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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington D.C. 20549
 FORM 10-K þ
    
    Annual report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
for the fiscal year ended January 1, 2005
 or o
    
    Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of
1934 for the transition period fromto.
 Commission file number 0-27598 IRIDEX CORPORATION (Exact name of registrant as specified in its charter)
 Delaware
(State or other jurisdiction
of incorporation or organization)
    
    77-0210467
(I.R.S. Employer
Identification Number)
 1212 Terra Bella Avenue, Mountain View CA 94043-1824
(Address of principal executive offices)
(Zip Code)
(650) 940-4700
(Registrants telephone number, including area code) 
 Securities registered pursuant to Section 12(b) of the Act:
None Securities registered pursuant to Section 12(g) of the Act:
Common Stock, par value $0.01 per share 
 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 filing requirements for the past 90 days. Yesþ Noo Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation
S-K (Section 229.405 of this chapter) is not contained herein, and will not be contained, to the
best of 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. þ Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule
12b-2 of the Act.) Yes o  No þ The aggregate market value of the voting common equity held by non-affiliates of the
Registrant was approximately $ 32,821,341, as of July 3, 2004, the last business day of the
Registrants most recently completed second fiscal quarter, based on the closing price reported for
such date on the NASDAQ National Market System. The registrant did not have any non-voting common
equity outstanding. For purposes of this disclosure, shares of common stock held by each executive
officer and director and by each holder of 5% or more of the outstanding shares of common stock
have been excluded from this calculation, because such persons may be deemed to be affiliates.
This determination of affiliate status is not necessarily a conclusive determination for other
purposes. As of March 16, 2005, Registrant had 7,427,148 shares of common stock outstanding.   DOCUMENTS INCORPORATED BY REFERENCE Certain parts of the Proxy Statement for the Registrants 2005 Annual Meeting of Stockholders
(the Proxy Statement) are incorporated by reference into Part III of this Annual Report on Form
10-K.




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Table of Contents
    
    
    
    
    
    Page No.Part IItem 1.
    
    Business
    
    
    1Item 2.
    
    Properties
    
    
    17Item 3.
    
    Legal Proceedings
    
    
    18Item 4.
    
    Submission of Matters to a Vote of Security Holders
    
    
    18Part IIItem 5.
    
    Market for Registrants Common Equity and Related Stockholder Matters and Issuer
Purchases of Equity Securities
    
    
    19Item 6.
    
    Selected Financial Data
    
    
    21Item 7.
    
    Managements Discussion and Analysis of Financial Condition and Results
of Operations
    
    
    23Item 7A.
    
    Quantitative and Qualitative Disclosure about Market Risk
    
    
    41Item 8.
    
    Financial Statements and Supplementary Data
    
    
    42Item 9.
    
    Changes in and Disagreements with Accountants on Accounting and Financial
Disclosure
    
    
    63Item 9A.
    
    Controls and Procedures
    
    
    64Part IIIItem 10.
    
    Directors and Executive Officers of the Registrant
    
    
    65Item 11.
    
    Executive Compensation
    
    
    65Item 12.
    
    Security Ownership of Certain Beneficial Owners and Management and
Related Stockholder Matters
    
    
    65Item 13.
    
    Certain Relationships and Related Transactions
    
    
    65Item 14.
    
    Principal Accountant Fees and Services
    
    
    65Part IVItem 15.
    
    Exhibits, Financial Statement Schedules and Reports on Form 8-K
    
    
    66Signatures
    
    
    
    
    
    
    69EXHIBIT 23.1EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1




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PART I This Annual Report onForm 10-Kcontains certain forward-looking statements within the meaning
of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities
Exchange Act of 1934, as amended, such as statements relating to levels of future sales and
operating results; actual order rate and market acceptance of our products; opportunities in the
adjunctive visualization systems market and our efforts to provide total disease management
solutions; expectations for future sales growth, generally, including expectations of additional
sales from our new products and new applications of our existing products; the potential for
production cost decreases and higher gross estimate of the size of our markets; levels of future
investment in research and development efforts; our ability to develop and introduce new products
through strategic alliances; favorable Center for Medicare and Medicaid coverage decisions
regarding AMD procedures that use our products; results of clinical studies and risks associated
with bringing new products to market, general economic conditions and levels of international
sales. In some cases, forward-looking statements can be identified by terminology, such as may,
will, should, expects, plans, anticipates, believes, estimates, predicts,
intends, potential, continue, or the negative of such terms or other comparable terminology.
These statements involve known and unknown risks, uncertainties and other factors which may cause
our actual results, performance or achievements to differ materially from those expressed or
implied by such forward-looking statements. The reader is strongly urged to read the information
contained under the captions Part I, Item 1, Business, and Part II, Item 7, Managements
Discussion and Analysis of Financial Condition and Results of Operations-Factors That May Affect
Future Results in this Annual Report for a more detailed description of these significant risks
and uncertainties. The reader is cautioned not to place undue reliance on these forward-looking
statements, which reflect managements analysis only as of the date of thisForm 10-K. We
undertake no obligation to update such forward-looking statements to reflect events or
circumstances occurring after the date of this report. 
 Item 1. Business General IRIDEX Corporation is a leading worldwide provider of semiconductor-based laser systems used
to treat eye diseases in ophthalmology and skin conditions in dermatology (also referred to
as aesthetics). Our products are sold in the United States predominantly through a
direct sales force and internationally through 68 independent distributors into 107 countries.
Total product sales in 2004, 2003 and 2002 were $32.8 million, $31.7 million and $30.6 million
respectively, which generated a net income (loss) for those
corresponding years of ($402,000), $371,000 and $150,000.
The net loss for 2004 of ($402,000) included a one-time $1.0 million
charge to establish a reserve for sales taxes and interest, which the Company chose not to retroactively
collect from our customers. Our ophthalmology products are used in the treatment of serious eye diseases, including the
three leading causes of irreversible blindness, age-related macular degeneration (AMD), diabetic
retinopathy and glaucoma. The current family of ophthalmology laser systems, which accounts for
the majority of our revenues, is used for ophthalmic applications primarily in hospitals, clinics
and doctors offices, includes the IRIS Medical IQ810 Laser System, the OcuLight Symphony (Laser
Delivery System), OcuLight SL, OcuLight SLx, OcuLight GL and OcuLight GLx laser photocoagulation
systems. Our ophthalmology products contributed $27.8 million, $26.2 million and $24.1 million to
our total revenues in 2004, 2003 and 2002, respectively. Our dermatology products treat skin
conditions, primarily vascular and pigmented lesions and remove unwanted hair. Our dermatology
laser systems are the DioLite 532, the Apex 800 and the VariLite Dual Wavelength Laser systems.
Our dermatology products are primarily used in the
practitioners office and contributed $5.0
million, $5.5 million and $6.5 million to our total revenues in 2004, 2003 and 2002, respectively.
Each ophthalmic and dermatology laser system consists of a small, portable laser console and
delivery devices, primarily for hospital and office-based use by ophthalmologists and
dermatologists. - 1 -




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We believe that our semiconductor-based systems were among the first to be developed and since
our first shipment in 1990, more than 7,100 IRIDEX medical laser systems have been sold worldwide. IRIDEX Corporation was incorporated in California in February 1989 as IRIS Medical
Instruments, Inc. In 1996, we changed our name to IRIDEX Corporation and reincorporated in
Delaware. Our executive offices are located at 1212 Terra Bella Avenue, Mountain View, California
94043-1824, and our telephone number is (650) 940-4700. We can also be reached at our Web site at
www.iridex.com, however, the information on, or that can be accessed through, our Web site is not
part of this report. As used in this Form 10-K, the terms Company, IRIDEX, we, us and
our refer to IRIDEX Corporation, a Delaware corporation, and, when the context so requires, our
wholly owned subsidiaries, IRIS Medical Instruments, Inc. and Light Solutions Corporation, both
California corporations. The IRIDEX Strategy We are one of the worldwide leaders in developing, manufacturing, marketing, selling and
servicing innovative and cost-effective medical laser systems. The key elements of our strategy
are: Broaden Product Lines.One of our core strengths has been our regular introduction of new
laser systems, delivery devices and product upgrades to enhance the benefits of our laser systems.
We attempt to leverage our existing products and technology when developing new products. In 1997,
we introduced the DioLite 532, based on the same visible (green) light technology as the OcuLight
GL, for the dermatology market. In 1998, we introduced the OcuLight GLx, a new version of the
OcuLight GL, with increased power and delivery device capability. In October 1999, we introduced
the next generation of OcuLight SLx, which offers added features to our OcuLight SL, such as
LongPulse and MicroPulse operating modes. These features enable the OcuLight SLx to perform the
latest in clinical infrared applications. In October 2000, we introduced the EasyFit family of
portable slit lamp adapters (or SLAs), which allow for improved viewing clarity of the retina by
the physician. In October 2002, we introduced the OcuLight Symphony Laser Delivery System which
combines the clinical versatility and convenience of infrared and visible photocoagulation consoles
into one delivery device. We also introduced an expanded EndoProbe product line and a 5 millimeter
Large Spot Slit Lamp Adapter. In December 2002, we commenced shipment of the Millennium Endolase
module, which we manufacture to be included in Bausch & Lombs Millennium Microsurgical System. In
2003, we introduced a 50 micron spot Easy View slit lamp adapter, the smallest spot size diameter
available on IRIDEX slit lamp adapters. In addition, in 2003 and the first quarter of 2004, we
introduced four additions to our Endoprobe product line. In 2004, we launched a new, menu driven
infrared platform for ophthalmology, the IQ810, designed to allow easier physician access to a
variety of advanced laser energy delivery modes used to perform Minimum Intensity Photocoagulation
(MIP) procedures. The IQ810 platform also includes some new delivery devices such as the IQ Slit
Lamp Adapter with Fiber Check and accessories such as the SmartControl footswitch and remote
control. For the dermatology market, we introduced the VariLite, a dual wavelength laser in the
fourth quarter of 2004 that offers both 532 nm and 940 nm wavelengths for added clinical
versatility and convenience for the physician. The characteristics of these new products since 1997
are similar to those which have made our previous products successful, such as low cost ownership,
reliability and portability. We intend to continue our investment in research and development to
improve the performance of our systems and broaden our product offerings. We also intend to
develop additional technologies which can more cost effectively address the needs of the ophthalmic
and dermatology markets. Develop and Validate New Applications. We seek to develop and validate applications that are
less costly, reduce side effects and achieve better clinical results than existing treatments. The
objectives of developing new applications are to expand the number of patients who can be treated,
to more effectively treat diseases, to treat patients earlier in the treatment regimen, and to
reduce the side effects of treatment. An - 2 -




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example of this is continued development of Minimum Intensity Photocoagulation (MIP)
protocols. MIP is a laser treatment approach pioneered by IRIDEX, which uses our OcuLight infrared
lasers to maximize preservation of sensitive retinal tissues while stimulating a therapeutic
effect. We believe that maintaining leadership in MIP will allow us to make a substantial
contribution in the treatment of serious eye diseases such as age-related macular degeneration,
diabetic retinopathy and glaucoma. Our products are currently being used in multiple
studies in the United States and internationally to demonstrate the clinical benefits of MIP
protocols. For example, our OcuLight SLx laser has been used in several studies to treat the
various stages of both dry and wet forms of age-related macular degeneration (or AMD). We
announced in October 1999 that a clinical pilot study on occult wet AMD produced results supporting
that Transpupillary Thermotherapy (or TTT) was effective in improving or stabilizing vision in 75%
of patients with a procedure using our OcuLight infrared laser photocoagulator. In November 2001,
we announced that enrollment for the PTAMD study on dry AMD was completed as sufficient enrollment
had been achieved to detect a clinically relevant difference in the clinical outcomes of the study.
In October 2004, we announced that the preliminary visual outcome data in the intent-to-treat
evaluation of the Company supported TTT4CNV clinical trial showed that TTT, as applied in this
trial, while trending favorably, did not result in a statistically significant beneficial effect
relative to sham and that further subgroup analysis would be conducted. Since that time, interim
results of subgroup analysis has demonstrated a statistically significant benefit in a subgroup of
patients with baseline visual acuity of 20/100 or worse, 22% of treated eyes improved vision by one
or more lines compared with none of the eyes in the untreated control group. Furthermore, at 18
months, there was a 2 line benefit in preserving vision in this subgroup when compared to sham
treated eyes. Both of these trends were statistically significant. In addition, two papers were
recently published in the British Journal of Ophthalmology showing the effectiveness of MIP for
treating diabetic retinopathy. Likewise, the IRIDEX family of dermatology lasers uses MIP to
provide effective and gentle laser procedures. MIP technology is also important for dermatology
applications where skin protection and patient comfort combined with effective outcome are
essential. The DioLite 532 and VariLite treatment parameters are optimized to close damaged blood
vessels and remove pigmented spots quickly and effectively while minimizing injury to the
non-target tissue for a bruise-free result. See Managements Discussion and Analysis of
Financial Condition and Results of Operations  Factors That May Affect Future Results  We are
Dependent on the Successful Outcome of Clinical Trials of Our Products and New Applications Using
Our Products. Provide Total Disease Management. We intend to expand our product offering by utilizing a
total disease management approach. We pursue this on the therapeutic side by increasing the number
of delivery devices and disposable EndoProbes tailored for use in procedures that treat specific
diseases. We are also pursuing this on the diagnostic side by developing adjunctive visualization
systems which could be used to either identify patients who require therapy, target laser therapy
more accurately, or assess the adequacy of therapy. Examples of products we have already
introduced which may be utilized for both visualization and treatment include our TruFocus Laser
Indirect Ophthalmoscope and our line of clear view Slit Lamp Adapters, such as the Easy View. We
believe that a significant opportunity exists to provide additional delivery devices used in
treatment procedures and adjunctive visualization systems. By pursuing both delivery and diagnosis
systems we intend to provide total disease management solutions for our customers. Develop New Markets Through Strategic Alliances.We intend to establish strategic alliances
in order to expedite and lower the cost of developing and bringing to market new products, both to
the ophthalmology and dermatology markets and to markets not currently addressed by our products.
Through these alliances, we will seek access to technologies that we do not currently possess. In
October 2002, we announced our collaboration with Bausch & Lomb to design and manufacture a
solid-state green light laser photocoagulator module called the Millennium Endolase module. The
Millennium Endolase module is designed to be a component of Bausch & Lombs ophthalmic surgical
suite product offering and is not designed to be sold as a stand-alone product. We intend to
pursue additional strategic alliances in the future, - 3 -




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in order to gain access to new markets for our products. See Managements Discussion and
Analysis of Financial Condition and Results of Operations  Factors That May Affect Future Results
 We Depend on Collaborative Relationships to Develop, Introduce and Market New Products, Product
Enhancements and New Applications. Products We utilize a systems approach to product design. Each system includes a console, which
generates the laser energy, and a number of interchangeable peripheral delivery devices, including
disposable delivery devices, sometimes referred to as EndoProbes, for use in specific clinical
applications. This approach allows our customers to purchase a basic console system and add
additional delivery devices as their needs expand or as we develop new applications. We believe
that this systems approach also brings economies-of-scale to our product development and
manufacturing efforts because individual applications do not require the design and manufacture of
complete stand-alone products. Our primary non-disposable products range in price from $2,000 to
$60,000 and consist of laser consoles and specialized delivery devices and our line of disposable
products has an average sales price of approximately $140. Consoles:Our laser consoles incorporate the economic and technical benefits of semiconductor
laser technology. Ophthalmogy Photocoagulator Consoles. The OcuLight family makes up the worlds largest installed base of solid-state ophthalmic
lasers. Widely accepted for their reliability, performance, ease of use, and portability,
OcuLight lasers are used for the office or operating room environments. There are no
special electrical or plumbing requirements needed for the lasers contributing to their low
cost of ownership. Infrared (810 nm) Product Family: The IQ 810 is our top-of-the-line solid-state infrared
console for ophthalmologists. The IQ 810 features interactive software for ease of use and
clinical versatility, advanced waveform capability for performing conventional or MIP
treatments, and the widest range of delivery devices for maximum clinical versatility. The
OcuLight SLx is the industry standard in infrared systems and is designed to bridge
conventional and emerging laser photocoagulation procedures with its unique Tri-Mode
capability. The OcuLight SL laser is the specialty laser for ophthalmologists treating
retinopathy of prematurity, glaucoma, or intraocular tumors. Visible (or Green) Photocoagulator Family.The OcuLight GLx is the top-of-the line green
Photocoagulator representing the latest in technological innovation. It offers 1.5 Watts of
power to the cornea and is compatible to the widest array of delivery devices. The OcuLight
GL was the first portable green laser photocoagulator and has become the industry standard
in solid-state systems. This laser offers the greatest value to a practice. The green
lasers perform the same clinical applications as traditional argon gas-tube lasers but
eliminate the installation and maintenance costs associated with that technology. In December 2002, we commenced shipment of the Millennium Endolase module, which is sold
exclusively to Bausch & Lomb for use in their Millennium Microsurgical System. It
integrates 532nm photocoagulator capability into Bausch & Lombs array of microsurgical
capabilities. The Millennium Endolase module is compatible with the IRIDEX EndoProbe
handpieces and Laser Indirect Ophthalmoscope. - 4 -




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Combination Infrared/Visible Photocoagulator Consoles.The OcuLight Symphony Laser Delivery
System, which we introduced in October 2002, is used by the ophthalmologist and consists of
an OcuLight SLx infrared (810nm) laser console, OcuLight GLx green (532 nm) laser console,
multi-fiber slit lamp adapter, slit lamp and a custom cart. The OcuLight Symphony Laser
Delivery System combines the clinical versatility and convenience of a 532 nm, 810 nm and
large spot 810 nm into one delivery device for retinal photocoagulation and glaucoma
procedures. We believe that this product offers a unique value-added proposition and the
efficiency of dual laser wavelength delivery in a single product. Dermatology Laser Consoles.Dermatology lasers offer advanced, solid-state
semiconductor-based technology. Lasers are reliable, portable, efficient and clinically
versatile. The systems are easy to set up and operate and do not require special cooling or
electrical requirements. The DioLite 532 is an advanced, compact laser system available for
the treatment of vascular and pigmented skin lesions.The 532 nm is used to treat
superficial vascular lesions and pigmented lesions and can also be used for laser facial
treatment when combined with the ScanLite product. The system offers treatment parameters
for safe, predictable, and clinically effective results. The more recently introduced
VariLite is a dual wavelength system offering 532 nm and 940 nm wavelengths in a clinically
versatile and convenient package. This laser can perform all the applications of the
DioLite 532 as well as treat acne, melasma, and cutaneous lesions. We believe that the
smaller overall sizes, lower weights and low power requirements to operate represent
distinct advantages of our dermatology laser consoles over competing products. Specialized Delivery Devices:Our versatile family of consoles and delivery devices has been
designed to accommodate the addition of new capabilities with a minimal incremental investment.
Users of this product can add capabilities by simply purchasing new interchangeable delivery
devices and utilizing them with their existing console. We have developed both disposable and
nondisposable delivery devices and expect to continue to develop additional devices. Ophthalmic Delivery Devices: TruFocus Laser Indirect Ophthalmoscope.The indirect ophthalmoscope is designed to be worn
on the physicians head during procedures to treat peripheral retinal disorders, particularly
in infants or adults requiring treatment in the supine position. This product can be used
in both diagnosis and treatment procedures at the point-of-care. Slit Lamp Adapter.These adapters allow the physician to utilize a standard slit lamp in
both diagnosis and treatment procedures. Doctors can install a slit lamp adapter in a few
minutes and convert over 50 variations of standard diagnostic slit lamps into a therapeutic
photocoagulator delivery system. Slit lamp adapters are used in treatment procedures for
both retinal diseases and glaucoma. These devices are available in a wide variety of spot
diameters. In 2004, we introduced the EasyView slit lamp adapter and IQ Slit Lamp Adapter
with Fibercheck. Operating Microscope Adapter.These adapters allow the physician to utilize a standard
operating microscope in both diagnosis and laser treatment procedures. These devices are
similar to slit lamp adapters, except that they are oriented horizontally and therefore can
be used to deliver retinal photocoagulation to a supine patient. EndoProbe.The single use EndoProbe is used for endophotocoagulation, a retinal treatment
procedure performed in the hospital operating room or surgery center. These sterile
disposable probes are available in tapered, angled, fluted and illuminating styles. In 2003
and the first quarter of - 5 -




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2004, we introduced four additions to our EndoProbe product line, including straight and
angled illuminating laser probes, a 25 gauge probe and an aspirating probe. G-Probe.The G-Probe is used in procedures to treat medically and surgically uncontrolled
glaucoma, in many instances replacing cyclocryotherapy, or local freezing of eye tissue.
The G-Probes non-invasive procedure takes approximately ten minutes, is done to an
anesthetized eye in the doctors office and results in less pain and fewer adverse side
effects than cyclocryotherapy. The G-Probe is a sterile disposable product. DioPexy Probe.The DioPexy Probe is a hand-held instrument which is used in procedures to
treat retinal tears and breaks, noninvasively through the sclera, as an alternative method
of attaching the retina. Our DioPexy Probe results in increased precision, less pain and
less inflammation than traditional cryotherapy. Dermatology Delivery Devices: DioLite Handpiece.The DioLite Handpiece is a hand held instrument that is used in the
treatment of vascular and pigmented skin lesions. These devices are available in 200, 500,
700, 1000 and 1400 micron spot diameters. VariLite Handpiece.The VariLite handpiece is a handheld instrument used in the treatment
of vascular, pigmented cutaneous skin lesions and small area hair removal. Ergonomic
handpieces can be used with both the 532 nm and 940 nm wavelengths and are available in 0.7,
1.0, 1.4, 2.0 and 2.8 spot sizes. ScanLite Scanner. The ScanLite is a computer pattern generator with integrated controls
designed to enhance the capabilities of the DioLite 532 and VariLite laser systems. It
allows rapid and uniform treatment of large-area vascular and pigmented skin lesions
including port wine stains, matted telangiectasia, and cafe au lait stains as well as laser
facial treatments. Apex 800 ColdTip Handpiece. The ColdTip Handpiece is a handheld instrument used with the
Apex 800 for large hair removal. It offers subzero contact cooling of the epidermis to
allow the use of higher treatment fluences for improved treatment effectiveness and patient
comfort. Apex 800 Varispot Handpiece. The VariSpot Handpiece is a hand held instrument used with the
Apex 800 for area hair removal. It offers an aiming beam which aids visualization of the
target area allowing precise treatment. The following chart lists the eye disease procedures that can utilize our photocoagulator
systems, including the console and delivery devices that we offer for use in treating these
diseases. The selection of delivery device is often determined by the severity and location of the
disease. The chart also lists the procedures for treating skin diseases that can utilize our
dermatology laser systems. Condition
    
    Procedure
    
    Console
    
    Delivery DevicesOphthalmology Treatments:Age-related Macular Degeneration
    
    Retinal Photocoagulation
    
    Infrared & Visible
    
    Slit Lamp AdapterDiabetic Retinopathy
 - 6 -




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Condition
    
    Procedure
    
    Console
    
    Delivery DevicesMacular Edema
    
    Grid Retinal Photocoagulation
    
    Infrared & Visible
    
    Slit Lamp Adapter &
Operating Microscope
Adapter,Focal Retinal
Photocoagulation
    
    Visible
    
    Slit Lamp AdapterProliferative
    
    Pan-Retinal Photocoagulation
    
    Infrared & Visible
    
    Slit Lamp Adapter, Operating
Microscope Adapter, Laser
Indirect Ophthalmoscope,
EndoProbeGlaucomaPrimary Open-Angle
    
