing or to recall the modified device until we obtain clearance or approval, and we may be subject to significant regulatory fines or penalties.



If we fail to comply with Quality System regulations, our manufacturing operations could be delayed, and our product sales and
profitability could suffer.



Our
manufacturing processes and those of our suppliers are required to comply with the FDAs Quality System regulations, which cover the procedures and documentation of the design, testing, production, control, quality assurance, labeling,
packaging, storage and shipping of our instruments. The FDA enforces its Quality System regulations through periodic unannounced inspections. The FDA conducted an inspection of our manufacturing facility in May 2002 and the FDA inspector made a
single observation. We responded to the FDA in June 2002. There has been no further correspondence from the FDA regarding the inspection. If we fail a Quality System inspection, our operations could be disrupted and our manufacturing delayed.
Failure to take adequate corrective action in response to an adverse Quality System inspection could force a shut-down of our manufacturing operations and/or a recall of our instruments, which would cause our instrument sales and business to suffer.



We have limited operating experience and a
history of net losses and may never achieve or maintain profitability.



We have a limited operating history upon which you can evaluate our business. We commenced commercial sales of our KyphX instruments in May 2000. We have incurred losses every year since we began
operations. In particular, we incurred losses of $17.7 million in 2000, $17.8 million in 2001 and $15.3 million in 2002. As of December 31, 2002, we had an accumulated deficit of approximately $60.0 million. Even if we are able to increase revenue
from our instrument sales, we may have operating losses based on our plans to expand our sales and marketing efforts, both domestically and internationally, and devote substantial resources to our continuing research and development efforts and
clinical studies. It is possible that we will never generate sufficient revenues from instrument sales to achieve profitability.



If reimbursement for the procedures using our instruments becomes difficult to obtain or is not available in sufficient amounts, our
instruments may not be widely adopted.



In some cases, physicians performing a procedure using our instruments have not been reimbursed. Widespread adoption of our instruments by the medical community is unlikely to occur if physicians do not receive sufficient
reimbursement from payors for their services in performing the procedures using our instruments. Currently, there is no specific procedure code under which reimbursement to physicians is available for procedures performed using our KyphX
instruments. Physicians must report procedures using our instruments under an unlisted current procedural terminology, or CPT, code, and hospitals receive reimbursement for an inpatient stay. Physicians have obtained reimbursement from Medicare for
the use of our products in all 50 states and in the District of Columbia. Until a specific CPT code is granted, physician reimbursement from Medicare may be difficult to obtain in some states. Future regulatory action by a government agency or
negative clinical results may diminish reimbursement coverage for both the physician and hospital. Finally, reimbursement differs from state to state, and some states may not reimburse for a procedure in an adequate amount. If physicians are unable
to obtain adequate reimbursement for procedures in which our KyphX instruments are used, we may be unable to sell our instruments and our business could suffer.



Adverse changes in reimbursement procedures by domestic and international payors may impact our ability
to market and sell our instruments.



Even if the use of our instruments is reimbursed by private payors and Medicare, adverse changes in payors policies toward reimbursement for the procedure would harm our ability to market and sell our instruments. We



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are unable to predict what changes will be made in the reimbursement methods used by payors. We cannot be certain that under prospective
payment systems, such as those utilized by Medicare, and in many managed care systems used by private health care payors, the cost of our instruments will be justified and incorporated into the overall cost of the procedure.



Even if we fulfill international regulatory requirements to
market our instruments, our success will be partly dependent upon the availability of reimbursement within prevailing health care payment systems. Reimbursement and health care payment systems in international markets vary significantly by country
and include both government-sponsored health care and private insurance. In addition, health care cost containment efforts similar to those we face in the United States are prevalent in many of the other countries in which we intend to sell our
instruments, and these efforts are expected to continue. Although we intend to seek international reimbursement approvals, we may not obtain approvals in a timely manner, if at all.



To be commercially successful, we will have to convince physicians that using our instruments to repair
spine fractures is an effective alternative to existing therapies and treatments.



We believe that physicians will not widely adopt our instruments unless they determine, based on experience, clinical data and published peer reviewed journal articles, that the use of our KyphX
instruments provides an effective alternative to conventional means of treating spine fractures. Patient studies or clinical experience may indicate that treatment with our instruments does not provide patients with sustained benefits. Further,
because some of the data has been produced in studies that involve small patient groups, the data may not be reproduced in wider patient populations. In addition, we believe that continued recommendations and support for the use of KyphX instruments
by influential physicians are essential for widespread market acceptance. If our KyphX instruments do not continue to receive support from these physicians or from long-term data, surgeons may not use, and hospitals may not purchase, our
instruments.



Because injuries that occur
during spine surgery can be significant, we are subject to an increased risk of product liability lawsuits. If we are sued in a product liability action, we could be forced to pay substantial damages.



We manufacture medical devices that are used on patients in
spine surgery procedures. Spine surgery involves significant risk of serious complications, including bleeding, nerve injury, paralysis and death. Consequently, companies that produce instruments for use in the spine are subject to a significant
risk of product liability litigation. If our instruments are found to have caused or contributed to any injury, we could be held liable for substantial damages, and our current product liability coverage limits may not be adequate to protect us from
any liabilities we might incur. In addition, we may require increased product liability coverage if sales of our instruments increase. Product liability insurance is expensive and may not be available to us in the future on acceptable terms, if at
all.



Our reliance on suppliers could limit
our ability to meet demand for our products in a timely manner or within our budget.



We are dependent upon outside suppliers to provide us with our KyphX Inflation Syringe, as well as other key components necessary for the manufacture of our products. Generally we obtain components
through purchase orders rather than long-term supply agreements and do not maintain large volumes of inventory, the disruption or termination of the supply of components could lead to:



| |  |  | a significant increase in manufacturing costs associated with the need to obtain replacement components;
| | - |  | --------------------------------------------------------------------------------------------------------



| |  |  | our inability to meet demand for our instruments, which could lead to customer dissatisfaction and damage our reputation; and
| | - |  | -----------------------------------------------------------------------------------------------------------------------------



| |  |  | delays associated with regulatory qualifications required for use of replacement suppliers.
| | - |  | -------------------------------------------------------------------------------------------



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Any one of
these results could harm our sales and profits and make it difficult to meet our business goals.



If we do not effectively manage our growth, our existing infrastructure may become strained, and we will be unable to increase sales of our KyphX instruments or generate significant revenue
growth.



Our direct sales organization
has increased from 31 employees in October 2000 to 130 employees in December 2002. The growth that we have experienced, and in the future may experience, provides challenges to our organization, requiring us to rapidly expand our personnel and
manufacturing operations. We may not be able to hire sufficient personnel to meet our growth goals. As a result, our failure to recruit additional sales personnel may result in our inability to meet our projections. Future growth may strain our
infrastructure, operations, product development and other managerial and operating resources. If our business resources become strained, we may not be able to deliver instruments in a timely manner.



Because we face significant competition from other
medical device companies with greater resources than we have, we may be unable to maintain our competitive position and sales of our instruments may decline.



The market for medical devices is intensely competitive, subject to rapid change and significantly affected
by new product introductions and other market activities of industry participants. Our industry also includes large pharmaceutical companies that are developing drug products that may reduce the incidence of osteoporosis and, therefore, the market
for our instruments. Our ability to compete successfully depends in part on our ability to respond quickly to medical and technological change and user preference through the development and introduction of new products that are of high quality and
that address patient and surgeon requirements. We compete with many larger companies that enjoy several competitive advantages, including:



| |  |  | established distribution networks;
| | - |  | ----------------------------------



| |  |  | established relationships with health care providers and payors;
| | - |  | ----------------------------------------------------------------



| |  |  | additional lines of products, and the ability to bundle products to offer higher discounts or other incentives to gain a competitive advantage; and
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | greater resources for product development, sales and marketing and patent litigation.
| | - |  | -------------------------------------------------------------------------------------



At any time, other companies may develop additional competitive products. If we are unable to compete
effectively against existing or future competitors, sales of our instruments will decline.



If we are unable to prevent third parties from using our intellectual property, our ability to compete in the market will be harmed.



We believe that the proprietary technology embodied in our
instruments and methods gives us a competitive advantage. Maintaining this competitive advantage is important to our future success. We rely on patent protection, as well as on a combination of copyright, trade secret and trademark laws, to protect
our proprietary technology. However, these legal means afford only limited protection and may not adequately protect our rights or permit us to gain or keep any competitive advantage. For example, our patents may be challenged, invalidated or
circumvented by third parties. Our patent applications may not issue as patents at all or in a form that will be advantageous to us. We may not be able to prevent the unauthorized disclosure or use of our technical knowledge or other trade secrets
by consultants, vendors, former employees and current employees, despite the existence of nondisclosure and confidentiality agreements and other contractual restrictions. Furthermore, the laws of foreign countries may not protect our intellectual
property rights to the same extent as the laws of the United States. If our intellectual property rights are not adequately protected, we may be unable to keep other companies from competing directly with us, which could result in a decrease in our
market share. Enforcement of our intellectual property rights to prevent or inhibit appropriation of our technology by competitors can be expensive and time-consuming to litigate or otherwise dispose of and can divert managements attention
from our core business.



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Our
instruments could infringe on the intellectual property rights of others, which may lead to costly litigation, payment of substantial damages or royalties and/or our inability to use essential technologies.



The medical device industry has been characterized by
extensive litigation and administrative proceedings regarding patents and other intellectual property rights. Whether an instrument infringes a patent involves complex legal and factual issues, the determination of which is often uncertain. Our
competitors may assert that our instruments and methods infringe their patents. In addition, they may claim that their patents have priority over ours because their patents issued first. Because patent applications can take many years to issue,
there may be applications now pending of which we are unaware, which may later result in issued patents that our instruments or methods may infringe. There could also be existing patents that one or more of our instruments or methods may
inadvertently be infringing of which we are unaware. As the number of competitors in the market for minimally-invasive spine disorder treatments grow, the possibility of a patent infringement claim against us increases.



Infringement and other intellectual property claims, with or
without merit, can be expensive and time-consuming to litigate or otherwise dispose of and can divert managements attention from our core business. In addition, if we lose an intellectual property litigation matter, a court could require us to
pay substantial damages and/or royalties and/or prohibit us from using essential technologies. Also, although we may seek to obtain a license under a third partys intellectual property rights to bring an end to any claims or actions asserted
or threatened against us, we may not be able to obtain a license on reasonable terms or at all.



We may become involved in litigation to protect our intellectual property rights.



We may in the future initiate claims or litigation against third parties for infringement of our proprietary rights to protect these
rights or further determine the scope and validity of our intellectual property protection. These claims could result in costly litigation and the diversion of management attention and resources away from our business.



Risks Related to the Public Market



Our principal stockholders have significant voting
power and may take actions that may not be in the best interests of our other stockholders.



Our officers, directors and principal stockholders together control approximately 62.6% of our outstanding common stock as of March 14,
2003. If these stockholders act together, they will be able to control our management and affairs in all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions. This
concentration of ownership may have the effect of delaying or preventing a change in control and might adversely affect the market price of our common stock. This concentration of ownership may not be in the best interest of our other stockholders.



We may be unable to obtain future capital
on satisfactory terms.



We believe our
current cash, cash equivalents, investments, and cash generated from operations will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for at least the next 12 months. We may seek additional funds from
public and private stock offerings, borrowings under lease lines of credit or other sources. We cannot assure you that additional financing will be available on a timely basis on terms acceptable to us, or at all, or that any financing will not be
dilutive to stockholders. If adequate funds are not available, we may have to delay development or commercialization of our instruments or license to third parties the rights to commercialize products or technologies that we would otherwise seek to
commercialize for ourselves. We also may have to reduce the marketing, customer support or other resources devoted to our instruments.



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Anti-takeover provisions in our certificate of incorporation, our bylaws and Delaware law could discourage a takeover.



Our basic corporate documents and Delaware law contain provisions that might enable our management to resist a takeover. Those provisions
might discourage, delay or prevent a change in the control of our company or a change in our management. The existence of these provisions could adversely affect the voting power of holders of common stock and limit the price that investors might be
willing to pay in the future for shares of our common stock.



Our common stock has recently become publicly traded, and we expect that the price of our common stock may fluctuate substantially.



We consummated the initial public offering of our common stock in May 2002. Accordingly, there has only been
a public market for shares of our common stock since May 2002. An active public trading market may not develop or, if developed, may not be sustained. Further, we expect that the market price of our common stock may fluctuate substantially. The
market price for the common stock may be affected by a number of factors, including:



| |  |  | regulatory or reimbursement developments in the United States or other countries;
| | - |  | ---------------------------------------------------------------------------------



| |  |  | product liability claims or other litigation;
| | - |  | ---------------------------------------------



| |  |  | the announcement of new products or product enhancements by us or our competitors;
| | - |  | ----------------------------------------------------------------------------------



| |  |  | quarterly variations in our or our competitors results of operations;
| | - |  | ----------------------------------------------------------------------



| |  |  | changes in earnings estimates or recommendations by securities analysts;
| | - |  | ------------------------------------------------------------------------



| |  |  | developments in our industry; and
| | - |  | ---------------------------------



| |  |  | general market conditions and other factors, including factors unrelated to our operating performance or the operating performance of our competitors.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------



ITEM 2.    PROPERTIES



Our operations are headquartered in a 42,500 square foot building in Sunnyvale, California. This facility is leased through March 2005 with an option to renew through 2010. We are actively looking at larger facilities and
may move to a larger facility during 2003.



ITEM 3.    LEGAL PROCEEDINGS



We are not a party to any material litigation.



ITEM 4.    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS



No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year covered by this report.



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PART II



ITEM 5.    MARKET FOR THE REGISTRANTS COMMON EQUITY AND RELATED

STOCKHOLDER MATTERS



We
had our initial public offering on May 17, 2002. Our Common Stock is traded on the NASDAQ National Stock Market under the symbol KYPH. The following table shows the high and low closing sale prices of our Common Stock for each quarterly
period since the date of our initial public offering as reported on the Nasdaq National Stock Market:



|                                   |  | 2002
|---------------------------------- |  | ----
|                                   |  | High
|Second quarter (from May 17, 2002) |  | $   
|Third quarter                      |  | $   
|Fourth quarter                     |  | $   



As of
March 14, 2003, the closing price of our Common Stock on the NASDAQ National Stock Market was $10.48 per share, and the number of registered stockholders on record was 265.



