** **

**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM10-Q**

 

**(MarkOne)**

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

 

**For the quarterly period ended September 30, 2004**

 

**OR**

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

 

**For the transition period from             to             .**

 

**COMMISSION FILE NUMBER 000-22743**

 

**VISTAMEDICAL TECHNOLOGIES, INC.**

(Exact name of Registrant as Specified in Its Charter)

 

| **DELAWARE**                                                   | ** ** | **94-3184035**                       |
|----------------------------------------------------------------|------------|--------------------------------------|
| (State or other jurisdiction of incorporation or organization) |       | (I.R.S. Employer Identification No.) |

 

**2101 FARADAY AVENUE**

**CARLSBAD, CA 92008**

(Address of principal executive offices, including zip code)

 

**(760) 603-9120**

(Registrant’s telephone number, including area code)

 

**Indicate by check mark whether the registrant (1) has filedall reports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports) and (2) has been subjectto such filing requirements for the past 90 days:**

 

**(1)    Yes****ý****      No****o**

**(2)    Yes****ý****      No****o**

 

**Indicate by check mark whether the registrant is anaccelerated filer (as defined in rule 12b-2 of the Exchange Act) Yes ****o****     No ****ý**

 

Asof October 29, 2004, there were 10,939,817 shares of $.01 par value commonstock outstanding.

 

----

 

**VISTA MEDICAL TECHNOLOGIES, INC.**

**FORM 10-Q**

**TABLE OF CONTENTS**

 
| PART 1. FINANCIAL INFORMATION |                                                                                                                   |
|-------------------------------|------------------------------------------------------------------------------------------------------------------------|
|                          |                                                                                                                   |   |
| Item 1.                       | Condensed Financial Statements  (unaudited)                                                                            |   |
|                          |                                                                                                                   |   |
|                          | Condensed Consolidated Balance  Sheets as of September 30, 2004 and December 31, 2003                        |   |
|                          |                                                                                                                   |   |
|                          | Condensed Consolidated  Statements of Operations for the three and nine months ended  September 30, 2004 and 2003 |   |
|                          |                                                                                                                   |   |
|                          | Condensed  Consolidated Statements of Cash Flows for the nine months ended  September 30, 2004 and 2003           |   |
|                          |                                                                                                                   |   |
|                          | Notes to  Condensed Consolidated Financial Statements                                                                  |   |
|                          |                                                                                                                   |   |
| Item 2.                       | Management’s Discussion and  Analysis of Financial Condition and Results of Operations                            |   |
|                          |                                                                                                                   |   |
| Item 3.                       | Quantitative and Qualitative Disclosures  About Market Risk                                                            |   |
|                          |                                                                                                                   |   |
| Risks  and Uncertainties      |                                                                                                                   |
|                          |                                                                                                                   |   |
| Item 4.                       | Controls and Procedures                                                                                                |   |
|                          |                                                                                                                   |   |
| PART II. OTHER INFORMATION    |                                                                                                                   |
|                          |                                                                                                                   |   |
| Item 1.                       | Legal Proceedings                                                                                                      |   |
|                          |                                                                                                                   |   |
| Item  2.                      | Unregistered  Sales of Equity Securities and Use of Funds                                                              |   |
|                          |                                                                                                                   |   |
| Item 3.                       | Defaults Upon  Senior Securities                                                                                       |   |
|                          |                                                                                                                   |   |
| Item  4.                      | Submission  of Matters to a Vote of Security Holders                                                                   |   |
|                          |                                                                                                                   |   |
| Item 5.                       | Other Information                                                                                                      |   |
|                          |                                                                                                                   |   |
| Item 6.                       | Exhibits and  Reports on Form 8-K                                                                                      |   |
|                          |                                                                                                                   |   |
| SIGNATURES                    |                                                                                                                   |

 

 

2

----

 

PART I.  FINANCIAL INFORMATION

## Item1.    Financial Statements

Vista Medical Technologies, Inc.

ConsolidatedBalance Sheets

 
| ** **                                                                                                                                                                                                | ** ** | **September 30, 2004** | ** ** | **December 31, 2003** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|----------------------------|------------|
| ** **                                                                                                                                                                                                | ** ** | **(Unaudited)**        | ** ** | **(Restated)**             | ** ** |
| ASSETS                                                                                                                                                                                                    |       |                   |       |                       |       |
| Current assets:                                                                                                                                                                                           |       |                   |       |                       |       |
| Cash and cash equivalents                                                                                                                                                                                 |       | $                      | 2,945,377  |                       | $          | 448,943 |   |
| Short-term investments                                                                                                                                                                                    |       | 3,714                  |       | 187,209                    |       |
| Accounts receivable                                                                                                                                                                                       |       | 171,250                |       | 286,152                    |       |
| Due from Viking Systems, Inc.                                                                                                                                                                             |       | 334,430                |       | —                     |       |
| Inventories                                                                                                                                                                                               |       | 116,608                |       | 45,275                     |       |
| Assets related to discontinued operations                                                                                                                                                                 |       | —                 |       | 1,881,237                  |       |
| Other current assets                                                                                                                                                                                      |       | 148,100                |       | 108,322                    |       |
| Total current assets                                                                                                                                                                                      |       | 3,719,479              |       | 2,957,138                  |       |
| Property and equipment, net                                                                                                                                                                               |       | 36,004                 |       | 34,023                     |       |
| Investment in equity securities of Viking Systems, Inc.                                                                                                                                                   |       | 33,080                 |       | —                     |       |
| TOTAL ASSETS                                                                                                                                                                                              |       | $                      | 3,788,563  |                       | $          | 2,991,161 |   |
|                                                                                                                                                                                                      |       |                   |       |                       |       |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                                                 |       |                   |       |                       |       |
| Current liabilities:                                                                                                                                                                                      |       |                   |       |                       |       |
| Accounts payable                                                                                                                                                                                          |       | $                      | 298,662    |                       | $          | 141,631 |   |
| Current portion of capital lease obligations                                                                                                                                                              |       | 16,246                 |       | 16,517                     |       |
| Short term bank borrowings                                                                                                                                                                                |       | —                 |       | 200,000                    |       |
| Short term notes                                                                                                                                                                                          |       | 81,616                 |       | —                     |       |
| Accrued compensation                                                                                                                                                                                      |       | 93,745                 |       | 134,156                    |       |
| Deferred revenue payments                                                                                                                                                                                 |       | 156,250                |       | 442,500                    |       |
| Liabilities related to discontinued operations                                                                                                                                                            |       | —                 |       | 755,550                    |       |
| Accrued liabilities                                                                                                                                                                                       |       | 100,816                |       | 174,019                    |       |
| Total current liabilities                                                                                                                                                                                 |       | 747,335                |       | 1,864,373                  |       |
|                                                                                                                                                                                                      |       |                   |       |                       |       |
| Total long term capital lease obligations                                                                                                                                                                 |       | 15,040                 |       | 18,624                     |       |
|                                                                                                                                                                                                      |       |                   |       |                       |       |
| TOTAL LIABILITIES                                                                                                                                                                                         |       | 762,375                |       | 1,882,997                  |       |
|                                                                                                                                                                                                      |       |                   |       |                       |       |
| Stockholders’ equity:                                                                                                                                                                                |       |                   |       |                       |       |
| Preferred stock, $.01 par value: Authorized shares - 5,000,000 Issued  and outstanding shares - 915,000 at September 30, 2004 and1,000,000 at  December 31, 2003 (Liquidation Value $3,477,000) |       | 1,074,913              |       | 1,068,686                  |       |
| Common stock, $.01 par value: Authorized shares - 35,000,000 Issued  and outstanding shares - 10,939,817 at September 30, 2004 and 5,007,918  at December 31, 2003                              |       | 109,398                |       | 50,079                     |       |
| Additional paid-in capital                                                                                                                                                                                |       | 72,714,107             |       | 68,111,244                 |       |
| Deferred compensation                                                                                                                                                                                     |       | (10,770                | )          | (29,856                    | )          |
| Accumulated deficit                                                                                                                                                                                       |       | (70,861,460            | )          | (68,091,989                | )          |
| Total stockholders’ equity                                                                                                                                                                           |       | 3,026,188              |       | 1,108,164                  |       |
|                                                                                                                                                                                                      |       |                   |       |                       |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                                           |       | $                      | 3,788,563  |                       | $          | 2,991,161 |   |
|                                                                                                                                                                                                           |            |                        |            |                            |            |  |  |  |

 

 

See accompanying notes.

 

3

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Vista Medical Technologies, Inc.

ConsolidatedStatements of Operations

(Unaudited)

