**UNITEDSTATES********SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM10-Q**

 

**QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d)********OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For thequarterly period ended September 30, 2005**

 

**Commissionfile number 000-50856**

 

**NEUROMETRIX,INC.**

(Exact name of registrantas specified in its charter)

 
| **Delaware**                                                     | ** ** | **04-3308180**                        |
|------------------------------------------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of incorporation or  organization) |       | (I.R.S. Employer  Identification No.) |
|                                                             |       |                                  |
| **62  Fourth Avenue, Waltham, Massachusetts**                    | ** ** | **02451**                             |
| (Address of principal  executive offices)                        |       | (Zip Code)                            |

 

**(781)890-9989**

(Registrant’s telephonenumber, including area code)

 

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Actof 1934 during the preceding twelve (12) months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past ninety (90) days.

 

Yes ý    No o

 

Indicate by check mark whether the registrant is an accelerated filer(as defined in Rule 12b-2 of the Act).

 

Yes o    No ý

 

Indicate by check mark whether the registrant is a shell company (asdefined in Rule 12b-2 of the Act).

 

Yes o    No ý

 

APPLICABLE ONLY TO CORPORATEISSUERS

 

Indicate the number of shares outstanding of each of the issuer’sclasses of common stock as of the latest practicable date:

 

12,205,825 shares of common stock, par value $0.0001 per share, wereoutstanding as of November 7, 2005

 

 

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**NEUROMETRIX,INC.**

**FORM10-Q**

**INDEX**

 
| **PART I  - FINANCIAL INFORMATION** |
|-------------------------------------|
|                                |   |   |
| Item 1.                             | Condensed Financial Statements |   |
|                                |   |   |
|                                | Balance Sheets (unaudited) as of September 30, 2005  and December 31, 2004 |   |
|                                |   |   |
|                                | Statements of Operations (unaudited) for the three and  nine months ended September 30, 2005 and 2004 |   |
|                                |   |   |
|                                | Statements of Cash Flows (unaudited) for the nine  months ended September 30, 2005 and 2004 |   |
|                                |   |   |
|                                | Notes  to Financial Statements (unaudited) |   |
|                                |   |   |
| Item  2.                            | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |   |
|                                |   |   |
| Item 3.                             | Quantitative  and Qualitative Disclosures About Market Risk |   |
|                                |   |   |
| Item 4.                             | Controls and  Procedures |   |
|                                |   |   |
| **PART II - OTHER  INFORMATION**    |   |
|                                |   |   |
| Item 1.                             | Legal Proceedings |   |
|                                |   |   |
| Item 2.                             | Unregistered  Sales of Equity Securities and Use of Proceeds |   |
|                                |   |   |
| Item 3.                             | Defaults  Upon Senior Securities |   |
|                                |   |   |
| Item 4.                             | Submission  of Matters to a Vote of Security Holders |   |
|                                |   |   |
| Item 5.                             | Other Information |   |
|                                |   |   |
| Item  6.                            | Exhibits |   |
|                                |   |
| Signatures                          |   |
|                                     |  |  |  |

 

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**NeuroMetrix,Inc.**

**Balance Sheets**

**(Unaudited)**

 
| ** **                                                                                                                                                                               | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|
|                                                                                                                                                                                     |       |                    |       |                   |       |
| **Assets**                                                                                                                                                                               |       |                    |       |                   |       |
| Current assets:                                                                                                                                                                          |       |                    |       |                   |       |
| Cash and cash  equivalents                                                                                                                                                               |       | $                       | 3,303,619  |                   | $          | 1,936,241 |   |
| Short-term  investments                                                                                                                                                                  |       | 27,519,760              |       | 18,574,593             |       |
| Accounts  receivable, net of allowance for doubtful accounts of $375,000 and $300,000  at September 30, 2005 and December 31, 2004, respectively                                    |       | 4,160,668               |       | 3,126,565              |       |
| Inventory                                                                                                                                                                                |       | 2,123,043               |       | 1,284,261              |       |
| Prepaid expenses  and other current assets                                                                                                                                               |       | 519,074                 |       | 672,970                |       |
| Current portion  of deferred costs                                                                                                                                                       |       | 195,723                 |       | 140,719                |       |
| Total current  assets                                                                                                                                                                    |       | 37,821,887              |       | 25,735,349             |       |
|                                                                                                                                                                                     |       |                    |       |                   |       |
| Restricted cash                                                                                                                                                                          |       | 1,458,600               |       | 1,897,200              |       |
| Long-term  investments                                                                                                                                                                   |       | —                  |       | 9,497,158              |       |
| Fixed assets,  net                                                                                                                                                                       |       | 789,676                 |       | 679,359                |       |
| Deferred costs,  net of current portion                                                                                                                                                  |       | 212,631                 |       | 143,462                |       |
| Total assets                                                                                                                                                                             |       | $                       | 40,282,794 |                   | $          | 37,952,528 |   |
|                                                                                                                                                                                     |       |                    |       |                   |       |
| **Liabilities  and Stockholders’ Equity**                                                                                                                                           |       |                    |       |                   |       |
| Current  liabilities:                                                                                                                                                                    |       |                    |       |                   |       |
| Accounts payable                                                                                                                                                                         |       | $                       | 1,268,054  |                   | $          | 899,291 |   |
| Accrued expenses                                                                                                                                                                         |       | 1,056,398               |       | 593,420                |       |
| Accrued  compensation                                                                                                                                                                    |       | 1,663,373               |       | 1,343,206              |       |
| Current portion  of deferred revenue                                                                                                                                                     |       | 645,316                 |       | 399,468                |       |
| Total current  liabilities                                                                                                                                                               |       | 4,633,141               |       | 3,235,385              |       |
|                                                                                                                                                                                     |       |                    |       |                   |       |
| Deferred  revenue, net of current portion                                                                                                                                                |       | 756,948                 |       | 471,734                |       |
| Other long-term  liabilities                                                                                                                                                             |       | 145,455                 |       | 189,091                |       |
| Total  liabilities                                                                                                                                                                       |       | 5,535,544               |       | 3,896,210              |       |
|                                                                                                                                                                                     |       |                    |       |                   |       |
| Commitments and  contingencies                                                                                                                                                           |       |                    |       |                   |       |
|                                                                                                                                                                                     |       |                    |       |                   |       |
| Stockholders’  equity:                                                                                                                                                              |       |                    |       |                   |       |
| Preferred stock,  $0.001 par value, 5,000,000 shares authorized, none outstanding                                                                                                        |       | —                  |       | —                 |       |
| Common stock,  $0.0001 par value; 50,000,000 shares authorized; 12,205,700 and 12,034,650  shares issued and outstanding at September 30, 2005 and December 31,  2004, respectively |       | 1,221                   |       | 1,203                  |       |
| Additional  paid-in capital                                                                                                                                                              |       | 92,584,941              |       | 92,278,379             |       |
| Deferred  compensation                                                                                                                                                                   |       | (493,541                | )          | (745,086               | )          |
| Accumulated deficit                                                                                                                                                                      |       | (57,345,371             | )          | (57,478,178            | )          |
| Total  stockholders’ equity                                                                                                                                                         |       | 34,747,250              |       | 34,056,318             |       |
| Total  liabilities and stockholders’ equity                                                                                                                                         |       | $                       | 40,282,794 |                   | $          | 37,952,528 |   |

 

The accompanying notesare an integral part of these financial statements.

 

1

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**NeuroMetrix,Inc.**

**Statementsof Operations**

**(Unaudited)**

 
| ** **                                                                            | ** ** | **Three Months Ended**  | ** ** | **Nine Months Ended**   | ** ** |
|---------------------------------------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                                                                            | ** ** | **September 30,  2005** | ** ** | **September 30,  2004** | ** ** | **September 30,  2005** | ** ** | **September 30,  2004** | ** ** |
|                                                                                  |       |                    |       |                    |       |   |   |   |   |
| Revenues:                                                                             |       |                    |       |                    |       |   |   |   |   |
| Diagnostic  device                                                                    |       | $                       | 1,133,378  |                    | $          | 614,565 |   | $ | 2,906,291 |   | $ | 1,502,482 |   |
| Biosensor                                                                             |       | 7,976,058               |       | 4,204,753               |       | 21,060,415 |   | 10,643,118 |   |
| Total revenues                                                                        |       | 9,109,436               |       | 4,819,318               |       | 23,966,706 |   | 12,145,600 |   |
|                                                                                  |       |                    |       |                    |       |   |   |   |   |
| Cost of revenues                                                                      |       | 2,317,841               |       | 1,290,243               |       | 6,225,630 |   | 3,287,873 |   |
| Gross margin                                                                          |       | 6,791,595               |       | 3,529,075               |       | 17,741,076 |   | 8,857,727 |   |
|                                                                                  |       |                    |       |                    |       |   |   |   |   |
| Operating  expenses:                                                                  |       |                    |       |                    |       |   |   |   |   |
| Research and  development                                                             |       | 929,905                 |       | 942,913                 |       | 2,863,179 |   | 2,434,792 |   |
| Sales and  marketing                                                                  |       | 3,489,091               |       | 2,037,840               |       | 10,228,241 |   | 5,634,389 |   |
| General and  administrative                                                           |       | 1,821,878               |       | 1,306,172               |       | 5,094,398 |   | 3,347,124 |   |
| Total operating  expenses                                                             |       | 6,240,874               |       | 4,286,925               |       | 18,185,818 |   | 11,416,305 |   |
|                                                                                  |       |                    |       |                    |       |   |   |   |   |
| Income (loss)  from operations                                                        |       | 550,721                 |       | (757,850                | )          | (444,742 | ) | (2,558,578 | ) |
|                                                                                  |       |                    |       |                    |       |   |   |   |   |
| Interest income                                                                       |       | 218,544                 |       | 51,629                  |       | 579,591 |   | 70,166 |   |
| Interest expense                                                                      |       | —                  |       | (666,674                | )          | (2,042 | ) | (960,404 | ) |
|                                                                                  |       |                    |       |                    |       |   |   |   |   |
| Net income  (loss)                                                                    |       | 769,265                 |       | (1,372,895              | )          | 132,807 |   | (3,448,816 | ) |
|                                                                                  |       |                    |       |                    |       |   |   |   |   |
| Accretion of redeemable  convertible preferred stock                                  |       | —                  |       | (190,874                | )          | — |   | (1,386,301 | ) |
| Deemed dividend  on redeemable convertible preferred stock                            |       | —                  |       | —                  |       | — |   | (787,885 | ) |
| Beneficial  conversion feature associated with redeemable convertible preferred stock |       | —                  |       | —                  |       | — |   | (7,050,771 | ) |
|                                                                                  |       |                    |       |                    |       |   |   |   |   |
| Net income  (loss) attributable to common stockholders                                |       | $                       | 769,265    |                    | $          | (1,563,769 | ) | $ | 132,807 |   | $ | (12,673,773 | ) |
|                                                                                  |       |                    |       |                    |       |   |   |   |   |
| Basic and  diluted net income (loss) per common share                                 |       | $                       | 0.06       |                    | $          | (0.18 | ) | $ | 0.01 |   | $ | (3.46 | ) |
|                                                                                  |       |                    |       |                    |       |   |   |   |   |
| Weighted average  shares used to compute net income (loss) per common share           |       |                    |       |                    |       |   |   |   |   |
| Basic                                                                                 |       | 12,187,835              |       | 8,819,558               |       | 12,105,992 |   | 3,660,515 |   |
| Diluted                                                                               |       | 13,103,158              |       | 8,819,558               |       | 12,880,666 |   | 3,660,515 |   |

 

The accompanying notesare an integral part of these financial statements.