    Trabeculoplasty
    
    Infrared & Visible
    
    Slit Lamp AdapterAngle-closure
    
    Iridotomy
    
    Infrared & Visible
    
    Slit Lamp AdapterUncontrolled
    
    Transscleral
Cyclophotocoagulation
    
    Infrared
    
    G-ProbeRetinal Detachment
    
    Retinopexy Retinal
Photocoagulation
    
    Infrared & Visible
    
    Slit Lamp Adapter, Laser
Indirect Ophthalmoscope,
Operating Microscope
Adapter, EndoProbe,Transscleral Retinal
Photocoagulation
    
    Infrared
    
    DioPexy ProbeRetinopathy of Prematurity
    
    Retinal Photocoagulation
    
    Infrared
    
    Laser Indirect OphthalmoscopeOcular Tumors
    
    Retinal Photocoagulation
    
    Infrared
    
    Slit Lamp Adapter, Operating
Microscope Adapter, Laser
Indirect OphthalmoscopeDermatology Treatments:Vascular Lesions
    
    Selective Photothermolysis
    
    Visible & Infrared
    
    DioLite Handpiece, VariLite
HandpiecePigmented Lesions
    
    Selective Photothermolysis
    
    Visible & Infrared
    
    DioLite Handpiece, VariLite
HandpieceCutaneous Lesions
    
    Selective Photothermolysis
    
    Visible
    
    VariLite HandpieceLaser Facial
    
    Selective Photothermolysis
    
    Visible
    
    ScanLite ScannerHair Removal
    
    Selective Photothermolysis
    
    Infrared
    
    Cold Tip Handpiece, Varispot
Handpiece, VariLite
 Research and Development Our research and development activities are performed internally by our research and
development staff which is comprised of 17 individuals. From time to time, we supplement our
internal research and development staff by hiring consultants with specialized expertise. Research
and development efforts are directed toward the development of new products and new applications
for our existing products, as well as the identification of markets which may include clinical
trials and may not be currently addressed by our products. Our expenditures for research and
development totaled approximately $4.5 million, $4.0 million and $4.3 million in 2004, 2003 and
2002, respectively. We expect to continue to devote a significant portion - 7 -




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of our resources to our research and development efforts for new products and new applications
for existing products. We have close working relationships with researchers, clinicians and
practicing physicians around the world who provide new ideas, test the feasibility of these new
ideas, and assist us in validating new products and new applications before they are introduced. We are continuing to develop MIP protocols. MIP is a laser treatment approach pioneered by
IRIDEX, which uses our OcuLight SLx infrared lasers to maximize preservation of sensitive retinal
tissues while stimulating a therapeutic effect. We believe that maintaining leadership in MIP will
allow us to make a substantial contribution in the treatment of serious eye diseases such as
age-related macular degeneration, diabetic retinopathy, and glaucoma. We are supporting pre-clinical and clinical studies to develop new photocoagulation treatments
and applications using MIP protocols. The objectives of developing new applications are to expand
the number of patients who can be treated, to more effectively treat diseases, to treat patients
earlier in the treatment regimen and to reduce the side-effects of treatment. Examples of such
studies with regard to particular eye afflictions are included in the following paragraphs. Age-Related Macular Degeneration (AMD)  Wet Form.AMD is a progressive disease that
damages the central vision and affects a persons ability to read, see faces, and drive.
About 50 million people worldwide have AMD and, of these, about 5 million have the more
severe wet form. Though the wet form of AMD constitutes about 10% of all AMD, it
accounts for about 80% of all severe vision loss associated with AMD. We are pursuing
several approaches to treat wet AMD at different stages. All of these approaches close new
blood vessels in the eyes macula caused by wet AMD with less damage than conventional laser
treatments. One promising approach is Transpupillary Thermotherapy (TTT). TTT is a MIP
protocol that uses a milder form of retinal photocoagulation to treat wet AMD while sparing
the sensory retina, as compared to conventional laser photocoagulation techniques. The
protocol uses the OcuLight SLx laser and Large Spot Slit Lamp Adapter to produce favorable
therapeutic responses with minimal side effects and preservation of vision in patients with
occult choroidal neovascularization (CNV) secondary to AMD . Favorable results of
a pilot TTT study were published in October 1999. We announced results from a multi-center
randomized trial called the TTT4CNV Trial, which are discussed in the section titled We are
Dependent on the Successful Outcome of Clinical Trials of Our Products and New Applications
Using Our Products. Age-Related Macular DegenerationDry Form.About 90% of AMD is the dry form. Our approach
to the treatment of dry AMD is to preserve or improve vision by following a MIP protocol
that uses the OcuLight infrared laser to cause resorption of dry AMD deposits (drusen) which
have accumulated in the macula. We are supporting a multi-center clinical trial which is
testing a treatment of eyes with dry age-related macular degeneration (PTAMD trial). In
November 2001, we announced that enrollment for the PTAMD trial was completed as sufficient
enrollment had been achieved to detect a clinically relevant difference in the clinical
outcomes of the study. This trial treats patients with dry AMD using our OcuLight infrared
laser systems with the objective of determining whether patient vision is better as a result
of treatment compared to no treatment; and secondarily, to determine whether treatment
reduces the rate of progression of the disease from the dry form of AMD to the wet form of
AMD. We expect results of this trial to be released prior to 2006 year end. Glaucoma.Preliminary studies are underway to evaluate the use of the G-Probe as a primary
surgical treatment modality for glaucoma in various parts of the world. - 8 -




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Diabetic Retinopathy. Other MIP studies are underway to investigate the treatment of
diabetic retinopathy using the MicroPulse operating mode available in our OcuLight SLx
product with the objective of causing regression of the disease with less loss of vision
than conventional laser therapy. Ocular Tumors.Clinical studies have reported successful treatment of ocular tumors using
OcuLight infrared lasers using the TTT approach. Customers and Customer Support Our products are currently sold to general ophthalmologists, as well as those specializing in
retina, glaucoma and pediatrics, dermatologists and plastic surgeons. Other customers include
research and teaching hospitals, government installations, surgi-centers and hospitals. No
customer or distributor accounted for 10% or more of total sales in 2004, 2003 or 2002. See Item
7, Managements Discussion and Analysis of Financial Condition and Results of Operations. We are continuing our efforts to broaden our customer base through the development of new
products and new applications of our existing products for use by ophthalmologists and
dermatologists. We currently estimate that there are approximately 20,000 ophthalmologists in the
United States and 50,000 worldwide who are each potential customers for at least one laser system.
Additionally, we estimate that there are approximately 4,900 and 18,000 hospitals in the United
States and internationally, respectively, as well as approximately 4,000 ambulatory surgical
centers in the United States which potentially represent multiple unit sales. We believe there are
approximately 10,000 dermatologists and approximately 9,000 plastic surgeons in the United States
who are potential customers. Because independent ophthalmologists and dermatologists frequently
practice at their own offices as well as through affiliation with hospitals or other medical
centers, each independent ophthalmologist, dermatologist, plastic surgeon, hospital and medical
center is a potential customer for our products. We are seeking to broaden our customer base by
developing new products directed at addressing the needs of ophthalmologists and dermatologists. We seek to provide superior customer support and service and therefore created our Global
Customer Care Group with the responsibility for our customer requests and product repairs, which
has resulted in a significant improvement in our response times. We believe that our superior
customer service and technical support distinguish our product offerings from those of our
competitors. Our customer support representatives assist customers with orders, shipments,
warranty returns and other administrative functions. Our technical support engineers provide
customers with answers to technical and product-related questions. We maintain an
around-the-clock telephone service line to service our customers. If a problem with a product
cannot be diagnosed and resolved by telephone, a replacement unit is shipped overnight to any
domestic customer and to any international customer, and the problem unit is returned to us. The
small size and rugged design of our products allows for economical shipment and quick response to
customers almost anywhere in the world. Sales and Marketing We market our products in the United States predominantly through our direct sales force. As
of January 1, 2005, our direct sales force consisted of 13 employees, with 3 open positions,
engaged in sales efforts within the United States. Our sales and marketing organization is based
at our corporate headquarters in Mountain View, California with area sales managers located
throughout the United States. International product sales represented 39.4%, 36.7% and 36.1% of our sales in 2004, 2003 and
2002, respectively. We believe that our international sales will continue to represent a
significant portion of our revenues for the foreseeable future. Our international sales are made
principally to customers in Europe - 9 -




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and the Asia/Pacific Rim region. Our products are sold internationally through our 66
independent distributors into 107 countries. International sales are administered through our
corporate headquarters in Mountain View, California, along with four international area sales
managers located overseas. Our distribution agreements with our international distributors are
generally exclusive and typically can be terminated by either party without cause on 90 days
notice. International sales may be adversely affected by the imposition of governmental controls,
currency fluctuations, restrictions on export technology, political instability, trade
restrictions, changes in tariffs and the economic condition in each country in which we sell our
products. See Item 7, Managements Discussion and Analysis of Financial Condition and Results of
OperationsFactors That May Affect Future ResultsWe Depend on International Sales. To support our sales process, we conduct marketing programs which include direct mail, trade
shows, public relations, and advertising in trade and academic journals and newsletters. We
annually participate in approximately 91 trade shows or meetings in the United States and
approximately 60 trade shows or meetings internationally. These meetings allow us to present our
products to existing and prospective buyers. We believe that educating patients and physicians at an early stage about the long-term health
benefits and cost-effectiveness of diagnosis and treatment of diseases that cause blindness is
critical to market acceptance of our ophthalmic products. We believe that the trend toward
management of health care costs in the United States will lead to increased awareness of and
emphasis on disease prevention and cost-effective treatments and, as a result, will increase demand
for our ophthalmic products. We collaborate with our customers to enhance our ability to identify new applications for our
products, validate new procedures using our products, and expedite regulatory clearances and
approvals of new products and applications. Customers include key opinion leaders who are often
the heads of the departments in which they work or professors at universities. We believe that
these luminaries in the field of ophthalmology and dermatology are key to the successful
introduction of new products and the subsequent acceptance of these new products by the general
market. Acceptance of our products by these early adopters is key to our strategy in the
validation of our new products. Operations The manufacture of our infrared and visible light photocoagulators and the related delivery
devices is a highly complex and precise process. Completed systems must pass quality control and
reliability tests before shipment. Our manufacturing activities consist of specifying, sourcing,
assembling and testing of components and certain subassemblies for assembly into our final product.
As of January 1, 2005, we had a total of 52 employees engaged in manufacturing activities. The medical devices manufactured by us are subject to extensive regulation by numerous
governmental authorities, including federal, state, and foreign governmental agencies. The
principal regulator in the United States is the Food and Drug Administration (the FDA). In April
1998, we received certification for ISO 9001/EN 46001. ISO 9001/EN 46001 is a documented
international quality system standard that documents compliance to the European Medical Device
Directive. In February 2004, we were certified to ISO 13485:1996 which replaced ISO 9001/EN46001
as the international standard for quality systems as applied to medical devices. We rely on third parties to manufacture substantially all of the components used in our
products, although we assemble critical subassemblies and the final product at our facility in
Mountain View, California. Some of these suppliers and manufacturers are sole source. We have
some long-term or volume purchase agreements with our suppliers and currently purchase most
components on a purchase order basis. - 10 -




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These components may not be available in the quantities required, on reasonable terms, or at
all. Financial or other difficulties faced by our suppliers or significant changes in demand for
these components or materials could limit their availability. Any failures by such third parties
to adequately perform may delay the submission of products for regulatory approval, impair our
ability to deliver products on a timely basis or otherwise impair our competitive position. See
Item 7, Managements Discussion and Analysis of Financial Condition and Results of
OperationsFactors That May Affect Future ResultsWe Face Risks of Manufacturing and We Depend on
Key Manufacturers and Suppliers. International regulatory bodies often establish varying product standards, packaging
requirements, labeling requirements, tariff regulations, duties and tax requirements. As a result
of our sales in Europe, we are required to have all products CE marked, an international symbol
affixed to all products demonstrating compliance to the European Medical Device Directive and all
applicable standards. In July 1998, we received a CE mark under Annex II guidelines, the most
stringent path to CE certification. With Annex II CE certification, we have demonstrated our
ability to both understand and comply with all applicable European standards. This allows us to CE
mark any product upon our internal verification of compliance to all applicable European standards.
Currently, all released products are CE marked. Continued certification is based on successful
review of the process by our European Registrar during its annual audit. Any loss of certification
would have a material adverse effect on our business, results of operations and financial
condition. See Item 7, Managements Discussion and Analysis of Financial Condition and Results of
Operations  Factors That May Affect Future Results-We Are Subject to Government Regulation. Competition Competition in the market for devices used for ophthalmic and dermatology treatment procedures
is intense and is expected to increase. This market is also characterized by rapid technological
innovation and change, and our products could become obsolete as a result of future innovations.
Our competitive position depends on a number of factors including product performance,
characteristics and functionality, ease of use, scalability, durability and cost. In addition to
other companies that manufacture photocoagulators and dermatological devices, we compete with
pharmaceutical solutions, other technologies and other surgical techniques available in both the
dermatologic and ophthalmic markets. Our principal laser competitors in ophthalmology are Lumenis Ltd.,
Carl Zeiss Meditec AG, Alcon Inc., Quantel, Laserex and Nidek, Inc. All of these companies currently offer
a competitive, semiconductor-based laser system for ophthalmology.
Also within ophthalmology pharmaceutical alternative treatments for
AMD such as Visudyne (Novartis) and Macugen (Eyetech) compete
rigorously with traditional laser procedures.

 Our principal competitors in
dermatology are Palomar Technologies, Laserscope, Candela Corporation, Lumenis Ltd., and Cutera
Inc. Some competitors have substantially greater financial, engineering, product development,
manufacturing, marketing and technical resources than we do. Some companies also have greater name
recognition than us and long-standing customer relationships. In addition, other medical
companies, academic and research institutions, or others, may develop new technologies or
therapies, including medical devices, surgical procedures or pharmacological treatments and obtain
regulatory approval for products utilizing such techniques that are more effective in treating the
conditions targeted by us, or are less expensive than our current or future products. Our
technologies and products could be rendered obsolete by such developments. Any such developments
could have a material adverse effect on our business, financial condition and results of
operations. See Item 7, Managements Discussion and Analysis of Financial Condition and Results
of OperationsFactors That May Affect Future ResultsOur Market is Competitive. - 11 -




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Patents and Proprietary Rights Our success and ability to compete is dependent in part upon our proprietary information. We
rely on a combination of patents, trade secrets, copyright and trademark laws, nondisclosure and
other contractual agreements and technical measures to protect our intellectual property rights.
We file patent applications to protect technology, inventions and improvements that are significant
to the development of our business. We have been issued 15 United States patents and five foreign
patents on the technologies related to our products and processes, which have expiration dates
ranging from 2009 to 2023.We have approximately four pending patent applications in the United
States and five foreign pending patent applications that have been filed. Our patent applications
may not be approved. Any patents granted now or in the future may offer only limited protection
against potential infringement and development by competitors of competing products. Moreover, our
competitors, many of which have substantial resources and have made substantial investments in
competing technologies, may seek to apply for and obtain patents that will prevent, limit or
interfere with our ability to make, use or sell our products either in the United States or in
international markets. In addition to patents, we rely on trade secrets and proprietary know-how which we seek to
protect, in part, through proprietary information agreements with employees, consultants and other
parties. Our proprietary information agreements with our employees and consultants contain
provisions requiring such individuals to assign to us, without additional consideration, any
inventions conceived or reduced to practice by them while employed or retained by us, subject to
customary exceptions. Proprietary information agreements with employees, consultants and others
may be breached, and we may not have adequate remedies for any breach. Additionally, our trade
secrets may become known to or independently developed by competitors. The laser and medical device industry is characterized by frequent litigation regarding patent
and other intellectual property rights. Companies in the medical device industry have employed
intellectual property litigation to gain a competitive advantage. Numerous patents are held by
others, including academic institutions and our competitors. Until recently, patent applications
were maintained in secrecy in the United States until issued. Patent applications filed in the
United States after November 2000 generally will be published eighteen months after the filing
date. However, since patent applications continue to be maintained in secrecy for at least some
period of time, both within the United States and with regard to international patent applications,
we cannot assure you that our technology does not infringe any patents or patent applications held
by third parties. We have, from time to time, been notified of, or have otherwise been made aware
of, claims that we may be infringing upon patents or other proprietary intellectual property owned
by others. Any claims that we may be infringing upon patents or other proprietary intellectual property
owned by others, with or without merit, and regardless of whether we are successful on the merits,
would be time-consuming, result in costly litigation and diversion of technical and management
personnel, cause shipment delays, require us to develop noninfringing technology or require us to
enter into royalty or licensing agreements. An adverse determination in a judicial or
administrative proceeding and the failure to obtain necessary licenses or develop alternate
technologies could prevent us from manufacturing and selling our products, which would have a
material adverse effect on our business, results of operations and financial condition.
Conversely, litigation may be necessary to enforce patents issued to us, to protect trade secrets
or know-how owned by us or to determine the enforceability, scope and validity of the proprietary
rights of others. Both the defense and prosecution of intellectual property suits or interference
proceedings are costly and time consuming. See Item 7, Managements Discussion and Analysis of
Financial Condition and Results of Operations  Factors That May Affect Future Results  We Rely on
Patents and Proprietary Rights. - 12 -




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Government Regulation The medical devices to be marketed and manufactured by us are subject to extensive regulation
by numerous governmental authorities, including federal, state, and foreign governmental agencies.
Pursuant to the Federal Food, Drug, and Cosmetic Act, as amended, and the regulations promulgated
thereunder (the FDA Act), the FDA serves as the principal federal agency within the United States
with authority over medical devices and regulates the research, clinical testing, manufacture,
labeling, distribution, sale, marketing and promotion of such devices. Noncompliance with
applicable requirements can result in, among other things, warning letters, fines, injunctions,
civil penalties, recall or seizures of products, total or partial suspension of production, failure
of the government to grant premarket clearance or approval for devices, withdrawal of marketing
approvals, and criminal prosecution. The FDA also has the authority to request repair, replacement
or refund of the cost of any device manufactured or distributed by us. In the United States, medical devices are classified into one of three classes (Class I, II or
III), on the basis of the controls deemed necessary by the FDA to reasonably assure the safety and
effectiveness of such products. Under FDA regulations, Class I devices are subject to general
controls (for example, labeling, premarket notification and adherence to Quality System Regulations
(QSRs) requirements). Class II devices are subject to general and special controls (for example,
performance standards, postmarket surveillance, patient registries, and FDA guidelines).
Generally, Class III devices are those which must receive premarket approval (or PMA) by the FDA
to ensure their safety and effectiveness. Unless otherwise exempt, before a new device can be introduced into the market, the
manufacturer must obtain marketing clearance through either a 510(k) premarket notification or a
PMA. A 510(k) clearance will be granted if the submitted information establishes that the proposed
device is substantially equivalent to a legally marketed Class I or II medical device, or to a
Class III medical device for which the FDA has not called for a PMA. The FDA may determine that a
proposed device is not substantially equivalent to a legally marketed device, or that additional
information or data are needed before a substantial equivalence determination can be made. A
request for additional data may require that clinical studies of the devices safety and efficacy
be performed. Commercial distribution of a device for which a 510(k) notification is required can begin only
after the FDA issues an order finding the device to be substantially equivalent to a previously
cleared device. The FDA has recently been requiring a more rigorous demonstration of substantial
equivalence than in the past. Even in cases where the FDA grants a 510(k) clearance, it can take
the FDA from four to twelve months or longer from the date of submission to grant a 510(k)
clearance, but it may take longer. A not substantially equivalent determination, or a request for additional information, could
delay the market introduction of new products that fall into this category and could have a
materially adverse effect on our business, financial condition and results of operations. For any
of our products that are cleared through the 510(k) process, modifications or enhancements that
could significantly affect the safety or efficacy of the device or that constitute a major change
to the intended use of the device will require new 510(k) submissions. A PMA application must be submitted if a proposed device is not substantially equivalent to a
legally marketed Class I or Class II device, or if it is a Class III device for which the FDA has
called for PMAs. A PMA application must be supported by valid scientific evidence which typically
includes extensive data, including human clinical trial data, to demonstrate the safety and
effectiveness of the device. The PMA application must also contain the results of all relevant
bench tests, laboratory and animal studies, a complete description of the device and its
components, and a detailed description of the methods, facilities and controls used to manufacture
the device. In addition, the submission must also contain the proposed labeling, advertising
literature and training methods. - 13 -




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Upon receipt of a PMA application, the FDA makes a threshold determination as to whether the
application is sufficiently complete to permit a substantive review. If the FDA determines that
the PMA application is sufficiently complete to permit a substantive review, the FDA will accept
the application for filing. Once the submission is accepted for filing, the FDA begins an in-depth
review of the PMA. An FDA review of a PMA application generally takes one to two years from the
date the PMA application is accepted for filing, but may take significantly longer. The review
time is often significantly extended as a result of the FDA asking for more information or
clarification of information already provided in the submission. During the review period, an
advisory committee, typically a panel of clinicians, will likely be convened to review and evaluate
the application and provide recommendations to the FDA as to whether the device should be approved.
The FDA is not bound by the recommendations of the advisory panel. Toward the end of the PMA
review process, the FDA generally will conduct an inspection of the manufacturers facilities to
ensure that the facilities are in compliance with applicable QSR requirements. If the FDAs evaluations of both the PMA application and the manufacturing facilities are
favorable, the FDA will either issue an approval letter or an approvable letter, which may contain
a number of conditions which must be met in order to secure final approval of the PMA. When, and
if, those conditions have been fulfilled to the satisfaction of the FDA, the agency will issue a
PMA approval letter, authorizing commercial marketing of the device for certain indications. The
FDA may also determine that additional clinical trials are necessary or other deficiencies exist in
the PMA, in which case PMA approval may be delayed. The PMA process can be expensive, uncertain and
lengthy, and a number of devices for which the FDA approval has been sought by other companies have
never been approved for marketing. If human clinical trials of a device are required in connection with either a 510(k)
notification or a PMA, and the device presents a significant risk, the sponsor of the trial
(usually the manufacturer or the distributor of the device) is required to file an investigational
device exemption (IDE) application prior to commencing human clinical trials. The IDE
application must be supported by data, typically including the results of animal and laboratory
testing. If the IDE application is reviewed and approved by the FDA and one or more appropriate
institutional review boards (IRBs), human clinical trials may begin at a specific number of
investigational sites with a specific number of patients, as approved by the FDA. If the device
presents a nonsignificant risk to the patient, a sponsor may begin the clinical trial after
obtaining approval for the study by one or more appropriate IRBs. We have obtained 510(k) clearance for all of our marketed products. We have also modified
aspects of our products since receiving regulatory clearance, but we believe that new 510(k)
clearances are not required for these modifications. After a device receives 510(k) clearance or a
PMA, any modification that could significantly affect its safety or effectiveness, or that would
constitute a major change in its intended use, will require a new clearance or approval. The FDA
requires each manufacturer to make this determination initially, but the FDA can review any such
decision and can disagree with a manufacturers determination. If the FDA disagrees with our
determination not to seek a new 510(k) clearance or PMA, the FDA may retroactively require us to
seek 510(k) clearance or premarket approval. The FDA could also require us to cease marketing and
distribution and/or recall the modified device until 510(k) clearance or premarket approval is
obtained. Also, in these circumstances, we may be subject to significant regulating fines or
penalties. Any products manufactured or distributed by us pursuant to FDA clearances or approvals are
subject to pervasive and continuing regulation by the FDA, including record keeping requirements
and reporting of adverse experiences with the use of the device. Device manufacturers are required
to register their establishments and list their devices with the FDA and certain state agencies,
and are subject to periodic inspections by the FDA and certain state agencies. The FDA Act
requires devices to be manufactured to comply with applicable QSR regulations which impose certain
procedural and documentation requirements - 14 -