 
| ** **                                                         | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|--------------------------------------------------------------------|------------|-------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                         | ** ** | **2004**                                  | ** ** | **2003**                                 | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                         | ** ** | ** **                                | ** ** | **(Restated)**                           | ** ** | ** ** | ** ** | **(Restated)** | ** ** |
| ** **                                                         | ** ** | ** **                                | ** ** | ** **                               | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues                                                           |       | $                                         | 374,777    |                                     | $          | 750,635 |   | $ | 1,277,492 |   | $ | 2,056,188 |   |
|                                                               |       |                                      |       |                                     |       |   |   |   |   |
| Cost of revenues                                                   |       | 45,177                                    |       | 224,584                                  |       | 324,958 |   | 522,501 |   |
| Sales and marketing                                                |       | 619,364                                   |       | 404,527                                  |       | 1,728,592 |   | 1,207,020 |   |
| General and administrative                                         |       | 507,780                                   |       | 262,510                                  |       | 1,090,377 |   | 905,360 |   |
|                                                               |       |                                      |       |                                     |       |   |   |   |   |
| Total cost and expenses                                            |       | 1,172,321                                 |       | 891,621                                  |       | 3,143,927 |   | 2,634,881 |   |
|                                                               |       |                                      |       |                                     |       |   |   |   |   |
| Loss from continuing operations                                    |       | (797,544                                  | )          | (140,986                                 | )          | (1,866,435 | ) | (578,693 | ) |
|                                                               |       |                                      |       |                                     |       |   |   |   |   |
| Interest income                                                    |       | 11,374                                    |       | 1,593                                    |       | 16,814 |   | 38,186 |   |
| Interest expense                                                   |       | (2,144                                    | )          | (2,349                                   | )          | (4,812 | ) | (3,403 | ) |
| Other expenses                                                     |       | (48,294                                   | )          | —                                   |       | (48,294 | ) | — |   |
|                                                               |       |                                      |       |                                     |       |   |   |   |   |
| Net loss from continuing operations                                |       | (836,608                                  | )          | (141,742                                 | )          | (1,902,727 | ) | (543,910 | ) |
|                                                               |       |                                      |       |                                     |       |   |   |   |   |
| Loss from discontinued operations                                  |       | —                                    |       | (555,834                                 | )          | (632,516 | ) | (657,711 | ) |
|                                                               |       |                                      |       |                                     |       |   |   |   |   |
| Net loss                                                           |       | (836,608                                  | )          | (697,576                                 | )          | (2,535,243 | ) | (1,201,621 | ) |
|                                                               |       |                                      |       |                                     |       |   |   |   |   |
| Accretion of preferred stock dividends                             |       | (32,865                                   | )          | (35,918                                  | )          | (103,  057 | ) | (82,767 | ) |
| Deemed dividend on redemption of preferred stock                   |       | —                                    |       | —                                   |       | (131,985 | ) | — |   |
|                                                               |       |                                      |       |                                     |       |   |   |   |   |
| Net loss applicable to common stockholders                         |       | $                                         | (869,473   | )                                        | $          | (733,494 | ) | $ | (2,770,285 | ) | $ | (1,284,388 | ) |
|                                                               |       |                                      |       |                                     |       |   |   |   |   |
| Net loss per share basic and diluted:                              |       |                                      |       |                                     |       |   |   |   |   |
| Continuing operations                                              |       | $                                         | (0.08      | )                                        | $          | (0.04 | ) | $ | (0.27 | ) | $ | (0.13 | ) |
| Discontinued operations                                            |       | —                                    |       | (0.11                                    | )          | (0.08 | ) | (0.13 | ) |
|                                                               |       |                                      |       |                                     |       |   |   |   |   |
| Basic and diluted loss per share applicable to common stockholders |       | $                                         | (0.08      | )                                        | $          | (0.15 | ) | $ | (0.35 | ) | $ | (0.26 | ) |
|                                                               |       |                                      |       |                                     |       |   |   |   |   |
| Shares used in computing basic and diluted loss per share          |       | 10,905,871                                |       | 5,003,471                                |       | 7,973,058 |   | 5,002,620 |   |
|                                                                    |            |                                           |            |                                          |            |  |  |  |  |  |  |  |  |  |  |  |

 

Seeaccompanying notes

 

4

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Vista Medical Technologies, Inc.

ConsolidatedStatements of Cash Flows

(Unaudited)

 
| ** **                                                                                          | ** ** | **Nine Months Ended September 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                          | ** ** | **2004**                            | ** ** | **2003** | ** ** |
| ** **                                                                                          | ** ** | ** **                          | ** ** | **(Restated)** | ** ** |
| OPERATING ACTIVITIES                                                                                |       |                                |       |   |   |
| Net loss from continuing operations                                                                 |       | $                                   | (2,535,243 | ) | $ | (1,201,621 | ) |
| Adjustments to reconcile net loss to net cash used for operating  activities:                       |       |                                |       |   |   |
| Noncash compensation expense                                                                        |       | —                              |       | 78,375 |   |
| Depreciation and amortization                                                                       |       | 31,145                              |       | 28,445 |   |
| Amortization of deferred compensation                                                               |       | 19,086                              |       | 31,946 |   |
| Changes in operating assets and liabilities:                                                        |       |                                |       |   |   |
| Accounts receivable                                                                                 |       | 114,902                             |       | 547,161 |   |
| Inventories                                                                                         |       | (71,333                             | )          | 24,896 |   |
| Other current assets                                                                                |       | (39,778                             | )          | 25,148 |   |
| Accounts payable                                                                                    |       | 157,031                             |       | (90,125 | ) |
| Accrued compensation                                                                                |       | (40,411                             | )          | 23,330 |   |
| Deferred revenue payments                                                                           |       | (286,250                            | )          | (177,500 | ) |
| Accrued liabilities                                                                                 |       | (73,203                             | )          | (183,961 | ) |
| Changes in assets and liabilities related to discontinued operations                                |       | 379,073                             |       | (275,904 | ) |
| Net cash flows used for operating activities                                                        |       | (2,344,981                          | )          | (1,169,810 | ) |
|                                                                                                |       |                                |       |   |   |
| INVESTING ACTIVITIES                                                                                |       |                                |       |   |   |
| Maturities of short-term investments                                                                |       | 183,495                             |       | 184,714 |   |
| Purchases of property and equipment                                                                 |       | (33,126                             | )          | (65,530 | ) |
| Proceeds from sale of business                                                                      |       | 351,103                             |       | — |   |
| Net cash flows provided by investing activities                                                     |       | 501,472                             |       | 119,184 |   |
|                                                                                                |       |                                |       |   |   |
| FINANCING ACTIVITIES                                                                                |       |                                |       |   |   |
| Issuance of common stock, net                                                                       |       | 4,662,182                           |       | 6,444 |   |
| Issuance of Series A preferred stock                                                                |       | —                              |       | 950,000 |   |
| Issuance of short term notes                                                                        |       | 114,262                             |       | — |   |
| Redemption of Series A preferred stock                                                              |       | (200,000                            | )          | — |   |
| Payment on short term notes                                                                         |       | (32,646                             | )          | — |   |
| Payment on capital leases                                                                           |       | (3,855                              | )          | 37,167 |   |
| Repayment of short term bank borrowings                                                             |       | (200,000                            | )          | — |   |
| Net cash flows provided by financing activities                                                     |       | 4,339,943                           |       | 993,611 |   |
| Net increase (decrease) in cash and cash equivalents                                                |       | 2,496,434                           |       | (57,015 | ) |
| Cash and cash equivalents at beginning of period                                                    |       | 448,943                             |       | 457,052 |   |
| Cash and cash equivalents at end of period                                                          |       | $                                   | 2,945,377  |   | $ | 400,037 |   |
|                                                                                                |       |                                |       |   |   |
| Non Cash-transactions:                                                                              |       |                                |       |   |   |
| Accretion of dividends on preferred stock                                                           |       | $                                   | 103,057    |   | $ | 82,767 |   |
| Common shares of Viking Systems, Inc. received for the sale of  Visualization Technologies business |       | $                                   | 61,080     |   | — |   |
| Common shares of Viking Systems, Inc. distributed to preferred  stockholders                        |       | (28,000                             | )          | — |   |
| Net Investment                                                                                      |       | $                                   | 33,080     |   | — |   |

 

Seeaccompanying notes

 

5

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VISTA MEDICAL TECHNOLOGIES,INC.NOTES TO CONSOLIDATED FINANCIALSTATEMENTS

SEPTEMBER 30, 2004

(UNAUDITED)

 

### 1.                                       Basis of Presentation

###  

Theaudited financial statements of Vista Medical Technologies, Inc and the notesthereto for the year ended December 31, 2003 included in our Annual Reporton Form 10-K/A previously filed with the Securities and Exchange Commission(“SEC”), contain additional information about us, our operations, and ourfinancial statements and accounting practices, and should be read inconjunction with this quarterly report on Form 10-Q.  The accompanying unaudited condensedconsolidated financial statements have been prepared in accordance withaccounting principles generally accepted in the United States of America ,pursuant to the rules and regulations of the SEC, and certain information andfootnote disclosures normally contained in financial statements prepared inaccordance with accounting principles generally accepted in the United Statesof America have been condensed or omitted, unless significant changes havetaken place since the end of the most recent fiscal year.

 

Ouraccompanying unaudited consolidated financial statements reflect alladjustments of a normal recurring nature, which are, in the opinion ofmanagement, necessary for a fair presentation of the financial position,results of operations and cash flows for all periods presented.  The interim financial information containedherein is not necessarily indicative of results for any future interim periodsor for the full fiscal year ending December 31, 2004.

 

### 2.                                       Discontinued Operations

###  

OnApril 15, 2004 we sold our Visualization Technology business unit toViking Systems, Inc. (“Viking”) under an Asset Purchase Agreement (the “AssetPurchase Agreement”) signed on December 22, 2003.  In accordance with SFAS No. 144 “Accountingfor the Impairment or Disposal of Long-Lived Assets”, the financial results ofthis business have been reported separately as discontinued operations and thefinancial statements for all prior periods have been restated accordingly.  Such restated financial statements have beenfiled with our Annual Report on Form 10-K/A.  Prior to the sale we conducted our operations through two separatebusiness units.  The Obesity Surgical andMedical Management Services business unit (operated via our wholly-ownedsubsidiary, VOW Solutions, Inc.), based in Carlsbad, CA, provides services tophysicians and hospitals involved in the surgical treatment of morbidobesity.  In addition, our formerVisualization Technology business unit, based in Westborough, Massachusetts,developed, manufactured and marketed products that provide information tophysicians performing minimally invasive general surgical, cardiac surgical andother selected endoscopic and interventional procedures.

 

Underthe Asset Purchase Agreement, we sold all the operating assets and relatedliabilities of the Visualization Technology business to Viking.  In return, Viking agreed to (a) pay us$159,000 at closing, (b) issue to us 3,054,000 shares of Viking common stock,representing approximately ten percent (10%) of its common shares outstandingon a fully diluted basis, and (c) remit to us the value of any formerVisualization Technology inventory sold by Viking before April 15, 2005.  We also entered into a license agreement withViking that will pay us royalties over the next five (5) years based on salesof the acquired products of the Visualization Technology business with minimumroyalties during the five (5) year period as follows: first year $150,000, yearstwo through four $300,000 and year five $375,000 with a maximum aggregateroyalties of $4,500,000 over the five (5) year period.  We will maintain ownership rights of allintellectual property and product rights under the license agreement withViking until at least the minimum royalty obligations have been satisfied, atwhich time we will transfer such ownership rights to Viking.