 

2

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**NeuroMetrix,Inc.**

**Statementsof Cash Flows**

**(Unaudited)**

 
| ** **                                                                                           | ** ** | **Nine Months Ended**   | ** ** |
|------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                                           | ** ** | **September 30,  2005** | ** ** | **September 30,   2004** | ** ** |
|                                                                                                 |       |                    |       |   |   |
| **Cash flow for operating activities:**                                                              |       |                    |       |   |   |
| Net income (loss)                                                                                    |       | $                       | 132,807    |   | $ | (3,448,816 | ) |
| Adjustments to  reconcile net income (loss) to net cash provided by (used in) operating  activities: |       |                    |       |   |   |
| Provision for doubtful accounts                                                                      |       | 180,199                 |       | 167,945 |   |
| Depreciation and amortization                                                                        |       | 204,033                 |       | 145,219 |   |
| Compensation expense associated with stock options                                                   |       | 259,506                 |       | 949,908 |   |
| Accretion of debt issuance discount                                                                  |       | —                  |       | 437,778 |   |
| Amortization of premium on investments                                                               |       | 357,997                 |       | — |   |
| Changes in operating assets and liabilities:                                                         |       |                    |       |   |   |
| Accounts  receivable                                                                                 |       | (1,214,302              | )          | (1,243,802 | ) |
| Inventory                                                                                            |       | (838,782                | )          | (245,525 | ) |
| Prepaid expenses  and other current assets                                                           |       | 153,896                 |       | (90,823 | ) |
| Accounts payable                                                                                     |       | 368,763                 |       | 543,876 |   |
| Accrued expenses  and compensation                                                                   |       | 783,145                 |       | 470,049 |   |
| Other long-term  liabilities                                                                         |       | (43,636                 | )          | 2,728 |   |
| Deferred revenue  and costs                                                                          |       | 406,889                 |       | 207,152 |   |
| Net cash provided by (used in) operating activities                                                  |       | 750,515                 |       | (2,104,311 | ) |
|                                                                                                 |       |                    |       |   |   |
| **Cash flows for investing activities:**                                                             |       |                    |       |   |   |
| Purchases of investments                                                                             |       | (13,310,598             | )          | — |   |
| Maturities of investments                                                                            |       | 13,504,592              |       | — |   |
| Release of restricted cash                                                                           |       | 438,600                 |       | — |   |
| Purchases of fixed assets                                                                            |       | (314,350                | )          | (503,080 | ) |
| Net cash provided by (used in) investing activities                                                  |       | 318,244                 |       | (503,080 | ) |
|                                                                                                 |       |                    |       |   |   |
| **Cash flows from financing activities:**                                                            |       |                    |       |   |   |
| Proceeds from exercise of stock options                                                              |       | 171,356                 |       | 46,911 |   |
| Proceeds from issuance of redeemable convertible  preferred stock, net of issuance costs             |       | —                  |       | 10,553,484 |   |
| Proceeds from initial public offering, net of  offering costs of $3,572,908                          |       | —                  |       | 24,027,092 |   |
| Proceeds from issuance of common stock under  employee stock purchase plan                           |       | 127,263                 |       | — |   |
| Repayments of long-term debt                                                                         |       | —                  |       | (3,000,000 | ) |
| Net cash provided by financing activities                                                            |       | 298,619                 |       | 31,627,487 |   |
|                                                                                                 |       |                    |       |   |   |
| Net increase in cash and cash equivalents                                                            |       | 1,367,378               |       | 29,020,096 |   |
| Cash and cash equivalents, beginning of period                                                       |       | 1,936,241               |       | 1,622,516 |   |
| Cash and cash equivalents, end of period                                                             |       | $                       | 3,303,619  |   | $ | 30,642,612 |   |
|                                                                                                 |       |                    |       |   |   |
| Supplemental disclosure of cash flow information:                                                    |       |                    |       |   |   |
| Cash paid for interest                                                                               |       | $                       | 2,042      |   | $ | 493,752 |   |
| Reclassification of deferred compensation and  additional paid-in capital                            |       | $                       | 33,405     |   | $ | — |   |
| Accretion of redeemable convertible preferred stock                                                  |       | $                       | —     |   | $ | 1,386,301 |   |
| Deemed dividend on redeemable convertible preferred  stock                                           |       | $                       | —     |   | $ | 787,885 |   |
| Beneficial conversion feature associated with  redeemable convertible preferred stock                |       | $                       | —     |   | $ | 7,050,771 |   |

 

The accompanying notesare an integral part of these financial statements.

 

3

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**NeuroMetrix,Inc.**

**Notes toFinancial Statements**

 

**1.     Natureof the Business and Basis of Presentation**

 

NeuroMetrix, Inc. (the “Company”), a Massachusetts corporation,was formed in June 1996 and reincorporated in Delaware in May 2001. The Company designs, develops and sells proprietary medical devices used todiagnose neuropathies. Neuropathies are diseases of the peripheral nerves andparts of the spine that frequently are caused by or associated with diabetes,low back pain and carpal tunnel syndrome, as well as other clinical disorders.The Company operates in one business segment.

 

On July 27, 2004, the Company completed an initial public offering(“IPO”) of 3,000,000 shares of its common stock at $8.00 per share, for grossconsideration of $24 million.  All of the shares were sold by theCompany.  In connection with the IPO, the Company granted the underwritersa 30-day over-allotment option to purchase up to an additional 450,000 sharesof common stock from the Company, which the underwriters exercised in full onAugust 17, 2004.  The Company’s shares trade on The Nasdaq National Marketunder the symbol “NURO.”

 

On July 27, 2004, upon completion of the Company’s IPO, all sharesof the Company’s redeemable convertible preferred stock outstanding on thatdate converted into 7,488,758 shares of common stock and the outstandingwarrant to purchase redeemable convertible preferred stock converted into awarrant to purchase 100,000 shares of common stock.  This warrant was exercised in full on June13, 2005.

 

The accompanying unaudited balance sheet as of September 30, 2005 andunaudited statements of operations for the three and nine month periods ended September30, 2005 and 2004 and the unaudited statements of cash flows for the nine monthperiods ended September 30, 2005 and 2004 have been prepared in accordance withaccounting principles generally accepted in the United States for interimfinancial information and with the instructions to Form 10-Q andArticle 10 of Regulation S-X. Accordingly, they do not include all of theinformation and footnotes required by accounting principles generally acceptedin the United States for complete financial statements. In the opinion ofmanagement, all adjustments (consisting only of normal recurring accruals) considerednecessary for a fair statement of the results of operations have been included.Operating results for the nine month period ended September 30, 2005 are notnecessarily indicative of the results that may be expected for the year endingDecember 31, 2005 or any other period. These financial statements andnotes should be read in conjunction with the financial statements for the yearended December 31, 2004 included in the Company’s Annual Report on Form10-K (File No. 000-50856). The accompanying balance sheet as ofDecember 31, 2004 has been derived from audited financial statementsprepared at that date, but does not include all disclosures required byaccounting principles generally accepted in the United States.

 

**Use of Estimates**

 

The preparation of financial statements in conformity with accountingprinciples generally accepted in the United States requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and the disclosure of contingent assets and liabilities at the dateof the financial statements and the reported amounts of revenues and expensesduring the reporting period. Actual results could differ from those estimates.

 

**Recent Accounting Pronouncements**

 

In March 2005, the Financial Accounting Standards Board (“FASB”) issuedFASB Interpretation No. 47, *Accounting forConditional Asset Retirement Obligations*, which is an interpretationof Statement of Financial Accounting Standards (“SFAS”) No. 143, *Accounting for Asset Retirement Obligations*.The interpretation requires a liability for the fair value of a conditionalasset retirement obligation be recognized if the fair value of the liabilitycan be reasonably estimated. The interpretation is effective for fiscal yearsending after December 15, 2005. The interpretation did not have a materialimpact on our results of operations or financial position.

 

In December 2004, the FASB issued SFAS No. 123(R), *Share-Based Payment* (SFAS 123(R)), whichis a revision of SFAS No. 123, *Accountingfor Stock-Based Compensation*(SFAS 123)*,* and supersedes Accounting Principles Board (“APB”) OpinionNo. 25, *Accounting for Stock Issued toEmployees*(APB 25)**andSFAS 148 *Accounting for Stock-BasedCompensation — Transition and Disclosure*.  This statement requires that the costresulting from all share-based payment transactions be recognized in thefinancial statements. This statement establishes fair value as the measurementobjective in accounting for share-based payment arrangements and requires allentities to apply a fair value based measurement method in accounting forshare-based payment transactions with employees except for equity instrumentsheld by employee share ownership plans. As a result, beginning January 1, 2006,the Company will adopt SFAS 123(R) and begin reflecting the stock compensationexpense determined under fair value based methods in

 

4

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the income statement rather than as pro forma disclosure in the notesto the financial statements. The Company is currently reviewing the effect ofthis statement on its financial statements and expects there to be a materialimpact on the Company’s results of operations.