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upon us with respect to design, development, manufacturing and quality assurance activities.
We are subject to unannounced inspections by the FDA and the Food and Drug Branch of the California
Department of Health Services, or CDHS, to determine our compliance with the QSR and other
regulations, and these inspections may include the manufacturing facilities of our subcontractors. Labeling and promotion activities are subject to scrutiny by the FDA and, in certain
instances, by the Federal Trade Commission. The FDA actively enforces regulations prohibiting
marketing of products for unapproved uses. We and our products are also subject to a variety of
state laws and regulations in those states or localities where our products are or will be
marketed. Any applicable state or local regulations may hinder our ability to market our products
in those states or localities. Manufacturers are also subject to numerous federal, state and local
laws relating to such matters as safe working conditions, manufacturing practices, environmental
protection, fire hazard control and disposal of hazardous or potentially hazardous substances. We
may be required to incur significant costs to comply with such laws and regulations now or in the
future. Such laws or regulations may have a material adverse effect upon our ability to do
business. Exports of our products are regulated by the FDA and are covered by the Export Amendment of
1996, which greatly expanded the export of approved and unapproved United States medical devices.
However, some foreign countries require manufacturers to provide an FDA certificate for products
for export (CPE) which requires the device manufacturer to certify to the FDA that the product
has been granted premarket clearance in the United States and that the manufacturing facilities
appeared to be in compliance with QSR at the time of the last QSR inspection. The FDA will refuse
to issue a CPE if significant outstanding QSR violations exist. We are also regulated under the Radiation Control for Health and Safety Act, which requires
laser products to comply with performance standards, including design and operation requirements,
and manufacturers to certify in product labeling and in reports to the FDA that their products
comply with all such standards. The law also requires laser manufacturers to file new product and
annual reports, maintain manufacturing, testing and sales records and report product defects.
Various warning labels must be affixed and certain protective devices installed, depending on the
class of the product. The introduction of our products in foreign markets will also subject us to foreign regulatory
clearances which may impose substantial additional costs and burdens. International sales of
medical devices are subject to the regulatory requirements of each country. The regulatory review
process varies from country to country. Many countries also impose product standards, packaging
requirements, labeling requirements and import restrictions on devices. In addition, each country
has its own tariff regulations, duties and tax requirements. The approval by the FDA and foreign
government authorities is unpredictable and uncertain. The necessary approvals or clearances may
not be granted on a timely basis, if at all. Delays in receipt of, or a failure to receive, such
approvals or clearances, or the loss of any previously received approvals or clearances, could have
a material adverse effect on our business, financial condition and results of operations. Changes in existing requirements or adoption of new requirements or policies by the FDA or
other foreign and domestic regulatory authorities could adversely affect our ability to comply with
regulatory requirements. Failure to comply with regulatory requirements could have a material
adverse effect on our business, financial condition and results of operations. We may be required
to incur significant costs to comply with laws and regulations in the future. These laws or
regulations may have a material adverse effect upon our business, financial condition or results of
operations. - 15 -




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Reimbursement The cost of a significant portion of medical care in the United States is funded by government
programs, health maintenance organizations and private insurance plans. Our products are typically
purchased by doctors, clinics, hospitals and other users, which bill various third-party payers,
such as government programs and private insurance plans, for the health care services provided to
their patients. Government imposed limits on reimbursement of hospitals and other health care
providers have significantly impacted the spending budgets of doctors, clinics and hospitals to
acquire new equipment, including our products. Under certain government insurance programs, a
health care provider is reimbursed for a fixed sum for services rendered in treating a patient,
regardless of the actual charge for such treatment. The Center for Medicare and Medicaid Services
(CMS) reimburses hospitals on a prospectively-determined fixed amount for the costs associated with
an in-patient hospitalization based on the patients discharge diagnosis. CMS reimburses
physicians a prospectively-determined fixed amount based on the procedure performed, regardless of
the actual costs incurred by the hospital or physician in furnishing the care and regardless of the
specific devices used in that procedure. In addition, many of the Ophthalmologic diseases that we
treat, especially AMD, affect individuals primarily covered by Medicare. Reimbursement issues have
affected sales of our ophthalmic products to a greater extent than sales of our dermatologic
products because dermatology procedures, in general, are not covered under most insurance programs
and the cost of these procedures are paid for by the patient. Private third-party reimbursement plans are also developing increasingly sophisticated methods
of controlling health-care costs by imposing limitations on reimbursable procedures and the
exploration of more cost-effective methods of delivering health care. In general, these government
and private measures have caused health care providers, including our customers, to be more
selective in the purchase of medical products. In addition, changes in government regulation or in
private third-party payers policies may limit or eliminate reimbursement for procedures employing
our products, which could have a material adverse effect on our business, results of operations and
financial condition. See Item 7, Managements Discussion and Analysis of Financial Condition and
Results of Operations  Factors That May Affect Future Results  We Depend on Third Party Coverage
and Reimbursement Policies. Doctors, clinics, hospitals and other users of our products may not obtain adequate
reimbursement for use of our products from third-party payers. While we believe that the laser
procedures using our products have generally been reimbursed, payers may deny coverage and
reimbursement for our products if they determine that the device was not reasonable and necessary
for the purpose used, was investigational or was not cost-effective. For example, during July
2000, the CMS advised that claims for reimbursement for certain AMD procedures that use our
OcuLight SLx laser system would not be reimbursed by CMS. As a result, since July 2000, sales of
the OcuLight SLx laser system have dropped significantly. In September 2000, CMS changed its
position and advised that claims for reimbursement for two of the AMD procedures can be submitted
for reimbursement with coverage and payment to be determined by the local medical carriers at their
discretion. Sales of the OcuLight SLx continue, albeit at a lower level, because the OcuLight SLx
can also be used for other retinal procedures that are reimbursable by the CMS. Furthermore, since
CMS advisories are for domestic third party CMS payers, they are not likely to affect international
sales. We believe domestic sales of the OcuLight SLx laser system will continue at these lower
levels until more medical carriers reimburse for performing such AMD procedures or until CMS
advises that claims for these procedures may be submitted directly to CMS at the national level.
As an example, to date, Medicare reimbursement to ophthalmologists performing TTT procedures to
treat wet AMD is available in 17 states. We believe that more medical carriers will reimburse for
these procedures when the procedures are further validated by randomized clinical studies. We are
supporting a randomized clinical trial (TTT4CNV) which may further validate the position TTT will
have in the overall treatment regimen of AMD. - 16 -




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Product Liability and Insurance We may be subject to product liability claims in the future. Our products are highly complex
and are used to treat extremely delicate eye tissue and skin conditions on and near a patients
face. Our products are often used in situations where there is a high risk of serious injury or
adverse side effects. In addition, although we recommend that our disposable products only be used
once and prominently label these disposables; we believe that certain customers may nevertheless
reuse these disposable products. If a disposable product is not adequately sterilized by the
customer between such uses, a patient could suffer serious consequences, possibly resulting in a
suit against us for damages. Accordingly, the manufacture and sale of medical products entails
significant risk of product liability claims.
Although we currently maintain and intend to continue the
Companys product liability
insurance, adequate insurance may not be available on acceptable
terms, if at all, and may not provide adequate coverage against
potential liabilities.
 A successful claim brought
against us in excess of our insurance coverage could have a material adverse effect on our
business, results of operations and financial condition. To date, we have not experienced any
product liability claims which would result in payments in excess of our policy limits. Backlog We generally do not maintain a high level of backlog. As a result, we do not believe that our
backlog at any particular time is indicative of future sales levels. Employees At January 1, 2005, we had a total of 108 full-time employees, including 52 in operations, 28
in sales and marketing, 17 in research and development and 11 in finance and administration. We
also employ, from time to time, a number of temporary and part-time employees as well as
consultants on a contract basis. At January 1, 2005, we employed 2 such persons. We intend to
hire additional personnel during the next twelve months primarily in the direct sales and
production areas. Our future success will depend in part on our ability to attract, train, retain
and motivate highly qualified employees, who are in great demand. We may not be successful in
attracting and retaining such personnel. Our employees are not represented by a collective
bargaining organization, and we have never experienced a work stoppage or strike. We consider our
employee relations to be good. Available Information Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K
and amendments to reports pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of
1934, as amended, are available, free of charge, on our website at
www.iridex.com, as soon as
reasonably practicable after such reports are electronically filed with the Securities and Exchange
Commission and are also available on the SECs website at
www.sec.gov. Our website and the information contained therein or
connected thereto are not intended to be incorporated into this
Annual Report on Form 10-K. 
 Item 2. Properties Our
operating facility is located in 37,000 square feet of space in Mountain View,
California. This facility is being substantially utilized for all of our manufacturing and
research and development efforts and serves as our headquarter offices. This facility is utilized
for both our ophthalmology medical device segment and our dermatology medical device segment. We
lease this facility, and in September 2003, we entered into a
lease amendment for this facility in
Mountain View. The original lease term of this facility, - 17 -




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which ended in February 2004, was amended and extended until February 2009. The lease was
also amended to grant us an option to renew this lease for an additional five year period beginning
2009 and continuing until 2014 at a base monthly rental amount to be negotiated at the time of the
renewal. Management believes that our facility has capacity adequate for our current needs and that
suitable additional space or alternative space will be available as needed in the future on
commercially reasonable terms. 
 Item 3. Legal Proceedings The Company is not subject to any material legal proceedings as of the date of this report. 
 Item 4. Submission of Matters to a Vote of Security Holders Not applicable. - 18 -




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##### Table of Contents



PART II 
 Item 5. Market for Registrants Common Equity and Related Stockholder Matters, and Issuer
Purchases of Equity Securities Market Information for Common Equity Our common stock is currently quoted on the NASDAQ National Market System under the symbol
IRIX and has been since our initial public offering on February 15, 1996. The following table
sets forth for the periods indicated the high and low sales prices for our common stock, as
reported on the NASDAQ National Market. High
    
    
    LowFiscal 2005First Quarter (through March 16, 2005)
    
    $
    6.19
    
    
    $
    4.21Fiscal 2004First Quarter
    
    $
    9.17
    
    
    $
    5.09Second Quarter
    
    
    9.15
    
    
    
    6.08Third Quarter
    
    
    7.05
    
    
    
    5.82Fourth Quarter
    
    
    7.19
    
    
    
    3.80Fiscal 2003First Quarter
    
    $
    4.14
    
    
    $
    2.75Second Quarter
    
    
    4.23
    
    
    
    3.18Third Quarter
    
    
    5.15
    
    
    
    2.98Fourth Quarter
    
    
    6.10
    
    
    
    3.86
 Fiscal 2004 On March 16, 2005, the closing price on the NASDAQ National Market for our common stock was
$5.52 per share. As of March 16, 2005, there were approximately 73 holders of record (not in
street name) of our common stock. Because many of our shares of common stock are held by brokers
and other institutions on behalf of our stockholders, we are unable to estimate the total number of
stockholders represented by these record holders. Dividend Policy We have never paid cash dividends on our common stock. We currently intend to retain any
earnings for use in our business and do not anticipate paying cash dividends in the foreseeable
future. In addition, the payment of cash dividends to our stockholders is currently prohibited by
our bank line of credit. See Note 4 of Notes to Consolidated Financial Statements. -19-




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##### Table of Contents



Securities Authorized for Issuance Under Equity Compensation Plans As of January 1, 2005, we had three equity compensation plans. These plans are the 1995
Employee Stock Purchase Plan, 1995 Director Option Plan and 1998 Stock Option Plan, all of which
have been approved by our stockholders. The following table summarizes our equity compensation
plans as of January 1, 2005: (c)Number ofsecurities(a)
    
    
    
    
    
    
    remaining availableNumber of
    
    
    
    
    
    
    for future issuancesecurities to be
    
    
    (b)
    
    
    under equityissued upon
    
    
    Weighted-average
    
    
    compensation plansexercise of
    
    
    exercise price of
    
    
    (excludingoutstanding
    
    
    outstanding
    
    
    securitiesoptions, warrants
    
    
    options, warrants
    
    
    reflected in columnPlan category
    
    and rights
    
    
    and rights
    
    
    (a))Equity compensation
plans approved by
security holders
    
    
    1,823,392
    
    
    $
    5.18
    
    
    
    454,251Equity compensation
plans not approved
by security holders
    
    
    0
    
    
    
    0
    
    
    
    0Total
    
    
    1,823,392
    
    
    $
    5.18
    
    
    
    454,251
 -20-




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##### Table of Contents



Item 6. Selected Financial Data The following selected consolidated financial data as of January 1, 2005 and January 3, 2004,
and for the years ended January 1, 2005, January 3, 2004 and December 28, 2002, has been derived
from, and are qualified by reference to, our audited consolidated financial statements included
herein. The selected consolidated statement of operations data for the years ended December 29,
2001 and December 30, 2000 and the consolidated balance sheet data as of December 28, 2002,
December 29, 2001 and December 30, 2000 has been derived from our audited financial statements not
included herein. These historical results are not necessarily indicative of the results of
operations to be expected for any future period. The data set forth below (in thousands, except per share data) are qualified by reference to,
and should be read in conjunction with Item 7, Managements Discussion and Analysis of Financial
Condition and Results of Operations, and our consolidated financial statements, related financial
statement notes and other financial information included in Item 8, Financial Statements and
Supplementary Data. Fiscal Year 2004
    
    
    Fiscal Year 2003
    
    
    Fiscal Year 2002
    
    
    Fiscal Year 2001
    
    
    Fiscal Year 2000Consolidated Statement of Operations Data:Sales
    
    $
    32,810
    
    
    $
    31,699
    
    
    $
    30,634
    
    
    $
    27,275
    
    
    $
    32,838Cost of sales
    
    
    17,922
    
    
    
    17,628
    
    
    
    17,046
    
    
    
    14,205
    
    
    
    14,506Gross profit
    
    
    14,888
    
    
    
    14,071
    
    
    
    13,588
    
    
    
    13,070
    
    
    
    18,332Operating expenses:Research and development
    
    
    4,509
    
    
    
    4,032
    
    
    
    4,315
    
    
    
    4,808
    
    
    
    5,265Selling, general and administrative
    
    
    11,455
    
    
    
    10,087
    
    
    
    9,454
    
    
    
    10,251
    
    
    
    10,747Total operating expenses
    
    
    15,964
    
    
    
    14,119
    
    
    
    13,769
    
    
    
    15,059
    
    
    
    16,012Income (loss) from operations
    
    
    (1,076
    )
    
    
    (48
    )
    
    
    (181
    )
    
    
    (1,989
    )
    
    
    2,320Interest and other income, net
    
    
    319
    
    
    
    212
    
    
    
    122
    
    
    
    426
    
    
    
    569Income (loss) before provision for income taxes
    
    
    (757
    )
    
    
    164
    
    
    
    (59
    )
    
    
    (1,563
    )
    
    
    2,889Benefit from (provision for) income taxes
    
    
    355
    
    
    
    207
    
    
    
    209
    
    
    
    962
    
    
    
    (809
    )Income (loss) from continuing operations
    
    
    (402
    )
    
    
    371
    
    
    
    150
    
    
    
    (601
    )
    
    
    2,080Income (loss) from operations of discontinued
Laser Research segment (net of applicable
income tax benefit (provision) of $0, $0, $0,
$124 and $(131) respectively)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (204
    )
    
    
    336Loss on disposal of Laser Research segment
(net of applicable income tax benefit of $0,
$0, $0, $315 and $0 respectively)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (468
    )
    
    
    Net income (loss)
    
    $
    (402
    )
    
    $
    371
    
    
    $
    150
    
    
    $
    (1,273
    )
    
    $
    2,416Basic net income (loss) per share:Continuing operations
    
    $
    ( 0.06
    )
    
    $
    0.05
    
    
    $
    0.02
    
    
    $
    (0.09
    )
    
    $
    0.31Discontinued operations
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (0.10
    )
    
    
    0.05Basic net income (loss) per common
share.........................
    
    $
    (0.06
    )
    
    $
    0.05
    
    
    $
    0.02
    
    
    $
    (0.19
    )
    
    $
    0.36Diluted net income (loss) per share:Continuing operations
    
    $
    ( 0.06
    )
    
    $
    0.05
    
    
    $
    0.02
    
    
    $
    (0.09
    )
    
    $
    0.29Discontinued operations
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (0.10
    )
    
    
    0.04Diluted net income (loss) per share .............
    
    $
    (0.06
    )
    
    $
    0.05
    
    
    $
    0.02
    
    
    $
    (0.19
    )
    
    $
    0.33Shares used in net income (loss) per common
share basic calculations
    
    
    7,200
    
    
    
    6,933
    
    
    
    6,870
    
    
    
    6,757
    
    
    
    6,637Shares used in net income (loss) per common
share diluted calculations
    
    
    7,200
    
    
    
    7,072
    
    
    
    6,928
    
    
    
    6,757
    
    
    
    7,285
 -21-




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##### Table of Contents



January 1,
    
    
    January 3,
    
    
    December 28,
    
    
    December 29,
    
    
    December 30,2005
    
    
    2004
    
    
    2002
    
    
    2001
    
    
    2000Consolidated Balance
Sheet Data:Cash, cash equivalents
and available-for-sale
securities
    
    $
    18,028
    
    
    $
    16,292
    
    
    $
    11,542
    
    
    $
    9,102
    
    
    $
    12,994Working capital
    
    
    25,342
    
    
    
    28,462
    
    
    
    28,072
    
    
    
    26,374
    
    
    
    27,005Total assets
    
    
    39,093
    
    
    
    35,839
    
    
    
    34,272
    
    
    
    33,788
    
    
    
    35,025Total stockholders equity
    
    
    31,783
    
    
    
    30,834
    
    
    
    30,198
    
    
    
    29,833
    
    
    
    30,500
 -22-




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##### Table of Contents



Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations Overview IRIDEX Corporation is a leading worldwide provider of semiconductor-based laser systems used
to treat eye diseases in ophthalmology and skin conditions in dermatology (aesthetics). Our
products are sold in the United States predominantly through a direct sales force and
internationally through 68 independent distributors into 107 countries. Total sales in 2004, 2003,
and 2002 were $32.8 million, $31.7 million, and $30.6 million respectively. Our revenues arise primarily from the sale of our IRIS Medical OcuLight Systems, IQ810,
VariLite, DioLite 532 and Apex 800 systems, delivery devices, disposables and, to a lesser extent,
revenues from service and support activities. Our current family of OcuLight systems includes the
IRIS Medical OcuLight Symphony, OcuLight SL, OcuLight SLx, OcuLight GL and OcuLight GLx laser
photocoagulation systems. We also produce the Millennium Endolase module which is sold
exclusively to Bausch & Lomb and incorporated into their Millennium Microsurgical System. We
believe that future growth in laser unit sales will be derived from growth in sales of peripheral
delivery devices, disposable EndoProbes and service revenue, our new product introductions,
replacement of old laser instruments and technology and from the adoption of new less invasive
procedures (MIP), such as Transpupillary Thermotherapy. Sales to international distributors are made on open credit terms or letters of credit. Sales
of our products internationally currently are denominated in United States dollars and,
accordingly, are subject to risks associated with international monetary conditions and currency
fluctuations. In general, strengthening of the U.S. dollar relative to a foreign currency
increases the cost of our product to our customers. Other risks that international sales are
subject to include shipping delays, generally longer receivable collection periods, changes in
applicable regulatory policies, domestic and foreign tax policies, trade restrictions, duties and
tariffs and economic and political instability. Future currency fluctuations or other factors
discussed above may have a material adverse effect on our business, financial condition or results
of operation. See Factors That May Affect Future ResultsWe Depend on International Sales for a
Significant Portion of Our Operating Results. Cost of sales consists primarily of the cost of purchasing components and sub-systems,
assembling, packaging, shipping and testing components at our facility, and the direct labor and
associated overhead. Research and development expenses consist primarily of personnel costs,
materials and research support provided to clinicians at medical institutions developing new
applications which utilize our products. Research and development costs have been expensed as
incurred. Sales, general and administrative expenses consist primarily of costs of personnel,
sales commissions, travel expenses, advertising and promotional expenses, facilities, legal and
accounting, insurance and other expenses which are not allocated to other departments. -23-




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##### Table of Contents



Results of Operations The following table sets forth certain operating data as a percentage of sales for the periods
indicated: Fiscal Year Ended
    
    
    Fiscal Year Ended
    
    
    Fiscal Year Ended2004
    
    
    2003
    
    
    2002Sales
    
    
    100
    %
    
    
    100.0
    %
    
    
    100.0
    %Cost of sales
    
    
    54.6
    
    
    
    55.6
    
    
    
    55.6Gross profit
    
    
    45.4
    
    
    
    44.4
    
    
    
    44.4Operating expenses:Research and development
    
    
    13.7
    
    
    
    12.7
    
    
    
    14.1Sales, general and administrative
    
    
    35.0
    
    
    
    31.8
    
    
    
    30.9Total operating expenses
    
    
    48.7
    
    
    
    44.5
    
    
    
    45.0Operating loss
    
    
    (3.3
    )
    
    
    (0.1
    )
    
    
    (0.6
    )Other income, net
    
    
    1.0
    
    
    
    0.7
    
    
    
    0.4Income (loss)
before benefit for income taxes
    
    
    (2.3
    )
    
    
    0.6
    
    
    
    (0.2
    )Benefit from income taxes
    
    
    1.1
    
    
    
    0.7
    
    
    
    0.7Net income (loss)
    
    
    (1.2
    %)
    
    
    1.3
    %
    
    
    0.5
    %
 The following table sets forth for the years indicated the amount of sales (in thousands) for
our operating segments and sales as a percentage of total sales. Year Ended
    
    
    Year Ended
    
    
    Year EndedJanuary 1, 2005
    
    
    January 3, 2004
    
    
    December 28, 2002Percentage
    
    
    
    
    
    
    Percentage
    
    
    
    
    
    
    PercentageAmount
    
    
    of total sales
    
    
    Amount
    
    
    of total sales
    
    
    Amount
    
    
    of total salesDomestic
    
    $
    19,894
    
    
    
    60.6
    %
    
    $
    20,072
    
    
    
    63.3
    %
    
    $
    19,564
    
    
    
    63.9
    %International
    
    $
    12,916
    
    
    
    39.4
    %
    
    
    11,627
    
    
    
    36.7
    %
    
    
    11,070
    
    
    
    36.1
    %Total
    
    $
    32,810
    
    
    
    100
    %
    
    $
    31,699
    
    
    
    100.0
    %
    
    $
    30,634
    
    
    