 

Thenet operating assets sold to Viking and the total consideration paid orcontractually due from Viking, exclusive of any proceeds from the subsequentsale of Visualization Technology inventory by Viking, are as follows:

 

| Net assets sold      |   | ** ** | ** ** | ** ** |
|----------------------|--------|------------|------------|------------|
| Accounts receivable  |   | $          | 372,027    |       |
| Inventories          |   | 787,657    |       |
| Accounts payable     |   | (351,934   | )          |
| Other liabilities    |   | (61,136    | )          |
|                 |   | $          | 746,614    |       |
| Viking consideration |   |       |       |       |
| Cash                 |   | $          | 158,718    |       |
| Viking Common shares |   | 61,080     |       |
| Minimum royalties    |   | 1,425,000  |       |
|                 |   | $          | 1,644,798  |       |
|                      |        |            |            |            |  |  |

 

6

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Underaccounting principles generally accepted in the United States of America, thetransaction is principally the exchange of non-monetary assets between Vikingand us.  As a result, the value of thenet assets sold ($746,614) is considered to be equal to the value of the netassets received and we are not allowed to recognize a gain at the time of thetransaction.  The Viking consideration,exclusive of cash, is considered non-monetary because Viking is a relativelynew company that has not raised substantial funds and may be unable to raisesufficient funds to sustain its operations or fund its growth plan.  Additionally, there can be no assurance thatViking’s business will succeed.  As aresult, all contractual amounts due us are at risk.  All proceeds received from Viking will befirst credited against the Due from Viking account.  All proceeds in excess of that balance willbe recorded as a gain from discontinued operations when received.  During the quarter ended September 30, 2004we received from Viking $132,184 in proceeds from the sale of inventory byViking.

 

Ourfinancial results for the three months and nine months ended September 30,2004 and 2003 have been restated to show the results of operations for theVisualization Technology business as a discontinued operation.  There were no discontinued operationsactivities for the three months ended September 30, 2004.  The operating results of the discontinuedoperations were as follows:

 

 
| ** **                        | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|-----------------------------------|------------|-------------------------------------------|------------|------------------------------------------|------------|
| ** **                        | ** ** | **2003**                                  | ** ** | **2004**                                 | ** ** | **2003** | ** ** |
| Sales                             |       | $                                         | 929,708    |                                     | $          | 1,227,672 |   | $ | 4,752,230 |   |
| Costs and Expenses                |       |                                      |       |                                     |       |   |   |
| Cost of sales                     |       | 758,770                                   |       | 1,035,667                                |       | 3,330,360 |   |
| Research and development          |       | 397,740                                   |       | 330,014                                  |       | 949,921 |   |
| Sales and marketing               |       | 116,017                                   |       | 78,678                                   |       | 233,479 |   |
| General and administrative        |       | 212,015                                   |       | 415,529                                  |       | 895,181 |   |
| Total cost and expenses           |       | 1,484,542                                 |       | 1,859,888                                |       | 5,408,941 |   |
| Interest expense                  |       | 1,000                                     |       | 300                                      |       | 1,000 |   |
| Loss from discontinued operations |       | $                                         | (555,834   | )                                        | $          | (632,516 | ) | $ | (657,711 | ) |
|                                   |            |                                           |            |                                          |            |  |  |  |  |  |  |  |

 

Theequipment financing costs associated with the equipment sold to Viking has beenincluded in discontinued operations.

 

TheCompany had a severance agreement with a former employee who became an employeeof Viking upon the sale of the Visualization Technology business.  Under the agreement, the Company may berequired to pay the employee one year’s compensation (approximately $200,000)if the employee is terminated under certain circumstances within 18 monthsfollowing the sale of the business or prior to October 2005.  No provision for such payment has beenincluded in the results of discontinued operations and will not be provided foruntil such payment is probable.

 

3.                                       Investment inequity securities of Viking Systems, Inc.

 

Aspart of the sale of our Visualization Technology business in April 2004, wewere issued 3,054,000 shares of Viking common stock (see Note 2) that weretraded on the pink sheets.  1,400,000 ofthese shares were used to obtain certain rights from our Series A holders (seeNote 9).  The remaining 1,654,000 werevalued as $0.02 per share or $33,080, which reflects fair value at the time ofpurchase which was also the carrying value at September 30, 2004.  In October 2004 the Viking shares begantrading on the Over The Counter Bulletin Board and was quoted at $0.75 pershare on October 28, 2004, however, there has been limited activitythrough November 11, 2004. The Company will evaluate whether thisinvestment should be classified as available for sale during the fourth quarterof 2004.

 

### 4.                                       Segments

###  

Subsequentto the sale of our Visualization Technology business, we operate only onebusiness segment, focused on the disease state management of morbid obesity.This business provides program management, operational consulting and clinicaltraining services to physicians and hospitals involved in the medical andsurgical treatment of morbidly obese patients. We also provide vitamins to patients who have undergone obesity surgery.

 

### 5.                                       Inventories

###  

Inventoriesare stated at lower of cost (determined on a first-in, first-out basis) ormarket and include only finished 

 

7

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goodsrelated to our disease state management of morbid obesity business.

 

 

### 6.                                       Loss Per Share

###  

Basicnet loss per share is calculated based on the weighted average number of commonshares outstanding during the period. Diluted net loss per share incorporatesthe dilutive effect of potentially dilutive shares of common stock, includingshares attributable to stock options, warrants and other convertiblesecurities.  Potentially dilutive sharesof common stock have been excluded from the calculation of weighted averagenumber of diluted common shares, as their effect would be antidilutive for allperiods presented.  For the purpose ofdetermining basic and diluted net loss per share, dividends accreted onpreferred stock and the deemed dividend with respect to the preferred stockredemption (see Note 8) have been deducted from the net loss to arrive at netloss applicable to common stockholders. Potentially dilutive shares of commonstock that have been excluded from the calculation of weighted average numberof diluted common shares for the three and nine month periods ended September 30, 2004 include sharesattributable to options to purchase up to 705,787 shares of common stock,915,000 shares of preferred stock and warrants to purchase 3,764,953 shares ofcommon stock.  For the three and ninemonth periods ended September 30,2003, the potentially dilutive shares of Common stock that have been excludedfrom the calculation of weighted average number of diluted common sharesinclude options to purchase up to 773,828 shares of common stock and 1,000,000shares of preferred stock.

 

### 7.                                       Stock-Based Compensation

###  

TheCompany applies the principles of Accounting Principles Board Opinion No. 25, “*Accounting for Stock Issued to Employees*,”and related interpretations in accounting for its employee stock optioncompensation plans.  Under APB No. 25,compensation expense is measured as the difference, if any, between the optionexercise price and the fair value of the Company’s common stock at the date ofgrant.  The Company has historicallygranted options to employees and directors at exercise prices equal to the fairvalue of the Company’s common stock. Accordingly, minimal compensation expense has been recognized for itsemployee stock-based compensation plans.

 

SFASNo. 123, “*Accounting for Stock-BasedCompensation*,” establishes a fair value based approach for valuingstock options.  The Company follows thedisclosure-only alternative afforded by SFAS No. 123.  Had compensation costs for stock optionsissued to employees and directors been determined based on the estimated fairvalue at the grant dates as calculated in accordance with SFAS No. 123, theCompany’s reported net loss and basic and diluted net loss per common share forthe three and nine month periods ended September 30,2004 and 2003 would have been adjusted to the pro forma amounts indicatedbelow:

 

 
| ** **                           | ** ** | **For three months ended September 30,** | ** ** |
|--------------------------------------|------------|-----------------------------------------------|------------|
| ** **                           | ** ** | **2004**                                      | ** ** | **2003** | ** ** |
| Net Loss                             |       |                                          |       |   |   |
| As reported                          |       | $                                             | (836,608   | ) | $ | (697,576 | ) |
| Pro forma compensation expense       |       | (65,575                                       | )          | (52,372 | ) |
| Pro forma SFAS No. 123 net loss      |       | $                                             | (902,183   | ) | $ | (749,948 | ) |
|                                 |       |                                          |       |   |   |
| Basic and diluted net loss per share |       |                                          |       |   |   |
| As reported                          |       | $                                             | (0.08      | ) | $ | (0.14 | ) |
| Pro forma                            |       | $                                             | (0.08      | ) | $ | (0.15 | ) |

 
| ** **                           | ** ** | **For nine  months ended September 30,** | ** **       |
|--------------------------------------|------------|-----------------------------------------------|------------------|
| ** **                           | ** ** | **2004**                                      | ** **       | **2003** | ** ** |
| Net Loss                             | ** ** | ** **                                    | ** **       | ** ** | ** ** |
| As reported                          | ** ** | $                                             |  (2,535,243 | ) | $ |  (1,201,621 | ) |
| Pro forma compensation expense       | ** ** | (193,436                                      | )                | (167,101 | ) |
| Pro forma SFAS No. 123 net loss      | ** ** | $                                             |  (2,728,679 | ) | $ |  (1,368,722 | ) |
| Basic and diluted net loss per share | ** ** |                                          |             | ** ** | ** ** |
| As reported                          | ** ** | $                                             |  (0.32      | ) | $ |  (0.24 | ) |
| Pro forma                            | ** ** | $                                             |  (0.34      | ) | $ |  (0.27 | ) |

 

8

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### 8.                                       Stockholders’ Equity

 

### Preferred Stock

###  

InMarch 2003 the Company authorized and issued 1,000,000 shares of Series AConvertible Preferred Stock (the “Series A Shares”), which were createdpursuant to the terms of a Certificate of Designations, for an aggregate of$950,000 in cash.  In connection withthis financing, the purchasers of Series A Shares were granted severalsignificant rights senior to the rights of holders of our common stock. Amongother rights, in the event of a liquidation, dissolution or winding up of ourCompany (including consolidations, mergers or other sales), holders of Series AShares will be entitled to receive $3.80 per share, in preference to anydistribution to the holders of common stock. Also, pursuant to the Certificate of Designations, the Company mustobtain the consent of the holders of at least two-thirds of the outstandingSeries A Shares in order to undertake certain actions, including significantcapital expenditures and the issuance of equity securities.  Additionally, for so long as Series A Sharesremain outstanding beyond April 2004, the holders of Series A Shares willbe entitled to elect the greater of (i) two members of the Company’s Board ofDirectors or (ii) twenty-five percent (25%) of the total members of theCompany’s Board of Directors.