 

In December 2004, the FASB issued SFAS No. 153, *Exchanges of Nonmonetary Assets*(SFAS153), an amendment of APB Opinion No. 29, *Accountingfor Nonmonetary Transactions.* SFAS 153 requires that exchanges of nonmonetary assets be measured basedon the fair value of the assets exchanged. Further, it expands the exception for nonmonetary exchanges of similarproductive assets to nonmonetary assets that do not have commercialsubstance.  The provisions of thisStatement are effective for nonmonetary asset exchanges beginning after June15, 2005.  The adoption of the provisionsof SFAS 153 did not have a material impact on the Company’s financial positionor results of operations.

 

**2. Accounting for Stock-BasedCompensation**

 

Employee stock awards granted under the Company’s compensation plansare accounted for in accordance with APB 25 and related interpretations. TheCompany has not adopted the fair value method of accounting for stock-basedcompensation prescribed by SFAS 123. Accordingly, compensation expense isrecorded for options issued to employees to the extent that the fair value ofthe Company’s common stock exceeds the exercise price of the option at the dategranted and all other criteria for fixed accounting have been met. Allstock-based awards granted to non-employees are accounted for at their fairvalue and the resulting compensation expense is generally recognized over theperiod of service.

 

If compensation expense for the Company’s stock-based compensation planhad been determined based on the fair value at the grant dates as calculated inaccordance with SFAS 123, the Company’s net loss attributable to commonstockholders and net loss per common share would approximate the pro formaamounts below:

 
| ** **                                                                                               | ** ** | **Three Months Ended**  | ** ** | **Nine Months Ended**   | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                                                                                               | ** ** | **September 30,  2005** | ** ** | **September 30,  2004** | ** ** | **September 30,  2005** | ** ** | **September 30,  2004** | ** ** |
|                                                                                                     |       |                    |       |                    |       |   |   |   |   |
| Net income  (loss) attributable to common stockholders, as reported                                      |       | $                       | 769,265    |                    | $          | (1,563,769 | ) | $ | 132,807 |   | $ | (12,673,773 | ) |
| Add stock-based  compensation expense reported in net income (loss) attributable to common  stockholders |       | 111,615                 |       | 139,628                 |       | 259,506 |   | 949,908 |   |
| Less stock-based  compensation expense determined under fair value method                                |       | (364,551                | )          | (265,160                | )          | (1,044,214 | ) | (1,229,163 | ) |
| Net income  (loss) attributable to common stockholders – pro forma                                  |       | 516,329                 |       | (1,689,301              | )          | (651,901 | ) | (12,953,028 | ) |
| Basic and  diluted net income (loss) per common share                                                    |       |                    |       |                    |       |   |   |   |   |
| As reported                                                                                              |       | $                       | .06        |                    | $          | (.18 | ) | $ | .01 |   | $ | (3.46 | ) |
| Pro forma                                                                                                |       | $                       | .04        |                    | $          | (.19 | ) | $ | (.05 | ) | $ | (3.54 | ) |

 

Because additional stock-based compensation grants are expected to bemade each year, the above pro forma disclosures are not representative of thepro forma effect of reported net income for future years.

 

5

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Prior to the July 2004 IPO, theCompany established the fair value of common stock by reference to thepreviously issued redeemable convertible preferred stock and by reference to anexpected IPO price. The Company has estimated the fair value of its grantedstock options by using the Black Scholes option pricing model with thefollowing weighted average assumptions:

 
| ** **                                     | ** ** | **Three Months Ended**  | ** ** | **Nine months ended**   | ** ** |
|------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                                     | ** ** | **September 30,  2005** | ** ** | **September 30,  2004** | ** ** | **September 30,  2005** | ** ** | **September 30,  2004** | ** ** |
|                                           |       |                    |       |                    |       |   |   |   |   |
| Risk-free interest rate                        |       | 3.7%-4.1                | %          | 3.6                     | %          | 3.5%-4.3 | % | 3.1%-3.9 | % |
| Expected dividend yield                        |       | —                  |       | 3⁄4                  |       | — |   | 3⁄4 |   |
| Expected option term                           |       | 5 years                 |       | 5 years                 |       | 5 years |   | 5 years |   |
| Volatility                                     |       | 53.6                    | %          | 65.0                    | %          | 58.6 | % | 0%-65.0 | % |
| Weighted average fair value of options granted |       | $                       | 13.03      |                    | $          | 5.40 |   | $ | 6.40 |   | $ | 7.01 |   |
|                                                |            |                         |            |                         |            |  |  |  |  |  |  |  |  |

 

Prior to May 13, 2004, the Company applied the minimum value method anddid not consider expected volatility of the underlying stock.  Subsequent to this date, the Company hascomputed volatility based on the actual performance of the stock.

 

The Company amortizes employee stock-based compensation on a straight-linebasis over the applicable vesting period, generally four years.

 

**3. Earnings (Loss) Per Common Share**

 

The Company accounts for and discloses net income (loss) per commonshare in accordance with SFAS No. 128,*Earnings Per Share.*  Basic netincome (loss) per common share is computed by dividing net income (loss)attributable to common stockholders by the weighted average number of commonshares outstanding. Diluted net income (loss) per common share is computed bydividing net income (loss) attributable to common stockholders by the weightedaverage number of common shares and dilutive potential common share equivalentsthen outstanding. Potential common shares consist of shares issuable upon theexercise of stock options and warrants (using the treasury stock method) and,in 2004, the weighted average conversion of the redeemable convertiblepreferred stock into shares of common stock (using the if-converted method).

 
| ** **                                         | ** ** | **Three Months Ended**  | ** ** | **Nine Months Ended**   | ** ** |
|----------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                                         | ** ** | **September 30,  2005** | ** ** | **September 30,  2004** | ** ** | **September 30,  2005** | ** ** | **September 30,  2004** | ** ** |
|                                               |       |                    |       |                    |       |   |   |   |   |
| Basic:                                             |       |                    |       |                    |       |   |   |   |   |
| Net income (loss) available to common stockholders |       | $                       | 769,265    |                    | $          | (1,563,769 | ) | $ | 132,807 |   | $ | (12,673,773 | ) |
|                                               |       |                    |       |                    |       |   |   |   |   |
| Weighted average shares                            |       | 12,187,835              |       | 8,819,558               |       | 12,105,992 |   | 3,660,515 |   |
|                                               |       |                    |       |                    |       |   |   |   |   |
| Basic income (loss) per common share               |       | $                       | .06        |                    | $          | (.18 | ) | $ | .01 |   | $ | (3.46 | ) |
|                                               |       |                    |       |                    |       |   |   |   |   |
| Diluted:                                           |       |                    |       |                    |       |   |   |   |   |
| Net income (loss) available to common stockholders |       | $                       | 769,265    |                    | $          | (1,563,769 | ) | $ | 132,807 |   | $ | (12,673,773 | ) |
|                                               |       |                    |       |                    |       |   |   |   |   |
| Weighted average shares                            |       | 12,187,835              |       | 8,819,558               |       | 12,105,992 |   | 3,660,515 |   |
| Effect of stock options                            |       | 915,323                 |       | —                  |       | 753,425 |   | — |   |
| Effect of warrant                                  |       | —                  |       | —                  |       | 21,249 |   | — |   |
| Weighted average shares, as adjusted               |       | 13,103,158              |       | 8,819,558               |       | 12,880,666 |   | 3,660,515 |   |
|                                               |       |                    |       |                    |       |   |   |   |   |
| Diluted income (loss) per common share             |       | $                       | .06        |                    | $          | (.18 | ) | $ | .01 |   | $ | (3.46 | ) |

 

6

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The following potentially dilutive common share equivalents wereexcluded from the calculation of diluted net income (loss) per common sharebecause their effect was antidilutive for each of the periods presented:

 
| ** **           | ** ** | **Three Months Ended**  | ** ** | **Nine Months Ended**   | ** ** |
|----------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **           | ** ** | **September 30,  2005** | ** ** | **September 30,  2004** | ** ** | **September 30,  2005** | ** ** | **September 30,  2004** | ** ** |
|                 |       |                    |       |                    |       |   |   |   |   |
| Options outstanding  |       | 18,000                  |       | 1,024,871               |       | 38,500 |   | 1,024,871 |   |
| Warrants outstanding |       | —                  |       | 100,000                 |       | — |   | 100,000 |   |

 

**4.     Inventory**

 

Inventory consists of the following:

 
| ** **           | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|----------------------|------------|-------------------------|------------|------------------------|------------|
|                 |       |                    |       |                   |       |
| Purchased components |       | $                       | 386,393    |                   | $          | 293,263 |   |
| Finished goods       |       | 1,736,650               |       | 990,998                |       |
| Total inventory      |       | $                       | 2,123,043  |                   | $          | 1,284,261 |   |

 

**5.     Other Balance Sheet Items**

 

Accrued expenses consist of the following:

 
| ** **            | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|-----------------------|------------|-------------------------|------------|------------------------|------------|
|                  |       |                    |       |                   |       |
| Professional services |       | $                       | 200,188    |                   | $          | 164,701 |   |
| Other                 |       | 856,210                 |       | 428,719                |       |
|                  |       | $                       | 1,056,398  |                   | $          | 593,420 |   |

 

Product Warranty Costs

 

Estimated product warranty costs are accrued at the time of sale andare included in cost of sales in the statements of operations. The amount ofthe accrued warranty liability is based on historical information includingpast experience, user error, variability in physiology and anatomy of customers’patients, product failure rates, number of units repaired and estimated cost ofmaterial and labor. The Company’s accrued warranty liability is included inaccrued expenses in the accompanying balance sheets.