    100.0
    %Ophthalmology:Domestic
    
    $
    16,443
    
    
    
    50.1
    %
    
    $
    15,724
    
    
    
    49.6
    %
    
    $
    14,326
    
    
    
    46.8
    %International
    
    $
    11,310
    
    
    
    34.5
    %
    
    
    10,436
    
    
    
    32.9
    %
    
    
    9,843
    
    
    
    32.1
    %Total
    
    $
    27,753
    
    
    
    84.6
    %
    
    $
    26,160
    
    
    
    82.5
    %
    
    $
    24,169
    
    
    
    78.9
    %Dermatology:Domestic
    
    $
    3,451
    
    
    
    10.5
    %
    
    $
    4,348
    
    
    
    13.7
    %
    
    $
    5,238
    
    
    
    17.1
    %International
    
    $
    1,606
    
    
    
    4.9
    %
    
    
    1,191
    
    
    
    3.8
    %
    
    
    1,227
    
    
    
    4.0
    %Total
    
    $
    5,057
    
    
    
    15.4
    %
    
    $
    5,539
    
    
    
    17.5
    %
    
    $
    6,465
    
    
    
    21.1
    %
 -24-




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##### Table of Contents



Combined Ophthalmology and Dermatology Sales In 2004, sales increased by 3.5% to $32.8 million from $31.7 million in 2003. Domestic sales,
which represented 60.6% of total sales, decreased by 0.9% to $19.9 million in 2004 from $20.1
million in 2003. The decrease in domestic sales was a result of a $0.9 million decrease in
domestic dermatology revenue offset by a $0.7 million increase in domestic ophthalmology revenue.
International sales, which were 39.4% of total sales, increased by 11.1% to $12.9 million in 2004
from $11.6 million in 2003. Both international ophthalmology and dermatology sales increased in
2004, in part, as a result of currency fluctuations. The increase in international ophthalmology sales in 2004 was $0.9 million while
international dermatology sales increased by $0.4 million. In 2003, sales increased by 3.5% to $31.7 million from $30.6 million in 2002. Domestic sales,
which represented 63.3% of total sales, increased by 2.6% to $20.1 million in 2003 from $19.6
million in 2002. The increase in domestic sales was a result of $1.4 million increase in domestic
ophthalmology revenue offset by $0.9 million in decreased domestic dermatology revenue.
International sales, which were 36.7% of total sales, increased by 5.0% to $11.6 million in 2003
from $11.1 million in 2002. International ophthalmology sales increased in 2003 by $0.5 million
while international dermatology sales remained at $1.2 million. Ophthalmology Sales In 2004, ophthalmology sales increased 6.1% to $27.8 million from $26.2 million in 2003.
Domestic ophthalmology sales increased 4.6% to $16.4 million in 2004 from $15.7 million in 2003.
Domestic ophthalmology sales increased during this period mainly as a result of $0.5 million in
increased service revenue, $0.3 million in increased unit sales of delivery devices offset by $0.1
million in decreased unit sales of laser consoles. International ophthalmology sales increased 8.4%
to $11.3 million from $10.4 million. The increase in international sales was due primarily to a
$0.5 million increase in unit sales of laser consoles, $0.2 million in increased service revenue
and $0.2 million in increased delivery device unit sales. In 2003, ophthalmology sales increased 8.2% to $26.2 million from $24.2 million in 2002.
Domestic ophthalmology sales increased 9.8% to $15.7 million in 2003 from $14.3 million in 2002.
Domestic ophthalmology sales increased during this period mainly as a result of $0.5 million in
increased unit sales of delivery devices, $0.5 million in increased service revenue and $0.4
million in increased unit sales of laser consoles. International ophthalmology sales increased
6.0% to $10.4 million. The increase in international sales was due primarily to a $0.1 million
increase in unit sales of laser consoles, $0.2 million in increased service revenue, $0.2 million
in increased average selling prices and $0.1 million in increased unit sales of delivery devices. Dermatology Sales Dermatology sales decreased 8.7% in 2004 to $5.1 million from $5.5 million in 2003. Domestic
dermatology sales decreased 20.6% to $3.5 million in 2004 from $4.3 million in 2003. The decrease
in domestic dermatology sales was due primarily to $1.3 million in decreased unit sales of the
DioLite laser and Apex hair removal lasers and $0.1 million in decreased average selling prices
offset by $0.5 million in sales of the new VariLite laser. International dermatology sales
increased 34.9% to $1.6 million in 2004 from $1.2 -25-




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##### Table of Contents



million in 2003 due to a $0.3 million increase in
unit sales of laser consoles and a $0.1 million increase in service revenue. Dermatology sales decreased 14.3% in 2003 to $5.5 million from $6.5 million in 2002. Domestic
dermatology sales decreased 17.0% to $4.3 million in 2003 from $5.2 million in 2002. The decrease
in domestic dermatology sales was due primarily to a $0.8 million in decreased unit sales of the
DioLite and Apex laser, $0.3 million in decreased average selling prices, offset in part, by $0.2
million in increased service revenue. International dermatology sales remained constant at $1.2
million for 2003 and 2002. Gross Profit.Gross profit was $14.9 million in 2004, $14.1 million in 2003 and $13.6 million
in 2002. Gross profit represented 45.4% of sales in 2004 and 44.4% of sales in 2003 and 2002
respectively. The total 1.0% increase in gross profit as a percentage of revenue in 2004 was due
primarily to a 2.0% decrease in overhead spending and a 0.3% increase related to product mix offset
by a decrease of 1.2% related to an inventory reserve for saleable, but aging and potentially
excess inventory partially associated with the Companys recent introduction of new products and a
decrease of 0.1% associated with average selling prices. In 2003, a slight increase of 0.3% in
direct inventory costs was offset by the same level of decrease in overhead spending. Gross profit was $14.1 million in 2003, $13.6 million in 2002 and $13.1 million in 2001.
Gross profit represented 44.4% of sales in 2003 and 2002 and 47.9% in 2001. In 2003, a slight
increase of 0.3% in direct inventory costs was offset by the same level of decrease in overhead
spending. We intend to continue our efforts to reduce the cost of components and thereby mitigate the
impact of price reductions on our gross profit. We believe gross profit in dollars will increase
as volumes increase and unit production costs will decrease as costs are engineered out of new
products. In addition, as we evaluate gross margins on each of our product lines, we may choose to
place greater focus on product lines with better margins. Overall, however, gross margins as a
percentage of sales will continue to fluctuate due to changes in the relative proportions of
domestic and international sales, the product mix of sales, costs associated with future product
introductions and a variety of other factors. See Factors That May Affect Future Results  Our
Operating Results May Fluctuate from Quarter to Quarter. Research and Development.Research and development expenses increased by $0.5 million or
11.8% in 2004 to $4.5 million from $4.0 million in 2003. The increase in 2004, in absolute
dollars, consisted of a $0.6 million increase in project
spending related mainly to spending on two products released in
2004, the IQ810 and VariLite. Research and
development expenses decreased by 6.6% in 2003 to $4.0 million from $4.3 million in 2002. The
decrease in 2003, in absolute dollars, consisted of $0.2 million in reduced personnel spending
related to the reduction in force in June 2002, $0.1 million in decreased clinical spending and
$0.1 million in reduced occupancy spending associated with renegotiation of a lease, offset by $0.1
million in increased project spending. These expenses were 13.7% of sales in 2004, 12.7% of sales
in 2003 and 14.1% of sales in 2002. The increase, as a percentage of net sales, from 2003 to 2004
was attributable to the increase in research and development expense relative to the increase in
the level of sales. The decrease in research and development expenses in 2003, as a percentage of
sales, was due to the decline in expenses in absolute dollars and an increase in the level of
sales.
For fiscal 2005, we expect research and development expense to
increase slightly as a result of development spending for new
products and product improvement initiatives. Sales, General and Administrative.Sales, general and administrative expense increased by
13.6% in 2004 to $11.5 million from $10.1 million in 2003. Sales, general and administrative
expense increased by 6.7% in 2003 to $10.1 million from $9.5 million in 2002. The increase in
selling, general and administrative expenses in 2004 was driven primarily by a one-time $1.0
million charge to establish a reserve for unpaid sales taxes and interest, $0.1 million in
associated sales tax consulting fees and a $0.3 million increase in the allowance for doubtful
accounts.
The reserve for sales tax resulted from the completion of a
comprehensive review of our sales tax practices. Historically we had
been collecting and remitting sales tax in only those states where we
believed we had nexus. Based on the independent review, we are now
collecting and remitting sales tax from customers in additional
states and are in the process on entering into voluntary settlement
agreements with certain states. The Company chose not to retroactively collect this sales tax from our customers.
 The increase in selling, general and administrative expense in 2003 was driven primarily
by $0.4 million in increased non-commission related selling activities and $0.2 million in -26-




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##### Table of Contents



administrative spending associated primarily with increased consulting and insurance costs. These
expenses were 34.9% of sales in 2004, 31.8% of sales in 2003 and 30.9% of sales in 2002. The increase, as a
percentage of net sales, from 2003 to 2004, was attributable to the increase in sales, general and
administrative expense relative to the increase in the level of sales.
For 2005 we expect sales, general and administrative expense, in
absolute dollars, to decrease. Although spending in connection with
Sarbanes-Oxley compliance initiatives will increase, overall spending
for 2005 will decrease as it will not include the one-time charge of
$1.0 million for sales tax. Interest income, other income (expense), net.Other income, net consists primarily of
interest income. Interest income was $249,000, $159,000 and $151,000 in 2004, 2003 and 2002,
respectively. This income was primarily from interest earned on available-for-sale securities.
Interest income increased in 2004 over 2003 mainly as a result of higher average cash balances
during 2004. Income
Taxes.In 2004, our effective rate was a benefit of 47%. In 2003 and 2002, our effective rate was a
benefit of 127% and 360%, respectively. The tax rate for 2004 was higher than the Federal and
State combined statutory rate of 40% because of certain tax benefits associated with tax-exempt
interest on tax preferred securities and with tax credits for research and development activities.
The tax rates for 2003 and 2002 resulted primarily due to pretax income approaching breakeven and
the level of tax credits for research and development activities relative to the loss for 2003 and
2002. Liquidity and Capital Resources At January 1, 2005, our primary sources of liquidity included cash and cash equivalents of
$10.4 million and available-for-sale securities of $7.6 million, for a total of $18.0 million. In
addition, we have available $4.0 million under our unsecured line of credit which bears interest at
the banks prime rate and expires in October 2005. As of January 1, 2005, no borrowings were
outstanding under this credit facility. We expect to renew the line of credit in October 2005
assuming that terms continue to be acceptable. We believe that, based on current estimates, our
current cash, available-for-sale securities and the credit facility will be sufficient to meet our
working capital and capital expenditure requirements at least through the next twelve months. Net cash generated by operations in 2004 totaled $0.8 million as compared with $5.1 million
generated by operations in 2003 and $2.5 million by operations in 2002. In 2004, sources of cash
included an increase in net accrued expenses and accounts payable of $2.0 million, depreciation of
$0.4 million, an increase in deferred revenue of $0.3 million and a decrease in prepaid expense of
$0.1 million. Uses of cash in 2004 included a net increase in accounts receivable of $0.8 million,
an increase in the deferred tax asset of $0.6 million, a net loss of $0.4 million and an increase
in net inventory of $0.2 million. The increase in net accrued expenses related mainly to a reserve
and associated consulting fees for sales tax totalling $1.2 million, increased payroll accruals of
$0.2 million due to the timing of payroll and other increases in accrued royalties and accrued
warranty which individually were less significant. The increase in accounts receivable was due to
mainly to the timing of sales in the fourth quarter of 2004. Inventory increased in 2004 primarily
because of inventory purchases associated with new product introductions. In 2003, sources of cash
included decreases in net inventories of $2.0 million, decreases in net accounts receivable of $1.4
million, depreciation of $0.7 million, an increase in accrued expenses of $0.6 million, an increase
in accounts payable of $0.4 million, and net income of $0.4 million. Uses of cash in 2003 included
an increase in the deferred tax asset of $0.2 million and decreases in prepaid expenses of $0.2
million. The decrease in inventory was due mainly -27-




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to an ongoing inventory reduction program. The decrease in accounts receivable was due to increased collection efforts. The increase in
accrued expenses consisted mainly of $0.3 million for income tax payable and $0.2 million for
deferred revenue. In 2002, sources of cash included decreases in net inventories of $1.8 million,
depreciation of $0.9 million, increases in accrued expenses of $0.6 million, decreases in prepaid
expenses of $0.3 million and net income of $0.2 million. Uses of cash in 2002 included decreases
in accounts payable of $0.5 million, increases in net accounts receivable of $0.5 million and an
increase in the deferred tax asset of $0.3 million. The decrease in inventory and accounts payable
was due mainly to implementation of an inventory reduction program. The increase in accrued
expenses consisted mainly of $0.4 million for income tax payable, $0.1 million for an increase in
accrued warranty and $0.1 million for an accrued liability. The decrease in prepaid expenses
consisted primarily of $0.4 million for tax receivable. In
2004, we used $2.3 million in cash for investing activities. We
used $4.0 million in cash for investing
activities in 2003. In 2002, we generated $1.8 million of cash from investing activities. Net
cash provided by or used in investing activities was primarily due to the purchase and proceeds of
available-for-sale securities and the acquisition of fixed assets. Net cash provided by financing activities during 2004, 2003 and 2002 was $1.4 million, $0.2
million and $0.2 million, respectively, which consisted primarily of issuance of stock in
connection with our employee stock programs. In December 1998, we instituted a stock repurchase program whereby up to 150,000 shares of our
common stock may be repurchased in the open market. We plan to utilize all of the reacquired
shares for reissuance in connection with employee stock programs. No shares of our common stock
from the open market were purchased during 2004, 2003 and 2002. As of January 1, 2005, we have
repurchased 103,000 shares of common stock under this program. Critical Accounting Policies The preparation of our consolidated financial statements in conformity with United States
Generally Accepted Accounting Principles (GAAP) requires us to make estimates and judgments that
affect the reported amounts of assets and liabilities, net sales and expenses, and the related
disclosures. We base our estimates on historical experience, our knowledge of economic and market
factors and various other assumptions we believe to be reasonable under the circumstances. Actual
results may differ from these estimates under different assumptions or conditions. We believe the
following critical accounting policies are affected by significant estimates, assumptions, and
judgments used in the preparation of our condensed consolidated financial statements. Revenue Recognition Revenue from product sales is recognized upon receipt of a purchase order and product shipment
provided no significant obligations remain and collection of the
receivables is reasonably assured.
Shipments are generally made with Free-On-Board (FOB) shipping point terms, whereby title passes
upon shipment from our dock. Any shipments with FOB receiving point terms are recorded as revenue
when the shipment arrives at the receiving point. Deferred revenue relating to warranty contracts
is recognized on a straight line basis over the period of the applicable warranty contract. Cost
is recognized as incurred. Up-front fees received in connection with product sales are deferred
and recognized over the associated product shipments. -28-




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Warranty The Company accrues for estimated warranty costs upon shipment of products in accordance with
SFAS No. 5, Accounting for Contingencies. Actual warranty costs incurred have not materially
differed from those accrued. The Companys warranty policy is effective for shipped products which
are considered defective or fail to meet the product specifications.
We analyze failure rates, replacement cost, design changes when
evaluating the adequacy of our warranty reserve.
 Warranty costs are reflected
in the income statement as a cost of revenues.
Although we believe we have the ability to reasonably estimate
warranty expenses, unforeseen changes in factors affecting the
estimate for warranty could occur and such changes could cause a
material change in our warranty accrual estimate. Such a change would
be recorded in the period in which the change was identified. Sales Returns Allowance and Allowance for Doubtful Accounts In the process of preparing financial statements we must make estimates and assumptions that
affect the reported amount of assets and disclosures of contingent assets and liabilities at the
date of the financial statements and the reported amounts of revenues and expenses during the
reported period. Specifically, we must estimate future product returns related to current period
product revenue. We analyze historical returns, current economic trends and changes in customer
demand and acceptance of our products when evaluating the adequacy of the sales returns allowance
and other allowances. Significant management judgments and estimates must be made and used in
connection with establishing the sales returns and other allowances in any accounting period.
Material differences may result in the amount and timing of our revenue for any period if
management made different judgments or utilized different estimates. The provision for sales
returns amounted to $0.2 million in 2004. Similarly our management must make estimates of the
uncollectibility of our accounts receivable. Management specifically analyzes accounts receivable
and analyzes historical bad debts, customer concentrations, customer credit-worthiness, current
economic trends and changes in our customer payment terms when evaluating the adequacy of the
allowance for doubtful accounts. Our accounts receivable balance was $7.4 million, net of
allowance for doubtful accounts of $0.5 million as of January 1, 2005. Inventories. Inventories are stated at the lower of cost or market
and include on-hand inventory, sales demo inventory and service
loaner inventory as well as associated inventory reserves. Cost of
inventory is determined on a standard cost
basis which approximates actual cost on a first-in, first-out (FIFO) method. Adjustments to reduce
the cost of inventory to its net realizable value, if required, are made for estimated excess, obsolescence or impaired inventory
and are charged to cost of goods sold. Factors influencing these adjustments
include changes in demand, product life cycle and development plans, component cost trends, product
pricing, physical deterioration and quality issues. Revisions to these adjustments would be
required if these factors differ from our estimates. Income Taxes Deferred assets and liabilities are recognized for the future consequences attributable to
differences between the financial statement carrying amounts of existing assets and liabilities and
their respective tax basis. Deferred tax assets and liabilities are measured using enacted tax
rates expected to apply to taxable income in the years in which those temporary differences are
expected to be recovered or settled. Valuation allowances are established when necessary to reduce
deferred tax assets to the amounts expected to be realized. Changes in estimate of future levels
of taxable income or tax planning strategies could result in the need to provide or increase the
valuation allowance against the net deferred tax assets which could materially impact earnings in
the period of change. -29-




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Contractual Obligations The following table summarizes purchase commitments and minimum rentals due for our facility
and other leased assets under long-term, non-cancelable operating leases as of January 1, 2005(in
thousands): Payments Due by Period Contractual Obligations
    
    Total
    
    
    2005
    
    
    2006
    
    
    2007
    
    
    2008
    
    
    2009
    
    
    2010 and thereafterOperating Leases
    
    $
    1,709
    
    
    $
    390
    
    
    $
    402
    
    
    $
    416
    
    
    $
    429
    
    
    $
    72
    
    
    $
    0Unconditional
Purchase
Obligations*
    
    $
    10,050
    
    
    $
    8,814
    
    
    $
    1,236
    
    
    $
    0
    
    
    $
    0
    
    
    $
    0
    
    
    $
    0Total Contractual
Cash Obligations
    
    $
    11,759
    
    
    $
    9,204
    
    
    $
    1,638
    
    
    $
    416
    
    
    $
    429
    
    
    $
    0
    
    
    $
    0
   *
    
    Contractual purchase obligations have varying cancellation terms. Recent Accounting Pronouncements In November 2004, the Financial Accounting Standards Board ( FASB ) issued SFAS No. 151,
Inventory Costs, an amendment of ARB No. 43, Chapter 4. SFAS No. 151 clarifies the accounting for
abnormal amounts of idle facility expense, freight, handling costs and wasted material. SFAS No.
151 is effective for inventory costs incurred during fiscal years beginning in the second quarter
of fiscal 2006. We do not believe the adoption of SFAS No. 151 will have a material effect on our
consolidated financial position, results of operations or cash flows. In December 2004, the FASB issued SFAS No. 123R, Share-Based Payment, which replaced SFAS No.
123 and superseded APB 25. SFAS No. 123R addresses the accounting for share-based payment
transactions in which a company receives employee services in exchange for either equity
instruments of the company or liabilities that are based on the fair value of the Company s equity
instruments or that may be settled by the issuance of such equity instruments. Under SFAS No. 123R,
companies will no longer be able to account for share-based compensation transactions using the
intrinsic method in accordance with APB 25 but will be required to account for such transactions
using a fair-value method and recognize the expense in the consolidated statement of earnings. SFAS
No. 123R is effective beginning in the third quarter of fiscal
2005 and allows, but does not
require, companies to restate the full fiscal year of adoption to reflect the impact of expensing
share-based payments under SFAS No. 123R. The Company has not yet determined which fair-value
method and transitional provision it will follow. The pro forma impact on the Companys financial
statements of applying Black-Scholes option valuation method of accounting for stock options is
disclosed in the Notes to Consolidated Financial Statements. -30-




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Factors That May Affect Future Results In addition to the other information contained in this Form 10-K, we have identified the
following risks and uncertainties that may have a material adverse effect on our business,
financial condition or results of operation. You should carefully consider the risks described
below before making an investment decision. We Rely on Continued Market Acceptance of Our Existing Products and Any Decline in Sales of
Our Existing Products Would Adversely Affect Our Business and Results of Operations.We currently
market visible and infrared light semiconductor-based photocoagulator medical laser systems to the
ophthalmic market. We also market visible and infrared light semiconductor-based photocoagulator
medical laser systems to the dermatology market. We believe that continued and increased sales, if
any, of these medical laser systems is dependent upon a number of factors including the following:  
    Product performance, features, ease of use, scalability and durability;
    Recommendations and opinions by ophthalmologists, dermatologists, other
clinicians, plastic surgeons and their associated opinion leaders, including study
outcomes;
    Price of our products and prices of competing products and technologies;
    Availability of competing products, technologies and alternative treatments;
    Willingness of ophthalmologists and dermatologists to convert to
semiconductor-based or infrared laser systems from alternative technologies; and
    Level of reimbursement for treatments administered with our products. In addition, we derive a meaningful portion of our revenues from the sale of delivery devices. Our
ability to increase revenues from the sale of delivery devices will depend primarily upon the
features, ease of use and prices of our products, including the relationship to prices of competing
delivery devices. The level of service revenues will depend on our quality of care, responsiveness
and the willingness of our customers to request our services rather than purchase competing
products or services. Any significant decline in market acceptance of our products or our revenues
derived from the sales of laser consoles, delivery devices or services would have a material
adverse effect on our business, results of operations and financial condition. We Face Strong Competition in Our Markets and Expect the Level of Competition to Grow in the
Foreseeable Future.Competition in the market for devices used for ophthalmic and dermatology
treatment procedures is intense and is expected to increase. Our competitive position depends on a
number of factors including product performance, characteristics and functionality, ease of use,
scalability, durability and cost. Our principal laser competitors in ophthalmology are Lumenis Ltd.,
Carl Zeiss, Inc., Alcon, Quantel, Laserex and Nidek, Inc. All of these companies currently offer a
competitive semiconductor-based laser system in ophthalmology.
Also within ophthalmology pharmaceutical alternative treatments for
AMD such as Visudyne (Novartis) and Macugen (Eyetech) compete
rigorously with traditional laser procedures.
 Our principal competitors in
dermatology are Palomar Technologies, Laserscope, Candela Corporation, Lumenis Ltd. and Cutera,
Inc. Some competitors have substantially greater financial, engineering, product development,
manufacturing, marketing and technical resources than we do. Some companies also have greater name
recognition than we do and long-standing customer relationships. In addition to other companies
that manufacture photocoagulators, we compete with pharmaceuticals, other technologies and other
surgical techniques. Some medical companies, academic and research institutions, or others, may
develop new technologies or therapies that are more effective in
treating conditions targeted by us or are less expensive than our current or future products. Any such developments could have a
material adverse effect on our business, financial condition and results of operations. -31-