 

InJune 2004 we amended theSeries A Certificate of Designations to allow us the right to issue equity securitiesfor less than $2.00 per share.  For thatright, the Series A holders received 1,400,000 shares of Viking common stockvalued at $28,000.  In addition, weagreed to redeem 85,000 Series A Shares for $200,000.  In addition, we have obtained the right toredeem an additional 300,000 Series A Shares at any time on or beforeJanuary 15, 2006 in exchange for $500,000. The distribution of the Vikingshares and the excess of the $200,000 over the prior contractual redemptionvalue of the Series A shares ($131,985) have been accounted for as a deemeddividend.

 

Theholders of the outstanding Series A Shares have the right to one vote for eachshare of common stock into which such Series A Shares could then be converted,and with respect to such vote, such holder shall have full voting rights andpowers equal to the voting rights and powers of the holders of common stock.

 

Theholders of Series A Shares are entitled to receive dividends, out of any assetslegally available therefore, prior and in preference to any declaration orpayment of any cash dividend on the common stock, at the rate of $0.1425 pershare per annum.

 

Common Stock

 

## InFebruary 2004 we sold to a group of accredited investors 439,000 shares ofcommon stock and warrants to purchase up to 219,500 shares of common stock, fora total of $588,260 as part of a unit offering. The warrants are exercisable ata price of $1.97 per share and expire in February 2009.

##  

## InFebruary 2004 our subsidiary VOW Solutions, Inc. (“VOW”), adopted the VOWSolutions, Inc. 2004 Stock Option/Stock Issuance Plan (the “VOW Plan”) for thebenefit of VOW’s eligible employees, consultants, and directors. The VOW Planinitially reserved 150,000 shares of common stock of VOW for issuance upon theexercise of stock options.  Under the terms of the VOW Plan, nonqualifiedand incentive stock options may be granted at prices not less than 85% and 100%of the fair value on the date of grant, respectively. Options are typicallyimmediately exercisable and generally vest over a four year period from thedate of grant. Unvested common shares obtained upon early exercise of optionsare subject to repurchase by VOW at the original issue price. As ofSeptember 30, 2004, options to purchase up to an aggregate of 112,500shares of common stock had been issued under the VOW Plan, none of which hadbeen exercised. VOW had 1,000,000 shares of common stock outstanding as ofSeptember 30, 2004.

##  

## InMay 2004 we sold to a group of accredited investors 5,454,544 units of oursecurities for $0.85 per unit, each unit consisting of one share of commonstock and one warrant to purchase one-half share of common stock, for aggregategross proceeds of approximately $4.6 million, or $4.1 million net ofexpenses.  The warrants are exercisableat a price of $0.95 per share and expire in May 2009.  As part of the May 2004 unit sale, we issuedwarrants to the placement agent to purchase up to 818,181 shares of our commonstock.  545,454 of these warrants areexercisable at a price of $1.02 per share and the remaining 272,727 warrantsare exercisable at a price of $0.95 per share. The warrants expire in May 2009.

 

 

9.             Subsequent Event

 

                In October20, 2004 at a special meeting of the stockholders we received approval toincrease the aggregate number of shares of common stock available for issuanceunder our 1997 Stock Option/Stock Issuance Plan from 1,092,500 to 2,592,500.

 

 

9

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## Item2

##  

## Management’sDiscussion and Analysis of Financial Condition and Results of Operations

##  

THISQUARTERLY REPORT MAY CONTAIN PREDICTIONS, ESTIMATES AND OTHER FORWARD-LOOKINGSTATEMENTS THAT INVOLVE A NUMBER OF RISKS AND UNCERTAINTIES, INCLUDING THOSEDISCUSSED UNDER THE “RISKS AND UNCERTAINTIES” SECTION BELOW.  WHILE THIS OUTLOOK REPRESENTS OUR CURRENTJUDGMENT ON THE FUTURE DIRECTION OF OUR BUSINESS, SUCH RISKS AND UNCERTAINTIESCOULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM ANY FUTURE PERFORMANCESUGGESTED BELOW.  WE UNDERTAKE NOOBLIGATION TO RELEASE PUBLICLY THE RESULTS OF ANY REVISIONS TO THESEFORWARD-LOOKING STATEMENTS TO REFLECT EVENTS OR CIRCUMSTANCES ARISING AFTER THEDATE OF THIS QUARTERLY REPORT.  THEFOLLOWING DISCUSSION SHOULD BE READ IN CONJUNCTION WITH OUR CONSOLIDATEDFINANCIAL STATEMENTS AND THE NOTES THERETO INCLUDED IN ITEM 1 OF THIS QUARTERLYREPORT ON FORM 10-Q, OUR 2003 ANNUAL REPORT ON FORM 10-K/A AND OUR OTHERDISCLOSURE DOCUMENTS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION.

 

###                 Overviewof our business

###  

VistaMedical Technologies, Inc., through its wholly owned subsidiary VOW Solutions,Inc. is exclusively focused on the disease state management of morbid obesity.

 

Wepreviously conducted our operations through two separate business units.  The Obesity Surgical and Medical ManagementServices business unit (now our disease state management of morbid obesitybusiness operated via our wholly-owned subsidiary, VOW Solutions, Inc.), basedin Carlsbad, CA, provides services to physicians and hospitals involved in thesurgical treatment of morbid obesity. Our services include management of our original product offering, theLaparoscopic Bariatric Surgery Preceptorship, a comprehensive introduction tostarting a minimally invasive gastric bypass surgical program. We also offersystems, consulting and program management services, which enable the efficientoperation of obesity surgery programs. In addition, our former Visualization Technology business unit, based inWestborough, Massachusetts, developed, manufactured and marketed products thatprovided information to physicians performing minimally invasive generalsurgical, cardiac surgical and other selected endoscopic and interventionalprocedures.  On December 22, 2003 wesigned an agreement to sell the Visualization Technology business unit toViking Systems, Inc. (“Viking”).  Thissale was completed on April 15, 2004. Refer to our Proxy Satement filed with the SEC on March 25, 2004 forfurther details of the transaction.

 

Asa result of the sale of our Visualization Technology business unit, all of ouroperations are conducted through our subsidiary VOW Solutions, Inc., which werefer to as VOW, and are concentrated in the field of bariatric surgery andbariatric medicine.  The vision of ourVOW business is to enable healthcare providers and organizations in the ongoingevolution of the highest standards of treatment and services to optimize thequality of life for morbidly obese patients. Our mission is to deliver the leading management portfolio of servicesand products for the clinical and business development of continuallysuccessful obesity surgery programs.

 

InFebruary 2004 we sold to a group of accredited investors 439,000 shares ofcommon stock and warrants to purchase up to 219,500 shares of common stock, fora total of $588,260 as part of a unit offering. We sold 219,500 units; each unit consisted of two (2) shares of commonstock priced at $1.34 per share and a warrant to purchase one share of commonstock. The warrants are exercisable at a price of $1.97 per share and expire inFebruary 2009.  The proceeds wereused to fund our obesity disease state management business unit and ourVisualization Technology business unit until it was sold in April 2004.

 

InMay 2004 we sold to a group of accredited investors 5,454,544 units of oursecurities for $0.85 per unit, each unit consisting of one share of commonstock and one warrant to purchase one-half share of common stock, for aggregategross proceeds of approximately $4.6 million or $4.1 million net ofexpenses.  The warrants are exercisableat a price of $0.95 per share and expire in May 2009.  The proceeds are to be used to fund ourobesity disease state management business unit. As part of the May 2004 unit sale, we issued warrants to the placementagent to purchase up to 818,181 shares of our common stock.  545,454 of these warrants are exercisable ata price of $1.02 per share and the remaining 272,727 warrants are exercisableat a price of $0.95 per share.  Thewarrants expire in May 2009.

 

InJune 2004 we amended our Series A Certificate of Designations to allow usthe right to issue equity securities for 

 

10

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aprice under $2.00.  For that right, theSeries A holders received 1,400,000 shares of Viking common stock that we heldvalued at $28,000.  As part of theamendment, we were required to redeemed 85,000 Series A Shares for$200,000.  In addition, we have the rightto redeem an additional 300,000 at any time on or before January 15, 2006in exchange for $500,000. If we choose to redeem the additional 300,000 SeriesA Shares, we will use cash that would otherwise fund our business operations.

 

InAugust 2004 we announced the signing of the first full management contractfor a VOW Center, which covers the launch and ongoing management of an obesitysurgery program.  Theagreement is a 3-year renewable contract with Pioneers Memorial HealthcareDistrict of Brawley, CA.

 

InOctober 20, 2004 at a special meeting of the stockholders we received approvalto increase the aggregate number of shares of common stock available forissuance under our 1997 Stock Option/Stock Issuance Plan from 1,092,500 to2,592,500.

 

Ourdiscussion of our results of operations will be focused on our remainingbusiness, which is now exclusively focused on the disease state management ofmorbid obesity.

 

**Critical Accounting Policies**

 

Thepreparation of financial statements and related disclosures in conformity withaccounting principles generally accepted in the United States of Americarequires management to make judgments, assumptions and estimates that affectthe amounts reported in our consolidated financial statements and theaccompanying notes.  The amounts ofassets and liabilities reported in our balance sheets and the amounts ofrevenues and expenses reported for each of our fiscal periods are affected byestimates and assumptions which are used for, but not limited to, accountingfor product returns, allowance for doubtful accounts, warranty and technicalservice costs, inventory and income taxes. Actual results could differ from these estimates.  The following critical accounting policiesare significantly affected by judgments, assumptions and estimates used in thepreparation of the consolidated financial statements.

 

*Revenue Recognition*

 

Revenuegenerated from our disease state management of morbid obesity business arerecognized (i) with regard to management services, upon completion of theservice period and (ii) with regard to training services or other consultingservices, upon completion of the related training or consulting component,provided that a contract exists, there are no uncertainties regarding customeracceptance, the sales price is fixed or determinable and collectibility isdeemed probable.  Sales of vitamins aresimilarly recognized upon shipment provided that a purchase order has beenreceived, there are no uncertainties regarding customer acceptance, the salesprice is fixed or determinable and collectibility is deemed probable.

 

Wehave received semiannual payments as a result of fulfilling certain obligationsrelated to our strategic alliance agreement with Ethicon Endo-Surgery, Inc.(EES).  These payments are recognized asrevenue on a straight-line basis over the related contract term, provided thatwe have complied with all contractual obligations.  No further payments from EES are requiredunder the current agreement.