 

The following is a rollforward of the Company’s accrued warrantyliability for the three and nine month periods ended September 30, 2005 and 2004:

 
| ** **                     | ** ** | **Three Months Ended**  | ** ** | **Nine Months Ended**   | ** ** |
|--------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                     | ** ** | **September 30,  2005** | ** ** | **September 30,  2004** | ** ** | **September 30,  2005** | ** ** | **September 30,  2004** | ** ** |
|                           |       |                    |       |                    |       |   |   |   |   |
| Balance at beginning of period |       | $                       | 71,353     |                    | $          | 38,761 |   | $ | 59,876 |   | $ | 22,151 |   |
| Accrual for warranties         |       | 90,522                  |       | 49,135                  |       | 229,838 |   | 130,436 |   |
| Settlements made               |       | (89,407                 | )          | (39,025                 | )          | (217,246 | ) | (103,716 | ) |
| Balance at end of period       |       | $                       | 72,468     |                    | $          | 48,871 |   | $ | 72,468 |   | $ | 48,871 |   |

 

7

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**Item2.       Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

 

*You should read the followingdiscussion of our financial condition and results of operations in conjunctionwith our condensed financial statements and the accompanying notes to thosefinancial statements included elsewhere in this Quarterly Report on Form 10-Q.This discussion contains forward-looking statements that involve risks anduncertainties. As a result of many factors, such as those set forth under thesection of this Quarterly Report on Form 10-Q titled “Management’sDiscussion and Analysis of Financial Condition and Results ofOperations-Important Factors that May Affect Future Operating Results”, ouractual results may differ materially from those anticipated in theseforward-looking statements.*

 

**Overview**

 

NeuroMetrix was founded in June 1996. We design, develop and sellproprietary medical devices used to diagnose neuropathies. Our proprietarytechnology provides physicians with an in-office diagnostic system, the NC-statSystem, that enables physicians to make rapid and accurate diagnoses ofneuropathies. The NC-stat System is comprised of: (1) disposable NC-statbiosensors that are placed on the patient’s body; (2) the NC-stat monitorand related components; and (3) the NC-stat docking station, an optionaldevice that enables the physician’s office to transmit data to our onCallInformation System. Each component of the NC-stat System is also soldseparately. The sensitivity of the nervous system to metabolic and mechanicaldamage, compounded by its limited regenerative ability, creates a marketopportunity for a medical device that can assist in point-of-service diagnosesof neuropathies in a manner that is cost-effective for the patient andthird-party payer. We believe the ease of use, accuracy and convenienceprovided by the NC-stat System position it to become a standard of care for theassessment of neuropathies at the point-of-service.

 

From our inception until May 1999, we had devoted substantiallyall of our efforts to designing and developing the NC-stat System and otherpotential products, raising capital and recruiting personnel. We believe thatone of our strengths is our ability to develop and commercialize innovativeproducts for neurological applications. In May 1999, we shipped our firstNC-stat System. At that time we sold one type of biosensor for the testing ofthe median motor nerve. In 2000, we introduced an additional biosensor for thetesting of the ulnar motor nerve. In 2002, we introduced our second-generationNC-stat System, as well as two additional biosensors. In 2003, we added to ourproduct line two biosensors with higher functionality that have the ability totest both motor and sensory nerves. In 2004, we introduced two new NC-statbiosensors as well as components for the NC-stat monitor to utilize these newbiosensors. The first new biosensor is used to test the ulnar nerve at theelbow and the second to test the sural nerve. In the first nine months of 2005,our revenues grew 97.3% from the same period in 2004, generating $24.0 millionin revenues, of which 87.9% was attributable to sales of NC-stat biosensors.Our gross margin percentage in the first nine months of 2005 was 74.0%.

 

We derive our revenues from the saleof NC-stat biosensors, monitors and docking stations directly to end users,which are generally physician practice groups. Our NC-stat biosensors aredisposable products that are used once and inactivated after use. The NC-statmonitor is an electronic instrument that is used with the NC-stat biosensors toperform nerve conduction studies for the purpose of diagnosing neuropathies.The NC-stat monitor displays the pertinent results of nerve conduction studieson an LCD screen immediately at the conclusion of each study. The NC-statdocking station is an optional device that is used to transmit to the onCallInformation System data generated by the nerve conduction study performed withthe NC-stat monitor. The onCall Information System formulates the data itreceives for each test into a detailed report that is provided to the customerthrough facsimile or e-mail.

 

Diagnostic device revenues include revenues derived from the sale ofour NC-stat monitors and NC-stat docking stations. Biosensor revenues includerevenues derived from the sale of various types of disposable biosensors usedto perform nerve conduction studies with the NC-stat monitor. Our revenuerecognition policy is to recognize revenue from our monitors and biosensorsupon shipment if the fee is fixed and determinable, persuasive evidence of anarrangement exists, collection of the resulting receivable is reasonablyassured and product returns are reasonably estimable. Revenues from our dockingstation are deferred and recognized over the shorter of the estimated customerrelationship period or the estimated useful life of the product, currentlythree years.

 

Reimbursement from third-party payers is an important element ofsuccess for medical products companies.  Generally, we believe that the nerve conduction studiesperformed by our customers with the NC-stat System have been satisfactorilycovered by third-party payers.  As our presence in the market expands andthe use of the NC-stat System increases, we have experienced and arelikely to continue to experience an increased focus from third-party payersregarding the reimbursement of nerve conduction studies performed using theNC-stat System and an increased focus from third-party payers regarding theprofessional requirements for performing nerve conduction studies in general.Widespread adoption of the NC-stat System by the medical community is unlikelyto occur if physicians do not receive satisfactory reimbursement fromthird-party payers for procedures performed with the NC-stat System.

 

8

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One of the primary challenges we face in our business is successfullyexpanding the market for nerve conduction studies. A successful marketexpansion will depend upon, in part, our targeting of primary care andspecialty physicians who traditionally have not been targeted by companiesselling equipment used to perform nerve conduction studies and our ability toalter physicians’ practices relating to the diagnosis of neuropathies. In orderto successfully implement this growth strategy, we have increased our salesforce to 31 regional sales managers as of September 30, 2005 and plan to add10-15 additional regional sales managers with the hiring process planned forthe first quarter of 2006.  We also will participatein various industry conferences in order to accelerate the market awareness andadoption of our products.  These efforts,as well as the overall expansion of our business, will provide challenges toour organization and may increase the burden on our management and operations.We are focused on monitoring our business as it grows and appropriatelyacquiring and allocating resources to address these issues, with a goal ofachieving and sustaining profitability.

 

In March 2005, we entered into an education and developmentprogram agreement with Eli Lilly and Company (“Lilly”). Through this agreement,our Company and Lilly expect to conduct a broad series of up to84 educational and development programs across the country during 2005 and2006. The focus of each program is on educating physicians regarding thetreatment and diagnosis of diabetic peripheral neuropathy (“DPN”), nerveconduction studies, our NC-stat System and its application in DPN and thebenefits to physicians and patients of using the NC-stat System.  During the second quarter of 2005, the firstseries of programs were conducted as originally planned.  Lilly has a significant presence in thediabetes market, including drugs targeted at DPN.  Lilly has a drug known as Cymbalta approvedby the Food and Drug Administration (“FDA”) for the treatment of painassociated with DPN and they have a drug known as ruboxistaurin (or Arxxant)that is in Phase III clinical trials for the treatment of the underlyingdisease state in patients with DPN.  OnAugust 2, 2005, Lilly announced that it completed a Phase III trial todetermine the effect of ruboxistaurin on treatment of sensory symptomsassociated with DPN.  Lilly announcedthat, in this study, statistical comparison of the change in sensory symptomscores between the placebo and ruboxistaurin-treated group did not demonstratesignificant differences and did not meet the studies’ primary endpoints and,consequently, do not support a new drug application filing.  However, Lilly also announced that it wascontinuing an ongoing, three-year, placebo-controlled trial evaluatingruboxistaurin for the treatment of nerve dysfunction of DPN, scheduled tocomplete in 2007.  For this three-yeartrial, change in a composite of objective nerve function measures, includingnerve conduction studies, is the primary outcome.  As a result of these developments, we will bediscussing with Lilly our plans with regard to the series of educational anddevelopment programs that we were to jointly conduct with Lilly.  We cannot assure you that these programs willresume in this timeframe or at all.

 

Since our inception in 1996, we have incurred losses every quarter,with the exception of the third quarter of 2005. We incurred net losses ofapproximately $8.7 million in 2001, $4.8 million in 2002,$3.7 million in 2003 and $4.3 million in 2004 and recorded net incomeof $133,000 in the first nine months of 2005. We do not know whether we will beable to sustain the profitability achieved in the first nine months of 2005. Asof September 30, 2005, we had an accumulated deficit of approximately $57.3million. Historically, we have primarily financed our operations through thepublic and private placement of equity securities and through debt facilities.As of September 30, 2005, we had received net proceeds of $43.5 millionfrom the issuance of redeemable convertible preferred stock and$24.0 million in net proceeds from our initial public offering (“IPO”).

 

Our financial objective is to achieve and sustain profitable growth.Our efforts in 2005 will continue to focus primarily on expanding our sales andmarketing for the NC-stat System and continuing our ongoing program of makingenhancements and improvements to the NC-stat System, with the goal ofincreasing our market penetration. During the first nine months of 2005 we increased our direct sales forceto 31 regional sales managers and we expect to add 10-15 additional regionalsales managers with the hiring process planned for the first quarter of 2006.   During the first nine months of 2005 wecontinued efforts on improvements to our biosensors, on the development of newbiosensors and on the development of a third generation monitor and dockingstation. We are also in the early stages of designing a drug delivery systemfor the minimally invasive treatment of neuropathies by both primary care andspecialist physicians. We believe that the accomplishment of these goals willhave a positive impact on our progress toward the objective of achievingprofitability.

 

9

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**Results of Operations**

 

The following table presents certain statement of operationsinformation stated as a percentage of total revenues:

 
| ** **                     | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                     | ** ** | **2005**                              | ** ** | **2004**                             | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenues:                      |       |                                  |       |                                 |       |   |   |   |   |
| Diagnostic device              |       | 12.4                                  | %          | 12.8                                 | %          | 12.1 | % | 12.4 | % |
| Biosensor                      |       | 87.6                                  |       | 87.2                                 |       | 87.9 |   | 87.6 |   |
| Total revenues                 |       | 100.0                                 |       | 100.0                                |       | 100.0 |   | 100.0 |   |
|                           |       |                                  |       |                                 |       |   |   |   |   |
| Cost of revenues               |       | 25.4                                  |       | 26.8                                 |       | 26.0 |   | 27.1 |   |
|                           |       |                                  |       |                                 |       |   |   |   |   |
| Gross margins                  |       | 74.6                                  |       | 73.2                                 |       | 74.0 |   | 72.9 |   |
|                           |       |                                  |       |                                 |       |   |   |   |   |
| Operating expenses:            |       |                                  |       |                                 |       |   |   |   |   |
| Research and development       |       | 10.2                                  |       | 19.6                                 |       | 11.9 |   | 20.0 |   |
| Sales and marketing            |       | 38.3                                  |       | 42.3                                 |       | 42.7 |   | 46.4 |   |
| General and administrative     |       | 20.0                                  |       | 27.1                                 |       | 21.3 |   | 27.6 |   |
| Total operating expenses       |       | 68.5                                  |       | 89.0                                 |       | 75.9 |   | 94.0 |   |
| Income (loss) from operations  |       | 6.0                                   |       | -15.7                                |       | -1.9 |   | -21.1 |   |
| Interest income (expense), net |       | 2.4                                   |       | -12.8                                |       | 2.4 |   | -7.3 |   |
|                           |       |                                  |       |                                 |       |   |   |   |   |
| Net income (loss)              |       | 8.4                                   | %          | -28.5                                | %          | 0.6 | % | -28.4 | % |