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Our Future Success Depends on Our Ability to Develop and Successfully Introduce New Products
and New Applications. Our future success is dependent upon, among other factors, our ability to
develop, obtain regulatory approval or clearance of, manufacture and market new products. In
September and October 2004 we introduced two new laser products, the IQ810 in ophthalmology and the
VariLite in dermatology. In May 2004, we introduced a new type of illuminating Endoprobe. In
June 2003 we began shipment of two new products; a 50 micron slit lamp adaptor and a 25 gauge
single-use Endoprobe. In October 2002, we announced the introduction of a number of new products,
specifically the OcuLight Symphony multi-wavelength laser delivery system, an expanded EndoProbe
product line and a 5 mm Large Spot Slit Lamp Adapter. We also announced the Millennium Endolase
module in 2002, which we manufacture to be included in Bausch & Lombs Millennium Microsurgical
System. Successful commercialization of these and other new products and new applications will
require that we effectively transfer production processes from research and development to
manufacturing and effectively coordinate with our suppliers. In addition, we must successfully
sell and achieve market acceptance of new products and applications and enhanced versions of
existing products. The extent of, and rate at which, market acceptance and penetration are
achieved by future products is a function of many variables, which include, among other things,
price, safety, efficacy, reliability, marketing and sales efforts, the development of new
applications for these products, the availability of third-party reimbursement of procedures using
our new products, the existence of competing products and general economic conditions affecting
purchasing patterns. Our ability to market and sell new products may also be subject to government
regulation, including approval or clearance by the United States Food and Drug Administration, or
FDA, and foreign government agencies. Any failure in our ability to successfully develop and
introduce new products or enhanced versions of existing products and achieve market acceptance of
new products and new applications could have a material adverse effect on our operating results and
would cause our net revenues to decline. If We Cannot Increase Our Sales Volumes, Reduce Our Costs or Introduce Higher Margin Products
to Offset Anticipated Reductions in the Average Unit Price of Our Products, Our Operating Results
May Suffer.We have experienced declines in the average unit price of our products and expect to
continue to suffer from declines in the future. The average unit price of our products may
decrease in the future in response to changes in product mix, competitive pricing pressures, new
product introductions by our competitors or other factors. If we are unable to offset the
anticipated decrease in our average selling prices by increasing our sales volumes or through new
product introductions, our net revenues will decline. In addition, to maintain our gross margins,
we must continue to reduce the manufacturing cost of our products. If we cannot maintain our gross
margins, our business could be seriously harmed, particularly if the average selling price of our
products decreases significantly without a corresponding increase in sales. We Depend on Sales of Our Ophthalmology Products for a Significant Portion of Our Operating
Results. We derive, and expect to continue to derive, a large portion of our revenue and profits
from sales of our ophthalmology products. In 2004, 2003 and 2002 sales of our ophthalmology
products were $27.8 million, $26.2 million and $24.2 million or 84.6%, 82.5% and 78.9%,
respectively, of total sales. We anticipate that sales of our ophthalmology products will continue
to account for a significant portion of our revenues in the foreseeable future as we continue to
introduce new ophthalmology products, such as the IQ810 Laser System. -32-




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We Depend on International Sales for a Significant Portion of Our Operating Results. We
derive, and expect to continue to derive, a large portion of our revenue from international sales.
In 2004, 2003 and 2002, our international sales were $12.9 million, $11.6 million and $11.1
million, or 39.4%, 36.7% and 36.1%, respectively, of total sales. We anticipate that international
sales will continue to account for a significant portion of our revenues in the foreseeable future.
None of our international revenues and costs has been denominated in foreign currencies. As a
result, an increase in the value of the U.S. dollar relative to foreign currencies makes our
products more expensive and thus less competitive in foreign markets. The factors stated above
could have a material adverse effect on our business, financial condition or results of operations.
Our international operations and sales are subject to a number of other risks including: Changes in government legislation or regulation or in private third-party payers policies
toward reimbursement for procedures employing our products may prohibit adequate reimbursement.
There have been a number of legislative and regulatory proposals to change the healthcare system,
reduce the costs of healthcare and change medical reimbursement policies. Doctors, clinics,
hospitals and other users of our products may decline to purchase our products to the extent there
is uncertainty regarding reimbursement of medical procedures using our products and any healthcare
reform measures. Further proposed legislation, regulation and policy changes affecting third party
reimbursement are likely. We are unable to predict what legislation or
regulation, if any, relating to the health care industry or third-party coverage and
reimbursement may be enacted in the future, or what effect such legislation or regulation may have
on us. However, denial of coverage and reimbursement of our products would have a material adverse
effect on our business, results of operations and financial condition. We Rely on Our Direct Sales Force and Network of International Distributors to Sell Our
Products and any Failure to Maintain Our Direct Sales Force and Distributor Relationships Could
Harm Our Business.Our ability to sell our products and generate revenue depends upon our direct
sales force within the United States and relationships with independent distributors outside the
United States. As of January 1, 2005 our direct sales force consisted of 13 employees with 3
additional open positions and we maintained relationships with 68 independent distributors
internationally selling our products into 107 countries. We generally grant our distributors
exclusive territories for the sale of our products in specified countries. The amount and timing
of resources dedicated by our distributors to the sales of our products is not within our control.
Our international sales are entirely dependent on the efforts of these third parties. If any
distributor breaches or fails to generate sales of our products, we may be forced to replace the
distributor and our ability to sell our products into that exclusive sales territory would be
adversely affected. We do not have any long-term employment contracts with the members of our direct sales force. We
may be unable to replace our direct sales force personnel with individuals of equivalent technical
expertise and qualifications, which may limit our revenues and our ability to maintain market
share. The loss of the services of these key personnel would harm our business. Similarly, our
distributorship agreements are generally terminable at will by either party and distributors may
terminate their relationships with us, which would affect our international sales and results of
operations. -33-




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We are Dependent on the Successful Outcome of Clinical Trials of Our Products and New
Applications Using Our Products.Our success will depend in part on the successful outcome of
clinical trials of our products and new applications using our products. Clinical trials are long,
expensive and uncertain processes. We have supported several clinical trials, including, for
example, the TTT4CNV clinical trial. The TTT4CNV clinical trial is a physician initiated
multi-center, prospective, double-masked, placebo-controlled, randomized trial conducted at 22
centers in the United States. This is a clinical trial performed within the FDA cleared
indications of the OcuLight SLx and is being conducted to determine whether TTT laser treatment
using our OcuLight SLx infrared laser system and Large Spot Slit Lamp Adapter can reduce the risk
of vision loss for patients with wet AMD compared to a randomized control, which should reflect the
natural history of the disease. In June 2003, we announced the publication of two additional
clinical studies, which also support the effectiveness of TTT for the treatment of wet age-related
macular degeneration. Both studies were prospective, non-randomized, non-masked case series that
were performed using our OcuLight SLx laser and Large Spot Size Slit Lamp Adapter. In October 2004,
we announced that the preliminary visual outcome data in the intent-to-treat evaluation showed that
TTT, as applied in the TTT4CNV trial, did not result in a significant beneficial effect relative to
sham and that further subgroup analysis would be conducted. Since that time, interim results of
subgroup analysis have demonstrated a statistically significant benefit in a subgroup of patients
with baseline visual acuity of 20/100 or worse, 22% of treated eyes improved vision by one or more
lines compared with none of the eyes in the untreated control group. Furthermore, at 18 months,
there was a 2 line benefit in preserving vision in this subgroup when compared to sham treated
eyes. Any impact on laser sales related to these trial results may take a number of years. If
the future results of any clinical trial regarding our products fails to demonstrate improved
outcomes of treatments using our products, our ability to generate revenues from new products or
new applications using our products would be adversely affected. We Face Manufacturing Risks. The manufacture of our infrared and visible light
photocoagulators and the related delivery devices is a highly complex and precise process. We
assemble critical subassemblies and all of our final products at our facility in Mountain View,
California. We may experience manufacturing difficulties, quality control issues or assembly
constraints, particularly with regard to new products that we may introduce. We may not be able to
manufacture sufficient quantities of our products, which may require that we qualify
other manufacturers for our products. Furthermore, we may experience delays, disruptions, capacity
constraints or quality control problems in our manufacturing operations and, as a result, product
shipments to our customers could be delayed, which would negatively impact our net revenues. If We Fail to Accurately Forecast Demand For Our Product and Component Requirements For the
Manufacture of Our Product, We Could Incur Additional Costs or Experience Manufacturing Delays and
May Experience Lost Sales or Significant Inventory Carrying Costs.We use quarterly and annual
forecasts based primarily on our anticipated product orders to plan our manufacturing efforts and
determine our requirements for components and materials. It is very important that we accurately
predict both the demand for our product and the lead times required to obtain the necessary
components and materials. Lead times for components vary significantly and depend on numerous
factors, including the specific supplier, the size of the order, contract terms and current market
demand for such components. If we overestimate the demand for our product, we may have excess
inventory, which would increase our costs. Over the past several quarters, we have placed a high
priority on our asset management efforts to, among other things, reduce overall inventory levels
and increase our cash position. If we underestimate demand for our product and, consequently, our
component and materials requirements, we may have inadequate inventory, which could interrupt our
manufacturing, delay delivery of our product to our customers and result in the loss of customer
sales. Any of these occurrences would negatively impact our business and operating results. -34-




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We Depend on Sole Source or Limited Source Suppliers.We rely on third parties to manufacture
substantially all of the components used in our products, including optics, laser diodes and
crystals. We have some long term or volume purchase agreements with our suppliers and currently
purchase components on a purchase order basis. Some of our suppliers and manufacturers are sole or
limited sources. In addition, some of these suppliers are relatively small private companies that
may discontinue their operations at any time. There are risks associated with the use of
independent manufacturers, including the following:  
    Shortages or limitations on the ability to obtain supplies of components in the
quantities that we require;
    Delays in delivery or failure of suppliers to deliver critical components on the
dates we require;
    Failure of suppliers to manufacture components to our specifications, and
potentially reduced quality; and
    Inability to obtain components at acceptable prices. Our business and operating results may suffer from the lack of alternative sources of supply for
critical sole and limited source components.The process of qualifying suppliers is complex,
requires extensive testing with our products, and may be lengthy, particularly as new products are
introduced. New suppliers would have to be educated in our production processes. In addition, the
use of alternate components may require design alterations to our products and additional product
testing under FDA and relevant foreign regulatory agency guidelines, which may delay sales and
increase product costs. Any failures by our vendors to adequately supply limited and sole source
components may impair our ability to offer our existing products, delay the submission of new
products for regulatory approval and market introduction, materially harm our business and
financial condition and cause our stock price to decline. Establishing our own capabilities to
manufacture these components would be expensive and could significantly decrease our profit
margins. We do not currently intend to manufacture any of these components. Our business, results
of operations and financial condition would be adversely affected if we are unable to continue to
obtain components in the quantity and quality desired and at the prices we have budgeted. Our Operating Results May Fluctuate from Quarter to Quarter and Year to Year. Our sales and
operating results may vary significantly from quarter to quarter and from year to year in the
future. Our operating results are affected by a number of factors, many of which are beyond our
control. Factors contributing to these fluctuations include the following:  
    General economic uncertainties and political concerns;
    The timing of the introduction and market acceptance of new products, product
enhancements and new applications;
    Changes in demand for our existing line of dermatology and ophthalmic products;
    The cost and availability of components and subassemblies, including the ability of our
sole or limited source suppliers to deliver components at the times and prices that we have
planned;
    Our ability to maintain sales volumes at a level sufficient to cover fixed manufacturing
and operating costs;
    Fluctuations in our product mix between dermatology and ophthalmic products and foreign
and domestic sales;
    The effect of regulatory approvals and changes in domestic and foreign regulatory
requirements;
    Introduction of new products, product enhancements and new applications by our
competitors, entry of new competitors into our markets, pricing pressures and other
competitive factors;
    Our long and highly variable sales cycle;
    Changes in the prices at which we can sell our products;
    Changes in customers or potential customers budgets as a result of, among other
things, reimbursement policies of government programs and private insurers for treatments
that use our products; and
    Increased product development costs. In addition to these factors, our quarterly results have been, and are expected to continue to be,
affected by seasonal factors. -35-




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Our expense levels are based, in part, on expected future sales. If sales levels in a particular
quarter do not meet expectations, we may be unable to adjust operating expenses quickly enough to
compensate for the shortfall of sales, and our results of operations may be adversely affected. In
addition, we have historically made a significant portion of each quarters product shipments near
the end of the quarter. If that pattern continues, any delays in shipment of products could have a
material adverse effect on results of operations for such quarter. Due to these and other factors,
we believe that quarter to quarter and year to year comparisons of our past operating results may
not be meaningful. You should not rely on our results for any quarter or year as an indication of
our future performance. Our operating results in future quarters and years may be below
expectations, which would likely cause the price of our common stock to fall. We Depend on Collaborative Relationships to Develop, Introduce and Market New Products,
Product Enhancements and New Applications. We depend on both clinical and commercial collaborative
relationships. We have entered into collaborative relationships with academic medical centers and
physicians in connection with the research and development and clinical testing of our products.
Commercially, we currently collaborate with Bausch & Lomb to design and manufacture a solid-state
green wavelength (532 nm) laser photocoagulator module, called the Millennium Endolase module. The
Millennium Endolase module is designed to be a component of Bausch & Lombs ophthalmic surgical
suite product offering and is not expected to be sold as a stand-alone product. Sales of the
Millennium Endolase module are dependent upon the actual order rate from and shipment rate to
Bausch & Lomb, which depends on the efforts of our partner and is beyond our control. We cannot
assure you that our relationship with Bausch & Lomb will result in further sales of our Millennium
Endolase module. We also collaborated with Miravant Medical Technologies, a maker of photodynamic
drugs, on a device that emits a laser beam to activate a photodynamic drug developed by Miravant
for the treatment of wet AMD. In January 2002, Miravant announced that the top line results of
their Phase III clinical trial indicated that PHOTREX the photodynamic drug developed, did not meet
the primary efficacy endpoint in the study population. As we could
not be assured that PHOTREX would
be timely or successfully pursued through clinical trials by Miravant, we charged to expense in the
fourth quarter of 2001, $0.3 million of inventory related to the OcuLight 664, the laser used by
Miravant in the Phase III clinical trials. Miravant has since received an approvable letter from
the FDA for PHOTREX with conditions for final marketing approval which includes a request for an
additional confirmatory clinical trial. We are the exclusive provider of the OcuLight 664
activation laser used in this application. Successful commercialization of this product will
depend, among other things, on the results of the confirmatory clinical trial, acceptance of this
product and Miravants ability to successfully market and sell this therapy. The failure of any
current or future clinical or commercial collaboration relationships could have a material adverse
effect on our ability to introduce new products or applications and therefore could have a material
adverse effect on our business, results of operations and financial condition. We Face Risks Associated with our Collaborative Relationships.Our collaborators may not
pursue further development and commercialization of products resulting from collaborations with us
or may not devote sufficient resources to the marketing and sale of such products. Our reliance on
others for clinical development, manufacturing and distribution of our products may result in
unforeseen problems. Further, our collaborative partners may develop or pursue alternative
technologies either on their own or in collaboration with others. If a collaborator elects to
terminate its agreement with us, our ability to develop, introduce, market and sell the product may
be significantly impaired and we may be forced to discontinue altogether the product resulting from
the collaboration. We may not be able to negotiate alternative collaboration agreements on
acceptable terms, if at all. The failure of any current or future collaboration efforts could have
a material adverse effect on our ability to introduce new products or applications and therefore
could have a material adverse effect on our business, results of operations and financial
condition. -36-




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We Are Subject To Government Regulation Which May Cause Us to Delay or Withdraw the
Introduction of New Products or New Applications for Our Products.The medical devices that we
market and manufacture are subject to extensive regulation by the FDA and by foreign and state
governments. Under the Federal Food, Drug and Cosmetic Act and the related regulations, the FDA
regulates the design, development, clinical testing, manufacture, labeling, sale, distribution and
promotion of medical devices. Before a new device can be introduced into the market, the product
must undergo rigorous testing and an extensive regulatory review process implemented by the FDA
under federal law. Unless otherwise exempt, a device manufacturer must obtain market clearance
through either the 510(k) premarket notification process or the lengthier premarket approval
application (PMA) process. Depending upon the type, complexity and novelty of the device and the
nature of the disease or disorder to be treated, the FDA process can take several years, require
extensive clinical testing and result in significant expenditures. Even if regulatory approval is
obtained, later discovery of previously unknown safety issues may result in restrictions on the
product, including withdrawal of the product from the market. Other countries also have extensive
regulations regarding clinical trials and testing prior to new product introductions. Our failure
to obtain government approvals or any delays in receipt of such approvals would have a material
adverse effect on our business, results of operations and financial condition. The FDA imposes additional regulations on manufacturers of approved medical devices. We are
required to comply with the applicable Quality System Regulations (QSRs) and our manufacturing
facilities are subject to ongoing periodic inspections by the FDA and corresponding state agencies,
including unannounced inspections, and must be licensed as part of the product approval process
before being utilized for commercial manufacturing. Noncompliance with the applicable requirements
can result in, among other things, fines, injunctions, civil penalties, recall or seizure of
products, total or partial suspension of production, withdrawal of marketing approvals, and
criminal prosecution. The FDA also has the authority to request repair, replacement or refund of
the cost of any device we manufacture or distribute. Any of these actions by the FDA would
materially and adversely affect our ability to continue operating our business and the results of
our operations. In addition, we are also subject to varying product standards, packaging requirements,
labeling requirements, tariff regulations, duties and tax requirements. As a result of our sales
in Europe, we are required to have all products CE marked, an international symbol affixed to all
products demonstrating compliance with the European Medical Device Directive and all applicable
standards. While currently all of our released products are CE marked, continued certification is
based on the successful review of our quality system by our European Registrar during their annual
audit. Any loss of certification would have a material adverse effect on our business, results of
operations and financial condition. Our products could be subject to recalls even after receiving FDA approval or clearance. A
recall would harm our reputation and adversely affect our operating results.The FDA and similar
governmental authorities in other countries in which we market and sell our products have the
authority to require the recall of our products in the event of material deficiencies or defects in
design or manufacture. A government mandated recall, or a voluntary recall by us, could occur as a
result of component failures, manufacturing errors or design defects, including defects in
labeling. A recall could divert managements attention, cause us to incur significant expenses,
harm our reputation with customers and negatively affect our future sales. If we modify one of our FDA approved or cleared devices, we may need to seek new approvals or
clearances which, if not granted, would prevent us from selling our modified products. -37-




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Any modifications to an FDA-approved or cleared device that would significantly affect its
safety or effectiveness or that would constitute a major change in its intended use would require a
new 510(k) clearance or possibly a PMA approval. We may not be able to obtain additional 510(k)
clearances or PMA approvals for new products or for modifications to, or additional intended uses
or indications for, our existing products in a timely fashion, or at all. Delays in obtaining
future clearances would adversely affect our ability to introduce new or enhanced products in a
timely manner, which in turn would harm our revenue and future profitability. We have made
modifications to our devices and the labeling of our devices in the past and may make additional
modifications in the future that we believe do not or will not require additional clearances or
approvals. If the FDA disagrees and requires new clearances or
approvals for the modifications, we
may be required to recall and stop marketing the modified devices, which could harm our operating
results and require us to redesign or relabel our products. We Rely on Patents and Proprietary Rights to Protect our Intellectual Property and Business.
Our success and ability to compete is dependent in part upon our proprietary information. We rely
on a combination of patents, trade secrets, copyright and trademark laws, nondisclosure and other
contractual agreements and technical measures to protect our intellectual property rights. We file
patent applications to protect technology, inventions and improvements that are significant to the
development of our business. We have been issued fifteen United States patents and five foreign
patents on the technologies related to our products and processes. We have approximately four
pending patent applications in the United States and five foreign pending patent applications that
have been filed. Our patent applications may not be approved. Any patents granted now or in the
future may offer only limited protection against potential infringement and development by our
competitors of competing products. Moreover, our competitors, many of which have substantial
resources and have made substantial investments in competing technologies, may seek to apply for
and obtain patents that will prevent, limit or interfere with our ability to make, use or sell
our products either in the United States or in international markets. In addition to patents, we rely on trade secrets and proprietary know-how which we seek to
protect, in part, through proprietary information agreements with employees, consultants and other
parties. Our proprietary information agreements with our employees and consultants contain
industry standard provisions requiring such individuals to assign to us without additional
consideration any inventions conceived or reduced to practice by them while employed or retained by
us, subject to customary exceptions. Proprietary information agreements with employees,
consultants and others may be breached, and we may not have adequate remedies for any breach.
Also, our trade secrets may become known to or independently developed by competitors. The laser and medical device industry is characterized by frequent litigation regarding patent
and other intellectual property rights. Companies in the medical device industry have employed
intellectual property litigation to gain a competitive advantage. Numerous patents are held by
others, including academic institutions and our competitors. Until recently patent applications
were maintained in secrecy in the United States until the patents issued. Patent applications
filed in the United States after November 2000 generally will be published eighteen months after
the filing date. However, since patent applications continue to be maintained in secrecy for at
least some period of time, both within the United States and with regards to international patent
applications, we cannot assure you that our technology does not infringe any patents or patent
applications held by third parties. We have, from time to time, been notified of, or have
otherwise been made aware of, claims that we may be infringing upon patents or other proprietary
intellectual property owned by others. If it appears necessary or desirable, we may seek licenses
under such patents or proprietary intellectual property. Although patent holders commonly offer
such licenses, licenses under such patents or intellectual property may not be offered or the terms
of any offered licenses may not be reasonable. -38-