Since our incorporation, we have never declared or paid any dividends on our capital stock. We currently
expect to retain future earnings, if any, for use in the operation and expansion of our business and do not anticipate paying any cash dividends in the foreseeable future.



In May 2002, we completed our initial public offering, including exercise of the underwriters
over-allotment option, of 6,900,000 shares at an initial public offering price of $15.00 per share, for aggregate cash proceeds of approximately $103.4 million. Our managing underwriters for the offering were U.S. Bancorp Piper Jaffray Inc., Banc of
America Securities LLC and Bear, Stearns & Co. Inc. In connection with the offering, we paid a total of approximately $7.2 million in underwriting discounts and commissions and $1.3 million in other offering costs. After deducting the
underwriting discounts and commissions and the offering costs, our net proceeds from the offering, including the over-allotment option, were approximately $94.9 million.



Of the $94.9 million in net offering proceeds, through December 31, 2002, we have used $14.2 million for
repayment of outstanding convertible promissory notes held by affiliates, plus accrued interest; $27.6 million for sales and marketing initiatives to support the ongoing commercialization of our KyphX instruments; $3.3 million for support of
clinical studies and reimbursement efforts; $2.9 million for product research and development; $6.7 million for general corporate purposes and $12.3 million for the strategic acquisition of third party technology. All amounts represent estimates of
direct or indirect payments of amounts to third parties. In addition, we have invested $24.7 million in debt securities. We are currently investing the remaining net proceeds from the offering for future use as additional working capital. Such
remaining net proceeds have been invested in money market funds.



The Board of Directors approved a stock repurchase program on November 7, 2002 pursuant to which up to 2,000,000 shares of our outstanding common stock may be repurchased from time to time. The duration of the repurchase program is
open-ended. Under the program, we may purchase shares of common stock through open market transactions at prices deemed appropriate by management. The purchases will be funded from available working capital. As of December 31, 2002, we had
repurchased 30,000 shares pursuant to this repurchase program.



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ITEM 6.    SELECTED CONSOLIDATED FINANCIAL DATA



The following tables reflect selected consolidated financial data derived from our consolidated financial statements for each of the last five years. The consolidated statement of operations data for
the years ended December 31, 2002, 2001 and 2000, and the consolidated balance sheet data as of December 31, 2002 and 2001 are derived from our audited consolidated financial statements included in this report. The consolidated statement of
operations data for the years ended December 31, 1999 and 1998, and the consolidated balance sheet data as of December 31, 2000, 1999 and 1998 are derived from our audited consolidated financial statements not included in this report. Historical
results are not necessarily indicative of future results. The selected financial data set forth below should be read in conjunction with our financial statements, the related notes and Managements Discussion and Analysis of Financial
Condition and Results of Operations included elsewhere in this report.



|                                                                                       |  | Years Ended December 31,                 |        
|-------------------------------------------------------------------------------------- |  | ---------------------------------------- | -------
|                                                                                       |  | 2002                                     |        
|                                                                                       |  | (in thousands, except per share amounts) |        
|Consolidated Statement of Operations Data:                                             |  |                                          |        
|Net sales                                                                              |  | $                                        | 76,316 
|Cost of goods sold                                                                     |  |                                          | 10,416 
|                                                                                       |  |                                          |        
|Gross profit (loss)                                                                    |  |                                          | 65,900 
|                                                                                       |  |                                          |        
|Operating expenses:                                                                    |  |                                          |        
|Research and development                                                               |  |                                          | 10,145 
|Sales and marketing                                                                    |  |                                          | 43,509 
|General and administrative                                                             |  |                                          | 12,540 
|Purchased in-process research and development                                          |  |                                          | 12,250 
|                                                                                       |  |                                          |        
|Total operating expenses                                                               |  |                                          | 78,444 
|                                                                                       |  |                                          |        
|Loss from operations                                                                   |  |                                          | (12,544
|Interest income (expense) and other, net                                               |  |                                          | (2,794 
|                                                                                       |  |                                          |        
|Net loss                                                                               |  | $                                        | (15,338
|                                                                                       |  |                                          |        
|Net loss per common share, basic and diluted                                           |  | $                                        | (0.63  
|                                                                                       |  |                                          |        
|Weighted-average shares used in computing net loss per common share, basic and
diluted |  |                                          | 24,405 
|                                                                                       |  |                                          |        



|                                                  |  | As of December 31, |        
|------------------------------------------------- |  | ------------------ | -------
|                                                  |  | 2002               |        
|                                                  |  | (in thousands)     |        
|Consolidated Balance Sheet Data:                  |  |                    |        
|Cash, cash equivalents and short-term investments |  | $                  | 71,091 
|Working capital (deficit)                         |  |                    | 83,504 
|Total assets                                      |  |                    | 101,524
|Convertible promissory notes                      |  |                    |       
|Long-term obligations, net                        |  |                    |       
|Redeemable convertible preferred stock            |  |                    |       
|Deferred stock-based compensation, net            |  |                    | (11,947
|Total stockholders' equity (deficit)              |  |                    | 91,514 



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ITEM 7.    MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS



The following discussion of our financial condition and results of operations should be read in conjunction with the consolidated financial statements and the related notes included in Item 8 of this Form 10-K. This discussion
contains forward-looking statements. These statements are based on our current expectations, assumptions, estimates and projections about our business and our industry, and involve known and unknown risks, uncertainties and other factors that may
cause our or our industrys results, levels of activity, performance or achievement to be materially different from any future results, levels of activity, performance or achievements expressed or implied in or contemplated by the
forward-looking statements. Our actual results and the timing of selected events could differ materially from those anticipated in these forward-looking statements as a result of selected factors, including those set forth below under Risk
Factors Affecting Operations and Future Results.



Overview



We develop
medical devices to restore spinal anatomy using minimally invasive technology. Currently, our KyphX instruments consist of our KyphX Inflatable Bone Tamp, KyphX Inflation Syringe, KyphX Bone Access Systems, KyphX Bone Filler Device, and our KyphX
Bone Biopsy Device. Our KyphX Inflatable Bone Tamp currently has 510(k) clearance for use as a conventional bone tamp for the reduction of fractures and/or the creation of a void in cancellous bone in the spine, hand, tibia, radius and calcaneus.
The KyphX Xpander Inflatable Bone Tamp is marketed pursuant to the 510(k) clearance for the KyphX Inflatable Bone Tamp. The KyphX Inflation Syringe and 11 Gauge Bone Access Needle are 510(k)-cleared products that we currently obtain from a contract
supplier. We believe our KyphX Introducer Tool Kit, KyphX Osteo Introducer System, KyphX Advanced Osteo Introducer, KyphX Advanced Osteo Introducer System, KyphX Bone Biopsy Device, and KyphX Bone Filler Device, when sold as manual orthopedic
surgical instruments, are exempt from clearance or approval requirements. In May 2000, we commenced full commercial introduction of our KyphX instruments. From inception to December 31, 2002, we recognized $118.7 million in revenue from sales of our
products.



Since inception, we have been
unprofitable. We incurred net losses of approximately $17.7 million in 2000, $17.8 million in 2001 and $15.3 million in 2002. As of December 31, 2002, we had an accumulated deficit of approximately $60.0 million. Activities related to
commercializing our KyphX instruments, enhancing physician reimbursement and initiating clinical studies, together with our general and administrative expenses, will cause our expenses to increase. As we proceed with commercialization, we will
require additional sales and marketing resources, data from proposed clinical studies and greater physician reimbursement acceptance by payors.



We currently market our instruments in the United States through a direct sales organization to physicians who perform spine surgery,
including orthopedic spine surgeons and neurosurgeons. We have European operations headquartered in Belgium. We sell directly in some European countries and use distributors and agents in other European countries and in South Korea.



Our future growth depends on increased penetration of our
current market and on identifying new markets in which we can leverage our minimally invasive technology. To the extent any current or additional markets do not materialize or grow in accordance with our expectations, our sales could be lower than
expected. Surgeons typically use bone cement to fill the void created in a vertebral body by our instruments. The FDA recently published a Public Health Web Notification entitled Complications Related to the Use of Bone Cement in
Vertebroplasty and Kyphoplasty Procedures. The notification highlighted various safety concerns and indicates that the FDA is working with appropriate professional organizations and manufacturers of orthopedic devices to consider the
regulatory options available to evaluate the long-term safety and effectiveness of bone cement in vertebroplasty and kyphoplasty procedures.



Critical Accounting Policies and Estimates



Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements,
which have been prepared in accordance with accounting principles generally



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accepted in the United States. The preparation of financial statements requires management to make estimates and judgments that affect the
reported amounts of assets and liabilities, revenue and expenses and disclosures at the date of the financial statements. On an on-going basis, we evaluate our estimates, including those related to accounts receivables, inventories, other
intangibles and income taxes. We use authoritative pronouncements, historical experience and other assumptions as the basis for making estimates. Actual results could differ from those estimates.



We believe the following critical accounting policies affect
our more significant judgments and estimates used in the preparation of our consolidated financial statements. Revenue from product sales is recognized upon receipt of a valid purchase order, shipment of the products to customers and when collection
of the receivables is deemed probable. We maintain an accounts receivable allowance for an estimated amount of losses that may result from customers inability to pay for product purchased. If the financial condition of our customers were to
deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. We write down our inventories by estimating the potential for future loss based on a variety of factors, including the quantity of
particular items, their prospect for replacement or obsolescence, the remaining shelf life and the difference between cost and market. If actual market conditions are less favorable than those projected by management, additional inventory
write-downs may be required.



We have established
a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. We account for income taxes under the provisions of Statement of Financial Accounting Standards, or SFAS No. 109, Accounting for
Income Taxes. Under this method, deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities using the enacted tax rates in effect for the year in which the
differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized.



Purchase accounting requires extensive accounting estimates and judgments to allocate the purchase price
between in-process research and development, other identifiable intangible assets, tangible assets, and goodwill as required by generally accepted accounting principles in the United States. Purchased in-process research and development is defined
as the value assigned to those projects for which the related products have not received regulatory approval and have no alternative future use. Determining the portion of the purchase price allocated to in-process research and development and other
intangible assets requires us to make significant estimates. The amount of the purchase price allocated to purchased in-process research and development and other intangible assets is determined by estimating the future cash flows of each project or
technology and discounting the net cash flows back to their present values. The discount rate used is determined at the time of the acquisition in accordance with accepted valuation methods. For purchased in-process research and development, these
methodologies include consideration of the risk of the project not achieving commercial feasibility.



In June 2001, the Financial Accounting Standards Board (FASB) issued SFAS No. 141 (SFAS No. 141), Business
Combinations, and SFAS No. 142 (SFAS No. 142), Goodwill and Other Intangible Assets. SFAS No. 141 requires the purchase method of accounting for all business combinations after June 30, 2001 and that certain acquired
intangible assets in a business combination be recognized as assets separate from goodwill. SFAS No. 142 requires that goodwill and other intangibles determined to have an indefinite life are no longer to be amortized but are to be tested for
impairment at least annually. We have adopted SFAS No. 142 as of January 1, 2002. We will evaluate goodwill for impairment on an annual basis and on an interim basis if events or changes in circumstances between annual impairment tests indicate that
the asset might be impaired. We will also evaluate other intangible assets for impairment when impairment indicators are identified. In assessing the recoverability of the goodwill and other intangibles, we must make assumptions regarding estimated
future cash flows and other factors to determine the fair value of the respective assets. These estimates include forecasted revenues, which are inherently difficult to predict. If these estimates or their related assumptions change in the future,
we may be required to record impairment charges for these assets. Property, equipment, intangible and certain other long-lived assets are amortized over their useful lives. Useful lives are based on managements estimates of the period that the
assets will generate revenue.



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Results of Operations



Comparison of years ended December 31, 2002, 2001 and
2000



Net
Sales.    Net sales generated from sales of our products were $76.3 million, $36.1 million, and $6.1 million in 2002, 2001 and 2000, respectively. The increases in net sales resulted from an increase in the number of trained
physicians as well as an increase in the number of procedures performed by trained physicians. In 2002, 2001 and 2000, 93%, 98% and 98%, respectively, of net sales were recognized in the United States. No customer accounted for more than 10% of
total net sales in 2002, 2001 and 2000.



Cost
of Goods Sold.    Cost of goods sold consists of material, labor, subcontract, and overhead costs. Cost of goods sold were $10.4 million, $8.1 million and $3.6 million in 2002, 2001 and 2000, respectively. As a percentage of
net sales, cost of goods sold were 14%, 22%, and 59% in 2002, 2001 and 2000, respectively. The decrease is a result of fixed overhead costs being spread over increased production volume and decreased unit costs, primarily as we switched to lower
cost metal part suppliers and eliminated cleaning operations. The increase in cost of goods sold over the years from 2000 to 2002 resulted primarily from increased material, labor, subcontract, overhead costs and inventory provisions associated with
increased sales volume of our products. We continue to expect cost of goods sold to increase as our sales grow.



Research and Development.    Research and development expenses consist of costs of product research, product
development, regulatory and clinical functions and personnel. Research and development expenses were $10.1 million, $7.9 million and $4.5 million in 2002, 2001 and 2000, respectively. The increase in research and development expenses in 2002 from
2001 was primarily attributable to increased personnel costs of $1.0 million, increased amortization of deferred stock-based compensation of $832,000 and increased product testing and development expenditures of $429,000. The increase in 2001 from
2000 was primarily attributable to increased clinical trial consulting costs of $1.3 million, increased amortization of deferred stock-based compensation of $752,000, increased personnel costs of $728,000, increased product testing and development
expenditures of $321,000 and increased facilities expenses of $223,000. We expect to continue to make substantial investments in research and development and anticipate that research and development expenses will increase in the future.



Sales and
Marketing.    Sales and marketing expenses consist of costs for personnel, physician training programs and marketing activities. Sales and marketing expenses were $43.5 million, $27.9 million and $11.4 million in 2002, 2001
and 2000, respectively. The increase in sales and marketing expenses in 2002 from 2001 related primarily to a $9.2 million increase in the costs of hiring, training and compensating additional direct selling representatives, increased expenditures
related to advertising, promotion, trade shows and market research activities of $2.6 million, increased sales travel expenses of $1.5 million, and increased amortization of deferred stock-based compensation of $1.1 million. The increase in sales
and marketing expenses in 2001 from 2000 related primarily to increased personnel costs of $8.2 million, increased physicians training costs of $1.6 million, increased advertising and promotional activities of $1.6 million and increased amortization
of deferred stock-based compensation of $644,000. As we continue to commercialize our KyphX instruments, we expect to significantly increase our sales and marketing efforts and expenditures.