 

**Comparison of Three Months Ended September30, 2005 and September 30, 2004**

 

***Revenues***

 

The following tables present a breakdown of our customers, biosensorunits used and revenues:

 
| ** ** | ** ** | **12-Month Period  Ended September 30,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|------------|------------|------------------------------------------|------------|------------|------------|------------|------------|
| ** ** | ** ** | **2005**                                 | ** ** | **2004**   | ** ** | **Change** | ** ** | **% Change** | ** ** |
|       |       |                                     |       |       |       |       |       |   |   |
| Customers  |       | 2,969                                    |       | 2,064      |       | 905        |       | 43.8 | % |

 
| ** **           | ** ** | **Three Months Ended  September 30,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|----------------------|------------|---------------------------------------|------------|------------|------------|------------|------------|
| ** **           | ** ** | **2005**                              | ** ** | **2004**   | ** ** | **Change** | ** ** | **% Change** | ** ** |
|                 |       |                                  |       |       |       |       |       |   |   |
| Biosensor units used |       | 187,900                               |       | 96,800     |       | 91,100     |       | 94.1 | % |

 

**($ in thousands)**

 
| Revenues:         |   |    |    |    |   |    |   |   |    |
|-------------------|--------|---------|---------|---------|--------|---------|--------|--------|---------|
| Diagnostic device |   | $       | 1,133.4 |    | $      | 614.6   |   | $      | 518.8   |   | 84.4 |   |
| Biosensor         |   | 7,976.1 |    | 4,204.8 |   | 3,771.3 |   | 89.7   |    |
| Total revenues    |   | $       | 9,109.4 |    | $      | 4,819.3 |   | $      | 4,290.1 |   | 89.0 | % |

 

Diagnostic device revenues were $1.1 million and $614,600 for the threemonths ended September 30, 2005 and September 30, 2004, respectively, anincrease of $518,800, or 84.4%. Of this increase, approximately $366,900 isattributable to a greater number of units sold, primarily as a result of anincrease in the number of regional sales managers and expanded clinical usesfor the NC-stat System.  In addition, approximately $152,000 of thisincrease is attributable to an increase in the list price of our NC-statmonitors and docking stations from $3,500 to $4,000 effective January 1, 2005,which resulted in a higher average selling price during the three months ended September30, 2005 as compared to the same period in 2004. Diagnostic device revenuesaccounted for 12.4% and 12.8% of our total revenues for the three months ended September30, 2005 and September 30, 2004, respectively.

 

10

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Biosensor revenues were $8.0 million and $4.2 million for the threemonths ended September 30, 2005 and September 30, 2004, respectively, anincrease of $3.8 million, or 89.7%. The increase was primarily due to anincreased customer base for our biosensors, increased frequency of testing byour customers and the introduction of new biosensors, including the suralbiosensor in the fourth quarter of 2004.  Biosensor revenues accounted for87.6% and 87.2% of our total revenues for the three months ended September 30,2005 and September 30, 2004, respectively.

 

Our customers used 187,900 biosensor units in the three months ended September30, 2005, compared to 96,800 units for the same period in 2004, an increase of 91,100units, or 94.1%.  This increase in biosensor usage is primarily the resultof the increase in the customer base, increased usage by customers and theintroduction of new biosensors, including the sural biosensor in the fourthquarter of 2004.  The sural biosensor isan important additional biosensor for our customers’ use of the NC-stat Systemfor low back pain and DPN and we believe that its introduction is contributingto the growth in biosensor usage for these clinical indications.

 

Our total revenues were $9.1 millionand $4.8 million for the three months ended September 30, 2005 and September30, 2004, respectively, an increase of $4.3 million, or 89.0%. During the12-month period ending September 30, 2005, a total of 2,969 customers used ourNC-stat System compared to 2,064 customers for the same period ending September30, 2004. This represents a 43.8% year-over-year increase in the number ofcustomers that used our NC-stat System.

 

We expect revenues to continue to increase in 2005 as a result of therecent expansion of our sales force, which grew from 22 regional sales managersas of December 31, 2004 to 31 regional sales managers at the end of the thirdquarter of 2005, an increase in the number of active customer accounts andincreased usage per customer account.  However, our revenues could benegatively impacted by a variety of factors, including the level of demand fornerve conduction studies, potential for changes in third-party reimbursementfor nerve conduction studies, the overall economy and competitive factors.

 

***Costs and expenses***

 

The following table presents our costs and expenses and net income (loss):

 
| ** **                                | ** ** | **Three Months Ended  September 30,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|-------------------------------------------|------------|---------------------------------------|------------|------------|------------|------------|------------|
| **($ in thousands)**                 | ** ** | **2005**                              | ** ** | **2004**   | ** ** | **Change** | ** ** | **% Change** | ** ** |
| ** **                                |       |                                  |       |       |       |       |       |   |   |
| Cost of revenues:                         |       |                                  |       |       |       |       |       |   |   |
| Diagnostic device                         |       | $                                     | 281.6      |       | $          | 193.4      |       | $ | 88.2 |   | 45.6 | % |
| Biosensor                                 |       | 2,036.3                               |       | 1,096.9    |       | 939.4      |       | 85.6 |   |
| Total costs of revenues                   |       | 2,317.8                               |       | 1,290.2    |       | 1,027.6    |       | 79.6 |   |
|                                      |       |                                  |       |       |       |       |       |   |   |
| Gross margin:                             |       |                                  |       |       |       |       |       |   |   |
| Diagnostic device                         |       | 851.8                                 |       | 421.2      |       | 430.6      |       | 102.2 |   |
| Biosensor                                 |       | 5,939.8                               |       | 3,107.9    |       | 2,831.9    |       | 91.1 |   |
| Total gross margin                        |       | 6,791.6                               |       | 3,529.1    |       | 3,262.5    |       | 92.4 |   |
|                                      |       |                                  |       |       |       |       |       |   |   |
| Gross margin %:                           |       |                                  |       |       |       |       |       |   |   |
| Diagnostic device                         |       | 75.2                                  | %          | 68.5       | %          |       |       |   |   |
| Biosensor                                 |       | 74.5                                  |       | 73.9       |       |       |       |   |   |
| Total gross margin %                      |       | 74.6                                  |       | 73.2       |       |       |       |   |   |
|                                      |       |                                  |       |       |       |       |       |   |   |
| Operating expenses:                       |       |                                  |       |       |       |       |       |   |   |
| Research and development (1)              |       | 929.9                                 |       | 942.9      |       | (13.0      | )          | -1.4 |   |
| Sales and marketing (1)                   |       | 3,489.1                               |       | 2,037.8    |       | 1,451.3    |       | 71.2 |   |
| General and administrative (1)            |       | 1,821.9                               |       | 1,306.2    |       | 515.7      |       | 39.5 |   |
| Total operating expenses                  |       | 6,240.9                               |       | 4,286.9    |       | 1,953.9    |       | 45.6 |   |
| Income (loss) from operations             |       | 550.7                                 |       | (757.8     | )          | 1,308.6    |       | -172.7 |   |
| Interest income                           |       | 218.5                                 |       | 51.6       |       | 166.9      |       | 323.3 |   |
| Interest expense                          |       | —                                |       | (666.7     | )          | 666.7      |       | -100.0 |   |
| Net income (loss)                         |       | 769.3                                 |       | (1,372.9   | )          | 2,142.2    |       | -156.0 |   |
| Accretion of dividend on preferred stock  |       | —                                |       | (190.9     | )          | 190.9      |       | -100.0 |   |
|                                      |       |                                  |       |       |       |       |       |   |   |
| Net loss available to common stockholders |       | $                                     | 769.3      |       | $          | (1,563.7   | )          | $ | 2,333.0 |   | -149.2 |   |

 

11

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----

(1)                                  Includesnon-cash stock-based compensation of:

 
| Research and development                |   | $    | 19.2   |   | $      | 21.5   |   |   |   |   |   |
|-----------------------------------------|--------|------|--------|--------|--------|--------|--------|--------|--------|--------|--------|
| Sales and marketing                     |   | 67.8 |   | 48.9   |   |   |   |   |   |
| General and administrative              |   | 24.6 |   | 69.1   |   |   |   |   |   |
| Total non-cash stock based compensation |   | $    | 111.6  |   | $      | 139.6  |   |   |   |   |   |

 

Gross Margin

 

Diagnostic device gross margin percentage was 75.2% and 68.5% for thethree months ended September 30, 2005 and September 30, 2004, respectively. Theincrease in the gross margin percentage in the third quarter of 2005 comparedto the same period in 2004 is primarily attributable to an increase in the listprice of our NC-stat System from $3,500 to $4,000 effective January 1, 2005.

 

Biosensor gross margin percentageincreased to 74.5% for the three months ended September 30, 2005 from 73.9% forthe same period in 2004.  The increase inbiosensor gross margin percentage is primarily due to manufacturing costreductions realized for several of our biosensors, offset in part by a changein the mix of biosensors resulting from the introduction of new biosensors inthe second half of 2004 which have modestly lower gross margins.

 

Our overall gross margin percentage was 74.6% for the three monthsended September 30, 2005 compared to 73.2% for the same period in 2004.  At the beginning of 2005, we raised the listprice of our diagnostic devices. The list price increase should continue toresult in a higher diagnostic device gross margin percentage in 2005 whencompared to 2004. We anticipate our overall gross margin percentage will remainrelatively consistent for the remainder of 2005.  However, if salesvolumes do not increase, if the mix of sales shifts further toward lower marginbiosensors, if pricing pressures increase or if the cost of biosensors anddiagnostic devices through our third-party manufacturers increases, then grossmargin may be negatively impacted in future quarters.

 

Our biosensors are manufactured by the Parlex Polymer Flexible Circuitsdivision (“PPFC”) of Parlex Corporation. Johnson Electric, a Hong Kong based manufacturing company, announced inSeptember 2005 their plans to acquire Parlex Corporation, including PPFC, andthat the acquisition was expected to be completed in November 2005.  Currently, we are not aware of anysignificant anticipated changes in the operations of PPFC or the nature of ourrelationship with PPFC as a result of the proposed acquisition; however, wecannot assure you that the acquisition will not result in adverse changes inour relationship with PPFC.