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Any claims, with or without merit, and regardless of whether we are successful on the merits,
would be time-consuming, result in costly litigation and diversion of technical and management
personnel, cause shipment delays or require us to develop noninfringing technology or to enter into
royalty or licensing agreements. An adverse determination in a judicial or administrative
proceeding and failure to obtain necessary licenses or develop alternate technologies could prevent
us from manufacturing and selling our products, which would have a material adverse effect on our
business, results of operations and financial condition. Our Operating Results May be Adversely Affected by Changes in Third Party Coverage and
Reimbursement Policies and any Uncertainty Regarding Healthcare Reform Measures.Our ophthalmology
products are typically purchased by doctors, clinics, hospitals and other users, which bill various
third-party payers, such as governmental programs and private insurance plans, for the health care
services provided to their patients. Third-party payers are increasingly scrutinizing and
challenging the coverage of new products and the level of reimbursement for covered products.
Doctors, clinics, hospitals and other users of our products may not obtain adequate reimbursement
for use of our products from third-party payers. While we believe that the laser procedures using
our products have generally been reimbursed, payers may deny coverage and reimbursement for our
products if they determine that the device was not reasonable and necessary for the purpose used,
was investigational or was not cost-effective. In addition, third party payers may not initiate
coverage of new procedures using our products for a significant period. In September 2000, the
Center for Medicare and Medicaid Services, or CMS, advised that claims for reimbursement for
certain age related macular degeneration, or AMD, procedures which use our OcuLight SLx laser
system, could be submitted for reimbursement, with coverage and payment to be determined by the
local medical carriers at their discretion. To date five carriers representing 17 states have
written reimbursement coverage policies on Transpupillary Thermotherapy, or TTT. The states
reimbursing for TTT are Alaska, Arizona, California, Colorado, Hawaii, Iowa, Idaho, Mississippi,
North Carolina, North Dakota, Nevada, Oregon, Pennsylvania, South Dakota, Tennessee, Washington and
Wyoming. Domestic sales of the infrared laser systems may continue to be limited until more
local medical carriers reimburse for performing such AMD procedures or until CMS advises that
claims for these procedures may be submitted directly to CMS at the national level. Changes in government legislation or regulation or in private third-party payers policies
toward reimbursement for procedures employing our products may prohibit adequate reimbursement.
There have been a number of legislative and regulatory proposals to change the healthcare system,
reduce the costs of healthcare and change medical reimbursement policies. Doctors, clinics,
hospitals and other users of our products may decline to purchase our products to the extent there
is uncertainty regarding reimbursement of medical procedures using our products and any healthcare
reform measures. Further proposed legislation, regulation and policy changes affecting third party
reimbursement are likely. We are unable to predict what legislation or
regulation, if any, relating to the health care industry or third-party coverage and
reimbursement may be enacted in the future, or what effect such legislation or regulation may have
on us. However, denial of coverage and reimbursement of our products would have a material adverse
effect on our business, results of operations and financial condition. If Product Liability Claims are Successfully Asserted Against Us, We may Incur Substantial
Liabilities That May Adversely Affect Our Business or Results of Operations.We may be subject to
product liability claims from time to time. Our products are highly complex and some are used to
treat extremely delicate eye tissue and skin conditions on and near a patients face. Although we
maintain product liability insurance with coverage limits of $10.0 million per occurrence and an
annual aggregate maximum of $10.0 million, our coverage from our insurance policies may not be
adequate. Product liability insurance is expensive. We might not be able to obtain product
liability insurance in the future on acceptable terms or in sufficient amounts to
protect us, if at all. A successful claim brought against us in excess of our insurance
coverage could have a material adverse effect on our business, results of operations and financial
condition. -39-




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If We Fail to Manage Growth Effectively, Our Business Could Be Disrupted Which Could Harm Our
Operating Results.We have experienced, and may continue to experience growth in our business. We
have made and expect to continue to make significant investments to enable our future growth
through, among other things, new product development and clinical trials for new applications and
products. We must also be prepared to expand our work force and to train, motivate and manage
additional employees as the need for additional personnel arises. Our personnel, systems,
procedures and controls may not be adequate to support our future operations. Any failure to
effectively manage future growth could have a material adverse effect on our business, results of
operations and financial condition. If Our Facilities Were To Experience Catastrophic Loss, Our Operations Would Be Seriously
Harmed.Our facilities could be subject to catastrophic loss such as fire, flood or earthquake.
All of our research and development activities, manufacturing, our corporate headquarters and other
critical business operations are located near major earthquake faults in Mountain View, California.
Any such loss at any of our facilities could disrupt our operations, delay production, shipments
and revenue and result in large expense to repair and replace our facilities. We May Need Additional Capital, which May Not Be Available, and Our Ability to Grow May be
Limited as a Result.We believe that our existing cash balances, available-for-sale securities,
credit facilities and cash flow expected to be generated from future operations will be sufficient
to meet our capital requirements at least through the next 12 months. However, we may be required,
or could elect, to seek additional funding prior to that time. The development and marketing of
new products and associated support personnel requires a significant commitment of resources. If
cash from available sources is insufficient, we may need additional capital, which may not be
available on favorable terms, if at all. If we cannot raise funds on acceptable terms, we may not
be able to develop or enhance our products, take advantage of future opportunities, fund potential
acquisitions or respond to competitive pressures or unanticipated requirements. Any inability to
raise additional capital when we require it would seriously harm our business. Our Stock Price Has Been and May Continue to be Volatile and an Investment in Our Common Stock
Could Suffer a Decline in Value.The trading price of our common stock has been subject to wide
fluctuations in response to a variety of factors, some of which are beyond our control, including
quarterly variations in our operating results, announcements by us or our competitors of new
products or of significant clinical
achievements, changes in market valuations of other similar companies in our industry and
general market conditions. We receive only limited attention by securities analysts and may
experience an imbalance between supply and demand for our common stock resulting from low trading
volumes. In addition, the stock market has experienced extreme volatility in the last few years
that has often been unrelated to the performance of particular companies. These broad market
fluctuations could have a significant impact on the market price of our common stock regardless of
our performance. Changes in Accounting Rules.We prepare our financial statements in conformity with accounting
principles generally accepted in the United States of America. These principles are subject to
interpretation by the Securities and Exchange Commission, or the SEC, and various bodies formed to
interpret and create appropriate accounting policies. A change in these policies can have a
significant effect on our reported results and may even retroactively affect previously reported
transactions. -40-




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Changes in Accounting Rules
 for Stock-Based Compensation May Adversely Affect Our Operating Results, Our Stock Price and Our
 Competitiveness in the Employee Marketplace. We have a history of using
employee stock options and other stock-based compensation to hire, motivate and retain our
workforce. In December 2004, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 123R, Share-Based
Payment, which will require us, starting
in the second half of 2005, to measure compensation costs for all stock-based compensation
(including stock options and our employee stock purchase plan) at fair value and to recognize
these costs as expenses in our statements of operations. The recognition of these expenses in our
statements of operations will result in lower earnings per share, which could negatively impact
our future stock price. In addition, if we reduced or alter our use of stock-based compensation
to minimize the recognition of these expenses, our ability to recruit, motivate and retain
employees may be impaired, which could put us at a competitive disadvantage in the employee
marketplace. Compliance
With Internal Controls Evaluations and Attestation Requirements. Pursuant to Section 404 of
the Sarbanes-Oxley Act of 2002, we will be required, beginning in fiscal 2006, to perform an
evaluation of our internal controls over financial reporting and have our auditor publicly attest
to such evaluation. We have prepared an internal plan of action for compliance, which includes a
timeline and scheduled activities, although as of the date of this filing we have not yet prepared
the evaluation. Compliance with these requirements is expected to be expensive and
time-consuming. If we fail to timely complete this evaluation, or if our registered independent
public accounting firm cannot timely attest to our evaluation, we could be subject to regulatory
scrutiny and a loss of public confidence in our internal controls. In addition, any failure to
implement required new or improved controls, or difficulties encountered in their implementation,
could harm our operating results or cause us to fail to meet our reporting obligations. Item 7A. Quantitative and Qualitative Disclosures About Market Risk Quantitative Disclosures We are exposed to market risks inherent in our operations, primarily related to interest rate
risk and currency risk. These risks arise from transactions and operations entered into in the
normal course of business. We do not use derivatives to alter the interest characteristics of our
marketable securities or our debt instruments. We have no holdings of derivative or commodity
instruments. Interest Rate Risk. We are subject to interest rate risks on cash and cash equivalents,
available-for-sale marketable securities and any future financing requirements. Interest rate risks
related to marketable securities are managed by managing maturities in our marketable securities
portfolio. We have no long-term debt as of January 1, 2005. The fair value of our investment portfolio or related income would not be significantly
impacted by changes in interest rates since the marketable securities maturities or interest reset dates do not extend
beyond fiscal year 2005 and the interest rates are primarily fixed. Qualitative Disclosures Interest Rate Risk. Our primary interest rate risk exposures relate to:  
    The available-for-sale securities will fall in value if market interest rates increase.
    The impact of interest rate movements on our ability to obtain adequate financing to
fund future operations. -41-




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We have the ability to hold at least a portion of the fixed income investments until maturity
and therefore would not expect the operating results or cash flows to be affected to any
significant degree by a sudden change in market interest rates on our short and long-term
marketable securities portfolio. Management evaluates its financial position on an ongoing basis. Currency Rate Risk. We do not hedge any balance sheet exposures against future movements in foreign exchange
rates. The exposure related to currency rate movements would not have a material impact on future
net income or cash flows. 
 Item 8. Financial Statements and Supplementary Data Our consolidated balance sheets as of January 1, 2005 and January 3, 2004 and the consolidated
statements of operations, comprehensive income (loss), stockholders equity and cash flows for each
of the three years in the period ended January 1, 2005, together with the related notes and the
report of our independent auditors, are on the following pages. Additional required financial
information is described in Item 14. -42-




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Report of Independent Registered Public Accounting Firm To the Board of Directors and Stockholders of IRIDEX Corporation: In our opinion, the consolidated financial statements listed in the index appearing under Item
15(a)(1) present fairly, in all material respects, the financial position of IRIDEX Corporation and
its subsidiaries at January 1, 2005 and January 3, 2004, and the results of their operations and
their cash flows for each of the three years in the period ended January 1, 2005 in conformity with
accounting principles generally accepted in the United States of America. In addition, in our
opinion, the financial statement schedule listed in the index appearing under Item 15(a)(2)
presents fairly in all material respects, the information set forth therein when read in
conjunction with the related consolidated financial statements. These financial statements and
financial statement schedule 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 the
standards of the Public Company Accounting Oversight Board (United States). Those standards
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
April 1, 2005 -43-




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IRIDEX Corporation CONSOLIDATED BALANCE SHEETS
(in thousands, except share and per share data) January 1,
    
    
    January 3,2005
    
    
    2004ASSETSCurrent assets:Cash and cash equivalents
    
    $
    10,381
    
    
    $
    10,541Available-for-sale securities
    
    
    3,323
    
    
    
    5,751Accounts receivable, net of allowance for doubtful accounts of $496
in 2004 and $120 in 2003
    
    
    7,404
    
    
    
    6,548Inventories, net
    
    
    8,922
    
    
    
    8,721Prepaids and other current assets
    
    
    814
    
    
    
    934Short term deferred income taxes
    
    
    1,808
    
    
    
    972Total current assets
    
    
    32,652
    
    
    
    33,467Long term portion of available-for-sale securities
    
    
    4,324
    
    
    
    Property and equipment, net
    
    
    852
    
    
    
    850Deferred income taxes
    
    
    1,265
    
    
    
    1,522Total assets
    
    $
    39,093
    
    
    $
    35,839LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    1,233
    
    
    $
    1,029Accrued expenses
    
    
    5,167
    
    
    
    3,380Deferred revenue
    
    
    910
    
    
    
    596Total liabilities
    
    
    7,310
    
    
    
    5,005Commitments and contingencies (Note 5)Stockholders EquityConvertible Preferred Stock, $.01 par value:Authorized: 2,000,000 shares;Issued and outstanding: none
    
    
    
    
    
    
    Common Stock, $.01 par value:Authorized: 30,000,000 shares;Issued and outstanding: 7,308,857 shares in 2004 and 6,987,033
shares in 2003
    
    
    74
    
    
    
    70Additional paid-in capital
    
    
    25,281
    
    
    
    23,900Accumulated other comprehensive loss
    
    
    (35
    )
    
    
    (1
    )Treasury stock, at cost
    
    
    (430
    )
    
    
    (430
    )Retained earnings
    
    
    6,893
    
    
    
    7,295Total stockholders equity
    
    
    31,783
    
    
    
    30,834Total liabilities and stockholders equity
    
    $
    39,093
    
    
    $
    35,839
 The accompanying notes are an integral part of these consolidated financial statements. -44-




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IRIDEX Corporation CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data) Year Ended
    
    
    Year Ended
    
    
    Year EndedJanuary 1,
    
    
    January 3,
    
    
    December 28,2005
    
    
    2004
    
    
    2002Sales
    
    $
    32,810
    
    
    $
    31,699
    
    
    $
    30,634Cost of sales
    
    
    17,922
    
    
    
    17,628
    
    
    
    17,046Gross profit
    
    
    14,888
    
    
    
    14,071
    
    
    
    13,588Operating expenses:Research and development
    
    
    4,509
    
    
    
    4,032
    
    
    
    4,315Sales, general and administrative
    
    
    11,455
    
    
    
    10,087
    
    
    
    9,454Total operating expenses
    
    
    15,964
    
    
    
    14,119
    
    
    
    13,769Loss from operations
    
    
    (1,076
    )
    
    
    (48
    )
    
    
    (181
    )Interest income
    
    
    249
    
    
    
    159
    
    
    
    151Other income (expense), net
    
    
    70
    
    
    
    53
    
    
    
    (29
    )Income (loss) before income taxes
    
    
    (757
    )
    
    
    164
    
    
    
    (59
    )Benefit from income taxes
    
    
    355
    
    
    
    207
    
    
    
    209Net income (loss)
    
    $
    (402
    )
    
    $
    371
    
    
    $
    150Basic net income (loss) per common share
    
    $
    (0.06
    )
    
    $
    0.05
    
    
    $
    0.02Diluted net income (loss) per common share
    
    $
    (0.06
    )
    
    $
    0.05
    
    
    $
    0.02Shares used in net income (loss) per
common share basic calculations
    
    
    7,200
    
    
    
    6,933
    
    
    
    6,870Shares used in net income (loss) per
common share diluted calculations
    
    
    7,200
    
    
    
    7,072
    
    
    
    6,928
 The accompanying notes are an integral part of these consolidated financial statements. -45-




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IRIDEX Corporation CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY
(in thousands, except share data) AccumulatedAdditional
    
    
    
    
    
    
    OtherCommon Stock
    
    
    Paid-in
    
    
    Treasury
    
    
    Comprehensive
    
    
    RetainedShares
    
    
    Amount
    
    
    Capital
    
    
    Stock
    
    
    Income (Loss)
    
    
    Earnings
    
    
    TotalBalances, December
29, 2001
    
    
    6,815,672
    
    
    $
    69
    
    
    $
    23,417
    
    
    $
    (430
    )
    
    $
    3
    
    
    $
    6,774
    
    
    $
    29,833Issuance
of Common Stock
under Stock Option
Plan
    
    
    36,930
    
    
    
    
    
    
    
    78
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    78Issuance of Common Stock
under Employee Stock
Purchase Plan
    
    
    53,396
    
    
    
    1
    
    
    
    126
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    127Tax Benefit of Employee
Stock Option Plan
    
    
    
    
    
    
    
    
    
    
    10
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    10Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    150
    
    
    
    150Balances, December 28,
2002
    
    
    6,905,998
    
    
    
    70
    
    
    
    23,631
    
    
    
    (430
    )
    
    
    3
    
    
    
    6,924
    
    
    
    30,198Issuance of Common Stock
under Stock Option
Plan
    
    
    52,466
    
    
    
    
    
    
    
    179
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    179Issuance of Common Stock
under Employee Stock
Purchase Plan
    
    
    28,569
    
    
    
    
    
    
    
    75
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    75Tax Benefit of Employee
Stock Option Plan
    
    
    
    
    
    
    
    
    
    
    15
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    15Change in unrealized
gains on
available-for-sale
securities
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (4
    )
    
    
    
    
    
    
    (4
    )Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    371
    
    
    
    371Balances, January 3, 2004
    
    
    6,987,033
    
    
    
    70
    
    
    
    23,900
    
    
    
    (430
    )
    
    
    (1
    )
    
    
    7,295
    
    
    
    30,834Issuance of Common Stock
under Stock Option
Plan
    
    
    294,852
    
    
    
    4
    
    
    
    1,081
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,085Issuance of Common Stock
under Employee Stock
Purchase Plan
    
    
    26,972
    
    
    
    
    
    
    
    122
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    122Tax Benefit of Employee
Stock Option Plan
    
    
    
    
    
    
    
    
    
    
    178
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    178Change in unrealized
gains(losses) on
available-for-sale
securities
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (34
    )
    
    
    
    
    
    
    (34
    )Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (402
    )
    
    
    (402
    )Balances, January 1, 2005
    
    
    7,308,857
    
    
    $
    74
    
    
    $
    25,281
    
    
    $
    (430
    )
    
    $
    (35
    )
    
    $
    6,893
    
    
    $
    31,783
 The accompanying notes are an integral part of these consolidated financial statements. -46-




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IRIDEX Corporation CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) Year Ended
    
    
    Year Ended
    
    
    Year EndedJanuary 1,
    
    
    January 3,
    
    
    December 28,2005
    
    
    2004
    
    
    2002Cash flows from operating activities:Net income (loss)
    
    $
    (402
    )
    
    $
    371
    
    
    $
    150Adjustments to reconcile net income (loss) to net cash provided by operating activities:Depreciation and amortization
    
    
    384
    
    
    
    703
    
    
    
    869Provision for doubtful accounts
    
    
    376
    
    
    
    (142
    )
    
    
    (56
    )Provision for inventories
    
    
    694
    
    
    
    (63
    )
    
    
    125Deferred income taxes
    
    
    (579
    )
    
    
    (235
    )
    
    
    (333
    )Changes in assets and liabilities:Accounts receivable
    
    
    (1,232
    )
    
    
    1,631
    
    
    
    (426
    )Inventories
    
    
    (895
    )
    
    
    2,067
    
    
    
    1,712Prepaids and other current assets
    
    
    120
    
    
    
    (175
    )
    
    
    359Accounts payable
    
    
    204
    
    
    
    372
    
    
    
    (519
    )Accrued expenses
    
    
    1,787
    
    
    
    356
    
    
    
    574Deferred revenue
    
    
    314
    
    
    
    203
    
    
    
    64Net cash provided by operating activities
    
    
    771
    
    
    
    5,088
    
    
    
    2,519Cash flows from investing activities:Purchases of available-for-sale securities
    
    
    (7,681
    )
    
    
    (5,755
    )
    
    
    (2,356
    )Proceeds from maturity of available-for-sale securities
    
    
    5,751
    
    
    
    2,356
    
    
    
    4,489Acquisition of property and equipment
    
    
    (386
    )
    
    
    (603
    )
    
    
    (284
    )Net cash provided by (used in) investing activities
    
    
    (2,316
    )
    
    
    (4,002
    )
    
    
    1,849Cash flows from financing activities:Issuance of common stock under stock purchase and option plans
    
    
    1,385
    
    
    
    269
    
    
    
    205Net cash provided by financing activities
    
    
    1,385
    
    
    
    269
    
    
    
    205Net increase (decrease) in cash and cash equivalents
    
    
    (160
    )
    
    
    1,355
    
    
    
    4,573Cash and cash equivalents, beginning of year
    
    
    10,541
    
    
    
    9,186
    
    
    
    4,613Cash and cash equivalents, end of year
    
    $
    10,381
    
    
    $
    10,541
    
    
    $
    9,186Supplemental disclosure of cash flow information:Cash paid during the year for:Income taxes
    
    $
    25
    
    
    $
    138
    
    
    $
    8
 The accompanying notes are an integral part of these consolidated financial statements. -47-




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IRIDEX Corporation
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(in thousands) Year Ended
    
    
    Year Ended
    
    
    Year EndedJanuary 1,
    
    
    January 3,
    
    
    December 28,2005
    
    
    2004
    
    
    2002Net income (loss)
    
    $
    (402
    )
    
    $
    371
    
    
    $
    150Other comprehensive loss:Changes in unrealized losses on
available-for-sale securities, net
    
    
    (34
    )
    
    
    (4
    )
    
    
    Comprehensive income (loss)
    
    $
    (436
    )
    
    $
    367
    
    
    $
    150
 The accompanying notes are an integral part of these consolidated financial statements. -48-




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IRIDEX Corporation
Notes to Consolidated Financial Statements 1. Business of the Company Description of Business IRIDEX Corporation is a worldwide provider of semiconductor-based laser systems used to treat
eye diseases in ophthalmology and skin lesions in dermatology. 2. Summary of Significant Accounting Policies Financial Statement Presentation The consolidated financial statements include our accounts and our wholly-owned subsidiaries.
All significant intercompany accounts and transactions have been eliminated. Cash and Cash Equivalents The Company considers all highly liquid debt instruments purchased with an original maturity
of three months or less to be cash equivalents. The Company invests primarily in money market
funds and government paper which are subject to minimal credit risk. Available-for-Sale Securities All marketable securities as of January 1, 2005 and January 3, 2004 are considered to be
available-for-sale and therefore are carried at fair value. Available-for-sale securities are
classified as current assets when they have scheduled maturities of less than one year.
Available-for-sale securities are classified as non current assets when they have scheduled
maturities of more than one year. Marketable securities include auction rate and floating rate
securities. These securities are structured as short-term, highly liquid investments that can be
readily converted into cash every 30, 60 or 90 days. However, since the stated or contractual
maturities of these securities is greater than 90 days, these securities are classified as
marketable securities and not cash equivalents. Unrealized holding gains and losses on such
securities are reported net of related taxes as a separate component of stockholders equity until
realized. Realized gains and losses on sales of all such securities are reported in interest and
other income and are computed using the specific identification cost method. Sales Returns Allowance and Allowance for Doubtful Accounts In the process of preparing financial statements we must make estimates and assumptions that
affect the reported amount of assets and disclosures of contingent assets and liabilities at the
date of the financial statements and the reported amounts of revenues and expenses during the
reported period. Specifically, we must estimate future product returns related to current period
product revenue. We analyze historical returns, current economic trends and changes in customer
demand and acceptance of our products when evaluating the adequacy of the sales returns allowance
and other allowances. Significant management judgments and estimates must be made and used in
connection with establishing the sales returns and other allowances in any accounting period.
Material differences may result in the amount and timing of our revenue for any period if
management made different judgments or utilized different estimates. The provision for sales
returns amounted to $0.2 million in 2005. Similarly our management must make estimates of the
uncollectibility of our accounts receivable. Management specifically analyzes accounts receivable
and -49-




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analyzes historical bad debts, customer concentrations, customer credit-worthiness, current
economic trends and changes in our customer payment terms when evaluating the adequacy of the
allowance for doubtful accounts. Our accounts receivable balance was $7.4 million, net of
allowance for doubtful accounts of $0.5 million as of January 1, 2005. Inventories Inventories are stated at the lower of cost or market. Cost is determined on a standard cost
basis which approximates actual cost on a first-in, first-out (FIFO) method. Lower of cost or
market is evaluated by considering obsolescence, excessive levels of inventory, deterioration and
other factors. Adjustments to reduce the cost of inventory to its net realizable value, if
required, are made for estimated excess, obsolescence or impaired balances. Factors influencing
these adjustments include changes in demand, product life cycle and development plans, component
cost trends, product pricing, physical deterioration and quality issues. Revisions to these
adjustments would be required if these factors differ from our estimates. Property and Equipment Property and equipment are stated at cost less accumulated depreciation and amortization.
Depreciation is provided on a straight-line basis over the estimated useful lives of the assets,
which is generally three years. Amortization of leasehold improvements and property and equipment
is computed using the straight-line method over the shorter of the
lease duration or the estimated useful life of the related assets,
typically three years. Revenue Recognition Revenue from product sales is recognized upon receipt of a purchase order and product shipment
provided no significant obligations remain and collection of the
receivables is reasonably assured.
Shipments are generally made with Free-On-Board (FOB) shipping point terms, whereby title passes
upon shipment from our dock. Any shipments with FOB receiving point terms are recorded as revenue
when the shipment arrives at the receiving point. Up-front fees received in connection with
product sales are deferred and recognized over the associated product shipments. Deferred Revenue Deferred revenue related to warranty contracts is recognized on a straight line basis over the
period of the applicable contract. Cost is recognized as incurred. A reconciliation of the
changes in the Companys deferred revenue balances for the years ending January 3, 2004 and January
1, 2005 follows (in thousands): Balance, December 28, 2002
    