 

*Due from Viking*

 

Thisaccount represents the consideration due from Viking as a result of the sale ofour Visualization Technology business. Although we may receive amounts in excess of the account balance,realization of the balance is not assured.

 

Vikingis a relatively new company that has not raised substantial funds and may beunable to raise sufficient funds to sustain its operations or fund its growthplan.  Additionally, there can be noassurance that Viking’s business will succeed. As a result, all contractual amounts due us are at risk.

 

*Investment in Equity Securities of Viking Systems, Inc.*

 

Aspart of the sale of our Visualization Technology business in April 2004, wewere issued 3,054,000 shares of Viking common stock (see Note 2) that weretraded on the pink sheets.  1,400,000 ofthese shares were used to obtain certain rights from our Series A holders (seeNote 9).  The remaining 1,654,000 werevalued as $0.02 per share or $33,080, which reflects fair value at the time ofpurchase which was also the carrying value at September 30, 2004.  In October 2004 the Viking shares begantrading on the Over The Counter Bulletin Board and was quoted at $0.75 pershare on October 28, 2004, however, there has been limited activitythrough November 11, 2004. The Company will evaluate whether thisinvestment should be classified as available for sale during the fourth quarterof 2004.

 

Vikingis a relatively new company and there is a limited market for Viking commonstock even though it is 

 

11

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publiclyquoted.   The limited trading market forViking common stock may cause fluctuations in the market value of the commonstock to be exaggerated, leading to price volatility in excess of that whichwould occur in a more active trading market.

 

 

**Our results of operations for three-months and nine-monthsended September 30, 2004 versus three-months and nine-months endedSeptember 30, 2003**

 

Revenues.  Management and consulting services, productsales and contract revenue for the three and nine-months endedSeptember 30, 2004 were $375,000 and $751,000, respectively, compared to$1,277,000 and $2,056,000 for the same periods ended September 30,2003.    The decrease in revenue for both periods wasassociated with lower training and consulting services and contract revenue.While revenues for both the three and nine-month periods decreased, our mostimportant business indicator, VOW program management fees, increased as aresult of signing up our first, full-fledged VOW center in late August2004.  We also saw an increase in vitaminsales for both periods.  We anticipatethat revenues in the fourth quarter will increase slightly over current levelswith greater quarterly growth expected in 2005. However, contract revenue in the fourth quarter, which will be the lastquarter of revenues recognized under our contract, will be the same as thethird quarter.

 

| **Increase/(decrease) over prior year** | ** ** | **Three Months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|-----------------------------------------|------------|-------------------------------------------|------------|------------------------------------------|------------|
| Management fees                         |       | $                                         | 60,000     |                                     | $          | 154,000 |   |
| Training and consulting fees            |       | (335,000                                  | )          | (607,000                                 | )          |
| Vitamins sales                          |       | 24,000                                    |       | 49,000                                   |       |
| Contract revenue                        |       | (125,000                                  | )          | (375,000                                 | )          |
|                                    |       | $                                         | (376,000)  |                                     | $          | (779,000 | ) |

 

The decrease associated withlower clinical training services and to a lesser degree consulting services wasthe result of a change in the market as demand shifted from the requirement tobe trained to more of a focus on the operational aspects of bariatric programs.  Also, in the second quarter, we had anon-operational focus because of the necessity to complete the sale of thetechnology business and to raise new capital. This second quarter focus, affected the third quarter by providing alower revenue base to begin our transition to a pure play disease statemanagement business.   Other thirdquarter issues that contributed to the decrease in training and consultingservices included some market slowing because of payor uncertainty, and thehiring of a new sales vice president midway through the quarter.

 

Costof revenues.  Our cost of revenuesincludes direct costs associated with generating management and consultingservices revenues along with the fully burdened cost of our vitamin sales.  Costs of revenues for the three andnine-months ended September 30, 2004 were $45,000 and $325,000,respectively, compared to $225,000 and $523,000 for the three and nine-monthsended September 30, 2003.  Thedecrease in the three-months ended September 30, 2004 was primarily due tolower spending of $167,000 in direct expenses related to the decrease of$335,000 in revenues in the areas of training and consulting services.  Also, the decrease in the nine-months endedSeptember 30, 2004 was also primarily due to lower spending of $204,000 indirect expenses related to the decrease of $607,000 in revenues in the sameareas.  Increased revenues in futurequarters may bring an increase in cost of revenues.  The level of increase is difficult to projectdue to varying costs associated with each revenue type.

 

Salesand marketing expenses.  Sales andmarketing expenses were $619,000 and $1,729,000 for the three and nine-monthsended September 30, 2004, respectively, and $405,000 and $1,207,000 forthe three and nine-months ended September 30, 2003, respectively.  The increase for both periods was primarilydue to an increase in staffing related expenses of our obesity disease statemanagement business in 2004 as a result of divesting our technologybusiness.  We expect to see an increasein our sales and marketing expenses during the last quarter of 2004 as we rampup our activities and expand our staff.

 

Generaland administrative expenses.  General andadministrative expenses were $508,000 and $1,090,000 for the three and nine-monthsended September 30, 2004, respectively, and $263,000 and $905,000 for thethree and nine-months ended September 30, 2003, respectively.  The increase for both periods in 2004 was aresult of higher staffing related expenses of $57,000 and public companyexpenses; specifically audit fees of $50,000, legal fees of $57,000 and otherrelated public company expenses of $56,000. ** **We expect our general andadministrative expenses to increase during the coming quarters as we continueto implement procedures to comply with the Sarbanes-Oxley Act of 2002.

 

Otherincome and expense.  Our interest incomewas $11,000 and $17,000 for the three-and nine-months ended 

 

12

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September 30,2004, respectively, and $2,000 and $38,000 for the three and nine-months endedSeptember 30, 2003, respectively. It is expected that our net interest income will start to decrease inthe next quarters as we utilize the cash balance created by the fundraisingthat was completed in the second quarter of 2004.  Interest expense for the periods presented isrelated to equipment leasing.  Otherexpenses of $48,000 for the three and nine-months ended September 30, 2004 areassociated with S-3 filing related fees.

 

Discontinuedoperations.  There were no costsassociated with discontinued operations for the quarter ended September 30,2004, however, the loss from discontinued operations for the nine months endedSeptember 30, 2004 was $632,516. This compares to a loss of $556,000 for the quarter ended September 30, 2003 and $658,000 for thenine-months ended September 30, 2003. The increase in loss in the nine-months ended 2003 over same period in2004 was a result of comparing nine months of discontinued operations in 2003to three and one-half months in 2004.

 

 

**Liquidity and capital resources**

 

Netcash used for operating activities for the nine-months ended September 30,2004 was $2,345,000 compared to net cash used of $1,170,000 for thecorresponding nine-month period in 2003. The increase in net cash used in operating activities during the 2004period is primarily attributable to reduced revenues of $779,000 and higheroperating expenses of $549,000.

 

Netcash provided by investing activities was $501,000 for the nine-months endedSeptember 30, 2004 compared to $119,000 in the same period in 2003.  The increase in net cash provided byinvesting activities during the 2004 period was primarily attributable toproceeds from the sale of the Visualization Technology business of $351,000.

 

Netcash provided by financing activities was $4,340,000 for the nine-months endedSeptember 30, 2004, compared to $994,000 for the same period in 2003.  The increase in net cash provided byfinancing activities during the 2004 period was primarily attributable to theclosing of two private placements of shares of our Common Stock for aggregatenet proceeds of $4,637,000 in the first nine months of 2004 compared to$950,000 raised in the sale of our Series A Convertible Preferred Stock in thefirst nine months of 2003.  Also during2004, we redeemed 85,000 shares of our Series A Convertible Preferred Stock for$200,000 and paid off our short-term borrowings, net of new borrowings, of$118,000.

 

Sinceour formation in July 1993, and as of September 30, 2004 we have incurredcumulative net losses of $71.0 million. At September 30, 2004, we had cash and short-term investments of$2,949,000.  In February 2004, wesold $588,000 of common stock in a private placement and in May 2004 we sold anadditional $4,072,000 of common stock in a private placement.  We believe that these cash resources,excluding revenues from operations, will not be sufficient resources to operateour business beyond 2005.  Unless wegenerate significant cash flow from operations, we will need additional fundingto continue development of our business. There can be no assurance that therequisite funding will be consummated in the necessary time frame or on termsacceptable to us.  Should we be unable toraise sufficient funds, we may be required to curtail our operating plans andpossibly relinquish rights to portions of our services and products.  In addition, increases in expenses withoutincreasing revenues in the near term may adversely impact our cash position andrequire future cost reductions.  Noassurance can be given that we will be able to operate profitably on aconsistent basis, or at all, in the future.

 

Wehad a $2,000,000 credit facility with a financial institution.  Interest on this facility was prime plus 2%and could only be secured by qualified accounts receivable and only up to 80%of qualified accounts receivable.   Thefacility expired in September 2004.

 

## Item3     Quantitative and Qualitative DisclosuresAbout Market Risk

##  

AtSeptember 30, 2004, our investment portfolio included fixed-incomesecurities of $2.9 million.  Thesesecurities are subject to interest rate risk and will decline in value ifinterest rates increase.  Theseinvestments are not held for trading or other speculative purposes. Due to theshort duration of our investment portfolio, an immediate ten percent (10%)increase in interest rates would have no material impact on our financialcondition or results of operations.  Wegenerally conduct business in U.S. dollars and, as a result, have limitedforeign currency exchange rate risk.  Theeffect of an immediate ten percent (10%) increase in foreign currency exchangerates would have no material impact on our financial condition or results ofoperations.