 

The manufacturing of NC-stat monitors and docking stations is beingtransitioned from Advanced Electronics, Inc (“AEI”) to Sunburst EMS, Inc. as aresult of a decision by AEI to shut down its operations.  We expect this transition to be completed inNovember 2005.  Several AEI employees whowere involved in the manufacturing of our devices have been hired by Sunburstand we do not anticipate any interruptions during the transition.  However, we cannot assure you that thetransition will proceed smoothly or that Sunburst will be able to manufacturethe NC-stat monitors and docking stations with the same level of quality and onthe same delivery schedule as AEI.

 

Research and Development

 

Our research and development, or R&D, expenses include expensesassociated with our research, product development, clinical, regulatory andquality assurance departments.

 

R&D expenses decreased $13,000, or 1.4%, to $929,900 for the threemonths ended September 30, 2005 from $942,900 for the same period in 2004. As apercentage of revenues, R&D expenses were 10.2% and 19.6% for the threemonths ended September 30, 2005 and September 30, 2004, respectively. The decreasein expenses was primarily due to a decrease of $116,900 in product developmentcosts.  Product development costs in 2004included costs related to the development of the sural biosensor, which wasintroduced in the fourth quarter of 2004. This decrease was offset in part by a $92,000 increase in employeecompensation and benefit costs resulting from the hiring of additionalemployees in our R&D department, particularly in product development.

 

For the remainder of 2005, we expect our spending on R&D willincrease due to additional consulting services and the hiring of severaladditional employees to support product development efforts as well asincreased clinical study costs. We expect R&D expenses, as a percentage oftotal revenues, to continue to decrease slightly due to an expected increase inrevenue. This percentage may vary, however, depending primarily on our revenuesfor the remainder of 2005.

 

Sales and Marketing

 

Sales and marketing expenses increased $1.5 million, or 71.2%, to $3.5million for the three months ended September 30, 2005 from $2.0 million for thesame period in 2004. As a percentage of revenues, sales and marketing expenseswere 38.3% and 42.3% for the three months ended September 30, 2005 and September30, 2004, respectively. The change in expenses was primarily due to an increaseof $908,000 in employee compensation and benefit costs, including salescommissions paid to our regional sales managers.  This increase is due tothe expansion of the sales force and higher revenues in the third quarter of2005 as compared to the third

 

12

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quarter of 2004.   Also contributing to the change in expenseswas an increase of $384,800 in sales commissions paid to our independent salesagencies, which were related to our higher revenues in the third quarter of2005, and increases of $103,000 in travel expenses and $63,300 in recruitingcosts due to the expansion of the sales force.

 

We have increased the number of ourregional sales managers to 31 as of the end of the third quarter of 2005 andexpect add 10-15 additional regional sales managers with the hiring processplanned for the first quarter of 2006.  Forthe remainder of 2005, we expect sales and marketing expenses, as a percentageof total revenues, to remain relatively consistent with the level for the thirdquarter of 2005. This percentage may vary, however, depending primarily on ourrevenues for the remainder of 2005.

 

General and Administrative

 

Our general and administrative expenses include expenses from theexecutive, finance, administrative, customer service and information technologydepartments.

 

General and administrative expenses increased $515,700, or 39.5%, to $1.8million for the three months ended September 30, 2005 from $1.3 million for thesame period in 2004. As a percentage of revenues, general and administrativeexpenses were 20.0% and 27.1% for the three months ended September 30, 2005 andSeptember 30, 2004, respectively. The increase in expenses was primarily due to(a) an increase in employee compensation and benefit costs of $175,500 due tothe expansion of staff and increases in employee compensation; (b) an increaseof $99,600 in bad debt expense, which was based on an analysis of accountsoutstanding for greater than 90 days as well as, in 2005, an analysis ofaccounts in areas affected by Hurricane Katrina; (c) an increase of $82,900 inprofessional fees for legal services and for accounting and audit servicesprimarily as a result of the increased regulatory requirements associated withbeing a publicly-traded company; (d) an increase of $48,600 in credit cardand bank transaction fees related to customer sales, and (e) an increase inrecruiting costs of $39,100 associated with new hires.  The increases areoffset in part by a decrease of $44,500 in stock-based compensation expenserelated to employee stock options.  We expect our general andadministrative expenses to increase during the remainder of 2005 as a result ofour expected growth and the additional requirements that we will need tofulfill as a publicly-traded company.  These requirements include theprovisions of the Sarbanes-Oxley Act of 2002, and the rules promulgatedthereunder, regarding internal control over financial reporting which willbegin to apply to us as of December 31, 2005.  Total general andadministrative expenses, as a percentage of total revenues, may increase in thefourth quarter of 2005 due to costs incurred in connection with Sarbanes-Oxleycompliance efforts. This percentage may vary, however, depending primarily onour revenues for the fourth quarter of 2005.

 

Interest Income

 

Interest income was $218,500 and $51,600 during the three months ended September30, 2005 and September 30, 2004, respectively. Interest income was earned frominvestments in cash equivalents, short-term investments and long-terminvestments.  Interest income increased during the three months ended September30, 2005 compared to the same period in 2004 because of the investment of theproceeds from the IPO, which was completed during July of 2004, as well ashigher yields available during 2005. We expect interest income to be relativelyunchanged for the remainder of 2005.

 

Interest Expense

 

Interest expense was $666,700 during the three months ended September30, 2004.  Interest expense in 2004 wasprimarily the result of the full repayment of our borrowing under our line ofcredit entered into in May 2003 with Lighthouse Capital Partners.  The early repayment of this debt resulted ina charge of approximately $375,000 related to unamortized deferred issuancecosts and approximately $263,000 of balloon interest charges.

 

13

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**Comparison of Nine Months Ended September30, 2005 and September 30, 2004**

 

***Revenues***

 

The following tables present a breakdown of our customers, biosensorunits used and revenues:

 
| ** ** | ** ** | **12-Month Period  Ended September 30,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|------------|------------|------------------------------------------|------------|------------|------------|------------|------------|
| ** ** | ** ** | **2005**                                 | ** ** | **2004**   | ** ** | **Change** | ** ** | **% Change** | ** ** |
|       |       |                                     |       |       |       |       |       |   |   |
| Customers  |       | 2,969                                    |       | 2,064      |       | 905        |       | 43.8 | % |

 
| ** **           | ** ** | **Nine Months Ended  September 30,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|----------------------|------------|--------------------------------------|------------|------------|------------|------------|------------|
| ** **           | ** ** | **2005**                             | ** ** | **2004**   | ** ** | **Change** | ** ** | **% Change** | ** ** |
|                 |       |                                 |       |       |       |       |       |   |   |
| Biosensor units used |       | 498,600                              |       | 248,700    |       | 249,900    |       | 100.5 |   |

 

**($ inthousands)**

 
| Revenues:         |   |     |     |     |   |     |   |   |     |
|-------------------|--------|----------|----------|----------|--------|----------|--------|--------|----------|
| Diagnostic device |   | $        | 2,906.3  |     | $      | 1,502.5  |   | $      | 1,403.8  |   | 93.4 |   |
| Biosensor         |   | 21,060.4 |     | 10,643.1 |   | 10,417.3 |   | 97.9   |     |
| Total revenues    |   | $        | 23,966.7 |     | $      | 12,145.6 |   | $      | 11,821.1 |   | 97.3 | % |

 

Diagnostic device revenues were $2.9 million and $1.5 million for the ninemonths ended September 30, 2005 and September 30, 2004, respectively, anincrease of $1.4 million, or 93.4%. Of this increase, approximately $938,200 isattributable to a greater number of units sold, primarily as a result of anincrease in the number of regional sales managers and expanded clinical usesfor the NC-stat System.  In addition, approximately $465,700 of thisincrease is attributable to an increase in the list price of our NC-statmonitors and docking stations from $3,500 to $4,000 effective January 1, 2005,which resulted in a higher average selling price during the nine months ended September30, 2005 as compared to the same period in 2004. Diagnostic device revenuesaccounted for 12.1% and 12.4% of our total revenues for the nine months ended September30, 2005 and September 30, 2004, respectively.

 

Biosensor revenues were $21.1 million and $10.6 million for the ninemonths ended September 30, 2005 and September 30, 2004, respectively, anincrease of $10.4 million, or 97.9%. The increase was primarily due to anincreased customer base for our biosensors, increased frequency of testing byour customers and the introduction of new biosensors, including the suralbiosensor in the fourth quarter of 2004.  Biosensor revenues accounted for87.9% and 87.6% of our total revenues for the nine months ended September 30,2005 and September 30, 2004, respectively.

 

Our customers used 498,600 biosensor units in the nine months ended September30, 2005, compared to 248,700 units for the same period in 2004, an increase of249,900 units, or 100.5%.  This increase in biosensor usage is primarilythe result of the increase in the customer base, increased usage by customersand the introduction of new biosensors, including the sural biosensor in thefourth quarter of 2004.

 

Our total revenues were $24.0 million and $12.1 million for the ninemonths ended September 30, 2005 and September 30, 2004 respectively, anincrease of $11.8 million, or 97.3%. During the 12-month period ending September30, 2005, a total of 2,969 customers used our NC-stat System compared to 2,064customers for the same period ending September 30, 2004. This represents a 43.8%year-over-year increase in the number of customers that used our NC-statSystem.