    $
    393Additions to deferral
    
    
    670Revenue recognized
    
    
    (467
    )Balance, January 3, 2004
    
    
    596Additions to deferral
    
    
    1,146Revenue recognized
    
    
    (832
    )Balance, January 1, 2005
    
    $
    910
 -50-




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Warranty The Company accrues for estimated warranty costs upon shipment of products. Actual warranty
costs incurred have not materially differed from those accrued. The Companys warranty policy is
effective for shipped products which are considered defective or fail to meet the product
specifications. Warranty costs are reflected in the statement of operations as a cost of revenues.
A reconciliation of the changes in the Companys warranty liability for the years ending January
3, 2004 and January 1, 2005 follows (in thousands): Balance, December 28, 2002
    
    $
    796Accruals for warranties issued during the year
    
    
    361Settlements made in kind during the year
    
    
    (356
    )Balance, January 3, 2004
    
    $
    801Accruals for warranties issued during the year
    
    
    861Settlements made in kind during the year
    
    
    (729
    )Balance, January 1, 2005
    
    $
    933
 Research and Development Research and development expenditures are charged to operations as incurred. Advertising We expense advertising costs as they are incurred. Advertising expenses for 2004, 2003 and
2002 were $218,000, $311,000 and $242,000, respectively. Fair Value of Financial Instruments Carrying amounts of our financial instruments including cash and cash equivalents, accounts
receivable, accounts payable and accrued liabilities approximate fair value due to their short
maturities. Estimated fair values for available-for-sale securities, which are separately
disclosed elsewhere, are based on quoted market prices for the same or similar instruments. Income Taxes Deferred assets and liabilities are recognized for the future consequences attributable to
differences between the financial statement carrying amounts of existing assets and liabilities and
their respective tax basis. Deferred tax assets and liabilities are measured using enacted tax
rates expected to apply to taxable income in the years in which those temporary differences are
expected to be recovered or settled. Valuation allowances are established when necessary to reduce
deferred tax assets to the amounts expected to be realized. -51-




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Accounting for Stock-Based Compensation The Company accounts for stock-based compensation arrangements in accordance with provisions
of Accounting Principles Board Opinion (APB) No. 25, Accounting for Stock Issued to Employees)
and complies with the disclosure provisions of Statement of Financial Accounting Standards No. 123,
Accounting for Stock-Based Compensation (SFAS 123) as amended by SFAS No. 148, Accounting for
Stock-Based Compensation  Transition and Disclosure  an amendment of FASB Statement No. 123. Under APB 25, compensation expense for grants to employees is based on the difference, if any,
on the date of the grant, between the fair value of the Companys stock and the options exercise
price. SFAS 123 defines a fair value based method of accounting for an employee stock option or
similar equity investment. The pro forma disclosure of the difference between compensation expense
included in net loss and the related cost measured by the fair value method is presented below. The following table provides a reconciliation of net income (loss) to pro forma net loss as if
the fair value method had been applied to all awards (in thousands, except per share data): Year Ended
    
    
    Year Ended
    
    
    Year EndedJanuary 1,
    
    
    January 3,
    
    
    December 28,2005
    
    
    2004
    
    
    2002Net income (loss), as reported
    
    $
    (402
    )
    
    $
    371
    
    
    $
    150Add: Total stock based
compensation expense determined
under fair value based method for
all awards
    
    
    (560
    )
    
    
    (534
    )
    
    
    (438
    )Pro forma net loss
    
    $
    (962
    )
    
    $
    (163
    )
    
    $
    (288
    )Basic net income (loss) per share:As reported
    
    $
    (0.06
    )
    
    $
    0.05
    
    
    $
    0.02Pro forma
    
    $
    (0.13
    )
    
    $
    (0.02
    )
    
    $
    (0.04
    )Diluted net income (loss) per share:As reported
    
    $
    (0.06
    )
    
    $
    0.05
    
    
    $
    0.02Pro forma
    
    $
    (0.13
    )
    
    $
    (0.02
    )
    
    $
    (0.04
    )
 The fair value of each option grant has been estimated on the date of grant using the
Black-Scholes multiple option pricing model with the following weighted average assumptions: 2004
    
    
    2003
    
    
    2002Group A
    
    
    Group B
    
    
    Group A
    
    
    Group B
    
    
    Group A
    
    
    Group BRisk-free Interest Rates
    
    
    3.50
    %
    
    
    3.50
    %
    
    
    3.30
    %
    
    
    3.30
    %
    
    
    4.38
    %
    
    
    4.38
    %Expected Life from Date of Vesting
    
    5 yrs.
    
    2 yrs.
    
    4 yrs.
    
    2 yrs.
    
    4 yrs.
    
    2 yrs.Volatility
    
    
    0.88
    
    
    
    0.88
    
    
    
    0.88
    
    
    
    0.88
    
    
    
    0.84
    
    
    
    0.84Dividend Yield
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
 -52-




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##### Table of Contents



The weighted average expected life was calculated based on the exercise behavior of each
group. Group A represents officers and directors who are a smaller group holding a greater average
number of options than other option holders and who tend to exercise later in the vesting period.
Group B are all other option holders, virtually all of whom are employees. This group tends to
exercise earlier in the vesting period. The weighted average grant-date fair value per share of those options granted in 2004, 2003
and 2002 was $4.89, $2.96 and $2.48, respectively. The Company accounts for equity instruments issued to non-employees in accordance with the
provisions of SFAS 123 and Emerging Issues Task Force Issue No. 96-18, Accounting for Equity
Instruments that are Issued to Other Than Employees, or in Conjunction with Selling Goods and
Services, as amended by SFAS No. 148, Accounting for Stock-Based Compensation  Transition and
Disclosure  an Amendment of FASB Statement No. 123. Stock-based compensation expense related to
stock options granted to non-employees is recognized on a straight line basis as the stock options
are earned. The stock-based compensation expense will fluctuate as the deemed fair market value of
the common stock fluctuates. There were no equity instruments issued to non-employees in 2004,
2003 and 2002. We have also estimated the fair value for the purchase rights issued under our 1995 Employee
Stock Purchase Plan, under the Black-Scholes valuation model using the following assumptions for
2004, 2003 and 2002: 2004
    
    
    2003
    
    
    2002Risk-free Interest Rates
    
    
    2.56
    %
    
    
    1.45
    %
    
    
    2.01
    %Expected Life
    
    0.5 year
    
    0.5 year
    
    0.5 yearVolatility
    
    
    0.84
    
    
    
    0.86
    
    
    
    0.85Dividend Yield
    
    
    
    
    
    
    
    
    
    
    
 The weighted average grant-date fair value per share of those purchase rights granted in
2004, 2003 and 2002 was $1.37, $1.01 and $1.31, respectively. Concentration of Credit Risk and Other Risks and Uncertainties Our cash and cash equivalents are deposited in demand and money market accounts of three
financial institutions. Deposits held with banks may exceed the amount of insurance provided on
such deposits. Generally these deposits may be redeemed upon demand and therefore, bear minimal
risk. We market our products to distributors and end-users throughout the world. Sales to
international distributors are generally made on open credit terms and letter of credit. Management
performs ongoing credit evaluations of our customers and maintains an allowance for potential
credit losses. Historically, we have not experienced any significant losses related to individual
customers or group of customers in any particular geographic area. For the years ended January 1,
2005, January 3, 2004 and December 28, 2002 no customer accounted for greater than 10% of revenue.
As of January 1, 2005 and January 3, 2004 no customers accounted for more than 10% of accounts
receivable. Our products require approvals from the Food and Drug Administration and international
regulatory agencies prior to commercialized sales. Our future products may not receive required
approvals. If we were denied such approvals, or if such approvals were delayed, it would have a
materially adverse impact on our business, results of operations and financial condition. -53-




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Reliance on Certain Suppliers Certain components and services used by the Company to manufacture and develop its products
are presently available from only one or a limited number of suppliers or vendors. The loss of any
of these suppliers or vendors would potentially require a significant level of hardware and/or
software development to incorporate the products or services into the Companys products. Use of Estimates In accordance with accounting principles generally accepted in the United States of America,
management utilizes certain estimates and assumptions that affect the reported amounts of assets
and liabilities at the date of the financial statements and the reported amounts of revenues and
expense during the reporting period. The primary estimates underlying the Companys financial
statements include allowance for doubtful accounts receivable, reserves for obsolete and slow
moving inventory, product warranty, income taxes and accrual for other liabilities. Actual results
could differ from those estimates. Fiscal Year Our fiscal year covers a 52 or 53 week period and ends on the Saturday nearest December 31.
Fiscal year 2004 and 2002 included 52 weeks. Fiscal year 2003 included 53 weeks. Net Income (loss) per Share Basic and diluted net income (loss) per share are computed by dividing net income (loss) for
the year by the weighted average number of shares of common stock outstanding during the period.
The calculation of diluted net income (loss) per share excludes potential common stock if their
effect is anti-dilutive. Potential common stock consists of incremental common shares issuable
upon the exercise of stock options. See Note 6. Recent Accounting Pronouncements In November 2004, the Financial Accounting Standards Board ( FASB ) issued SFAS No. 151,
Inventory Costs, an amendment of ARB No. 43, Chapter 4. SFAS No. 151 clarifies the accounting for
abnormal amounts of idle facility expense, freight, handling costs and wasted material. SFAS No.
151 is effective for inventory costs incurred during fiscal years beginning in the second quarter
of fiscal 2006. We do not believe the adoption of SFAS No. 151 will have a material effect on our
consolidated financial position, results of operations or cash flows. In December 2004, the FASB issued SFAS No. 123R, Share-Based Payment, which replaced SFAS No.
123 and superseded APB 25. SFAS No. 123R addresses the accounting for share-based payment
transactions in which a company receives employee services in exchange for either equity
instruments of the company or liabilities that are based on the fair value of the Company s equity
instruments or that may be settled by the issuance of such equity instruments. Under SFAS No. 123R,
companies will no longer be able to account for share-based compensation transactions using the
intrinsic method in accordance with APB 25 but will be required to account for such transactions
using a fair-value method and recognize the expense in the consolidated statement of earnings. SFAS
No. 123R is effective beginning in the second quarter of fiscal 2006 and allows, but does not
require, companies to restate the full fiscal year of adoption to reflect the impact of expensing
share-based payments under SFAS No. 123R. The Company has not yet determined which fair-value
method and transitional provision it will follow. The pro forma impact on the Companys -54-




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financial statements of applying Black-Scholes option valuation method of accounting for stock
options is disclosed in the Notes to Consolidated Financial Statements. 3. Balance Sheet Detail Available-for-sale securities (in thousands): Unrealized
    
    
    Estimated
    
    
    MaturityCost
    
    
    Gain (Loss)
    
    
    Fair Value
    
    
    DatesAs of January 1, 2005,
short term available-for-sale securities consisted
of the following:Corporate notes
    
    $
    3,345
    
    
    $
    (22
    )
    
    $
    3,323
    
    
    
    5/05  8/05Total
    
    $
    3,345
    
    
    $
    (22
    )
    
    $
    3,323As of January 1, 2005,
long term available-for-sale securities consisted
of the following:Corporate notes
    
    $
    4,312
    
    
    $
    (12
    )
    
    $
    4,324
    
    
    
    2/06  5/06Total
    
    $
    4,312
    
    
    $
    (12
    )
    
    $
    4,324As of January 3, 2004,
short term available-for-sale securities consisted
of the following:Corporate notes
    
    $
    4,752
    
    
    $
    (1
    )
    
    $
    4,751
    
    
    
    2/04 - 10/04Government agencies
    
    
    1,000
    
    
    
    
    
    
    
    1,000
    
    
    
    2/04 - 4/04Total
    
    $
    5,752
    
    
    $
    (1
    )
    
    $
    5,751
 There were no realized capital gains or losses recognized in 2004, 2003 and 2002. January 1,
    
    
    January 3,2005
    
    
    2004Inventories:Raw materials and work in process
    
    $
    5,460
    
    
    $
    4,426Finished goods
    
    
    3,462
    
    
    
    4,295Total inventories
    
    $
    8,922
    
    
    $
    8,721Property and Equipment:Equipment
    
    $
    4,264
    
    
    $
    3,887Leasehold improvements
    
    
    1,903
    
    
    
    1,894Less: accumulated depreciation and amortization
    
    
    (5,315
    )
    
    
    (4,931
    )Property and equipment, net
    
    $
    852
    
    
    $
    850Accrued Expenses:Accrued payroll, vacation and related expenses
    
    $
    1,100
    
    
    $
    1,009Accrued warranty
    
    
    933
    
    
    
    801Income taxes payable
    
    
    783
    
    
    
    733Sales and use tax payable
    
    
    1,277
    
    
    
    122Other accrued expenses
    
    
    1,074
    
    
    
    715Total accrued expenses
    
    $
    5,167
    
    
    $
    3,380
 -55-




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4. Bank Borrowings We
have a revolving line of credit agreement with a bank expiring on October 5, 2006, which
provides for borrowings of up to $4.0 million at the banks prime rate (5.25% at January 1, 2005).
The agreement contains restrictive covenants including prohibiting payment of dividends without the
banks prior consent. There were no borrowings against the credit line at January 1, 2005. 5. Commitments and Contingencies Lease Agreements We lease our operating facilities under a noncancelable operating lease. In September 2003,
we entered into a lease amendment for our facility in Mountain View. The original lease term of
this facility, which ended in February 2004, was amended and extended until February 2009. The
lease was also amended to grant us an option to renew this lease for an additional five year period
beginning 2009 until 2014 at a base monthly rental amount to be negotiated at the time of the
renewal. Rent expense, net of sublease income, totaled $403,000, $606,000 and $642,000 for the
years ended January 1, 2005, January 3, 2004 and December 28, 2002 respectively. Future minimum lease payments under current operating leases at January 1, 2005 are summarized
as follows (in thousands): Fiscal Year
    
    Operating Lease Payments2005
    
    
    3902006
    
    
    4022007
    
    
    4162008
    
    
    4292009
    
    
    72$
    1,709
 License Agreements The Company is obligated to pay royalties equivalent to 5% and 7.5% of sales on certain
products under license agreements. Royalty expense was $80,000, $93,000 and $105,000 for the years
ended January 1, 2005, January 3, 2004 and December 28, 2002, respectively. Contingencies From time to time, the Company may be engaged in certain administrative proceedings,
incidental to its normal business activities. Management believes that liabilities resulting from
such proceedings, or claims which are pending or known to be threatened, are adequately covered by
liability insurance and will not have a material adverse effect on the Companys financial position
or results of operations. The Company enters into standard indemnification arrangements in our ordinary course of
business. Pursuant to these arrangements, the Company indemnifies, holds harmless, and agrees to
reimburse the indemnified parties for losses suffered or incurred by the indemnified party,
generally our business partners or customers, in connection with any trade secret, copyright,
patent or other intellectual property infringement claim by any third party with respect to our
products. The term of these indemnification agreements is generally perpetual anytime after the
execution of the agreement. The maximum potential amount of future payments the Company could be
required to make under these agreements is not -56-




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determinable. The Company has never incurred costs to defend lawsuits or settle claims related
to these indemnification agreements. As a result, the Company believes the estimated fair value of
these agreements is minimal. The Company has entered into indemnification agreements with its directors and officers that
may require the Company: to indemnify its directors and officers against liabilities that may arise
by reason of their status or service as directors or officers, other than liabilities arising from
willful misconduct of a culpable nature; to advance their expenses incurred as a result of any
proceeding against them as to which they could be indemnified; and to make good faith determination
whether or not it is practicable for the Company to obtain directors and officers insurance. The
Company currently has directors and officers insurance. 6. Stockholders Equity Convertible Preferred Stock Our Articles of Incorporation authorize 2,000,000 shares of undesignated preferred stock.
Preferred Stock may be issued from time to time in one or more series. As of January 1, 2005, we
had no preferred stock issued and outstanding. Treasury Stock In December 1998, we instituted a stock repurchase program whereby up to 150,000 shares of our
Common Stock may be repurchased in the open market. We plan to utilize all of the reacquired
shares for reissuance in connection with our employee stock programs. In 2002, 2003 and 2004, no
shares of Common Stock were repurchased. As of January 1, 2005 we have repurchased 103,000 shares
of common stock. Stock Option Plans Amended and Restated 1989 Incentive Stock Plan The Amended and Restated 1989 Plan (the 1989 Plan) provided for the grant of options and
stock purchase rights to purchase shares of our Common Stock to employees and consultants. The
terms of the 1989 Plan, which expired in August 1999, are substantially the same as the 1998 Plan
described below. 1998 Stock Plan The 1998 Stock Plan (the 1998 Plan) provides for the granting to employees (including
officers and employee directors) of incentive stock options and for the granting to employees
(including officers and employee directors) and consultants of nonstatutory stock options and stock
purchase rights (SPRs). The exercise price of incentive stock options and SPRs granted under the
1998 Plan must be at least equal to the fair market value of the shares at the time of grant. With
respect to any recipient who owns stock possessing more than 10% of the voting power of our
outstanding capital stock, the exercise price of any option or SPR granted must be at least equal
to 110% of the fair market value at the time of grant. Options granted under the 1998 Plan are
exercisable at such times and under such conditions as determined by the Administrator; generally
over a four year period. The maximum term of incentive stock options granted to any recipient must
not exceed ten years; provided, however, that the maximum term of an incentive stock option granted
to any recipient possessing more than 10% of the voting power of our outstanding capital stock must
not exceed five years. In the case of SPRs, unless the Administrator determines otherwise, we have
a repurchase option exercisable upon the voluntary or involuntary termination of the purchasers
employment with us for any -57-




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##### Table of Contents



reason (including death or disability). Such repurchase option lapses at a rate determined by
the Administrator. The purchase price for shares repurchased by us is the original price paid by
the purchaser. As of January 3, 2004 and December 28, 2002 no shares were subject to repurchase.
The form of consideration for exercising an option or stock purchase right, including the method of
payment, is determined by the Administrator. The 1998 Plan expires in June 2008. 1995 Director Option Plan In October 1995, we adopted the 1995 Director Option Plan (the Director Plan), under which
members of the Board of Directors are granted options to purchase 11,250 shares upon the first to
occur of their appointment or the adoption of the Director Plan (First Option) and an option to
purchase 3,750 shares (Subsequent Option) on July 1 of each year thereafter provided that he or
she has served on the Board for at least the preceding six months. The options granted are at fair
market value on the date of grant. The First Option becomes exercisable as to one-twelfth (1/12)
of the shares subject to the First Option for each quarter over a three-year period. Each
Subsequent Option becomes exercisable as to one-fourth (1/4) of the shares subject to the
Subsequent Option for each quarter, commencing one quarter after the First Option and any
previously granted Subsequent Options have become fully exercisable. Options granted under the
Director Plan have a term of 10 years. In the event of our merger with or into another corporation, resulting in a change of control,
or the sale of substantially all of our assets, each Director Plan options become exercisable in
full and shall be exercisable for 30 days after written notice to the holder of the event causing
the change in control. Unless terminated sooner, the Director Plan will terminate in 2005. The Board has authority to
amend or terminate the Director Plan, provided no such amendment may impair the rights of any
optionee without the optionees consent. 1995 Employee Stock Purchase Plan Our 1995 Employee Stock Purchase Plan (the Purchase Plan) was adopted by the Board of
Directors in October 1995. The total number of shares of common stock reserved for issuance under
the Purchase Plan at January 1, 2005 was 55,450. The Purchase Plan permits eligible employees
(including officers and employee directors) to purchase Common Stock through payroll deductions,
which may not exceed 10% of an employees compensation. No employee may purchase more than $25,000
worth of stock in any calendar year or more than 1,000 shares of
Common Stock in any six-month
period. The price of shares purchased under the Purchase Plan is 85% of the lower of the fair
market value of the Common Stock at the beginning of the offering period or the end of the offering
period. The Purchase Plan will terminate in 2005, unless terminated sooner by the Board of
Directors. -58-




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##### Table of Contents



Information with respect to activity under these option plans are set forth below (in
thousands): Outstanding OptionsShares
    
    
    
    
    
    
    
    
    
    
    WeightedAvailable
    
    
    Number
    
    
    Aggregate
    
    
    Averagefor Grant
    
    
    of Shares
    
    
    Price
    
    
    Exercise PriceBalances, December 29, 2001
    
    
    183,298
    
    
    
    1,656,817
    
    
    $
    8,831
    
    
    $
    5.34Additional shares reserved
    
    
    300,000
    
    
    
    
    
    
    
    
    
    
    
    Options granted
    
    
    (229,400
    )
    
    
    229,400
    
    
    
    858
    
    
    
    3.74Options exercised
    
    
    
    
    
    
    (36,930
    )
    
    
    (78
    )
    
    
    2.08Options cancelled
    
    
    (2,575
    )Options terminated
    
    
    148,424
    
    
    
    (148,424
    )
    
    
    (924
    )
    
    
    6.23Balances, December 28, 2002
    
    
    399,747
    
    
    
    1,700,863
    
    
    
    8,687
    
    
    
    5.11Additional shares reserved
    
    
    270,000
    
    
    
    
    
    
    
    
    
    
    
    Options granted
    
    
    (395,000
    )
    
    
    395,000
    
    
    
    1,516
    
    
    
    3.84Options exercised
    
    
    
    
    
    
    (52,466
    )
    
    
    (179
    )
    
    
    3.40Options cancelled
    
    
    (649
    )Options terminated
    
    
    39,114
    
    
    
    (39,114
    )
    
    
    (189
    )
    
    
    4.83Balances, January 3, 2004
    
    
    313,212
    
    
    
    2,004,283
    
    
    
    9,835
    
    
    
    4.91Additional shares reserved
    
    
    270,000
    
    
    
    
    
    
    
    
    
    
    
    Options granted
    
    
    (214,750
    )
    
    
    214,750
    
    
    
    1,379
    
    
    
    6.42Options exercised
    
    
    
    
    
    
    (294,852
    )
    
    
    (1,085
    )
    
    
    3.68Options cancelled
    
    
    (15,000
    )Options terminated
    
    
    100,789
    
    
    
    (100,789
    )
    
    
    (701
    )
    
    
    6.95Balances, January 1, 2005
    
    
    454,251
    
    
    
    1,823,392
    
    
    $
    9,428
    
    
    $
    5.18
 The following table summarizes information with respect to stock options outstanding at
January 1, 2005: Options Outstanding
    
    
    Options ExercisableWeighted AverageNumber
    
    
    Remaining
    
    
    Weighted Average
    
    
    Number
    
    
    Weighted AverageOutstanding
    
    
    Contractual Life
    
    
    Exercise
    
    
    Exercisable
    
    
    ExerciseRange of Exercise Prices
    
    at 1/01/05
    
    
    (Years)
    
    
    Price
    
    
    at 1/01/05
    
    
    Price$1.00 - $3.30
    
    
    231,110
    
    
    
    7.18
    
    
    $
    2.95
    
    
    
    104,576
    
    
    $
    2.57$3.41 - $3.71
    
    
    317,699
    
    
    
    7.30
    
    
    
    3.59
    
    
    
    199,782
    
    
    
    3.62$3.75 - $4.00
    
    
    342,989
    
    
    
    3.14
    
    
    
    3.99
    
    
    
    325,791
    
    
    
    4.00$4.01 - $4.74
    
    
    188,999
    
    
    