General and
Administrative.    General and administrative expenses consist of personnel costs, professional service fees, expenses related to intellectual property rights and general corporate expenses. General and administrative
expenses were $12.5 million, $9.7 million and $5.3 million in 2002, 2001 and 2000, respectively. The increase in general and administrative expenses in 2002 from 2001 resulted primarily from increased personnel costs of $1.0 million, including
$500,000 in accrued severance cost, increased miscellaneous taxes, licenses and insurance expenditures of $1.0 million and increased legal, public company expenses, accounting and consulting fees of $845,000 offset partially by decreased
amortization of deferred stock-based compensation of $910,000. The increase in general and administrative expenses in 2001 from 2000 resulted primarily from increased personnel costs of $2.2 million related to our growth in operations and
amortization of deferred stock-based compensation of $2.2 million offset by reduced expenditures. We expect general and administrative expenses to increase in the future as we add personnel, continue to expand our patent portfolio and incur
reporting and investor-related expenses as a public company.



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Purchased
In-Process Research and Development.    In August 2002, we entered into a patent sublicense agreement with Bonutti Research Inc. for the exclusive right to 23 U.S. patents issued to Dr. Peter Bonutti. Under the terms of the
agreement, we acquired the exclusive right to develop minimally-invasive balloons and related products for use within joints, ligaments, tendons, or cartilage in the spine and the co-exclusive right to develop minimally-invasive balloons and related
products for use in orthopedic applications in joints, ligaments, cartilage, nerves or tendons outside of the spine. We paid $12.3 million in cash for the rights, all of which was immediately expensed to purchased in-process research and development
in August 2002. The acquisition cost was immediately expensed to operations as the technology acquired will be used to develop products that have not been approved for sale by regulatory authorities, and the in-process projects to which the patents
may apply had not yet reached technological feasibility and had no alternative future uses.



Other and Interest Income (Expense), Net.    Other and interest income (expense), net, were ($2.8) million, ($309,000), and $1.1 million in 2002, 2001 and 2000, respectively.
The decrease in other and interest income, net in 2002 from 2001 includes non-cash interest expense of $3.1 million related to the beneficial conversion feature and the fair value of warrants issued in connection with the convertible promissory
notes. In addition, increased interest expense resulted from outstanding convertible promissory notes offset partially by increased interest income from higher cash, cash equivalent and investments balances resulting from the proceeds of our initial
public offering. Other and interest income (expense), net, decreased in 2001 from 2000 due to lower cash, cash equivalent and short-term investment balances and increased interest expense associated with outstanding convertible promissory notes.



Deferred Stock-Based Compensation



We recorded deferred stock-based compensation for financial
reporting purposes as the difference between the exercise price of options granted to employees and the deemed fair value of our common stock at the time of grant. Deferred stock-based compensation is amortized to cost of goods sold, research and
development expense, sales and marketing expense and general and administrative expense. Deferred stock-based compensation recorded through December 31, 2002 was $20.6 million, with accumulated amortization of $9.4 million. The remaining $11.2
million will be amortized over the vesting periods of the options, generally four years from the date of grant. All option amounts are being amortized using a straight-line method. We expect to record amortization expense for deferred stock-based
compensation as follows:



|Year |  | Amount      
|---- |  | ------------
|2003 |  | $4.6 million
|2004 |  | $3.8 million
|2005 |  | $2.6 million
|2006 |  | $0.2 million



Stock-based compensation expense related to stock options granted to non-employees is recognized as the stock options are earned. The stock-based compensation expense will fluctuate as the fair market value of our common stock
fluctuates. In connection with the grant of stock options to non-employees, we recorded deferred stock-based compensation of $4.2 million through December 31, 2002, of which $3.5 million has been amortized to expense as of December 31, 2002.



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Income Taxes



Realization of deferred tax assets is
dependent upon the uncertainty of the timing and amount of future earnings, if any. Accordingly, full deferred tax asset valuation allowances have been established as of December 31, 2002 and 2001 to reflect these uncertainties.



At December 31, 2002, we had approximately $28,500,000 and
$24,400,000 in federal and state net operating loss carryforwards, respectively, to reduce future taxable income. The federal and state carryforwards have expiration dates beginning in 2012 and 2003, respectively, in each case if not utilized.



At December 31, 2002, we had research and
development tax credits carryforwards of approximately $688,000 and $652,000 for federal and state income tax purposes, respectively. If not utilized, the federal research and development tax credit carryforwards will expire beginning in 2012. The
state research and development tax credit can be carried forward indefinitely.



The Tax Reform Act of 1986 limits the use of net operating loss and tax credit carryforwards in certain situations where changes occur in the stock ownership of a company. Ownership changes, as
defined, occurred on August 8, 1996, December 14, 1999 and May 17, 2002. In accordance with Internal Revenue Code Section 382, utilization of the carryforwards is subject to annual limitation. The annual limitation will not result in the expiration
of net operating losses prior to utilization.



At
December 31, 2002, we had approximately $300,000 of net operating losses in Belgium, which can be carried forward indefinitely, absent any changes in control.



Liquidity and Capital Resources



In May 2002, we received net proceeds of $94.9 million from our initial public offering of common stock. From inception through June 2001,
we raised $38.0 million through private sales of redeemable convertible preferred stock. From July 2001 through February 2002, pursuant to a loan agreement, we issued to affiliates $14.0 million in promissory notes, all of which have either been
repaid or converted into common stock. As of December 31, 2002, we had $49.9 million of cash and cash equivalents, $24.4 million of investments, and working capital of $83.5 million.



Cash Provided by (Used in) Operating Activities.    Net cash provided by operating
activities was $937,000 in 2002 attributable primarily to the add back of $12.3 million write-off of in-process research and development charge, non-cash charges related to $6.3 million amortization of deferred stock-based compensation, and $3.1
million of non-cash interest expense offset partially by net loss of $15.3 million, and increases in accounts receivable and inventories due to increased sales. Net cash used in operations was $13.0 million in 2001 and $18.3 million in 2000. For
2001 and 2000, cash used in operations were attributable primarily to net losses after adjustment for non-cash charges related to depreciation and amortization of deferred stock-based compensation, and increases in accounts receivable and
inventories as we increased our net sales. These increases in use of cash in operations were offset in part by increases in accounts payable, accrued compensation and other accrued liabilities as we increased our operating expenses.



Cash Used in Investing
Activities.    Net cash used in investing activities was $39.5 million, $1.6 million and $799,000 in 2002, 2001 and 2000, respectively. Cash used in investing activities reflected purchases of property and equipment for all
periods. During 2002, cash used for investing activities reflected the purchases of investments of $24.7 million and payment of $12.3 million in connection with the patent sublicense agreement. During 2000, cash used in investing activities also
reflected net purchases of short-term investments.



Cash Provided by Financing Activities.    Net cash provided by financing activities was $85.0 million, $9.1 million and $4.0 million in 2002, 2001 and 2000, respectively. Cash provided during 2002 was
attributable primarily from proceeds of $94.9 million from issuing common stock in our initial public offering partially offset



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by repayment of convertible promissory notes of $13.3 million. Cash provided during 2001 was primarily from the proceeds of convertible
promissory notes. Cash provided during 2000 was primarily from proceeds from the issuance of redeemable convertible preferred stock.



Convertible Promissory Notes.    Between July 2001 and February 2002, we raised $13.3 million through the sale
of convertible promissory notes to several of our affiliates pursuant to a loan agreement. We repaid the outstanding principal and accrued interest upon the closing of our initial public offering. In addition, in November 2001, we raised $700,000
through the sale of a convertible promissory note to one affiliate pursuant to the same loan agreement. The principal and accrued interest due on this note automatically converted into 49,090 shares of our common stock at the initial public offering
price of $15.00 per share. As required by the terms of the loan agreement, upon the closing date of our initial public offering, we issued warrants exercisable for an aggregate of 99,334 shares of our common stock at an exercise price of $0.01 per
share to the holders of the convertible promissory notes. As of December 31, 2002, warrants for an aggregate of 64,070 shares of our common stock remained outstanding and exercisable.



We allocated the gross proceeds received from the convertible promissory notes and accrued interest to the
convertible promissory notes and the warrants, based on their relative fair values. This allocation resulted in $13.3 million of the proceeds being assigned to the convertible promissory note and $1.5 million being assigned to the warrants. We
valued the warrants at the May 22, 2002 issuance date using the Black-Scholes pricing model. We recognized the allocated fair value of the warrants of $1.5 million as an immediate charge to interest expense. Based on the difference between the
effective conversion price of the proceeds allocated to the convertible promissory notes and the fair market value of the common stock at the issuance date, we determined that the allocated value of the convertible promissory notes contained a
beneficial conversion feature. The beneficial conversion feature, amounting to $1.6 million, represented additional interest yield on the convertible promissory notes and was also recognized as an immediate charge to interest expense.



The following table describes our commitments to settle
contractual obligations in cash related to our facility lease not recorded on the balance sheet as of December 31, 2002 (in thousands):



|Years Ending December 31,          |  |  
|---------------------------------- |  | -
|2003                               |  | $
|2004                               |  |  
|2005                               |  |  
|                                   |  |  
|Total contractual cash obligations |  | $
|                                   |  |  



We
expect to increase capital expenditures consistent with our anticipated growth in manufacturing, infrastructure and personnel. We also may increase our capital expenditures as we expand our product lines or invest to address new markets.



We believe our current cash, cash equivalents,
investments, and cash generated from operations will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for at least the next 12 months. If existing cash, cash equivalents, and cash generated from
operations are insufficient to satisfy our liquidity requirements, we may seek to sell additional equity or debt securities or obtain an additional credit facility. The sale of additional equity or convertible debt securities could result in
dilution to our stockholders. If additional funds are raised through the issuance of debt securities, these securities could have rights senior to those associated with our common stock, and could contain covenants that would restrict our
operations. Any additional financing may not be available in amounts or on terms acceptable to us, or at all. If we are unable to obtain this additional financing, we may be required to reduce the scope of our planned product development and
marketing efforts.



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Recent Accounting
Pronouncements



In April of 2002, the FASB
issued SFAS No. 145, Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections, which is effective for fiscal years beginning after May 15, 2002. Under SFAS No. 145, gains and losses
from the extinguishment of debt should be classified as extraordinary items only if they meet the criteria of Accounting Principles Board Opinion No. 30, Reporting the Results of OperationsReporting the Effects of Disposal of a Segment
of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions Relating to Extraordinary Items. SFAS No. 145 also addresses financial accounting and reporting for capital leases that are modified in such a way as
to give rise to a new agreement classified as an operating lease. We believe that the adoption of SFAS No. 145 will not have a material impact on our consolidated financial position or our results of operations.



In June of 2002, the FASB issued SFAS No. 146 (SFAS No.
146), Accounting for Costs Associated with Exit or Disposal Activities, which is effective for exit or disposal activities initiated after December 31, 2002. SFAS No. 146 nullifies Emerging Issues Task Force Issue No. 94-3,
Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring). Under SFAS No. 146, a liability is required to be recognized for a cost associated
with an exit or disposal activity when the liability is incurred. SFAS No. 146 applies to costs associated with an exit activity that does not involve an entity newly acquired in a business combination or with a retirement or disposal activity
covered by FASB Statements No. 143, Accounting for Asset Retirement Obligations, and No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. We believe that the adoption of SFAS No. 146 will not have a
material impact on our consolidated financial position or our results of operations.



In November 2002, the FASB issued FASB Interpretation No. 45 (FIN 45), Guarantors Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of
Indebtedness of Others. FIN 45 requires that a liability be recorded in the guarantees that an entity has issued, including a reconciliation of changes in the entitys product warranty liabilities. The initial recognition and initial
measurement provisions of FIN 45 are applicable on a prospective basis to guarantees issued or modified after December 31, 2002, irrespective of interim or annual periods ending after December 15, 2002. The adoption of FIN 45 did not have a material
impact on our consolidated financial position or on our results of operations.



In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based CompensationTransition and Disclosurean amendment of FASB Statement No. 123. SFAS No. 148 provides
alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. SFAS No. 148 also requires prominent disclosures of the pro forma effect of using the fair value method of
accounting for stock-based employee compensation in both annual and interim financial statements. The transition and annual disclosure requirements of SFAS No. 148 are effective for fiscal years ending after December 15, 2002. The interim disclosure
requirements are effective for interim periods beginning after December 15, 2002. The adoption of SFAS No. 148 did not have a material impact on our consolidated financial position or on our results of operations.



In January 2003, the FASB issued FASB Interpretation No. 46
(FIN 46), Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51. FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in
the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is
effective immediately for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or
annual period beginning after June 15, 2003. We do not have any ownership in any variable interest entities as of December 31, 2002. We believe that the adoption of FIN 46 will not have a material impact on our consolidated financial position or on
our results of operations.



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|ITEM |  | 7A.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
|---- |  | -----------------------------------------------------------------



Our exposure to interest rate risk at December 31, 2002 is
related to our investment portfolio and our borrowings. Fixed rate investments and borrowings may have their fair market value adversely impacted from changes in interest rates. Floating rate investments may produce less income than expected if
interest rates fall, and floating rate borrowings will lead to additional interest expense if interest rates increase. Due in part to these factors, our future investment income may fall short of expectations due to changes in U.S. interest rates.



We invest our excess cash in debt instruments of
the U.S. government and its agencies and in high quality corporate issuers. As a result, other than changes in interest income due to changes in interest rates, we do not believe that near-term changes in interest rates will have a material effect
on our future results of operations. A hypothetical 10% increase or decrease in interest rates would not materially affect the fair value of our available-for-sale securities and the impact on our investment portfolio would be less than $100,000.



We have operated mainly in the United States,
and 93%, 98%, and 98% of our sales were made in U.S. dollars in 2002, 2001, and 2000 respectively. To date, we have not had any material exposure to foreign currency rate fluctuations. The majority of our European sales are derived from European
Union countries and are denominated in the Euro. Monthly income and expense from our European operations are translated using average rates and balance sheets are translated using month end rates. Differences are recorded within stockholders
equity (deficit) as a component of accumulated other comprehensive income (loss).