 

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***Costs and expenses***

 

The following table presents our costs and expenses and net loss:

 
| ** **                                                                            | ** ** | **Nine Months Ended  September 30,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|---------------------------------------------------------------------------------------|------------|--------------------------------------|------------|------------|------------|------------|------------|
| **($ in thousands)**                                                             | ** ** | **2005**                             | ** ** | **2004**   | ** ** | **Change** | ** ** | **% Change** | ** ** |
| ** **                                                                            |       |                                 |       |       |       |       |       |   |   |
| Cost of revenues:                                                                     |       |                                 |       |       |       |       |       |   |   |
| Diagnostic device                                                                     |       | 760.6                                |       | $          | 515.3      |       | 245.3      |   | 47.6 | % |
| Biosensor                                                                             |       | 5,465.1                              |       | 2,772.5    |       | 2,692.5    |       | 97.1 |   |
| Total costs of revenues                                                               |       | 6,225.6                              |       | 3,287.9    |       | 2,937.8    |       | 89.4 |   |
|                                                                                  |       |                                 |       |       |       |       |       |   |   |
| Gross margin:                                                                         |       |                                 |       |       |       |       |       |   |   |
| Diagnostic device                                                                     |       | 2,145.7                              |       | 987.1      |       | 1,158.5    |       | 117.4 |   |
| Biosensor                                                                             |       | 15,595.3                             |       | 7,870.5    |       | 7.724.8    |       | 98.1 |   |
| Total gross margin                                                                    |       | 17,741.1                             |       | 8,857.7    |       | 8,883.3    |       | 100.3 |   |
|                                                                                  |       |                                 |       |       |       |       |       |   |   |
| Gross margin %:                                                                       |       |                                 |       |       |       |       |       |   |   |
| Diagnostic device                                                                     |       | 73.8                                 | %          | 65.7       | %          |       |       |   |   |
| Biosensor                                                                             |       | 74.1                                 |       | 73.9       |       |       |       |   |   |
| Total gross margin %                                                                  |       | 74.0                                 |       | 72.9       |       |       |       |   |   |
|                                                                                  |       |                                 |       |       |       |       |       |   |   |
| Operating expenses:                                                                   |       |                                 |       |       |       |       |       |   |   |
| Research and development (1)                                                          |       | 2,863.2                              |       | 2,434.8    |       | 428.4      |       | 17.6 |   |
| Sales and marketing (1)                                                               |       | 10,228.2                             |       | 5,634.4    |       | 4,593.9    |       | 81.5 |   |
| General and administrative (1)                                                        |       | 5,094.4                              |       | 3,347.1    |       | 1,747.3    |       | 52.2 |   |
| Total operating expenses                                                              |       | 18,185.8                             |       | 11,416.3   |       | 6,769.5    |       | 59.3 |   |
| Loss from operations                                                                  |       | (444.7                               | )          | (2,558.6   | )          | 2,113.8    |       | -82.6 |   |
| Interest income                                                                       |       | 579.6                                |       | 70.2       |       | 509.4      |       | 726.0 |   |
| Interest expense                                                                      |       | (2.0                                 | )          | (960.4     | )          | 958.4      |       | -99.8 |   |
| Net income (loss)                                                                     |       | 132.8                                |       | (3,448.8   | )          | 3,581.6    |       | -103.9 |   |
| Accretion of dividend on preferred stock                                              |       | 3⁄4                               |       | (1,386.3   | )          | 1,386.3    |       | -100.0 |   |
| Deemed dividend  on redeemable convertible preferred stock                            |       | 3⁄4                               |       | (787.9     | )          | 787.9      |       | -100.0 |   |
| Beneficial  conversion feature associated with redeemable convertible preferred stock |       | 3⁄4                               |       | (7,050.8   | )          | 7,050.8    |       | -100.0 |   |
|                                                                                  |       |                                 |       |       |       |       |       |   |   |
| Net income (loss) available to common stockholders                                    |       | $                                    | 132.8      |       | $          | (12,673.8  | )          | $ | 12,806.6 |   | -101.0 |   |
|                                                                                       |            |                                      |            |            |            |            |            |  |  |  |  |  |

 

----

(1)                                  Includesnon-cash stock-based compensation of:

 
| Research and development                |   | $     | 58.2   |   | $      | 227.8  |   |   |   |   |   |
|-----------------------------------------|--------|-------|--------|--------|--------|--------|--------|--------|--------|--------|--------|
| Sales and marketing                     |   | 137.6 |   | 320.0  |   |   |   |   |   |
| General and administrative              |   | 63.7  |   | 402.1  |   |   |   |   |   |
| Total non-cash stock based compensation |   | $     | 259.5  |   | $      | 949.9  |   |   |   |   |   |

 

Gross Margin

 

Diagnostic device gross margin percentage was 73.8% and 65.7% for the ninemonths ended September 30, 2005 and September 30, 2004, respectively. Theincrease in the gross margin percentage in the first nine months of 2005compared to the same period in 2004 is primarily attributable to an increase inthe list price of our NC-stat System from $3,500 to $4,000 effective January 1,2005.

 

Biosensor gross margin percentage was 74.1% for the nine months endedSeptember 30, 2005 compared to 73.9% for the same period in 2004.

 

Our overall gross margin percentage was 74.0% for the nine months endedSeptember 30, 2005 compared to 72.9% for the same period in 2004.

 

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Research and Development

 

R&D expenses increased $428,400, or 17.6%, to $2.9 million for the ninemonths ended September 30, 2005 from $2.4 million for the same period in 2004.As a percentage of revenues, R&D expenses were 11.9% and 20.0% for the ninemonths ended September 30, 2005 and September 30, 2004, respectively. Theincrease in expenses was primarily due to an increase of $359,800 in employeecompensation and benefit costs resulting from the hiring of additionalemployees in our R&D department and an increase of $236,100 in outsideconsulting costs.  These increases are primarily related to effortsexpended on the development of a third generation monitor and docking stationand on new biosensors and improvements to existing biosensors.   These increases were offset in part by adecrease in stock-based compensation expense of $169,600 related to employeestock options.

 

Sales and Marketing

 

Sales and marketing expenses increased $4.6 million, or 81.5%, to $10.2million for the nine months ended September 30, 2005 from $5.6 million for thesame period in 2004. As a percentage of revenues, sales and marketing expenseswere 42.7% and 46.4% for the nine months ended September 30, 2005 and September30, 2004, respectively. The change in expenses was primarily due to an increaseof $3.0 million in employee compensation and benefit costs, including salescommissions paid to our regional sales managers.  This increase is due tothe expansion of the sales force and higher revenues in the first nine monthsof 2005 as compared to the first nine months of 2004.   Alsocontributing to the change in expenses was an increase of $1.1 million in salescommissions paid to our independent sales agencies, which were related to ourhigher revenues in the first nine months of 2005, and increases of $352,600 intravel expenses and $115,300 in recruiting costs due to the expansion of thesales force. The change in expenses was also partially due to an increase of $256,100in costs for trade shows, advertising and promotional materials as we haveincreased our presence at tradeshows and developed new promotionalmaterials.  These increases were offsetin part by a decrease in stock-based compensation expense of $182,400 relatedto employee stock options.

 

General and Administrative

 

General and administrative expenses increased $1.7 million, or 52.2%,to $5.1 million for the nine months ended September 30, 2005 from $3.3 millionfor the same period in 2004. As a percentage of revenues, general and administrativeexpenses were 21.3% and 27.6% for the nine months ended September 30, 2005 and September30, 2004, respectively. The increase in expenses was primarily due to (a) anincrease in employee compensation and benefit costs of $702,500 due to theexpansion of staff and salary increases and increases in incentive compensation;(b) an increase of $352,800 in professional fees for legal services and for accountingand audit services primarily as a result of the increased regulatoryrequirements associated with being a publicly-traded company; (c) an increaseof $335,800 in our insurance costs, primarily relating to increases in directorand officer insurance premiums as a result of the transition to apublicly-traded company; (d) an increase of $130,800 in credit card andbank transaction fees related to customer sales; (e) an increase of $124,400 infranchise taxes and other fees; and (f) an increase in recruiting costs of $102,600associated with new hires.  Theseincreases were offset in part by a decrease in stock-based compensation expenseof $338,400 related to employee stock options.

 

Interest Income

 

Interest income was $579,600 and $70,200 during the nine months ended September30, 2005 and September 30, 2004, respectively. Interest income was earned frominvestments in cash equivalents, short-term investments and long-terminvestments.  Interest income increased during the nine months ended September30, 2005 compared to the same period in 2004 because of the investment of theproceeds from the IPO, which was completed in the third quarter of 2004, andfrom the proceeds of the sale of preferred stock in March 2004.

 

Interest Expense

 

Interest expense was $2,000 and $960,400 during the nine months ended September30, 2005 and September 30, 2004, respectively, representing a decrease of $958,400.The decrease in interest expense was due to the payment in the third quarter of2004 of the outstanding balance of $3.0 million under the line of credit withLighthouse Capital Partners using a portion of the proceeds from the IPO.

 

Deemed Dividend and Beneficial Conversion Feature onRedeemable Convertible Preferred Stock

 

In the first nine months of 2004, we recorded a $787,900 deemeddividend as a result of the March 2004 Series E-1 redeemable convertiblepreferred stock financing. The deemed dividend resulted from an adjustment tothe conversion ratios pursuant to the anti-dilution protection provisions associatedwith the Series D redeemable convertible preferred stock. We also recorded acharge of $7.1 million for a beneficial conversion feature associated with theSeries E-1 redeemable convertible preferred stock issued in March 2004. Therewas no deemed dividend or beneficial conversion charge in the first nine monthsof 2005.  All issued and outstandingshares of preferred stock were converted into shares of common stock inconnection with the initial public offering.

 

16

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**Liquidity and Capital Resources**

 

Our principal source of liquidity isour current cash and cash equivalents and short-term investments. As of September30, 2005, the weighted average maturity of our investments was 177 days. Ourability to generate cash from operations is dependent upon our ability togenerate revenue from sales of our disposable biosensors and diagnosticdevices, as well as our ability to manage our operating costs, capitalinvestments and working capital. A decrease in demand for our products orunanticipated increases in our operating costs would likely have an adverseeffect on our liquidity and cash generated from operations. The following setsforth information relating to our liquidity:

 
| **($ in thousands)**                                                       | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** | **Change** | ** ** | **% Change** | ** ** |
|---------------------------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|------------|------------|--------------|------------|
| ** **                                                                      |       |                    |       |                   |       |       |       |         |       |
| Cash and cash  equivalents                                                      |       | $                       | 3,304      |                   | $          | 1,936      |       |         |       |   |   |
| Short-term  investments                                                         |       | 27,520                  |       | 18,575                 |       |       |       |         |       |
| Long-term  investments                                                          |       | —                  |       | 9,497                  |       |       |       |         |       |
| Total cash, cash  equivalents, short-term investments and long-term investments |       | $                       | 30,824     |                   | $          | 30,008     |       | $            | 816        |   | 2.7 | % |
|                                                                                 |            |                         |            |                        |            |            |            |              |            |  |  |  |

 

During the first nine months of 2005, our cash and cash equivalents,short-term investments and long-term investments increased $816,000, primarilydue to positive cash flow from operations of $750,500 and cash totaling$438,600 which became unrestricted from our facility deposit, offset in part bycapital expenditures of $314,000.