 

 

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## RISKSAND UNCERTAINTIES

##  

*Youshould carefully consider the following risks and uncertainties before youinvest in our common stock.  Investing inour common stock involves risk.  If anyof the following risks or uncertainties actually occurs, our business, financialcondition or results of operations could be materially adversely affected.  Additional risks and uncertainties of whichwe are unaware or which we currently believe are immaterial could alsomaterially adversely affect our business, financial condition or results ofoperations.  In any case, the tradingprice of our common stock could decline, and you could lose all or part of yourinvestment.*

 

**Risks Related to our Business and Industry**

 

**As a company, we do not have direct experience in themanagement of health care service businesses.**

 

Asa company we do not have direct experience in the management of bariatricsurgical programs.  We have been involvedin the development of bariatric surgical programs since 2000, but have neverdirectly managed these programs.  Assuch, we have only a limited and indirect operating history upon which anevaluation of our prospects can be based. In addition, the bariatric surgical market is relatively new and isexpanding rapidly, which can cause changes in the way clients react to theservices offered.  We believe that ourmanagement model is appropriate for the market, but we have yet to proveit.  To be successful, it is crucial thatwe develop strong affiliations with hospitals and surgical centers, and we havenot yet proven our ability to do so. Also, we must respond to competitive developments and attract, retainand motivate experienced staff.  Therecan be no assurance that we will be successful in addressing those marketconditions or in implementing our business strategy.  There can be no assurance that we will beable to achieve or sustain revenue growth or profitability.

 

Inaddition, our business model is to provide management services to owners ofsurgical programs.  As a result, we willnot have an ownership interest in those programs, which will make it moredifficult to sustain revenues.  Ourservices could be terminated due to this lack of ownership.

 

**Roll-out of our VOW Centers depends on our entering intoagreements with hospitals and surgeons; the time to conclude these agreementsmay be extended and thereby delay or prevent the implementation of ourstrategy.**

 

Weplan to set up our VOW Centers in conjunction with hospitals and surgeons.  There can be no assurance that negotiationsfor the establishment of these Centers will not be protracted or impossible tonegotiate satisfactorily.  Our experienceto date is limited to one existing management contract in place sinceFebruary 2004 and one contract entered into in August 2004.  We are in active negotiation for others;however, we cannot accurately predict the time and expense involved in thesenegotiations, and any unexpected delays could negatively impact the executionof our strategic plan.

 

**We need to increase market awareness and acceptance of ournew business model.**

 

Toour company’s knowledge, the comprehensive services offered by our new VOWSolutions business model have not been available to date on a nationallevel.  While we have previously suppliedclinical training services to some 60 clients and consulting services to some35 clients, we have not yet widely promoted our program managementservices.  As a result, providers ofbariatric surgery are not yet generally aware of the services we offer.  In order to accomplish our strategic andbusiness plans, we will have to quickly and effectively increase marketawareness of our management model and the VOW brand name, and convince doctors,hospitals and patients of the benefits of these services.  Among other things, this will require thatwe:

 

•                                            increase awareness of our completeservice offering;

 

•                                            strengthen ourbrand name to increase visibility;

 

•                                            continue toupgrade and expand our services; and

 

•                                            increaseawareness of the availability of surgery as a means of treating severe obesity.

 

Wecannot assure you that we will be able to accomplish these objectives.

 

**After establishing VOW Centers, we must continue to prove ourvalue proposition.**

 

Inorder to successfully negotiate and complete agreements with doctors andhospitals to establish VOW Centers, we will present them with our projectedrevenues and operational metrics.  Wecannot assure you that our projections will prove accurate or that we will beable to provide the anticipated metrics. Our projections are based on limited input and operational history andfailure to meet such projections will negatively impact our business.

 

14

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**The provision of health care services is subject toconsiderable regulation by state and federal agencies.**

 

TheCenters we intent to establish in cooperation with surgery providers, which werefer to as centers, will need to comply with many laws and regulations, bothstate and federal, which govern the provision of health care services.  If they fail to comply with any such laws andregulations, then the penalties involved could be serious, time-consuming formanagement and expensive.  Inexperiencein health care services could contribute to an inadvertent breach of laws orregulations.

 

**We operate in a competitive market; new technologies,procedures, or pharmaceuticals could radically change the modality of treatmentof morbid obesity and negatively impact the economics of our obesity surgerybusiness.**

 

Themarket for products and services that address morbid obesity is attractive andtherefore competitive and new offerings and technologies are in development byseveral companies.  For example, we areaware of developments, primarily involving stimulation or balloon technology, whichmay come to the market in the next few years. These devices would be implanted or placed in a relatively simpleendoscopic procedure.  These alternativesmay prove to be more effective, less risky and/or cheaper than gastricbypass.  If this turns out to be thecase, our ability to generate revenues will be negatively affected. Also, manypharmaceutical companies are researching drug therapies for combatingobesity.  If they prove successful infinding a more effective solution for morbid obesity, then demand for asurgical option is likely to decline substantially.  We cannot guarantee that we will competesuccessfully against our current or potential competitors, especially thosewith significantly greater financial resources or brand name recognition.

 

**We expect to compete with several companies, which have thesame objectives as us.**

 

Thereare several companies which intend to provide services to the morbid obesitymarket; while their business model is not identical to ours, the end result islikely to be that we will compete with each other in offering consulting andprogram management services.  Three ofthese companies, to the best of our knowledge, include bariatric surgeons intheir management or ownership.  This mayprove to be an advantage over us in gaining access to potential clients.  Other companies have only a partial serviceoffering, which may allow them, because of lower overhead, to operate in theirniche at a price advantage to full-service companies such as ours.  In any case, we expect that the market willcontinue to be attractive and that new entrants are likely.

 

**If we fail to retain our key personnel and hire, train andretain additional qualified and experienced employees, we may not be able tocompete effectively, or expand our consulting business and the number of Centersas planned, both of which could result in reduced revenues.**

 

Ourfuture success will depend to a large extent on retaining our core operatingmanagement team and recruiting sufficient qualified employees to manage andstaff our Centers.  There is likely to bea competitive labor market for such staff and there is no assurance that wewill be able to attract and retain an adequate number of suitableemployees.  If we are unable to do this,then we may not be able to operate and expand our Centers as planned, which mayreduce our revenues.

 

Tobe successful, we must strengthen awareness of our services through ourmarketing efforts and through establishment of additional VOW Centers.  We have a limited marketing and businessdevelopment force through which the efforts will be conducted, and we will relyheavily on each of these individuals.  Wecannot assure you that we will be able to attract and retain sufficientqualified personnel.

 

Ourcurrent key employees are John R. Lyon, President and Chief Executive Officer;Michael H. Owens, M.D., Chief Medical Officer and President of VOW SolutionsInc.; Howard Sampson, Chief Financial Officer; Joann Harper, PhD., VicePresident Product Development, Implementation and Operations; Michelle CowensVice President Sales, Stephen F. Sedlock, Vice President of Marketing; Mary LouWalen, Associate Vice President, Customer Relations; Aimee Johnston, AssistantVice President, Bariatric Management Services and Teri Kai Holtzclaw, PhD.,Associate Vice President of Behavioral and Psychotherapeutic Services.  We do not maintain key personnel lifeinsurance policies on any of these individuals.

 

**If we are not able to attract and retain key doctors toparticipate in our advisory board, it may adversely affect our ability to developour products and services and expand our business.**

 

Membersof our clinical advisory board consult with us exclusively but are free toconsult with other non-competing companies and are employed elsewhere on afull-time basis.  As a result, they onlyspend a limited amount of time on our business. Although we have entered into consulting agreements, includingconfidentiality provisions with each of the members of our clinical advisoryboard, the consulting and confidentiality agreements between us and each of themembers 

 

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ofour clinical advisory board may be terminated or breached.

 

**Our failure to effectively manage our growth could have amaterial adverse effect on our business.**

 

Growthin our business will place a significant strain on our management systems andresources.  We have only recently begunto focus on providing management services, and we have hired persons withappropriate skills.  However, thesepeople have not previously worked together, and it will take time and effort todevelop efficient working processes and relationships.  We will need to continue to improve ouroperational and financial systems and managerial controls and procedures, andwe will need to continue to expand, train and manage our workforce.  We are a small company with limitedresources, so we lack the ability to increase our capacity to provide servicesprior to assurances that those services will be paid for by customers.  As a result, each new management contractwill require significant operational efforts as we hire personnel to staff thenew project.  We expect that the numberof our employees will continue to increase for the foreseeable future.  We will have to maintain close coordinationamong our technical, accounting, finance, marketing and sales departments.

 

**Now that we have disposed of our Visualization Technologybusiness, our future success will depend solely on our ability to establish andgrow our obesity disease state management business.**

 

Thesale of our Visualization Technology business closed on April 15, 2004 andour future success as a company will depend on our ability to execute on theestablishment and growth of our obesity disease state management business.  As a company, we have limited experience inthe provision of surgical services.  Wewill also be required to build this business from a relatively small base,finding partners and surgeons willing to participate.  We cannot assure you that we will be able tobuild a successful services business in the long term.

 

**We have only limited experience directly marketing ourservice products overseas and may not be successful in exporting our businessmodel into international markets.**

 

Wehave limited experience in directly marketing our services overseas.  While the increase in severe obesity is aglobal health care problem, the individual complexity of foreign health caresystems may prevent acceptance of our business model, which has been originallydesigned for the United States market. Also, changes in overseas economic conditions, currency exchange rates,foreign tax laws or tariffs or other trade regulations could negatively impactour efforts to expand business.  Theanticipated international nature of our business is also expected to subjectour representatives, agents and distributors to laws and regulations of theforeign jurisdictions in which they operate or in which our services are sold.

 

**Risks Related to our Financial Results and Need forFinancing**

 

**We will likely require additional funding to continuedevelopment of our business and support our future operating plans.  These funds may not be available onacceptable terms, if at all.**

 

AtSeptember 30, 2004, we had cash, cash equivalents and short-terminvestments of $2,949,000.  We believethat these cash resources, excluding revenues from operations, will not besufficient resources to operate our business beyond 2005.  Unless we generate significant revenues fromoperations, we will need additional funding to continue development of ourbusiness.

 

Weexpect that the cash flows produced by our VOW business will be unpredictablein the near term, increasing our likely need for additional funding.  There can be no assurance that such capitalwill be available to the extent required, or at all, and such capital may notbe available on commercially reasonable terms. The amount of additional capital which, we may need to raise will dependon many factors, including:

 

•                    the extent to which the VOW Centers and other servicesgain market acceptance,

 

•                    the speed with which we can execute our plan;

 

•                    the levels of reimbursement for procedures performed;and

 

•                    the extent of competition.