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ITEM 8.    CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA



KYPHON INC.



INDEX TO CONSOLIDATED FINANCIAL STATEMENTS



|                                                                                                                    |  | Page
|------------------------------------------------------------------------------------------------------------------- |  | ----
|Consolidated Financial Statements:                                                                                  |  |     
|Report of Independent Accountants                                                                                   |  | 36  
|Consolidated Statements of Operations for the three years ended December 31,
2002,2001 and 2000                     |  | 37  
|Consolidated Balance Sheets at December 31, 2002 and 2001                                                           |  | 38  
|Consolidated Statements of Cash Flows for the three years ended December 31,
2002,2001 and 2000                     |  | 39  
|Consolidated Statements of Stockholders Equity (Deficit) for the three years
endedDecember 31, 2002, 2001 and 2000 |  | 40  
|Notes to Consolidated Financial Statements                                                                          |  | 41  
|                                                                                                                   
|Financial Statement Schedule:                                                                                       |  |     
|Report of Independent Accountants on Financial Statement Schedule                                                   |  | 58  
|Schedule II Valuation and Qualifying Accounts                                                                       |  | 59  



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REPORT OF INDEPENDENT ACCOUNTANTS



The Board of Directors and Stockholders

Kyphon Inc.



In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the
financial position of Kyphon Inc. (the Company) and its subsidiaries at December 31, 2002 and 2001 and the results of their consolidated operations and their cash flows for each of the three years in the period ended December 31, 2002 in
conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Companys management; our responsibility is to express an opinion on these financial statements
and financial statement schedule based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting
principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.



/s/    PRICEWATERHOUSECOOPERS LLP



San Jose, California

January 31, 2003,

except for Note 14, as to which the date
is February 25, 2003



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KYPHON INC.



CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)



|                                                                                       |  | Years Ended December 31, |        
|-------------------------------------------------------------------------------------- |  | ------------------------ | -------
|                                                                                       |  | 2002                     |        
|Net sales                                                                              |  | $                        | 76,316 
|Cost of goods sold                                                                     |  |                          | 10,416 
|                                                                                       |  |                          |        
|Gross profit                                                                           |  |                          | 65,900 
|                                                                                       |  |                          |        
|Operating expenses:                                                                    |  |                          |        
|Research and development                                                               |  |                          | 10,145 
|Sales and marketing                                                                    |  |                          | 43,509 
|General and administrative                                                             |  |                          | 12,540 
|Purchased in-process research and development                                          |  |                          | 12,250 
|                                                                                       |  |                          |        
|Total operating expenses                                                               |  |                          | 78,444 
|                                                                                       |  |                          |        
|Loss from operations                                                                   |  |                          | (12,544
|Interest income                                                                        |  |                          | 929    
|Interest expense                                                                       |  |                          | (3,672 
|Other expense                                                                          |  |                          | (51    
|                                                                                       |  |                          |        
|Net loss                                                                               |  | $                        | (15,338
|                                                                                       |  |                          |        
|Net loss per common share, basic and diluted                                           |  | $                        | (0.63  
|                                                                                       |  |                          |        
|Weighted-average shares used in computing net loss per common share, basic and
diluted |  |                          | 24,405 
|                                                                                       |  |                          |        



The
accompanying notes are an integral part of these consolidated financial statements.



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KYPHON INC.



CONSOLIDATED BALANCE SHEETS

(in thousands, except per share amounts)



|                                                                                                                                                                                 |  | December 31, |        
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------ | -------
|                                                                                                                                                                                 |  | 2002         |        
|Assets                                                                                                                                                                           |  |              |        
|Current assets:                                                                                                                                                                  |  |              |        
|Cash and cash equivalents                                                                                                                                                        |  | $            | 49,867 
|Investments                                                                                                                                                                      |  |              | 21,224 
|Accounts receivable, net of allowance for doubtful accounts of $100 in 2002and
2001                                                                                              |  |              | 13,934 
|Inventories                                                                                                                                                                      |  |              | 4,416  
|Prepaid expenses and other current assets                                                                                                                                        |  |              | 1,683  
|Related party note receivable, net of discount                                                                                                                                   |  |              | 2,390  
|                                                                                                                                                                                 |  |              |        
|Total current assets                                                                                                                                                             |  |              | 93,514 
|Investments                                                                                                                                                                      |  |              | 3,212  
|Property and equipment, net                                                                                                                                                      |  |              | 4,265  
|Related party note receivable, net of discount                                                                                                                                   |  |              |       
|Other assets                                                                                                                                                                     |  |              | 533    
|                                                                                                                                                                                 |  |              |        
|Total assets                                                                                                                                                                     |  | $            | 101,524
|                                                                                                                                                                                 |  |              |        
|                                                                                                                                                                                
|Liabilities, Redeemable Convertible Preferred Stock andStockholders Equity
(Deficit)                                                                                            |  |              |        
|Current liabilities:                                                                                                                                                             |  |              |        
|Accounts payable                                                                                                                                                                 |  | $            | 2,518  
|Accrued liabilities                                                                                                                                                              |  |              | 7,492  
|Current portion of notes payable                                                                                                                                                 |  |              |       
|Convertible promissory notes                                                                                                                                                     |  |              |       
|                                                                                                                                                                                 |  |              |        
|Total current liabilities                                                                                                                                                        |  |              | 10,010 
|Notes payable, net of current portion                                                                                                                                            |  |              |       
|                                                                                                                                                                                 |  |              |        
|Total liabilities                                                                                                                                                                |  |              | 10,010 
|                                                                                                                                                                                 |  |              |        
|Commitments and contingencies (Note 6)                                                                                                                                           |  |              |        
|Redeemable convertible preferred stock, par value: $0.001 Authorized: no shares in 2002
and 26,438 shares in 2001 Issued and outstanding: none in 2002 and 26,291 shares in 2001 |  |              |       
|                                                                                                                                                                                 |  |              |        
|Stockholders equity (deficit):                                                                                                                                                  |  |              |        
|Preferred stock, par value: $0.001                                                                                                                                               |  |              |        
|Authorized: 5,000 shares; none issued and outstanding                                                                                                                            |  |              |       
|Common stock, par value: $0.001                                                                                                                                                  |  |              |        
|Authorized: 120,000 shares                                                                                                                                                       |  |              |        
|Issued: 37,360 shares in 2002 and 2,330 shares in 2001                                                                                                                           |  |              |        
|Outstanding: 37,330 shares in 2002 and 2,330 shares in 2001                                                                                                                      |  |              | 37     
|Additional paid-in capital                                                                                                                                                       |  |              | 163,354
|Treasury stock, at cost: 30 shares in 2002 and none in 2001                                                                                                                      |  |              | (201   
|Deferred stock-based compensation, net                                                                                                                                           |  |              | (11,947
|Accumulated other comprehensive income (loss)                                                                                                                                    |  |              | 302    
|Accumulated deficit                                                                                                                                                              |  |              | (60,031
|                                                                                                                                                                                 |  |              |        
|Total stockholders equity (deficit)                                                                                                                                             |  |              | 91,514 
|                                                                                                                                                                                 |  |              |        
|Total liabilities, redeemable convertible preferred stock and stockholders equity
(deficit)                                                                                     |  | $            | 101,524
|                                                                                                                                                                                 |  |              |        



The
accompanying notes are an integral part of these consolidated financial statements.



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KYPHON INC.



CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)



|                                                                                          |  | Years Ended December 31, |        
|----------------------------------------------------------------------------------------- |  | ------------------------ | -------
|                                                                                          |  | 2002                     |        
|Cash flows from operating activities:                                                     |  |                          |        
|Net loss                                                                                  |  | $                        | (15,338
|Adjustments to reconcile net loss to net cash provided by (used in) operating
activities: |  |                          |        
|Provision for doubtful accounts receivable                                                |  |                          | 3      
|Provision for excess and obsolete inventories                                             |  |                          | 470    
|Depreciation and amortization                                                             |  |                          | 1,298  
|Loss on disposal of property and equipment                                                |  |                          | 60     
|Non-cash interest expense                                                                 |  |                          | 3,081  
|Amortization of deferred stock-based compensation                                         |  |                          | 6,328  
|Realized gain on investments                                                              |  |                          |       
|Write-off of in-process research and development                                          |  |                          | 12,250 
|Changes in operating assets and liabilities:                                              |  |                          |        
|Accounts receivable                                                                       |  |                          | (8,358 
|Inventories                                                                               |  |                          | (2,493 
|Prepaid expenses and other current assets                                                 |  |                          | (1,739 
|Other assets                                                                              |  |                          | 1,100  
|Accounts payable                                                                          |  |                          | 518    
|Accrued liabilities                                                                       |  |                          | 3,757  
|                                                                                          |  |                          |        
|Net cash provided by (used in) operating activities                                       |  |                          | 937    
|                                                                                          |  |                          |        
|                                                                                         
|Cash flows from investing activities:                                                     |  |                          |        
|Acquisition of property and equipment                                                     |  |                          | (2,571 
|Proceeds from disposal of property and equipment                                          |  |                          | 20     
|Maturities and sales of investments                                                       |  |                          |       
|Purchases of investments                                                                  |  |                          | (24,663
|Purchase of in-process research and development                                           |  |                          | (12,250
|                                                                                          |  |                          |        
|Net cash used in investing activities                                                     |  |                          | (39,464
|                                                                                          |  |                          |        
|Cash flows from financing activities:                                                     |  |                          |        
|Proceeds from issuance of common stock, net                                               |  |                          | 94,925 
|Proceeds from issuance of redeemable convertible preferred stock, net                     |  |                          |       
|Repurchase of common stock                                                                |  |                          | (23    
|Proceeds from exercise of warrants                                                        |  |                          | 77     
|Proceeds from exercise of stock options                                                   |  |                          | 1,254  
|Proceeds from payment of related party note receivable                                    |  |                          | 379    
|Issuance of related party note receivable                                                 |  |                          |       
|Acquisition of treasury stock                                                             |  |                          | (201   
|Proceeds from convertible promissary notes                                                |  |                          | 2,000  
|Repayment of convertible promissory notes                                                 |  |                          | (13,300
|Repayment of notes payable                                                                |  |                          | (159   
|                                                                                          |  |                          |        
|Net cash provided by financing activities                                                 |  |                          | 84,952 
|                                                                                          |  |                          |        
|Effect of foreign exchange rates on cash                                                  |  |                          | 90     
|Net increase (decrease) in cash and cash equivalents                                      |  |                          | 46,515 
|Cash and cash equivalents at beginning of year                                            |  |                          | 3,352  
|                                                                                          |  |                          |        
|Cash and cash equivalents at end of year                                                  |  | $                        | 49,867 
|                                                                                          |  |                          |        
|Supplementary disclosure of noncash financing activities:                                 |  |                          |        
|Deferred stock-based compensation                                                         |  | $                        | 2,193  
|                                                                                          |  |                          |        
|Issuance of warrants                                                                      |  | $                        | 1,540  
|                                                                                          |  |                          |        
|Conversion of redeemable convertible preferred stock to common stock                      |  | $                        | 38,024 
|                                                                                          |  |                          |        
|Supplemental disclosure of cash flow information:                                         |  |                          |        
|Cash paid during period for interest                                                      |  | $                        | 854    
|                                                                                          |  |                          |        



The
accompanying notes are an integral part of these consolidated financial statements.



39



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##### Table of Contents

KYPHON INC.



CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY

(in thousands)