    6.84
    
    
    
    4.27
    
    
    
    119,543
    
    
    
    4.19$4.88 - $5.50
    
    
    212,991
    
    
    
    6.04
    
    
    
    5.22
    
    
    
    139,448
    
    
    
    5.15$5.65 - $7.25
    
    
    198,279
    
    
    
    7.95
    
    
    
    6.65
    
    
    
    64,804
    
    
    
    6.61$7.38 - $9.00
    
    
    236,075
    
    
    
    4.49
    
    
    
    8.60
    
    
    
    225,257
    
    
    
    8.66$9.06- $12.19
    
    
    80,250
    
    
    
    5.73
    
    
    
    9.73
    
    
    
    67.875
    
    
    
    9.85$12.75 - $12.75
    
    
    11,250
    
    
    
    5.50
    
    
    
    12.75
    
    
    
    11,250
    
    
    
    12.75$14.88 - $14.88
    
    
    3,750
    
    
    
    1.49
    
    
    
    14.88
    
    
    
    3,750
    
    
    
    14.88$1.00    $14.88
    
    
    1,823,392
    
    
    
    5.92
    
    
    $
    5.18
    
    
    
    1,262,076
    
    
    
    5.36
 At January 3, 2004 and December 28, 2002 options to purchase 1,354,937 and 1,184,805
shares of common stock were exercisable at a weighted average exercise price of $ 5.29 and $5.22,
respectively. -59-




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##### Table of Contents



7. Employee Benefit Plan We have a plan known as the IRIS Medical Instruments 401(k) trust to provide retirement
benefits through the deferred salary deductions for substantially all employees. Employees may
contribute up to 15% of their annual compensation to the plan, limited to a maximum amount set by
the Internal Revenue Service. The plan also provides for Company contributions at the discretion of
the Board of Directors. On April 1, 2000 the Company commenced a Company match for the 401(k) in
the amount of 50% of employee contributions up to an annual maximum of $1,000 per year. The
Company contributions totaled $88,000 in 2004, $89,000 in 2003 and $98,000 in 2002. 8. Income Taxes The provision for income taxes includes: Year Ended
    
    
    Year Ended
    
    
    Year EndedJanuary 1,
    
    
    January,
    
    
    December 28,2005
    
    
    2004
    
    
    2002Current:Federal
    
    $
    212
    
    
    $
    19
    
    
    $
    121State
    
    
    14
    
    
    
    9
    
    
    
    5226
    
    
    
    28
    
    
    
    126Deferred:Federal
    
    
    (519
    )
    
    
    (148
    )
    
    
    (231
    )State
    
    
    (62
    )
    
    
    (87
    )
    
    
    (104
    )(581
    )
    
    
    (235
    )
    
    
    (335
    )Income tax benefit
    
    $
    (355
    )
    
    $
    (207
    )
    
    $
    (209
    )
 The Companys effective tax rate differs from the statutory federal income tax rate as
shown in the following schedule: Year Ended
    
    
    Year Ended
    
    
    Year EndedJanuary 1,
    
    
    January 3,
    
    
    December 28,2005
    
    
    2004
    
    
    2002Income tax provision (benefit) at statutory rate
    
    
    34
    %
    
    
    34
    %
    
    
    (34
    %)State income taxes, net of federal benefit
    
    
    8
    %
    
    
    6
    %
    
    
    (6
    %)Tax exempt interest
    
    
    0
    %
    
    
    0
    %
    
    
    0
    %Nondeductible permanent differences
    
    
    -5
    %
    
    
    19
    %
    
    
    56
    %Research and development credits
    
    
    12
    %
    
    
    (164
    %)
    
    
    (377
    %)Other
    
    
    -2
    %
    
    
    (22
    %)
    
    
    1
    %Effective tax rate
    
    
    47
    %
    
    
    (127
    %)
    
    
    (360
    %)
 -60-




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##### Table of Contents



The tax effect of temporary differences and carry-forwards that give rise to significant
portions of the net deferred tax assets are presented below (in thousands): January 1,
    
    
    January 3,2005
    
    
    2004Fixed assets
    
    $
    640
    
    
    $
    610Accrued liabilities
    
    
    1,039
    
    
    
    492Allowance for excess and obsolete inventories
    
    
    514
    
    
    
    413Research credit
    
    
    626
    
    
    
    852State tax
    
    
    1
    
    
    
    1Allowance for doubtful accounts
    
    
    184
    
    
    
    47Other
    
    
    69
    
    
    
    79Net deferred tax asset
    
    $
    3,073
    
    
    $
    2,494
 9. Major Customers and Business Segments We operate in two reportable segments: the ophthalmology medical device segment and the
dermatology medical device segment. In both segments, we develop, manufacture and market medical
devices. Our revenues arise from the sale of consoles, delivery devices, disposables and service
and support activities. In the years ended January 1, 2005, January 3, 2004, and December 28, 2002, no customer
individually accounted for more than 10% of our revenue. Revenue information shown (in thousands) by geographic region is as follows: January 1,
    
    
    January 3,
    
    
    December 28,2005
    
    
    2004
    
    
    2002United States
    
    $
    19,894
    
    
    $
    20,072
    
    
    $
    19,564Europe
    
    $
    6,498
    
    
    
    5,297
    
    
    
    5,429Rest of Americas
    
    $
    631
    
    
    
    1,000
    
    
    
    833Asia/Pacific Rim
    
    $
    5,787
    
    
    
    5,330
    
    
    
    4,808$
    32,810
    
    
    $
    31,699
    
    
    $
    30,634
 Revenues are attributed to countries based on location of customers. In the years ended January 1, 2005, January 3, 2004 and December 28, 2002, no country
individually accounted for more than 10% of our sales, except for the United States, which
accounted for 60.6% of sales in 2004, 63.3% in 2003 and 63.9% in 2002. -61-




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##### Table of Contents



Information on reportable segments for the three years ended January 1, 2005, January 3, 2004,
and December 28, 2002 is as follows: Year Ended January 1, 2005Ophthalmology MedicalDevices
    
    

    Dermatology Medical Devices
    
    

    TotalSales
    
    $
    27,753
    
    
    $
    5,057
    
    
    $
    32,810Direct cost of goods sold
    
    $
    9,876
    
    
    $
    2,898
    
    
    $
    12,774Direct gross margin
    
    $
    17,877
    
    
    $
    2,159
    
    
    $
    20,036Total unallocated
indirect costs
    
    
    
    
    
    
    
    
    
    $
    21,112Income (loss) from
operations
    
    
    
    
    
    
    
    
    
    $
    (1,076
    )
 Year Ended January 3, 2004Ophthalmology MedicalDevices
    
    
    Dermatology Medical Devices

    
    
    TotalSales
    
    $
    26,160
    
    
    $
    5,539
    
    
    $
    31,699Direct cost of goods sold
    
    $
    9,217
    
    
    $
    2,782
    
    
    $
    11,999Direct gross margin
    
    $
    16,943
    
    
    $
    2,757
    
    
    $
    19,700Total unallocated
indirect costs
    
    
    
    
    
    
    
    
    
    $
    19,748Income (loss) from
operations
    
    
    
    
    
    
    
    
    
    $
    (48
    )
 Year Ended December 28, 2002Ophthalmology MedicalDevices
    
    
    Dermatology Medical Devices
    
    
    TotalSales
    
    $
    24,169
    
    
    $
    6,465
    
    
    $
    30,634Direct cost of goods sold
    
    $
    7,917
    
    
    $
    2,844
    
    
    $
    10,761Direct gross margin
    
    $
    16,252
    
    
    $
    3,621
    
    
    $
    19,873Total unallocated
indirect costs
    
    
    
    
    
    
    
    
    
    $
    20,054Income (loss) from
operations
    
    
    
    
    
    
    
    
    
    $
    (181
    )
 Indirect costs of manufacturing, research and development and selling, general and
administrative costs are not allocated to the segments. The Companys assets and liabilities are not evaluated on a segment basis. Accordingly, no
disclosure on segment assets and liabilities is provided. -62-




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##### Table of Contents



10. Computation of Net Income Per Common Share and Per Diluted Common Share A reconciliation of the numerator and denominator of net income (loss) per common share and
diluted net income (loss) per common share is provided as follows (in thousands, except per share
amounts): Year Ended
    
    
    Year Ended
    
    
    Year EndedJanuary 1,
    
    
    January 3,
    
    
    December 28,2005
    
    
    2004
    
    
    2002Net income (loss)
    
    $
    (402
    )
    
    $
    371
    
    
    $
    150Denominator  Net income (loss) per common share
Weighted average common stock outstanding
    
    
    7,200
    
    
    
    6,933
    
    
    
    6,870Effect of dilutive securities
Weighted average common stock options
    
    
    
    
    
    
    139
    
    
    
    58Total weighted average stock and options outstanding
    
    
    7,200
    
    
    
    7,072
    
    
    
    6,928Net income (loss) per common share
    
    $
    (0.06
    )
    
    $
    0.05
    
    
    $
    0.02Diluted net income (loss) per common share
    
    $
    (0.06
    )
    
    $
    0.05
    
    
    $
    0.02
 In 2004, there were 463,588 options outstanding at a weighted average exercise price of
$8.65 that were not included in the computation of dilutive net loss per common share because their
effect was antidilutive. In 2003 and 2002, there were 791,406 and 1,296,391, outstanding options
to purchase shares, respectively, at weighted average exercise prices of $6.99 and $5.97 per
share, respectively, that were not included in the computation of diluted net income (loss) per
common share since, in each case, the exercise price of the options exceeded the market price of
the common stock. These options could dilute earnings per share in future periods. 11. Selected Quarterly Financial Data, (Unaudited) QuarterFirst
    
    
    Second
    
    
    Third
    
    
    Fourth(In thousands, except per share amounts)Year Ended January 1, 2005Sales
    
    $
    7,392
    
    
    $
    8,109
    
    
    $
    8,178
    
    
    $
    9,131Gross profit
    
    $
    3,215
    
    
    $
    3,807
    
    
    $
    3,470
    
    
    $
    4,396Net income (loss)
    
    $
    (17
    )
    
    $
    133
    
    
    $
    (720
    )
    
    $
    202Net income (loss) per common share
    
    $
    (0.00
    )
    
    $
    (0.02
    )
    
    $
    (0.10
    )
    
    $
    0.03Diluted net income (loss) per common share
    
    $
    (0.00
    )
    
    $
    (0.02
    )
    
    $
    (0.10
    )
    
    $
    0.03Year Ended January 3, 2004Sales
    
    $
    7,226
    
    
    $
    7,435
    
    
    $
    8,267
    
    
    $
    8,771Gross profit
    
    $
    3,238
    
    
    $
    3,120
    
    
    $
    3,589
    
    
    $
    4,124Net income (loss)
    
    $
    (82
    )
    
    $
    (299
    )
    
    $
    261
    
    
    $
    491Net income (loss) per common share
    
    $
    (0.01
    )
    
    $
    (0.04
    )
    
    $
    0.04
    
    
    $
    0.07Diluted net income (loss) per common share
    
    $
    (0.01
    )
    
    $
    (0.04
    )
    
    $
    0.04
    
    
    $
    0.07The fourth quarter of 2003 includes 14 weeks
 
 Item 9. Changes in And Disagreements with Accountants On Accounting and Financial Disclosure Not applicable. -63-




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Item 9A. Controls and
Procedures. Disclosure controls and procedures Our management evaluated, with the participation of our Chief Executive Officer and our Chief
Financial Officer, the effectiveness of our disclosure controls and procedures as of the end of the
period covered by this Annual Report on Form 10-K. Based on this evaluation, our Chief Executive
Officer and our Chief Financial Officer have concluded that our disclosure controls and procedures
are effective to ensure that information we are required to disclose in reports that we file or
submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported
within the time periods specified in Securities and Exchange Commission rules and forms. Changes in internal control over financial reporting. There was no change in our internal control over financial reporting that occurred during the
period covered by this Annual Report on Form 10-K that has materially affected, or is reasonably
likely to materially affect, our internal control over financial reporting. Item 9B. Other Information Not
applicable. -64-




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##### Table of Contents



PART III Certain information required by Part III has been omitted from this Form 10-K. This
information is instead incorporated herein by reference to our definitive Proxy Statement for our
2005 Annual Meeting of Stockholders (the Proxy Statement), which we will file within 120 days
after the end of our fiscal year pursuant to Regulation 14A in time for our Annual Meeting of
Stockholders to be held June 1, 2005. 
 Item 10. Directors and Executive Officers of the Registrant Information
regarding our directors required by this item is incorporated herein by reference to
our Proxy Statement. The information concerning our current
executive officers, delinquent filers, our code
of business conduct and ethics, members of our Audit Committee, the
identification of the Audit Committee Financial Expert and
stockholder nominators of directors is also incorporated our Proxy
Statement. 
 Item 11. Executive Compensation The information required by this item is incorporated herein by reference to Executive
Compensation in our Proxy Statement. 
  Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder
Matters The information required by this Item is incorporated herein by reference to Security
Ownership of Certain Beneficial Owners and Management in our Proxy Statement. 
 Item 13. Certain Relationships and Related Transactions The information required by this Item is incorporated herein by reference to Certain
Relationships and Related Transactions in our Proxy Statement. 
 Item 14. Principal Accountant Fees and Services. The information required by this item is incorporated herein by reference to Proposal Five 
Ratification of Appointment of Independent Registered Public Accounting Firm in our Proxy
Statement. -65-




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##### Table of Contents



PART IV 
 Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K Page inForm 10-KReport(a)
    
    The following documents are filed in Part II of this Annual
Report on Form 10-K:1.
    
    
    Financial Statements
Report of Independent Registered Public Accounting Firm
    
    
    43Consolidated Balance Sheets as of January 1, 2005 and
January 3, 2004
    
    
    44Consolidated Statements of Operations for the years ended
January 1, 2005, January 3, 2004 and December 28, 2002
    
    
    45Consolidated Statements of Stockholders Equity for the years
ended anuary 1, 2005, January 3, 2004 and December 28, 2002
    
    
    46Consolidated Statements of Cash Flows for the years ended
January 1, 2005, January 3, 2004 and December 28, 2002
    
    
    47Consolidated Statements of Comprehensive Income (Loss) for the
years ended January 1, 2005, January 3, 2004 and December 28,
2002
    
    
    48Notes to Consolidated Financial Statements
    
    
    492.
    
    
    Financial Statement ScheduleThe following financial statement schedule of IRIDEX
Corporation for the years ended January 1, 2005, January 3,
2004 and December 28, 2002 is filed as part of this Annual
Report and should be read in conjunction with the Consolidated
Financial Statements of IRIDEX Corporation.Schedule II  Valuation and Qualifying Accounts
    
    
    68
 Other schedules have been omitted because they are either not required, not applicable, or the
required information is included in the consolidated financial statements or notes thereto. 3. Exhibits Exhibits
    
    Exhibit Title3.1(1)
    
    Amended and Restated Certificate of Incorporation of Registrant.3.2(2)
    
    Amended and Restated Bylaws of Registrant.10.1(1)
    
    Form of Indemnification Agreement with directors and officers.10.2(3)
    
    1995 Employee Stock Purchase Plan, as amended and form of agreement
thereunder.10.3(3)
    
    1995 Director Option Plan and form of agreement thereunder.10.4(1)
    
    1995 Profit Sharing Plan.10.5(1)
    
    Third Restated Registration Rights Agreement dated as of October 27,
1995 by and among Registrant and certain individuals and entities named
therein.10.6(4)
    
    Lease Agreement dated
December 6, 1996 by and between Zappettini Investment Co. and the Registrant, as amended.
 -66-




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##### Table of Contents



Exhibits
    
    Exhibit Title10.7(3)
    
    1998 Stock Option Plan, as amended.10.8(5)
    
    2005 Employee Stock Purchase Plan and form of agreement thereunder.10.9(6)
    
    2005 Bonus Plan.21.1(1)
    
    Subsidiaries of Registrant.23.1
    
    Consent of Independent Registered
Public Accounting Firm.24.1
    
    Power of Attorney (See page 69).31.1
    
    Certification of Chief Executive Officer pursuant
to Section 302 of the Sarbanes-Oxley Act of 2002.31.2
    
    Certification of Chief Financial Officer pursuant
to Section 302 of the Sarbanes-Oxley Act of 2002.32.1
    
    Certification of Chief Executive Officer and Chief Financial Officer
pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906
of the Sarbanes-Oxley Act of 2002.
   (1)
    
    Incorporated by reference to the Exhibits filed with the Registration
Statement on Form SB-2 (No. 333-00320-LA) which was declared effective on February
15, 1996.(2)
    
    Incorporated by reference to the Exhibits in the Registrants Report on
Form 10-Q for the quarter ended October 3, 1998.(3)
    
    Incorporated by reference to the Exhibits in the Registrants Registration Statement on Form S-8 which was filed on August 3, 2004 which was filed
April 30, 1998.(4)
    
    Incorporated by reference to the Exhibits in the Registrants Report on
Form 10-Q for the quarter ended September 27, 2003.(5)
    
    Incorporated by reference to the Exhibits in the Registrants Proxy Statement for the Registrants 2004 Annual Meeting of Stockholders.(6)
    
    Incorporated by reference to Exhibit 10.1 to the Registrants Current Report on Form 8-K filed on March 22, 2005.
    
    Indicates a management Compensatory Plan, contract or arrangement. Trademark Acknowledgments IRIDEX, the IRIDEX logo, IRIS Medical, OcuLight, SmartKey, EndoProbe and Apex are our
registered trademarks. IRIDERM, G-Probe, DioPexy, DioVet, TruFocus, TrueCW, UltraView, DioLite 532,
Long Pulse, MicroPulse Scanlite Scanner, ColdTip Handpiece, Varispot Handpiece and EasyFit product
names are our trademarks. All other trademarks or trade names appearing in this Annual Report on
Form 10-K are the property of their respective owners. -67-




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##### Table of Contents



Schedule II IRIDEX CORPORATION AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS
(in thousands) Balance at
    
    
    Charged to
    
    
    
    
    
    
    BalanceBeginning of
    
    
    Costs and
    
    
    
    
    
    
    at End ofDescription
    
    The Period
    
    
    Expenses
    
    
    Deductions
    
    
    The PeriodBalance for the year ended
December 28, 2002:Allowance for doubtful
accounts receivable
    
    $
    318
    
    
    $
    (56
    )
    
    $
    
    
    
    $
    262Provision for inventory
    
    $
    981
    
    
    $
    125
    
    
    $
    
    
    
    $
    1,106Balance for the year ended
January 3, 2004:Allowance for doubtful
accounts receivable
    
    $
    262
    
    
    $
    (142
    )
    
    $
    
    
    
    $
    120Provision for inventory
    
    $
    1,106
    
    
    $
    (63
    )
    
    $
    
    
    
    $
    1,043Balance for the year ended
January 1, 2005:Allowance for doubtful
accounts receivable
    
    $
    120
    
    
    $
    376
    
    
    $
    
    
    
    $
    496Provision for inventory
    
    $
    1,043
    
    
    $
    694
    
    
    $
    
    
    
    $
    1,737
 -68-




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##### Table of Contents



SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto
duly authorized, in the City of Mountain View, State of California, on 1st day of April, 2005. IRIDEX CORPORATIONBy:
    /s/ Theodore A. BoutacoffTheodore A. BoutacoffPresident, Chief Executive Officer,
and Director KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes
and appoints Theodore A. Boutacoff and Larry Tannenbaum, jointly and severally, their
attorney-in-fact, each with full power of substitution, for him in any and all capacities, to sign
on behalf of the undersigned any amendments to this Annual Report on Form 10-K, and to file the
same, with exhibits thereto and other documents in connection therewith, with the Securities and
Exchange Commission, and each of the undersigned does hereby ratifying and confirming all that each
of said attorneys-in-fact, or his substitutes, may do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Act of 1934, this report has been signed by the
following persons in the capacities and on the dates indicated. /s/ Theodore A. Boutacoff

(Theodore A. Boutacoff)
    
    President, Chief
Executive Officer,
and Director
(Principal Executive
Officer)
    
    April 1, 2005/s/ Larry Tannenbaum

(Larry Tannenbaum)
    
    Chief Financial
Officer and Vice
President,
Administration
(Principal Financial
and Accounting
Officer)
    
    April 1, 2005/s/ James L. Donovan

(James L. Donovan)
    
    Vice President,
Corporate Business
Development and
Director
    
    April 1, 2005/s/ Robert K. Anderson

(Robert K. Anderson)
    
    Director
    
    April 1, 2005/s/ Sanford Fitch

(Sanford Fitch)
    
    Director
    
    April 1, 2005/s/Garrett A. Garrettson

(Garrett A. Garettson)
    
    Director
    
    April 1, 2005/s/ Joshua Makower

(Joshua Makower)
    
    Director
    
    April 1, 2005/s/ Donald L. Hammond

(Donald L. Hammond)
    
    Chairman of the Board
    
    April 1, 2005
 -69-




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##### Table of Contents



EXHIBIT INDEX Exhibits
    
    Exhibit Title3.1(1)
    
    Amended and Restated Certificate of Incorporation of Registrant.3.2(2)
    
    Amended and Restated Bylaws of Registrant.10.1(1)
    
    Form of Indemnification Agreement with directors and officers.10.2(3)
    
    1995 Employee Stock Purchase Plan, as amended and form of agreement
there under.10.3(3)
    
    1995 Director Option Plan and form of agreement there under.10.4(1)
    
    1995 Profit Sharing Plan.10.5(1)
    
    Third Restated Registration Rights Agreement dated as of October 27,
1995 by and among Registrant and certain individuals and entities named
therein.10.6(4)
    
    Lease Agreement dated December 6, 1996 by and between Zappettini
Investment Co. and the Registrant.10.7(3)
    
    1998 Stock Option Plan, as amended.10.8(5)
    
    2005 Employee Stock Purchase Plan and form of agreement thereunder.10.9(6)
    
    2005 Bonus Plan.21.1(1)
    
    Subsidiaries of Registrant.23.1
    
    Consent of Independent Registered Public Accounting Firm.24.1
    
    Power of Attorney (See page 69).31.1
    
    Certification of Chief Executive Officer pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002.31.2
    
    Certification of Chief Financial Officer pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002.32.1
    
    Certification Of Chief Executive Officer and Chief Financial Officer
Pursuant To 18 U.S.C. Section 1350, As Adopted Pursuant To Section 906
Of The Sarbanes-Oxley Act Of 2002.
   (1)
    Incorporated by reference to the Exhibits filed with the Registration Statement
on Form SB-2(No. 333-00320-LA) which was declared effective on February 15, 1996.(2)
    Incorporated by reference to the Exhibits in the Registrants Report on Form 10-Q
for the quarter ended October 3, 1998.(3)
    Incorporated by reference to the Exhibits in the Registrants Statement on Form S-8 which was filed on August 3, 2004.(4)
    Incorporated by reference to the Exhibits in the Registrants Report on Form 10-Q
for the quarter ended September 27, 2003.(5)
    Incorporated by reference to the Exhibits in the Registrants Proxy Statement for the Registrants 2004 Annual Meeting of Stockholders.(6)
    Incorporated by reference to Exhibit 10.1 to the Registrants Current Report on Form 8-K
filed on March 22, 2005.
    Indicates a management compensatory plan, contract or arrangement.