 

Theamount of additional capital we will need will depend on many factors,including the extent to which we strive to expand our business.  Most of the additional funding we willrequire will go towards the marketing our services to increase market awarenessand acceptance.  If we are unable toraise these additional funds, our ability to expand our business will beharmed.

 

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**We have a history of losses and may not become profitable.**

 

Sinceour formation in July 1993, and as of September 30, 2004, we haveincurred cumulative net losses of $71.0 million.  Specifically, we incurred net losses of $1.1million in 2002, $2.2 million in 2003 and $2.8 million for the nine monthsended September 30, 2004.  We expect toincur losses for the foreseeable future. We may never achieve or sustain profitability in the future.  Even if we achieve profitability, we may notbe able to sustain it on an ongoing basis.

 

**Our future financial results will fluctuate significantly.**

 

Asa result of our limited operating history, we cannot predict our futurerevenues or operating results.  We do,however, expect our future revenues and operating results to fluctuate due to acombination of factors, including the potential costs of establishing VOWCenters.

 

Ourfuture operating expenses are expected to increase in future periods as we intendto establish VOW Centers, expand our sales and marketing operations, expand ourservice capabilities and improve our internal operating and financialsystems.  In addition, our operatingexpenses are based on our expectations of future revenues, and are relativelyfixed in the short term.  We may beunable to adjust spending quickly enough to offset any unexpected revenueshortfall.  If we have a shortfall inrevenues in relation to our expenses, or if our expenses increase before ourrevenues do, then our business for a particular period would be materiallyadversely affected.

 

Becauseof all of these factors and the other risks discussed in this section, webelieve that our quarterly and annual revenues, expenses and operating resultslikely will vary significantly in the future. If this occurs, any or all of the following may result:

 

•                    the market trading price of our common stock mayfluctuate, negatively impacting the ability of stockholders to buy and sell ourshares at consistent prices;

 

•                    we may have difficulty raising funds in the future atprices that are acceptable to us; and

 

•                    investors may be less willing to purchase our sharesfor lack of consistent operating results.

 

In addition, we cannot be sure that the amountspotentially due to us from Viking Systems, Inc., which may be owed as a resultof the sale of our Visualization Technology business, will be paid to us.  This is because Viking is a relatively newcompany that has not raised substantial funds to date.  There is a significant risk that Viking maybe unable to raise sufficient funds to sustain its operations or fund itsgrowth plan.  Additionally, there can beno assurance that Viking’s business will succeed.  As a result, all contractual amounts due usare at risk.

 

**Our liquidity and capital requirements will be difficult topredict.**

 

Ourliquidity and capital requirements will depend upon other numerous factors,including the following:

 

•                    The extent to which our products and services gainmarket acceptance;

 

•                    Costs associated with establishing marketing, andoperating our obesity related programs; disease state management business,including the VOW Center.

 

•                    The timing and costs of product and servicesintroductions;

 

•                    The extent of our ongoing product and servicedevelopment programs;

 

•                    The costs of sponsorship training of the physicians tobecome proficient in the use of our products and procedures; and

 

•                    The costs of developing marketing and distributioncapabilities for our consumer products.

 

Evenif we are successful in raising additional funds, circumstances, including slowrate of market acceptance of our services or our inability to efficientlymanage our operations, would accelerate our use of proceeds from any offeringwe might do and require us to seek additional funds to support our operatingrequirements.

 

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**Risks Related to the Securities Markets and Ownershipof our Common Stock**

 

**The terms of our March 2003, preferred stock financingconfer senior rights on the holders of Series A Convertible Preferred Stock,and these rights may impair the interests of our common stockholders or impactour results of operations.**

 

Weissued 1,000,000 shares of our Series A Convertible Preferred Stock (the“Series A Shares”) in March 2003, which were created pursuant to the termsof a Certificate of Designations, for an aggregate of $950,000 in cash.  In connection with this financing, thepurchasers of Series A Shares were granted several significant rights senior tothe rights of holders of our common stock. Among other rights, in the event of a liquidation, dissolution orwinding up of our company (including consolidations, mergers or other sales),holders of Series A Shares will be entitled to receive up to $3.80 per shareheld by them, in preference to any distribution to the holders of commonstock.  Also, pursuant to the Certificateof Designations, we must obtain the consent of the holders of at leasttwo-thirds of the outstanding Series A Shares in order to undertake certain actions,including significant capital expenditures and the issuance of securities.  Additionally, for so long as any Series AShares remain outstanding after three hundred ninety (390) days following theinitial issuance of any Series A Shares, the holders of Series A Shares will beentitled to elect the greater of (i) two members of our Board of Directors or(ii) twenty-five percent (25%) of the total members of our Board of Directors.

 

Weredeemed 85,000 Series A Shares in June 2004, and have the right to redeeman additional 300,000 at any time on or before January 15, 2006 inexchange for $500,000.  If we choose toredeem the additional 300,000 Series A Shares, we will use cash that wouldotherwise fund our business operations. Although we may believe that such redemption is the best availablebusiness option, valuable cash would nonetheless be consumed, which wouldimpact our ability to fund operations or grow our business.

 

**Our common stock is currently listed in The Nasdaq SmallCapMarket pursuant to an exception from the continued listing rules and we mustcomply with the terms of that exception to maintain our listing.**

 

Thequantitative standards for continued listing on the Nasdaq SmallCap Marketrequires a company to have stockholders’ equity of at least $2,500,000 (orsatisfy alternative requirements). Failure to comply with these requirements subjects a company tode-listing proceedings.  We receivednotification on March 1, 2004 of a Nasdaq Staff Determination indicatingthat we fail to comply with the Stockholders’ Equity requirement for continuedlisting set forth in Marketplace Rule 4310(c)(2)(B), and that our common stockis, therefore, subject to delisting from the Nasdaq SmallCap Market.  We requested a hearing before a NasdaqListing Qualifications Panel to review the Staff Determination, which stayedthe delisting of our common stock pending the Panel’s decision.  On May 7, 2004 we received a decision fromthe Nasdaq Listing Qualifications Panel to continue the listing of our commonstock on the Nasdaq SmallCap Market pursuant to the following exceptions:  On or about June 1, 2004 we must havemade a public filing with the SEC and Nasdaq including disclosure that weraised at least $3,600,000 in additional equity, net of expenses, as well as adescription of the completed event or transaction(s) that enabled us to satisfythe $2,500,000 shareholders’ equity requirements; an affirmative statementthat, as of the date of the report, we believe we have regained compliance withthe $2,500,000 shareholders’ equity requirement based upon the event ortransaction(s) referenced therein; and a disclosure that the Panel willcontinue to monitor our ongoing compliance with the minimum shareholders’equity threshold until we have evidenced compliance with that requirement via apublicly filed balance sheet and demonstrated an ability to sustain compliancewith the minimum shareholders’ equity requirement over the long term.  With the closing of our recent financing, weachieved these requirements and made the required filings. In addition, on orbefore August 16, and November 15, 2004 we must file Forms 10-Q forthe quarters ending June 30, and September 30, 2004, respectively,with the SEC and Nasdaq, evidencing our continued compliance with the $2,500,000shareholders’ equity requirement.  Wemade the August 16 required filing.  Inorder to fully comply with the terms of this exception, we must be able todemonstrate compliance with all requirements for continued listing on theNasdaq SmallCap Market.  If we are unableto do so, our securities will be delisted from the Nasdaq SmallCap Market. Thedelisting of our common stock from the Nasdaq SmallCap Market may materiallyimpair our stockholders’ ability to buy and sell shares of our common stock andcould have an adverse effect on the market price of, and the efficiency of thetrading market for, our common stock.  Inaddition, the delisting of our common stock could significantly impair ourability to raise capital should we desire to do so in the future.  The continued listing of our common stock onthe Nasdaq SmallCap Market is therefore very important to us.

 

**There is a limited market for our common stock and thereforeinvestors may not be able to liquidate their investment in the foreseeablefuture, if at all.**

 

Thereis a limited market for our common stock even though it is publicly quoted, andthe market is not expected to increase significantly in the foreseeablefuture.  For example, we only haveapproximately 190 shareholders of record and the average daily trading volumein our stock is approximately 20,000 shares. The limited trading market for our common stock may cause fluctuationsin the market value of our common stock to be exaggerated, leading to pricevolatility in excess of that which would occur in a more active tradingmarket.  The lack of an active tradingmarket in our stock may also cause investors to be unable to sell all of theirdesired shares of common stock on short notice and the sale of a large numberof 

 

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sharesat one time could temporarily depress the market price. An investment in ourcompany is highly speculative, and an investor should be able to withstand atotal loss of the investment.

 

**Our stock price could continue to be volatile and yourinvestment in our common stock could suffer a decline in value, adverselyaffecting our ability to raise additional capital.**

 

Themarket prices and trading volumes for securities of emerging companies, likeours, have historically been highly volatile and have experienced significantfluctuations unrelated to the operating performance.  The market price of our common stock hashistorically been highly volatile.  Forexample, between February 2002 and May 2003, the trading price of ourcommon stock ranged from $0.77 to $4.59. The trading price of our common stock may continue to be significantlyaffected by factors such as:

 

•                    actual or anticipated fluctuations in our operatingresults,

 

•                    our ability to remain listed on Nasdaq,

 

•                    changes in financial estimates by securities analysts,

 

•                    announcements of technological innovations,

 

•                    new products or new contracts by us or ourcompetitors,

 

•                    regulatory announcements,

 

•                    developments with respect to patents or proprietaryrights,

 

•                    conditions and trends in the medical device and othertechnology industries,

 

•                    adoption of new accounting standards affecting themedical device industry, and

 

•                    general market conditions.

 

Inaddition, the stock market has from time to time experienced significant priceand volume fluctuations that have particularly affected the market prices forshares of early stage companies.  Thesebroad market fluctuations may adversely affect the market price of our commonstock.  In the past, following periods ofvolatility in the market price of a particular company’s securities, securitiesclass action litigation has often been brought against that company.  Such litigation, if brought against us, couldresult in substantial costs and a diversion of management’s attention andresources.