|                                                                                                 |  | Common Stock |   | Additional Paid-In Capital |        |    | Treasury Stock |   |         | Deferred Stock-Based Compensation |  |   | Accumulated Other Comprehensive Income (Loss) |   |  | Accumulated Deficit |         |   | Total Stockholders Equity (Deficit) |  
|------------------------------------------------------------------------------------------------ |  | ------------ | - | -------------------------- | ------ | -- | -------------- | - | ------- | --------------------------------- |  | - | --------------------------------------------- | - |  | ------------------- | ------- | - | ------------------------------------ | -
|                                                                                                 |  | Shares       |   |                            | Amount |    |                |   |         |                                   | 
|Balance at January 1, 2000                                                                       |  | 1,756        |   |                            | $      | 2  |                | $ | 904     |                                   |  | $ |                                              |   |  | $                   | (768    | ) |                                      | $
|Exercise of stock options                                                                        |  | 582          |   |                            |        |   |                |   | 201     |                                   |  |   |                                              |   |  |                     |        |   |                                      |  
|Issuance of warrants to purchase Series E redeemable convertible preferred
stock                 |  |             |   |                            |        |   |                |   | 52      |                                   |  |   |                                              |   |  |                     |        |   |                                      |  
|Change in unrealized appreciation on available-for-sale securities                               |  |             |   |                            |        |   |                |   |        |                                   |  |   |                                              |   |  |                     |        |   |                                      |  
|Deferred stock-based compensation                                                                |  |             |   |                            |        |   |                |   | 7,367   |                                   |  |   |                                              |   |  |                     | (7,367  | ) |                                      |  
|Amortization of deferred stock-based compensation                                                |  |             |   |                            |        |   |                |   |        |                                   |  |   |                                              |   |  |                     | 1,354   |   |                                      |  
|Net loss                                                                                         |  |             |   |                            |        |   |                |   |        |                                   |  |   |                                              |   |  |                     |        |   |                                      |  
|                                                                                                 |  |              |   |                            |        |    |                |   |         |                                   |  |   |                                               |   |  |                     |         |   |                                      |  
|Balance at December 31, 2000                                                                     |  | 2,338        |   |                            |        | 2  |                |   | 8,524   |                                   |  |   |                                              |   |  |                     | (6,781  | ) |                                      |  
|Exercise of stock options                                                                        |  | 461          |   |                            |        |   |                |   | 165     |                                   |  |   |                                              |   |  |                     |        |   |                                      |  
|Repurchase of common stock                                                                       |  | (469         | ) |                            |        |   |                |   | (24     | )                                 |  |   |                                              |   |  |                     |        |   |                                      |  
|Cumulative translation adjustment                                                                |  |             |   |                            |        |   |                |   |        |                                   |  |   |                                              |   |  |                     |        |   |                                      |  
|Deferred stock-based compensation                                                                |  |             |   |                            |        |   |                |   | 14,457  |                                   |  |   |                                              |   |  |                     | (14,457 | ) |                                      |  
|Amortization of deferred stock-based compensation                                                |  |             |   |                            |        |   |                |   |        |                                   |  |   |                                              |   |  |                     | 5,156   |   |                                      |  
|Net loss                                                                                         |  |             |   |                            |        |   |                |   |        |                                   |  |   |                                              |   |  |                     |        |   |                                      |  
|                                                                                                 |  |              |   |                            |        |    |                |   |         |                                   |  |   |                                               |   |  |                     |         |   |                                      |  
|Balance at December 31, 2001                                                                     |  | 2,330        |   |                            |        | 2  |                |   | 23,122  |                                   |  |   |                                              |   |  |                     | (16,082 | ) |                                      |  
|Exercise of stock options                                                                        |  | 1,742        |   |                            |        | 2  |                |   | 1,252   |                                   |  |   |                                              |   |  |                     |        |   |                                      |  
|Repurchase of common stock                                                                       |  | (30          | ) |                            |        |   |                |   | (23     | )                                 |  |   |                                              |   |  |                     |        |   |                                      |  
|Issuance of common stock upon filing of initial public offering, net of issuance costs
of $1,330 |  | 6,900        |   |                            |        | 7  |                |   | 94,918  |                                   |  |   |                                              |   |  |                     |        |   |                                      |  
|Conversion of redeemable convertible preferred stock into common stock                           |  | 26,291       |   |                            |        | 26 |                |   | 37,998  |                                   |  |   |                                              |   |  |                     |        |   |                                      |  
|Issuance of common stock upon exercise of warrants                                               |  | 78           |   |                            |        |   |                |   | 77      |                                   |  |   |                                              |   |  |                     |        |   |                                      |  
|Conversion of promissory note                                                                    |  | 49           |   |                            |        |   |                |   | 736     |                                   |  |   |                                              |   |  |                     |        |   |                                      |  
|Warrants issued in connection with promissory notes                                              |  |             |   |                            |        |   |                |   | 1,540   |                                   |  |   |                                              |   |  |                     |        |   |                                      |  
|Beneficial conversion feature associated with promissory notes                                   |  |             |   |                            |        |   |                |   | 1,541   |                                   |  |   |                                              |   |  |                     |        |   |                                      |  
|Acquisition of treasury stock                                                                    |  | (30          | ) |                            |        |   |                |   |        |                                   |  |   | (201                                          | ) |  |                     |        |   |                                      |  
|Cumulative translation adjustment                                                                |  |             |   |                            |        |   |                |   |        |                                   |  |   |                                               |   |  |                     |        |   |                                      |  
|Unrealized loss on available-for-sale securities                                                 |  |             |   |                            |        |   |                |   |        |                                   |  |   |                                               |   |  |                     |        |   |                                      |  
|Deferred stock-based compensation                                                                |  |             |   |                            |        |   |                |   | 2,193   |                                   |  |   |                                              |   |  |                     | (2,193  | ) |                                      |  
|Amortization of deferred stock-based compensation                                                |  |             |   |                            |        |   |                |   |        |                                   |  |   |                                              |   |  |                     | 6,328   |   |                                      |  
|Net loss                                                                                         |  |             |   |                            |        |   |                |   |        |                                   |  |   |                                              |   |  |                     |        |   |                                      |  
|                                                                                                 |  |              |   |                            |        |    |                |   |         |                                   |  |   |                                               |   |  |                     |         |   |                                      |  
|Balance at December 31, 2002                                                                     |  | 37,330       |   |                            | $      | 37 |                | $ | 163,354 |                                   |  | $ | (201                                          | ) |  | $                   | (11,947 | ) |                                      | $
|                                                                                                 |  |              |   |                            |        |    |                |   |         |                                   |  |   |                                               |   |  |                     |         |   |                                      |  



The
accompanying notes are an integral part of these consolidated financial statements.



40



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##### Table of Contents

KYPHON INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS





1.    ORGANIZATION



Kyphon Inc. (Kyphon or the Company) was incorporated in the state of Delaware on January 10, 1994 and commenced operations in September 1996. The Company develops medical devices to restore spinal anatomy
using minimally invasive technology. The Companys initial marketing focus is on surgeons who repair spine fractures caused by osteoporosis. The Companys first commercial products, comprising the KyphX instruments, utilize the
Companys proprietary balloon technology. Surgeons use those tools to help repair fractures during minimally-invasive spine surgeries.



2.    SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES



Basis of Consolidation and Foreign Currency Translation



The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries.
All material intercompany balances and transactions have been eliminated.



The Companys international subsidiaries use the local currency as their functional currency. Assets and liabilities are translated at exchange rates in effect at the balance sheet date and revenue and expense accounts
at average exchange rates during the period. Resulting translation adjustments are recorded directly to a separate component of stockholders equity (deficit).



Use of Estimates



The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America
requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and
expenses during the reporting period. Actual results could differ from those estimates.



Cash and Cash Equivalents



The Company considers all highly liquid investments purchased with original maturities of three months or less to be cash equivalents. Cash and cash equivalents include money market funds, certificates of deposit, and commercial
paper.



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##### Table of Contents

KYPHON INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)





Investments



All investments are classified as
available-for-sale and therefore are carried at fair market value. Unrealized gains and losses on such securities are reported as a separate component of stockholders equity (deficit). Realized gains and losses on sale of all such securities
are reported in earnings and computed using the specific identification cost method. The Company did not have any available-for-sale securities in 2001. As of December 31, 2002, the Companys available-for-sale securities are summarized as
follows (in thousands):



|                                               |  | Amortized Cost |        | Gross Unrealized Gains |   | Gross Unrealized Losses |  |   | Fair Value
|---------------------------------------------- |  | -------------- | ------ | ---------------------- | - | ----------------------- |  | - | ----------
|Certificates of deposit and money market funds |  | $              | 3,235  |                        | $ |                        |  | $ |          
|Corporate notes and bonds                      |  |                | 26,619 |                        |   | 68                      |  |   | (2        
|                                               |  |                |        |                        |   |                         |  |   |           
|Total                                          |  | $              | 29,854 |                        | $ | 68                      |  | $ | (2        
|                                               |  |                |        |                        |   |                         |  |   |           
|Reported as:                                   |  |                |        |                        |   |                         |  |   |           
|Cash and cash equivalents                      |  |                |        |                        |   |                         |  |   |           
|Short-term investments                         |  |                |        |                        |   |                         |  |   |           
|Long-term investments                          |  |                |        |                        |   |                         |  |   |           
|                                               |  |                |        |                        |   |                         |  |   |           
|Total                                          |  |                |        |                        |   |                         |  |   |           
|                                               |  |                |        |                        |   |                         |  |   |           



As of
December 31, 2002, maturities of available-for sale securities are summarized as follows (in thousands):



|                                                |  | Fair Value
|----------------------------------------------- |  | ----------
|Corporate notes and bonds:                      |  |           
|Original maturities of three months or less     |  | $         
|Maturities of one year or less                  |  |           
|Maturities between one and two years            |  |           
|                                                |  |           
|                                                |  |           
|Certificates of deposit and money market funds: |  |           
|Original maturities of three months or less     |  |           
|                                                |  |           
|Total                                           |  | $         
|                                                |  |           



Allowance for
Doubtful Accounts



The Company estimates the
allowance for doubtful accounts related to trade receivables based on an evaluation of the specific accounts where the Company has information that the customer may have an inability to meet its financial obligations. In those cases, the Company
uses its judgment, based on the best available facts and circumstances, and records a specific reserve for that customer against amounts due to reduce the receivable to the amount that is expected to be collected. These specific reserves are
reevaluated and adjusted as additional information is received that impacts the amount reserved.



Inventories



Inventories are stated at the lower of cost (principally standard cost, which approximates actual cost on a first-in, first-out basis) or market value. Inventory costs include direct materials, direct labor, direct
subcontract

costs, and manufacturing overhead. Reserves for potentially excess and obsolete inventory are made based on management analysis
of inventory levels and future sales forecasts.



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##### Table of Contents

KYPHON INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)





Depreciation and
Amortization



Property and equipment are
stated at cost less accumulated depreciation and amortization. Depreciation is provided using the straight-line method over the estimated useful lives of the assets, generally one to five years. Amortization of leasehold improvements is provided on
a straight-line basis over the life of the related asset or the lease term, if shorter. Upon sale or retirement of assets, the cost and related accumulated depreciation and amortization are removed from the balance sheet and the resulting gain or
loss is reflected in other expense.



Impairment of Long-Lived
Assets



The Company reviews long-lived
assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset might not be recoverable. When such an event occurs, management determines whether there has been an impairment by comparing the
anticipated undiscounted future net cash flows to the related assets carrying value. If an asset is considered impaired, the asset is written down to fair value, which is determined based either on discounted cash flows or appraised value,
depending on the nature of the asset.



Concentrations of
Credit Risk and Other Risks and Uncertainties



The Companys cash and cash equivalents are deposited with one major financial institution in the United States of America. Deposits in this institution may exceed the amount of insurance provided on such deposits.



For financial instruments consisting of cash and cash
equivalents, accounts receivable, accounts payable and accrued liabilities included in the Companys financial statements, the carrying amounts approximate fair value due to their short maturities. Estimated fair values for marketable
securities, which are separately disclosed elsewhere, are based on quoted market prices for the same or similar instruments.



The Companys accounts receivable are derived from net sales earned from customers located in the United States of America, Europe,
and Southeast Asia. The Company performs ongoing credit evaluations of its customers financial condition and, generally, requires no collateral from its customers.



No customer accounted for more than 10% of total net sales for the years ended December 31, 2002, 2001 and
2000. No customer accounted for more than 10% of total accounts receivable at December 31, 2002, and 2001.



Some of the Companys products require clearance or approval from the United States Food and Drug Administration (FDA)
prior to the commencement of commercialized sales. In July 1998, the Company received initial FDA clearance for its KyphXInflatable Bone Tamp. In February 2001, the Company received an additional 510(k) clearance that clarified that the KyphXInflatable Bone Tamp is intended for use in the spine, hand, tibia, radius and calcaneus. Internationally, the Company received CE Mark approval to market its products from the European regulatory
agency in April 2000. The Company cannot be assured that future products will receive the necessary approvals or clearances. If the Company is denied approval or clearance or if approval or clearance is delayed, this may have a material adverse
impact on the Company.



The Company is subject to
risks common to companies in the medical device industry including, but not limited to, new technological innovations, dependence on key personnel, protection of proprietary technology, compliance with government regulations, uncertainty of market
acceptance of products, product liability and the need to obtain additional financing.



43



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##### Table of Contents

KYPHON INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)





Revenue Recognition



The Companys revenue is derived from
the sale of its products. Revenue from product sales, net of discounts, is recognized upon receipt of a valid purchase order, shipment of the products to customers and when collection of the receivables is deemed probable.



Research and Development



Research and development expenses are charged to operations
as incurred.



Advertising Costs



Advertising costs, included in sales and marketing expenses,
are expensed as incurred. Advertising costs were approximately $1,873,000, $919,000, and $424,000 for the years ended December 31, 2002, 2001 and 2000, respectively.



Income Taxes



The Company accounts for income taxes under the liability method where by deferred tax asset or liability account balances are calculated
at the balance sheet date using current tax laws and rates in effect for the year in which the differences are expected to affect taxable income.



Segments



The Company operates in one segment, using one measurement of profitability to manage its business. As of December 31, 2002 and 2001, 91%
and 98%, respectively, of all long-lived assets were maintained in the United States of America. For the years ended December 31, 2002, 2001 and 2000, 93%, 98% and 98%, respectively, of net sales were generated in the United States of America.



Treasury Stock



In November 2002, the Board of Directors approved a stock
repurchase program pursuant to which up to 2,000,000 shares of the Companys outstanding common stock may be repurchased from time to time. The duration of the repurchase program is open-ended. Under the program, the Company may purchase shares
of common stock through open market transactions at prices deemed appropriate by management. As of December 31, 2002, the Company held 30,000 shares of treasury stock. Treasury stock is accounted for by the cost method.



Accounting for Stock-Based Compensation



The Company uses the intrinsic value method of Accounting
Principles Board Opinion No. 25 (APB No. 25), Accounting for Stock Issued to Employees, in accounting for its employee stock options, and presents disclosure of pro forma information required under Statement of Financial
Accounting Standards No. 123 (SFAS No. 123), Accounting for Stock-Based Compensation (see Note 9).



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##### Table of Contents

KYPHON INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)





The
following table provides a reconciliation of net loss to pro forma net loss as if the fair value method has been applied to all awards (in thousands, except per share amounts):



|                                                                                                                |  | Years Ended December 31, |        
|--------------------------------------------------------------------------------------------------------------- |  | ------------------------ | -------
|                                                                                                                |  | 2002                     |        
|Net loss, as reported                                                                                           |  | $                        | (15,338
|Add: Stock-based employee compensation expense included in reported net
loss                                    |  |                          | 5,183  
|Deduct: Total stock-based employee compensation expense determined under fair value
based method for all awards |  |                          | (6,313 
|                                                                                                                |  |                          |        
|Pro forma net loss                                                                                              |  | $                        | (16,468
|                                                                                                                |  |                          |        
|Net loss per common share, basic and diluted                                                                    |  |                          |        
|As reported                                                                                                     |  | $                        | (0.63  
|Pro forma                                                                                                       |  | $                        | (0.67  



The
Company accounts for equity instruments issued to non-employees in accordance with the provisions of SFAS No. 123 and Emerging Issues Task Force Issue No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for
Acquiring, or in Conjunction with Selling, Goods or Services, which require that these equity instruments are recorded at their fair value on the measurement date. The measurement of stock-based compensation is subject to periodic adjustment
as the underlying equity instruments vest.



Comprehensive
Income (Loss)



Comprehensive income (loss)
generally represents all changes in stockholders equity (deficit) except those resulting from investments or contributions by stockholders. The Companys unrealized gain (loss) on available-for-sale securities and cumulative translation
adjustment represent the components of comprehensive loss that are excluded from the net loss.



The changes in components of comprehensive loss for the periods presented are as follows (in thousands):



|                                                        |  | Years Ended December 31, |        
|------------------------------------------------------- |  | ------------------------ | -------
|                                                        |  | 2002                     |        
|Net loss                                                |  | $                        | (15,338
|Unrealized gain (loss) on available-for-sale securities |  |                          | 66     
|Cumulative translation adjustment                       |  |                          | 252    
|                                                        |  |                          |        
|Comprehensive loss                                      |  | $                        | (15,020
|                                                        |  |                          |        



Net Loss per Common
Share



Basic net loss per share is computed
by dividing net loss by the weighted-average number of common shares outstanding for the period. Diluted net loss per share is computed giving effect to all potential dilutive common stock, including options, warrants, convertible promissory notes
and redeemable convertible preferred stock. Options, common stock subject to a right of repurchase, warrants, convertible promissory notes and redeemable convertible preferred stock were not included in the computation of diluted net loss per share
for the Company because the effect would be antidilutive.



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##### Table of Contents

KYPHON INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)





A
reconciliation of the numerator and denominator used in the calculation of basic and diluted net loss per common share follows (in thousands):



|                                                                                      |  | Years Ended December 31, |        
|------------------------------------------------------------------------------------- |  | ------------------------ | -------
|                                                                                      |  | 2002                     |        
|Numerator:                                                                            |  |                          |        
|Net loss                                                                              |  | $                        | (15,338
|                                                                                      |  |                          |        
|Denominator:                                                                          |  |                          |        
|Weighted-average common stock outstanding                                             |  |                          | 24,514 
|Less: weighted-average shares subject to repurchase                                   |  |                          | (109   
|                                                                                      |  |                          |        
|Weighted-average shares used in computing basic and diluted net loss per common
share |  |                          | 24,405 
|                                                                                      |  |                          |        



The
following potential dilutive securities were excluded from the computation of diluted net loss per common share, as they had an antidilutive effect (in thousands):



|                                       |  | December 31,
|-------------------------------------- |  | ------------
|                                       |  | 2002        
|Options to purchase common stock       |  | 6,826       
|Common stock subject to repurchase     |  | 34          
|Redeemable convertible preferred stock |  |            
|Warrants                               |  | 64          



Reclassification



Certain amounts in the prior year
consolidated financial statements have been reclassified to conform to the current years presentation. The reclassification had no impact on the previously reported net loss.



Recent Accounting Pronouncements



In April of 2002, the Financial Accounting Standards Board (FASB) issued SFAS No. 145,
Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections, which is effective for fiscal years beginning after May 15, 2002. Under SFAS No. 145, gains and losses from the extinguishment
of debt should be classified as extraordinary items only if they meet the criteria of Accounting Principles Board Opinion No. 30, Reporting the Results of OperationsReporting the Effects of Disposal of a Segment of a Business, and
Extraordinary, Unusual and Infrequently Occurring Events and Transactions Relating to Extraordinary Items. SFAS No. 145 also addresses financial accounting and reporting for capital leases that are modified in such a way as to give rise to a
new agreement classified as an operating lease. The Company believes that the adoption of SFAS No. 145 will not have a material impact on the consolidated financial position or results of the operations of the Company.



In June of 2002, the FASB issued SFAS No. 146 (SFAS No.
146), Accounting for Costs Associated with Exit or Disposal Activities, which is effective for exit or disposal activities initiated after December 31, 2002. SFAS No. 146 nullifies Emerging Issues Task Force Issue No. 94-3,
Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring). Under SFAS No. 146, a liability is required to be recognized for a cost associated
with an exit or disposal activity when the liability is incurred. SFAS No. 146 applies to costs associated with an exit activity that



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##### Table of Contents

KYPHON INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



does not involve an entity newly acquired in a business combination or with a retirement or disposal activity covered by FASB Statements No.
143, Accounting for Asset Retirement Obligations, and No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. The Company believes that the adoption of SFAS No. 146 will not have a material impact on the
consolidated financial position or results of the operations of the Company.



In November 2002, the FASB issued FASB Interpretation No. 45 (FIN 45), Guarantors Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of
Indebtedness of Others. FIN 45 requires that a liability be recorded in the guarantees that an entity has issued, including a reconciliation of changes in the entitys product warranty liabilities. The initial recognition and initial
measurement provisions of FIN 45 are applicable on a prospective basis to guarantees issued or modified after December 31, 2002, irrespective of interim or annual periods ending after December 15, 2002. The adoption of FIN 45 did not have a material
impact on the Companys consolidated financial position or on its results of operations.



In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based Compensation- Transition and Disclosurean amendment of FASB Statement No. 123. SFAS No. 148 provides
alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. SFAS No. 148 also requires prominent disclosures of the pro forma effect of using the fair value method of
accounting for stock-based employee compensation in both annual and interim financial statements. The transition and annual disclosure requirements of SFAS No. 148 are effective for fiscal years ending after December 15, 2002. The interim disclosure
requirements are effective for interim periods beginning after December 15, 2002. The adoption of SFAS No. 148 did not have a material impact on the Companys consolidated financial position or on its results of operations.



In January 2003, the FASB issued FASB Interpretation No. 46
(FIN 46), Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51. FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in
the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is
effective immediately for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or
annual period beginning after June 15, 2003. The Company does not have any ownership in any variable interest entities as of December 31, 2002. The Company believes that the adoption of FIN 46 will not have a material impact on the Companys
consolidated financial position or on its results of operations.



3.    BALANCE SHEET COMPONENTS



Inventories



|                |  | December 31,
|--------------- |  | ------------
|                |  | 2002        
|Raw materials   |  | $           
|Work-in-process |  |             
|Finished goods  |  |             
|                |  |             
|                |  | $           
|                |  |             



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##### Table of Contents

KYPHON INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)





Property and Equipment



|                                                |  | December 31, |       
|----------------------------------------------- |  | ------------ | ------
|                                                |  | 2002         |       
|Furniture and fixtures                          |  | $            | 1,054 
|Computer software and hardware                  |  |              | 2,615 
|Laboratory and manufacturing equipment          |  |              | 2,080 
|Leasehold improvements                          |  |              | 811   
|                                                |  |              |       
|                                                |  |              | 6,560 
|Less: Accumulated depreciation and amortization |  |              | (2,841
|Plus: Construction-in-progress                  |  |              | 546   
|                                                |  |              |       
|                                                |  | $            | 4,265 
|                                                |  |              |       



Accrued Liabilities



|                                         |  | December 31,
|---------------------------------------- |  | ------------
|                                         |  | 2002        
|Payroll and related                      |  | $           
|Legal, accounting, and professional fees |  |             
|Professional training course             |  |             
|Travel and entertainment                 |  |             
|Interest on convertible promissory notes |  |             
|Deferred rent                            |  |             
|Other                                    |  |             
|                                         |  |             
|                                         |  | $           
|                                         |  |             



4.    NOTES PAYABLE



In 1997 and 1998, the Company entered into two equipment financing lines totaling $650,000. Prior to the lines expirations, the Company had drawn down $541,800, which was collateralized by the related equipment. Both of these
lines were repaid entirely in June 2002. The Company issued warrants to purchase an aggregate of 18,358 shares of convertible preferred stock to the lenders in connection with these lines at a weighted-average exercise price of $0.62 per share. To
effect a cashless exercise of the warrants, 17,601 shares of common stock were issued subsequent to the Companys initial public offering. No warrants were outstanding related to the equipment lease as of December 31, 2002.



5.    CONVERTIBLE PROMISSORY NOTES



Between July 2001 and February 2002, the Company raised
$13,300,000 through the sale of convertible promissory notes with several affiliates pursuant to a loan agreement. The convertible promissory notes bore interest at 10% rate per annum. The outstanding principal and accrued interest were repaid upon
the closing of the Companys initial public offering. In addition, in November 2001, the Company raised $700,000 through the sale of a convertible promissory note to one affiliate pursuant to the same loan agreement. The principal and accrued
interest due on this note automatically converted into 49,090 shares of the Companys common stock at the initial public offering price of $15.00 per share. As required by the terms of the loan agreement, upon the closing date of the
Companys initial public offering, the Company issued warrants exercisable for an aggregate



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KYPHON INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



of 99,334 shares of the Companys common stock at an exercise price of $0.01 per share to the holders of the convertible promissory
notes. As of December 31, 2002, warrants for an aggregate of 64,070 shares of the Companys common stock remained outstanding and exercisable.



The Company allocated the gross proceeds received from the convertible promissory notes and accrued interest to the convertible promissory
notes and the warrants, based on their relative fair values. This allocation resulted in $13,300,000 of the proceeds being assigned to the convertible promissory note and $1,540,500 being assigned to the warrants. The warrants were valued at the May
22, 2002 issuance date using the Black-Scholes pricing model. The Company recognized the allocated fair value of the warrants of $1,540,500 as an immediate charge to interest expense. Based on the difference between the effective conversion price of
the proceeds allocated to the convertible promissory notes and the fair market value of the common stock at the issuance date, the Company determined that the allocated value of the convertible promissory notes contained a beneficial conversion
feature. The beneficial conversion feature, amounting to $1,540,500, represented additional interest yield on the convertible promissory notes and was also recognized as an immediate charge to interest expense.



6.    COMMITMENTS AND CONTINGENCIES



Facility Lease



The Company leases office space under non-cancellable
operating leases expiring in March 2005. Under the terms of the lease agreement, the Company has the option to extend the lease term through March 2010. In addition, warrants to purchase 25,000 shares of Series E convertible preferred stock at an
exercise price of $3.09 per share were issued to the lessor in conjunction with the lease. The fair value of these warrants was $51,475, determined using the Black-Scholes pricing model, has been charged to additional paid-in capital and is being
amortized to rent expense over the life of the lease. The warrants were exercised for 25,000 shares of common stock subsequent to the Companys initial public offering.



Future minimum facility lease payments are as follows (in thousands):



|Years Ending December 31, |  |  
|------------------------- |  | -
|2003                      |  | $
|2004                      |  |  
|2005                      |  |  
|                          |  |  
|                          |  | $
|                          |  |  



Under
the terms of the lease agreement, the Company is liable for the cost of restoring unapproved changes or improvements to the facility unless the changes or improvements are approved by lessor. The lease is collateralized by a $286,300 security
deposit, which is included in other assets.



Rent
expense for the years ended December 31, 2002, 2001 and 2000 was $1,209,700, $1,073,700, and $933,300, respectively.



Litigation



In April 2000, a former employee filed a complaint against the Company in the Superior Court of California for wrongful termination. In
September 2000, this action was stayed by court order and the dispute was ordered to binding arbitration in accordance with arbitration provisions contained in the former employees employment agreement. In November 2002, the parties settled
the outstanding litigation.



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KYPHON INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)





From time
to time, the Company may become involved in litigation relating to additional claims arising from the ordinary course of business.



7.    INITIAL PUBLIC OFFERING



On May 17, 2002, the Company completed an initial public offering in which it sold 6,000,000 shares of common stock at $15.00 per share
for net cash proceeds of approximately $82,400,000, net of underwriting discounts, commissions and other offering costs. Upon the closing of the offering, all the Companys outstanding shares of redeemable convertible preferred stock converted
into 26,151,288 shares of common stock. On May 29, 2002, the underwriters exercised the over-allotment option to purchase an additional 900,000 shares, resulting in net cash proceeds of approximately $12,555,000.



8.    REDEEMABLE CONVERTIBLE PREFERRED STOCK



Under the Companys Amended and
Restated Certificate of Incorporation, as amended, the Companys redeemable convertible preferred stock is issuable in series and the Companys Board of Directors is authorized to determine the rights, preferences and terms of each series.
In January 2002, 140,000 shares of the Companys redeemable convertible preferred stock converted to common stock. Upon the closing of the Companys initial public offering in May 2002, the remaining outstanding shares of redeemable
convertible preferred stock converted into 26,151,288 shares of common stock.



As of December 31, 2001 and 2000, the redeemable convertible preferred stock comprises:



|Series   |  | Shares Designated |  | Shares Issued and Outstanding |  | ProceedsNet of IssuanceCosts and Repurchases |            |   | Noncumulative Annual DividendsPer Share |   | Liquidation Preference Per Share |  | Conversion Value/Price Per Share
|-------- |  | ----------------- |  | ----------------------------- |  | -------------------------------------------- | ---------- | - | --------------------------------------- | - | -------------------------------- |  | --------------------------------
|Series A |  | 3,065,000         |  | 3,065,000                     |  | $                                            | (208,683   | ) |                                         | $ | 0.028                            |  | $                               
|Series B |  | 3,466,872         |  | 3,457,144                     |  |                                              | 1,191,780  |   |                                         | $ | 0.028                            |  | $                               
|Series C |  | 4,772,654         |  | 4,764,023                     |  |                                              | 2,523,369  |   |                                         | $ | 0.042                            |  | $                               
|Series D |  | 6,633,590         |  | 6,633,590                     |  |                                              | 8,675,618  |   |                                         | $ | 0.105                            |  | $                               
|Series E |  | 8,500,000         |  | 8,371,531                     |  |                                              | 25,841,980 |   |                                         | $ | 0.247                            |  | $                               
|         |  |                   |  |                               |  |                                              |            |   |                                         |   |                                  |  |                                 
|         |  | 26,438,116        |  | 26,291,288                    |  | $                                            | 38,024,064 |   |                                         |   |                                  |  |                                 
|         |  |                   |  |                               |  |                                              |            |   |                                         |   |                                  |  |                                 



9.    STOCKHOLDERS EQUITY (DEFICIT)



Preferred Stock



In April 2002, the Board of Directors approved an amendment to the Companys certificate of incorporation to authorize 5,000,000 shares of undesignated preferred stock. The Companys Board of Directors is authorized to
determine the designation, powers, preferences and rights of preferred stock.



Common Stock



Each share
of common stock is entitled to one vote. The holders of common stock are also entitled to receive dividends whenever funds are legally available and when declared by the Board of Directors, subject to the prior rights of holders of all classes of
stock outstanding. No dividends have been declared or paid as of December 31, 2002.



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KYPHON INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)





The
Company issued shares of its common stock to certain employees under stock purchase agreements, some of which contain repurchase provisions in the event of termination of employment. The shares are generally released from repurchase provisions
ratably over four years. Included in common stock as of December 31, 2002 and December 31, 2001 are 34,371 and 112,500 shares subject to the Companys right of repurchase, respectively.