 

**We are required to register for resale certain outstandingshares of our common stock and failure to achieve and maintain an effectiveregistration statement may result in monetary penalties against us.**

 

Theholders of approximately 10,573,497 shares of our common stock, includingshares issuable upon exercise of outstanding warrants, have rights, subject tosome conditions, to require us to file registration statements covering theirshares or to include their shares in registration statements that we may filefor ourselves or other stockholders. These registration rights impose monetary penalties against us of up toapproximately $50,000 per month if we do not timely achieve an effective registrationstatement or if we are unable to maintain the effectiveness of a registrationstatement for one year.  Because of ourcash position, these penalties would negatively impact our ability to financeour operations.

 

**Anti-takeover provisions in our organizational documents andDelaware law may discourage or prevent a change of control, even if anacquisition would be beneficial to our stockholders, which could affect ourstock price adversely and prevent attempts by our stockholders to replace orremove our current management.**

 

Ourcertificate of incorporation and bylaws contain provisions that could delay orprevent a change of control of our company or changes in our board of directorsthat our stockholders might consider favorable. Some of these provisions:

 

•                    authorize the issuance of preferred stock which can becreated and issued by the board of directors without prior stockholderapproval, with rights senior to those of the common stock;

 

•                    provide for a classified board of directors, with eachdirector serving a staggered three-year term;

 

•                    prohibit our stockholders from filling boardvacancies, calling special stockholder meetings, or taking action by writtenconsent;

 

•                    prohibiting our stockholders from making certainchanges to our restated certificate of incorporation or restated bylaws exceptwith 66 2/3% stockholder approval; and

 

•                    require advance written notice of stockholderproposals and director nominations.

 

Inaddition, we are subject to the provisions of Section 203 of the DelawareGeneral Corporation Law, which may 

 

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prohibitcertain business combinations with stockholders owning 15% or more of ouroutstanding voting stock. These and other provisions in our certificate ofincorporation, bylaws and Delaware law could make it more difficult forstockholders or potential acquirers to obtain control of our board of directorsor initiate actions that are opposed by our then-current board of directors,including delay or impede a merger, tender offer, or proxy contest involving ourcompany. Any delay or prevention of a change of control transaction or changesin our board of directors could cause the market price of our common stock todecline.

 

**Risks Related to our Intellectual Property andPotential Litigation**

 

**We depend on our intellectual property for the establishmentand operation of our VOW Centers.**

 

Werely on a combination of trade secrets, know-how and confidentialityrestrictions for the establishment and operation of our VOW Centers.  We have expended significant efforts devisingthe types of products and services we will offer and the manner in which thesewill be delivered.  Our ability tomaintain the secrecy and confidentiality of our trade secrets and internalknowledge are crucial to the success of our business.  Any failure to do so may negatively impactour prospects.

 

Ourobesity disease state management business may be difficult to insure againstprofessional liability.

 

Withthe sale of our Visualization Technology business we need to change the type ofliability insurance which we carry.  Weare in the process of seeking amended insurance coverage, but may not be ableto secure it on acceptable terms, or at all.

 

**We may be subject to product liability claims and havelimited insurance coverage.**

 

Weface an inherent and significant business risk of exposure to product liabilityclaims in the event that the use of our products, which were sold by us priorto the sale of the Visualization Technology business, results in personalinjury or death.  Also, in the event thatany of those products proves to be defective, we may be required to recall orredesign such products.  We are in theprocess of negotiating insurance coverage to cover such circumstances.  However, we may not be able to obtain suchcoverage or our coverage limits may not be adequate to protect us from anyliabilities we might incur. Product liability insurance is expensive and in thefuture may not be available to us on acceptable terms, if at all.  A successful product liability claim orseries of claims brought against us in excess of our insurance coverage wouldnegatively impact our business.

 

**If we are unable to protect our intellectual property, we maybe unable to prevent other companies from using our technology in competitiveproducts.**

 

Wemaintain ownership of the technology transferred to Viking Systems, Inc. inconnection with the sale of our Visualization Technology business inApril 2004.  In the event VikingSystems does not make the required royalty payments to us, their rights in thetechnology will be terminated.  In suchcase, we will be able to continue to commercialize that technology.  To the extent we decide to incorporate thattechnology into our business, our future success will depend, in part, on ourability to continue developing patentable products, enforcing our patents andobtaining patent protection for our products both in the United States and inother countries.  The patent positions ofmedical device companies, however, are generally uncertain and involve complexlegal and factual questions.  Patents maynever issue from any patent applications owned by or licensed to us.  Even if patents do issue, the claims allowedmay not be sufficiently broad to protect our technology.  In addition, issued patents owned by orlicensed to us may be challenged, invalidated or circumvented, or the rightsgranted thereunder may not provide us with competitive advantages.  Further, the medical device industry has beencharacterized by extensive litigation regarding patents and other intellectualproperty rights.  Litigation, which wouldresult in substantial expense, may be necessary to enforce any patents issuedor licensed to us and/or to determine the scope and validity of proprietaryrights of third parties or whether our products, processes or proceduresinfringe any such third-party proprietary rights.

 

Inaddition to patents, we rely on unpatented trade secrets to protect ourbusiness and our proprietary technology. Others may independently develop or otherwise acquire the same or substantiallyequivalent plans or technologies or otherwise gain access to our proprietarytechnology or disclose our plans or technology. It is difficult to protect rights to unpatented ideas, plans orproprietary technology.  Third partiesmay obtain patent rights to these unpatented trade secrets, which patent rightscould be used to assert claims against us. We also rely on confidentiality agreements with our collaborators,employees, advisors, vendors and consultants to protect our proprietarytechnology.  These agreements may bebreached, we may not have adequate remedies for any breach and our tradesecrets may otherwise become known or be 

 

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independentlydeveloped by competitors.  In addition,our agreements with employees and consultants require disclosure of ideas,developments, discoveries or inventions conceived during employment orconsulting, as the case may be, and assignment to us of proprietary rights tosuch matters related to our business and technology.  The extent to which efforts by others willresult in patents and the effect on us of the issuance of such patents isunknown.

 

## Item4     Controls and Procedures

 

Asrequired by Securities and Exchange Commission Rule 13a-15(b), we carried out anevaluation, under the supervision and with the participation of our management,including our chief executive officer and chief financial officer, of theeffectiveness of our disclosure controls and procedures as of the end of thequarter covered by this report.  Based onthe foregoing, our chief executive officer and chief financial officerconcluded that our disclosure controls and procedures were effective as ofSeptember 30, 2004.

 

Therehas been no change in our internal controls over financial reporting during ourmost recent fiscal quarter that has materially affected, or is reasonablylikely to materially affect, our internal controls over financial reporting.

 

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# ***PART II.                OTHERINFORMATION***

# * *

## Item1.    Legal Proceedings

##  

Fromtime to time, we may be involved in litigation relating to claims arising outof our operations in the normal course of business.  We are currently not a party to anylitigation that could have a material adverse effect on our results ofoperations or the financial position of our business.

 

Wehave been notified of a Notice of Intent to Initiate Litigation against usregarding a medical malpractice lawsuit in process in Florida.  We are contesting the Notice of Intent andhave not yet been included in the litigation.

 

## Item 2.    UnregisteredSales of Equity Securities and Use of Funds

 

None.

 

## Item 3.    Defaultsupon Senior Securities

 

None.

 

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

 

None.

 

## Item5.    Other Information

##  

None.

 

## Item 6.    Exhibits

##  

(a)           Exhibits

 

| **Exhibit  No.** | ** ** | **Description**                                                                                                                                                                                           |
|------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1 (1)          |       | Second Restated  Certificate of Incorporation.                                                                                                                                                            |
|             |       |                                                                                                                                                                                                      |
| 3.2 (2)          |       | Certificate of  Amendment of Second Restated Certificate of Incorporation.                                                                                                                                |
|             |       |                                                                                                                                                                                                      |
| 3.3 (3)          |       | Certificate of  Designations of Series A Convertible Preferred Stock.                                                                                                                                     |
|             |       |                                                                                                                                                                                                      |
| 3.4 (4)          |       | Amended Certificate of  Designations of Series A Convertible Preferred Stock, as filed with the  Delaware Secretary of State on May 26, 2004.                                                             |
|             |       |                                                                                                                                                                                                      |
| 3.5 (1)          |       | Restated Bylaws.                                                                                                                                                                                          |
|             |       |                                                                                                                                                                                                      |
| 4.1 (5)          |       | Form of Certificate for  Common Stock.                                                                                                                                                                    |
|             |       |                                                                                                                                                                                                      |
| 31.1             |       | Certification of  Principal Executive Officer pursuant to Rules 13a-14 and 15d-14 promulgated  under the Securities Exchange Act of 1934.                                                                 |
|             |       |                                                                                                                                                                                                      |
| 31.2             |       | Certification of  Principal Financial Officer pursuant to Rules 13a-14 and 15d-14 promulgated  under the Securities Exchange Act of 1934.                                                                 |
|             |       |                                                                                                                                                                                                      |
| 32               |       | Certifications of  Principal Executive Officer and Principal Financial Officer pursuant to  18 U.S.C. Section 1350, as adopted pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002. |

----

 

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(1)                                  Incorporated by reference toour Registration Statement on Form S-1, as amended, filed March 7, 1997.

 

(2)                                  Incorporated by reference toour Form 10-Q, filed November 14, 2001.

 

(3)                                  Incorporated by reference toour Form 10-K, filed March 31, 2003.

 

(4)                                  Incorporated by reference toour Form 8-K, filed May 28, 2004.

 

(5)                                  Incorporated by reference toour Registration Statement on Form S-1, as amended, filed June 25, 1997.

 

 

 

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#### **SIGNATURES**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 

 
|                     | VISTA MEDICAL TECHNOLOGIES,INC.                                                                                                        |
|--------------------------|----------------------------------------------------------------------------------------------------------------------------------------|
|                     |                                                                                                                                   |
|                     |                                                                                                                                   |
| Date:  November 15, 2004 | /s/ JOHN R. LYON                                                                                                                       |
|                     | John  R. Lyon 

President,  Chief Executive Officer and 

Director  (Principal executive officer)                                      |
|                     |                                                                                                                                   |
| Date:  November 15, 2004 | /s/ HOWARD SAMPSON                                                                                                                     |
|                     | Howard  Sampson 

Vice  President of Finance, 

Chief  Financial Officer and Secretary 

(Principal  financial and accounting officer) |

 

 

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