2002 Employee Stock Purchase Plan



In April 2002, the Board of Directors adopted the 2002
Employee Stock Purchase Plan (2002 ESPP), under which eligible employees are permitted to purchase common stock at a discount through payroll deductions. 750,000 shares of common stock were reserved for issuance and will be increased on
the first day of each fiscal year, commencing in 2003, by an amount equal to the lesser of (i) 1,500,000, (ii) 2.0% of the outstanding shares of common stock on such date or (iii) an amount as determined by the Board of Directors. The 2002 ESPP
contains consecutive, overlapping twenty-four-month offering periods. Each offering period includes four six-month purchase periods. The price of the common stock purchased shall be the lower of 85% of the fair market value of the common stock at
the beginning of an offering period or at the end of a purchase period. The initial offering period commenced on May 17, 2002, the effective date of the Companys initial public offering.



2002 Director Option Plan



In April 2002, the Board of Directors adopted the 2002
Director Option Plan. The 2002 Director Options Plan, which will terminate no later than 2012, provides for the granting of nonstatutory stock options to non-employee directors. 200,000 shares of common stock were reserved for issuance and will be
increased on the first day of each fiscal year, commencing in 2003, by an amount equal to the lesser of (i) the number of shares subject to options granted under the 2002 Director Option Plan in the prior fiscal year or (ii) an amount as determined
by the Board of Directors.



2002 Stock Plan



In April 2002, the Board of Directors adopted the 2002 Stock
Plan. The 2002 Stock Plan, which will terminate no later than 2012, provides for the granting of incentive stock options to employees and nonstatutory stock options to employees, directors and consultants. 2,500,000 shares of common stock were
reserved for issuance and will be increased on the first day of each fiscal year, commencing in 2003, by an amount equal to the lesser of (i) 3,500,000, (ii) 5.0% of the outstanding shares of common stock on the last day of the preceding fiscal year
or (iii) an amount as determined by the Board of Directors.



1996 Stock Plan



The
Company has reserved shares of common stock for issuance under the 1996 Stock Incentive Plan (the 1996 Plan). Under the Plan, the Board of Directors may issue incentive stock options to employees and nonstatutory stock options to
consultants or employees of the Company.



For the
2002 Director, 2002 and 1996 Stock Plans, the Board of Directors has the authority to determine to whom options will be granted, the number of shares, the term and exercise price (which cannot be less than the estimated fair market value at date of
grant for incentive stock options or 85% of estimated fair market value for nonqualified stock options). If an employee owns stock representing more than 10% of the outstanding shares, the price of each share shall be at least 110% of estimated fair
market value, as determined by the Board of Directors. The options are exercisable at times and increments as specified by the Board of Directors, and generally expire ten years from date of grant.



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KYPHON INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)





Activities
under the Plans are as follows:



|                            |  |                            |   |  | Options Outstanding
|--------------------------- |  | -------------------------- | - |  | -------------------
|                            |  |                            |   |  | Employees          
|                            |  | Shares Available for Grant |   |  | Number of Shares   
|Balances, January 1, 2000   |  | 822,791                    |   |  | 1,771,583          
|                           
|Additional shares reserved  |  | 4,000,000                  |   |  |                   
|Options granted             |  | (4,056,000                 | ) |  | 3,599,500          
|Options exercised           |  |                           |   |  | (473,517           
|Options cancelled           |  | 470,583                    |   |  | (470,583           
|                            |  |                            |   |  |                    
|Balances, December 31, 2000 |  | 1,237,374                  |   |  | 4,426,983          
|                           
|Additional shares reserved  |  | 2,500,000                  |   |  |                   
|Options granted             |  | (3,630,033                 | ) |  | 3,206,783          
|Options exercised           |  |                           |   |  | (418,373           
|Options cancelled           |  | 858,009                    |   |  | (838,009           
|                            |  |                            |   |  |                    
|Balances, December 31, 2001 |  | 965,350                    |   |  | 6,377,384          
|                           
|Additional shares reserved  |  | 1,204,000                  |   |  |                   
|Shares repurchased          |  | 30,207                     |   |  |                   
|Options granted             |  | (2,223,000                 | ) |  | 2,151,500          
|Options exercised           |  |                           |   |  | (1,416,022         
|Options cancelled           |  | 980,981                    |   |  | (980,981           
|                            |  |                            |   |  |                    
|Balances, December 31, 2002 |  | 957,538                    |   |  | 6,131,881          
|                            |  |                            |   |  |                    



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KYPHON INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)





The
options outstanding and exercisable by exercise price at December 31, 2002 are as follows:



|Options Outstanding |  |                  
|------------------- |  | -----------------
|ExercisePrice       |  | NumberOutstanding
|Employees:          |  |                  
|$0.0525             |  | 101,250          
|$0.13               |  | 336,789          
|$0.31               |  | 203,172          
|$0.77               |  | 365,848          
|$1.00               |  | 3,056,322        
|$3.00               |  | 411,800          
|$6.95               |  | 235,000          
|$7.00               |  | 130,400          
|$10.50              |  | 73,500           
|$11.95              |  | 264,300          
|$12.67              |  | 953,500          
|                    |  |                  
|                    |  | 6,131,881        
|                    |  |                  
|Non-Employees:      |  |                  
|$0.0350             |  | 20,000           
|$0.0525             |  | 4,167            
|$0.13               |  | 11,750           
|$0.31               |  | 5,000            
|$0.77               |  | 53,000           
|$1.00               |  | 563,480          
|$3.00               |  | 36,667           
|                    |  |                  
|                    |  | 694,064          
|                    |  |                  
|                    |  | 6,825,945        
|                    |  |                  



At
December 31, 2001, 1,406,295 options outstanding granted to employees and 838,834 options outstanding granted to non-employees were exercisable.



Stock-Based Compensation



The Company has adopted the disclosure-only provisions of SFAS No. 123. The Company calculated the fair value of each option on the date
of grant using the minimum value method as prescribed by SFAS No. 123. The assumptions used are as follows:



|                                |  | Years Ended December 31,
|------------------------------- |  | ------------------------
|                                |  | 2002                    
|Risk-free interest rate         |  | 2.49% to 4.61%          
|Expected stock price volatility |  | 76%                     
|Expected life (in years)        |  | 4                       
|Dividend yield                  |  |                        



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KYPHON INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)





As the
determination of fair value of all options granted before the Company became a public company did not include an expected volatility factor, the proforma net loss (see Note 2) results may not be representative of future periods.



The weighted-average grant date fair value per share of
options granted during the years ended December 31, 2002, 2001 and 2000 was $4.89, $0.82, and $0.66, respectively.



Deferred Stock-Based Compensation



The Company has issued to certain employees options under the 1996 Plan and shares of common stock under stock purchase agreements, some
of which contain repurchase provisions, with exercise prices below the deemed fair market value of the Companys common stock at the date of grant. The Companys right to repurchase shares of restricted common stock lapses as these shares
become vested to the employee. In accordance with the requirements of APB No. 25, the Company has recorded deferred stock-based compensation for the difference between the exercise price of the stock options or restricted common stock and the deemed
fair market value of the Companys stock at the date of grant. This deferred stock-based compensation is amortized to expense on a straight line basis, over the period during which the Companys right to repurchase the restricted common
stock lapses or the options become exercisable, generally four years.



Stock-based compensation expense related to stock options granted to non-employees is recognized as the stock options are earned. The options generally vest ratably over four years. The values attributable to these options
have been amortized over the service period on a graded vesting method, and the vested portion of these options were remeasured at each vesting date. The Company believes that the fair value of the stock options is more reliably measurable than the
fair value of the services received. The fair value of the stock options granted were revalued at each reporting date using the Black-Scholes option pricing model as prescribed by SFAS No. 123 using the following assumptions:



|                         |  | Years Ended December 31,
|------------------------ |  | ------------------------
|                         |  | 2002                    
|Risk-free interest rate  |  | 3.69% to 5.40%          
|Expected life (in years) |  | 10                      
|Dividend yield           |  |                        
|Expected volatility      |  | 76%                     



As of
December 31, 2002, the Company has recorded a cumulative $24,800,000 of deferred stock-based compensation related to stock options granted to non-employees and employees. Stock compensation expense is being recognized on a straight-line basis over
the vesting periods of the related options, generally four years. The Company recognized stock compensation expense as follows (in thousands):



|                           |  | Years Ended December 31,
|-------------------------- |  | ------------------------
|                           |  | 2002                    
|Cost of goods sold         |  | $                       
|Research and development   |  |                         
|Sales and marketing        |  |                         
|General and administrative |  |                         
|                           |  |                         
|                           |  | $                       
|                           |  |                         



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KYPHON INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)





10.    EMPLOYEE BENEFIT PLAN



The Company maintains a Section 401(k) Plan. The 401(k) Plan provides participating employees with an opportunity to accumulate funds for retirement and hardship. Eligible participants may contribute up to 20% of their
eligible earnings to the Plan Trust. As of December 31, 2002, the Company has not made any contributions to the plan.



11.    PURCHASED IN-PROCESS RESEARCH AND DEVELOPMENT



In August 2002, the Company entered into a patent sublicense agreement with Bonutti Research Inc. for the
exclusive right to 23 U.S. patents issued to Dr. Peter Bonutti. Under the terms of the agreement, the Company acquired the exclusive right to develop minimally-invasive balloons and related products for use within joints, ligaments, tendons, or
cartilage in the spine and the co-exclusive right to develop minimally-invasive balloons and related products for use in orthopedic applications in joints, ligaments, cartilage, nerves or tendons outside of the spine. The Company paid $12,250,000 in
cash for the rights, all of which was immediately expensed to purchased in-process research and development in August 2002. The acquisition cost was immediately expensed to operations as the technology acquired will be used to develop products that
have not been approved for sale by regulatory authorities, and the in-process projects to which the patents may apply had not yet reached technological feasibility and had no alternative future uses. In addition, the Company also entered into a two
year consulting agreement with Dr. Peter Bonutti under which the Company paid $250,000. The prepayment has been capitalized and is being recognized as research and development expense ratably throughout the two year consulting period.



12.    RELATED PARTY TRANSACTIONS



In August 1996, the Company entered into two consulting
agreements with consultants who are stockholders of the Company, one of which was formerly a member of the Board of Directors. Amounts paid for services for the years ended December 31, 2002, 2001 and 2000 were $217,000, $216,000 and $244,000,
respectively.



In October 2001, the Company
entered into an agreement to loan $2,889,000 to its former President and Chief Executive Officer, Gary Grenter, for the purchase of a primary residence. The note is non-interest bearing and is collateralized by a deed of trust in the related primary
residence. $389,000 of the notes balance was due within one year, and was classified as a current asset as of December 31, 2001, and was paid in June 2002. In September 2002, upon Mr. Grenters resignation, $600,000 of the note became due
on May 17, 2003 and the balance of the note became due one year from the date of his resignation. The note has been reclassified from long term to current assets and the related discount has been adjusted accordingly. For the years ended December
31, 2002 and 2001, $120,000 and $26,000, respectively, of interest income and of compensation expense related to the above notes receivable were recognized. For the years ended December 31, 2002 and 2001, other assets included $110,000 and $961,000,
respectively, of unamortized compensation expense related to the above note receivable.



13.    INCOME TAXES



At December 31, 2002, the Company had approximately $28,500,000 and $24,400,000 in federal and state net operating loss carryforwards, respectively, to reduce future taxable income. The federal and state carryforwards have
expiration dates beginning in 2012 and 2003, respectively, in each case if not utilized.



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At December
31, 2002, the Company had research and development tax credits carryforwards of approximately $688,000 and $652,000 for federal and state income tax purposes, respectively. If not utilized, the federal research and development tax credit
carryforwards will expire beginning in 2012. The state research and development tax credit can be carried forward indefinitely.



The Tax Reform Act of 1986 limits the use of net operating loss and tax credit carryforwards in certain situations where changes occur in
the stock ownership of a company. Ownership changes, as defined, occurred on August 8, 1996, December 14, 1999 and May 17, 2002. In accordance with Internal Revenue Code Section 382, utilization of the carryforwards is subject to annual limitation.
The annual limitation will not result in the expiration of net operating losses prior to utilization.



At December 31, 2002, the Company had approximately $300,000 of net operating losses in Belgium, which can be carried forward
indefinitely, absent any changes in control.



Temporary differences and carryforwards that gave rise to significant portions of deferred tax assets are as follows:



|                                                                     |  | December 31, |        
|-------------------------------------------------------------------- |  | ------------ | -------
|                                                                     |  | 2002         |        
|Net operating loss carryforwards                                     |  | $            | 11,188 
|Research and development credit carryforwards                        |  |              | 1,341  
|Capitalized research and development costs                           |  |              | 744    
|Purchased research and development                                   |  |              | 4,763  
|Other accruals and reserves not currently deductiblefor tax purposes |  |              | 2,362  
|                                                                     |  |              |        
|                                                                     |  |              | 20,398 
|Less: Valuation allowance                                            |  |              | (20,398
|                                                                     |  |              |        
|Total deferred tax assets                                            |  | $            |       
|                                                                     |  |              |        



The
Company has established a full valuation allowance against its deferred tax assets due to the uncertainty surrounding the realization of such assets.



The Companys effective tax rate varies from the statutory rate as follows:



|                                              |  | Years Ended December 31, |  
|--------------------------------------------- |  | ------------------------ | -
|                                              |  | 2002                     |  
|Federal statutory rate                        |  | 34.0                     | %
|State taxes, net of federal effects           |  | 5.8                      |  
|Permanent differences                         |  | (13.3                    | )
|Temporary differences                         |  | (32.2                    | )
|Net operating loss utilization (not utilized) |  | 5.5                      |  
|Tax credit utilization                        |  | 0.2                      |  
|                                              |  |                          |  
|Effective tax rate                            |  | 0.0                      | %
|                                              |  |                          |  



14.    SUBSEQUENT EVENT



In February 2003, the Company acquired Sanatis GmbH (Sanatis), a privately-held developer and manufacturer of orthopedic biomaterials based in Rosbach, Germany. Under the terms of the agreement, the Company
acquired all of Sanatis outstanding shares for consideration of $3,200,000 in cash. An additional



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$1,100,000 has been reserved in escrow as contingent consideration. This transaction will be accounted for using the purchase method of
accounting. An independent appraisal is in the process of being performed to determine the fair value of identified intangible assets and the allocation of the purchase price.



15.    QUARTERLY FINANCIAL DATA (UNAUDITED)



The following tables contain selected unaudited Consolidated
Statement of Operations data for each quarter of 2002 and 2001 (in thousands, except per share amounts):



|                                     |  | Year 2002 Quarter Ended
|------------------------------------ |  | -----------------------
|                                     |  | Mar. 31,               
|Net sales                            |  | $                      
|Gross profit                         |  |                        
|Net income (loss)                    |  |                        
|Net income (loss) per share:         |  |                        
|Basic                                |  | $                      
|Diluted                              |  | $                      
|Weighted-average shares outstanding: |  |                        
|Basic                                |  |                        
|Diluted                              |  |                        

---

|* |  | Net loss includes purchased in-process research and development of $12,250,000.
|- |  | -------------------------------------------------------------------------------





|                                                                                       |  | Year 2001 Quarter Ended |       
|-------------------------------------------------------------------------------------- |  | ----------------------- | ------
|                                                                                       |  | Mar. 31,                |       
|Net sales                                                                              |  | $                       | 6,275 
|Gross profit                                                                           |  |                         | 4,632 
|Net loss                                                                               |  |                         | (4,047
|Net loss per common share, basic and diluted                                           |  | $                       | (2.43 
|Weighted-average shares used in computing net loss per common share, basic and
diluted |  |                         | 1,662 



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REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULE



To the Board of Directors

of Kyphon Inc.:



Our audits of the consolidated financial statements referred to in our report dated January 31, 2003, except for Note 14, as to which the
date is February 25, 2003, appearing in this Annual Report on Form 10-K also included an audit of the financial statement schedule listed in Item 15(a)(2) of this Form 10-K. In our opinion, the financial statement schedule presents fairly, in all
material respects, the information set forth therein when read in conjunction with the related consolidated financial statements.



/s/    PRICEWATERHOUSECOOPERS LLP



San Jose, California

January 31, 2003



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KYPHON INC.



SCHEDULE II



VALUATION AND QUALIFYING ACCOUNTS

FOR THE YEARS ENDED DECEMBER 31, 2000, 2001 AND 2002



|Description                                 |  | Balance at Beginning of Year |         | Charged to Costs and Expenses |         | Deductions |        | Balanceat End of Year
|------------------------------------------- |  | ---------------------------- | ------- | ----------------------------- | ------- | ---------- | ------ | ---------------------
|Allowance for doubtful accounts receivable: |  |                              |         |                               |         |            |        |                      
|Fiscal year ended 2000                      |  | $                            |        |                               | 80,000  |            |       |                      
|Fiscal year ended 2001                      |  |                              | 80,000  |                               | 20,000  |            |       |                      
|Fiscal year ended 2002                      |  | $                            | 100,000 |                               | 3,314   |            | 3,314  |                      
|                                           
|Allowance for inventories valuation:        |  |                              |         |                               |         |            |        |                      
|Fiscal year ended 2000                      |  | $                            | 100,000 |                               | 128,502 |            | 46,833 |                      
|Fiscal year ended 2001                      |  |                              | 181,669 |                               | 95,444  |            | 86,156 |                      
|Fiscal year ended 2002                      |  | $                            | 190,957 |                               | 469,685 |            | 53,490 |                      



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ITEM 9.    CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND

FINANCIAL DISCLOSURE



Not
applicable.

PART III



ITEM 10.    DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT



The information concerning the Companys directors required by this Item is incorporated by reference to the section entitled
Proposal One-Election of Directors in the Companys Proxy Statement.



The information concerning the Companys executive officers required by this Item is incorporated by reference to the section in Item 1 of Part I hereof entitled Executive Officers of the
Registrant.



Section 16(a) of the
Securities Exchange Act of 1934, as amended, requires our directors, officers and beneficial owners of more than 10% of our Common Stock to file with the SEC and the National Association of Securities Dealers reports of ownership on Form 3 and
reports of changes in ownership on Form 4 or Form 5. Such persons are required by SEC regulations to furnish us with copies of all Section 16(a) forms they file.



Based solely on our review of the copies of such report received by us, or written representations from
reporting persons that no Forms 3, 4, or 5 were required of such persons, we believe that during our fiscal year ended December 31, 2002, all reports were timely filed.



ITEM 11.    EXECUTIVE COMPENSATION



The information required by this Item is incorporated by reference to the sections entitled Compensation of Directors and Executive Compensation in the Companys Proxy
Statement.



ITEM 12.    SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT



The information required by this Item is incorporated by reference to the sections entitled Beneficial Stock Ownership in the
Companys Proxy Statement.



ITEM 13.    CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS



The information required by this Item is incorporated by reference to the sections entitled Related-Party Transactions in the
Companys Proxy Statement.



ITEM 14.    CONTROLS AND PROCEDURES



With the participation of management, our President and Chief Executive Officer along with our Vice President of Finance and Chief Financial Officer evaluated our disclosure controls and procedures
within 90 days of the filing date of this Annual Report on Form 10-K. Based upon this evaluation, our President and Chief Executive Officer along with our Vice President of Finance and Chief Financial Officer concluded that our disclosure controls
and procedures are effective in ensuring that material information required to be disclosed is included in the reports that we file with the Securities and Exchange Commission.



There were no significant changes in our internal controls or, to the knowledge of our management, in other
factors that could significantly affect these controls subsequent to the evaluation date.



60



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PART IV



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



|(a) |  | (1)    The financial statement required by Item 15(a) are filed as Item 8 of this annual report.
|--- |  | ------------------------------------------------------------------------------------------------



| | (2) |  | The financial statement schedules required by Item 15(a) are filed as Item 8 of this annual report.
| | --- |  | ---------------------------------------------------------------------------------------------------



| | (3) |  | Exhibits
| | --- |  | --------



|Number   |     |  | Description                                                                                                                                             
|-------- | --- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------
|        
|3.2 *    |     |  | Amended and Restated Certificate of Incorporation of the
Registrant.                                                                                    
|        
|3.4 *    |     |  | Bylaws of the Registrant.                                                                                                                               
|        
|4.1 *    |     |  | Specimen common stock certificate of the Registrant.                                                                                                    
|        
|10.1 *   |     |  | Form of Indemnification Agreement for directors and executive
officers.                                                                                 
|        
|10.2 *   |     |  | 1996 Stock Option Plan, including form of option agreement.                                                                                             
|        
|10.3 *   |     |  | 2002 Stock Plan, including form of option agreement.                                                                                                    
|        
|10.4 *   |     |  | 2002 Employee Stock Purchase Plan, including form of employee stock purchase plan
subscription agreement.                                               
|        
|10.5 *   |     |  | 2002 Director Option Plan, including form of option agreement.                                                                                          
|        
|10.8 *   |     |  | Lease dated January 27, 2000 for office space located at 1350 Bordeaux Drive,
Sunnyvale, CA 94089 and Second Amendment to Lease dated November 29, 2001.
|        
|10.8.1*  |     |  | Third Amendment to Lease dated March 29, 2002 for office space located at 1350
Bordeaux Drive, Sunnyvale, CA 94089.                                     
|        
|10.9 *   |     |  | Employment Agreement between the Registrant and Gary L. Grenter dated July 16,
2001.                                                                    
|        
|10.10*   |     |  | Promissory Note Secured by Deed of Trust between the Registrant and Gary L. Grenter
dated December 31, 2001.                                            
|        
|10.11*   |     |  | Amended and Restated Stockholder Rights Agreement effective as of December 14, 1999,
among the Registrant and certain stockholders of the Registrant.   
|        
|10.12**  |     |  | Employment Agreement between the Registrant and Richard W. Mott dated September 3,
2002.                                                                
|        
|10.13    | ** |  | Sublicense Agreement effective as of August 19, 2002, between the Registrant and
Bonutti Research, Inc.                                                 
|        
|10.14*** |     |  | Stock Purchase Agreement by and between Kyphon and the shareholders of Sanatis GmbH,
dated February 15, 2003.                                           
|        
|23.1     |     |  | Consent of Independent Accountants.                                                                                                                     
|        
|99.1     |     |  | Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18
U.S.C. Section 1350.                                                

---

|* |  | Incorporated by reference from our Registration Statement on Form S-1 (Registration No. 333-83678), which was declared effective on May 16, 2002.
|- |  | -------------------------------------------------------------------------------------------------------------------------------------------------

|** |  | Incorporated by reference from our Form 10-Q filed on November 13, 2002.
|-- |  | ------------------------------------------------------------------------

|*** |  | Incorporated by reference from our Form 8-K filed on March 7, 2003.
|--- |  | -------------------------------------------------------------------

| |  | Confidential treatment requested on portions of this exhibit. Unredacted versions of this exhibit have been filed separately with the Commission.
|- |  | -------------------------------------------------------------------------------------------------------------------------------------------------



|(b) |  | Reports on Form 8-K.
|--- |  | --------------------

None.



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SIGNATURES



Pursuant
to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on our behalf by the undersigned, thereunto duly authorized, in the City of Sunnyvale, State of California, on
the 28th day of March, 2003.



KYPHON INC.By:

/s/    RICHARD W.
MOTTRichard W. Mott President, Chief Executive Officer and Director(Principal Executive Officer)




KNOW ALL MEN AND WOMEN BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Richard W. Mott and Jeffrey L. Kaiser, his attorneys-in-fact, each with the power of substitution, for him in any and
all capacities, to sign any amendments to this Report on Form 10-K, and to file the same, with exhibits thereto and other documents in connection therewith, with the U.S. Securities and Exchange Commission, hereby ratifying and confirming all that
said attorneys-in-fact, or his or their substitute or substitutes, may do or cause to be done by virtue thereof.



Pursuant to the requirements of the Securities Act of 1933, this Registration Statement has been signed by the following persons in the
capacities and on the dates indicated:



|Signature                                              |  | Title                                                                                                                            |  | Date          
|------------------------------------------------------ |  | -------------------------------------------------------------------------------------------------------------------------------- |  | --------------
|                                                      
|/s/    RICHARD W.
MOTTRichard W. Mott                  |  | President, Chief Executive Officer and Director (Principal Executive
Officer)                                                    |  | March 28, 2003
|                                                      
|/s/    JEFFREY L.
KAISERJeffrey L. Kaiser              |  | Vice President of Finance and Administration, Treasurer and Chief Financial Officer
(Principal Accounting and Financial Officer) |  | March 28, 2003
|                                                      
|/s/    JAMES T.
TREACEJames T. Treace                  |  | Chairman of the Board                                                                                                            |  | March 28, 2003
|                                                      
|/s/    STEPHEN
CAMPEStephen Campe                      |  | Director                                                                                                                         |  | March 28, 2003
|                                                      
|/s/    DOUGLAS W.
KOHRSDouglas W. Kohrs                |  | Director                                                                                                                         |  | March 28, 2003
|                                                      
|/s/    JACK W. LASERSOHNJack W. Lasersohn              |  | Director                                                                                                                         |  | March 28, 2003
|                                                      
|/s/    KAREN D. TALMADGE
PH.D.Karen D.
Talmadge, Ph.D. |  | Director                                                                                                                         |  | March 28, 2003
|                                                      
|/s/    ELIZABETH H.
WEATHERMANElizabeth H.
Weatherman  |  | Director                                                                                                                         |  | March 28, 2003



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##### Table of Contents

CERTIFICATION OF CHIEF EXECUTIVE OFFICER

PURSUANT TO

SECTION 13(a) OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

AS ADOPTED PURSUANT TO

SECTION 302 OF THE
SARBANES-OXLEY ACT OF 2002



I, Richard W. Mott certify that:



|1. |  | I have reviewed this annual report on Form 10-K of Kyphon Inc;
|-- |  | --------------------------------------------------------------





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



|3. |  | Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the
financial condition, results of operations and cash flows of the Registrant as of, and for, the periods presented in this annual report;
|-- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|4. |  | The Registrants other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act
Rules 13a-14 and 15d-14) for the Registrant and we have:
|-- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | a) |  | designed such disclosure controls and procedures to ensure that material information relating to the Registrant, including its consolidated subsidiaries, is made
known to us by others within those entities, particularly during the period in which this annual report is being prepared;
| | -- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | b) |  | evaluated the effectiveness of the Registrants disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report
(the Evaluation Date); and
| | -- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | c) |  | presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;
| | -- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------



|5. |  | The Registrants other certifying officers and I have disclosed, based on our most recent evaluation, to the Registrants auditors and the audit committee
of Registrants board of directors (or persons performing the equivalent functions):
|-- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | a) |  | all significant deficiencies in the design or operation of internal controls which could adversely affect the Registrants ability to record, process, summarize
and report financial data and have identified for the Registrants auditors any material weaknesses in internal controls; and
| | -- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | b) |  | any fraud, whether or not material, that involves management or other employees who have a significant role in the Registrants internal controls; and
| | -- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------



|6. |  | The Registrants other certifying officers and I have indicated in this annual report whether or not there were significant changes in internal controls or in
other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
|-- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|                    
|--------------------
|Date: March 28, 2003
|                    



63



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##### Table of Contents

CERTIFICATION OF CHIEF FINANCIAL OFFICER

PURSUANT TO

SECTION 13(a) OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

AS ADOPTED PURSUANT TO

SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002



I, Jeffrey L. Kaiser certify that:



|1. |  | I have reviewed this annual report on Form 10-K of Kyphon Inc;
|-- |  | --------------------------------------------------------------



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



|3. |  | Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the
financial condition, results of operations and cash flows of the Registrant as of, and for, the periods presented in this annual report;
|-- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|4. |  | The Registrants other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act
Rules 13a-14 and 15d-14) for the Registrant and we have:
|-- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | a) |  | designed such disclosure controls and procedures to ensure that material information relating to the Registrant, including its consolidated subsidiaries, is made
known to us by others within those entities, particularly during the period in which this annual report is being prepared;
| | -- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | b) |  | evaluated the effectiveness of the Registrants disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report
(the Evaluation Date); and
| | -- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | c) |  | presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;
| | -- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------



|5. |  | The Registrants other certifying officers and I have disclosed, based on our most recent evaluation, to the Registrants auditors and the audit committee
of Registrants board of directors (or persons performing the equivalent functions):
|-- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | a) |  | all significant deficiencies in the design or operation of internal controls which could adversely affect the Registrants ability to record, process, summarize
and report financial data and have identified for the Registrants auditors any material weaknesses in internal controls; and
| | -- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | b) |  | any fraud, whether or not material, that involves management or other employees who have a significant role in the Registrants internal controls; and
| | -- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------



|6. |  | The Registrants other certifying officers and I have indicated in this annual report whether or not there were significant changes in internal controls or in
other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
|-- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|                    
|--------------------
|Date: March 28, 2003
|                    



64