 

In managing our working capital, two of the financial measurements wemonitor are days’ sales outstanding, or DSO, and inventory turnover rate, whichare presented in the table below for the year ended December 31, 2004 and thethree months ended September 30, 2005 and September 30, 2004:

 
| ** **                               | ** ** | **Year Ended  December 31,** | ** ** | **Three Months Ended****September 30,** | ** ** |
|------------------------------------------|------------|-----------------------------------|------------|-----------------------------------------|------------|
| ** **                               | ** ** | **2004**                          | ** ** | **2005**                                | ** ** | **2004** | ** ** |
|                                     |       |                              |       |                                    |       |   |   |
| Days’ sales outstanding (days)      |       | 50                                |       | 39                                      |       | 53 |   |
| Inventory turnover rate (times per year) |       | 4.1                               |       | 4.5                                     |       | 4.3 |   |

 

Our payment terms extended to our customers generally require paymentwithin 30 days from invoice date. At September 30, 2005, our DSO was at 39 days,a decrease of 11 days as compared to December 31, 2004. This decrease in DSOresulted from increasing revenues and a decrease in the percentage of accountsreceivable balances more than 60 days past due. This decrease in the percentageof accounts receivable balances more than 60 days past due was primarily due tomore aggressive management of collections and the significant revenue growth inthe three months ended September 30, 2005 relative to the more modest increasein our accounts receivable balances during the three months ended September 30,2005. We continue to focus our efforts on reducing our accounts receivablebalances over 60 days past due.  Accounts payable are normally paid within30 to 40 days from receipt of a vendor’s invoice.

 

Our inventory turnover for the threemonths ended September 30, 2005 was 4.5 times, compared with 4.1 times for theyear ended December 31, 2004. The increase in the inventory turnover rate forthe three months September 30, 2005 as compared to the year ended December 31,2004 was primarily due to the effective management of inventory levels ofbiosensors.  We are monitoring our inventories closely, especially as itpertains to the mix of different biosensors sold, and the sales volumes of newbiosensors launched in 2004.  We expectto increase our inventory levels through the balance of 2005 with a target ofmaintaining at least three months worth of inventory in our facility inWaltham, MA.  This may have the effect ofdecreasing our inventory turnover rate.

 

The following sets forth informationrelating to the sources and uses of our cash:

 
| ** **                                          | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                          | ** ** | **2005**                             | ** ** | **2004** | ** ** |
| ** **                                          | ** ** | **(in thousands)**                   | ** ** |
| Net cash provided by (used in) operating activities |       | $                                    | 750.5      |   | $ | (2,104.3 | ) |
| Net cash provided by (used in) investing activities |       | 318.2                                |       | (503.1 | ) |
| Net cash provided by financing activities           |       | 298.6                                |       | 31,627.5 |   |
|                                                     |            |                                      |            |  |  |  |  |

 

17

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Cash provided by operating activities was approximately $750,500 in thefirst nine months of 2005, compared with a usage of cash of $2.1 million in thefirst nine months of 2004. Increases in accrued expenses, deferred revenue (netof deferred costs) and accounts payable of $783,100, $406,900, and $368,800,respectively; non-cash items of $1.0 million; and net income of $132,800, inthe first nine months of 2005 were offset in part by increases in accountsreceivable and inventory of $1.2 million and $838,800, respectively.  The net loss in the first nine months of 2004 was $3.4 million, offset in partby non-cash expenses of $1.5 million.

 

Cash provided by investing activities was $318,200 in the first ninemonths of 2005, compared with cash used in investing activities of $503,100 inthe first nine months of 2004.  In the first nine months of 2005, therewere net maturities of investments in the amount of approximately $194,000,which was primarily reinvested in cash equivalents and short-term investments. In the first nine months of 2005 and 2004 cash was used for the purchase offixed assets in the amount of $314,400 and $503,100, respectively, primarilyrepresenting leasehold improvements and tooling equipment for new products in2005 and tooling and computer equipment in 2004.

 

Cash provided by financing activities was $289,600 and $31.6 million inthe first nine months of 2005 and 2004, respectively. The cash from financingactivities in the first nine months of 2004 primarily represented the netproceeds of $24.0 million realized from our initial public offering, includingthe proceeds from the over-allotment shares, and well as proceeds of $10.6million received from the issuance of preferred stock in a private placement,offset by payments on long-term debt of $3.0 million.  Cash provided byfinancing activities in the first nine months of 2005 represents the proceedsfrom the issuance of shares under our employee stock purchase plan and theexercise of stock options.

 

In connection with our property lease that we entered into with a termbeginning January 1, 2001, we are required to maintain, for the benefit of thelessor, an irrevocable standby letter of credit stating the lessor as thebeneficiary.  The original amount of theletter of credit was $1,860,000.  Duringthe September 2005, in accordance with the terms of the lease agreement, theamount required under the letter of credit was reduced to $1,430,000.  The letter of credit is secured by acertificate of deposit in an amount equal to 102% of the letter of credit. Thelease expires in March 2009. The certificate of deposit is renewable in 30-dayincrements. This amount is classified as restricted cash in the balance sheet.  The restricted cash balance has been reduced by$438,600 to $1,458,600.

 

During the remainder of 2005, we will be continuing to expend funds inconnection with our efforts to expand our sales and marketing for the NC-statSystem, although more modestly than the expansion in the last several quarters,and continue our ongoing program of making enhancements and improvements to theNC-stat System, including the development of new and/or improved biosensors andthe development of a third generation monitor and docking station. Inconnection with the development efforts on a third generation monitor anddocking station, we expect to incur increased capital expenditures over thenext several quarters for tooling costs. We also plan to expend funds on thedesign of a drug delivery system, which is in its early stages of development,for the minimally invasive delivery of therapeutic agents to treat neuropathiesby both primary care and specialist physicians. We believe that the combinationof funds available from cash and cash equivalents and funds available from ourshort-term investments will be adequate to finance our ongoing operations forat least twenty four months, including the expenditures described above.

 

To date, inflation has not had a material impact on our financialoperations.

 

*Off-Balance Sheet Arrangements*

 

As of September 30, 2005, we did not have any off-balance sheetfinancing arrangements.

 

Recent Accounting Pronouncements

 

In March 2005, the Financial Accounting Standards Board (“FASB”) issuedFASB Interpretation No. 47, *Accounting forConditional Asset Retirement Obligations*, which is an interpretationof Statement of Financial Accounting Standards (“SFAS”) No. 143, *Accounting for Asset Retirement Obligations*.The interpretation requires a liability for the fair value of a conditionalasset retirement obligation be recognized if the fair value of the liabilitycan be reasonably estimated. The interpretation is effective in 2005. Theinterpretation did not have a material impact on our results of operations orfinancial position.

 

In December 2004, the FASB issued SFAS No. 123(R), *Share-Based Payment* (SFAS 123(R)), whichis a revision of SFAS No. 123, *Accountingfor Stock-Based Compensation,*and supersedes Accounting PrinciplesBoard (“APB”) Opinion No. 25, *Accounting forStock Issued to Employees*and SFAS 148 *Accounting for Stock-Based Compensation — Transition and Disclosure*.  This statement requires that the costresulting from all share-based payment transactions be recognized in thefinancial statements. This statement establishes fair value as the measurementobjective in accounting for share-based payment arrangements and requires allentities to apply a fair value based measurement method in accounting forshare-based payment transactions with employees except for equity instrumentsheld by employee share ownership plans. As a result, beginning January 1, 2006,the Company will adopt SFAS 123(R) and begin reflecting the stock compensationexpense determined under fair value based methods in the income statementrather than as pro forma disclosure in the notes to the financial statements.The Company is currently reviewing the effect of this statement on itsfinancial statements and expects there to be a material impact on the Company’sresults of operations.

 

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In December 2004, the FASB issued SFAS No. 153, *Exchanges of Nonmonetary Assets*(SFAS153), an amendment of APB Opinion No. 29, *Accountingfor Nonmonetary Transactions.* SFAS 153 requires that exchanges of nonmonetary assets be measured basedon the fair value of the assets exchanged. Further, it expands the exception for nonmonetary exchanges of similarproductive assets to nonmonetary assets that do not have commercialsubstance.  The provisions of thisStatement are effective for nonmonetary asset exchanges beginning after June15, 2005.  The adoption of the provisionsof SFAS 153 did not have a material impact on the Company’s financial positionor results of operations

 

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**Important Factors That May AffectFuture Operating Results**

 

*You should carefully consider thefollowing risks and all other information contained in this quarterly report onForm 10-Q and our other public filings before making any investment decisionswith respect to our common stock.  If any of the following risks occurs,our business, prospects, reputation, results of operations or financialcondition could be harmed.  In that case, the trading price of our commonstock could decline, and you could lose all or part of your investment. This quarterly report also contains forward-looking statements that involve risksand uncertainties. Our actual results could differ materially from thoseanticipated in the forward-looking statements as a result of specific factors,including the risks described below and elsewhere in this quarterly report.*

 

**We have incurred significant operatinglosses since inception and cannot assure you that we will maintainprofitability.**

 

Since our inception in 1996, we have incurred losses every quarter withthe exception of the third quarter of 2005. We began commercial sales of ourproducts in May 1999 and we have yet to demonstrate that we can consistentlygenerate sufficient sales of our products to maintain profitability. The extentof our future operating income or losses is highly uncertain, and we may not beable to sustain profitability. We have incurred significant net losses sinceour inception, including net losses of approximately $8.7 million in 2001,$4.8 million in 2002, $3.7 million in 2003 and $4.3 million for in2004.  For the nine months endedSeptember 30, 2005 we recorded net income of $133,000.  At September 30,2005, we had an accumulated deficit of approximately $57.3 million.  We cannotassure you that we will be able to sustain the profitability achieved in thefirst nine months of 2005.

 

**If physicians or other healthcareproviders are unable to obtain sufficient reimbursement from third-partyhealthcare payers for procedures performed using the NC-stat System, theadoption of the NC-stat System and our future product sales will be severelyharmed.**

 

Widespread adoption of the NC-stat System by the medical community isunlikely to occur if physicians do not receive sufficient reimbursement fromthird-party payers for performing nerve conduction studies using the NC-statSystem or if certain changes are imposed on the professional requirements forperforming nerve conduction studies and we may be required to expendsubstantial resources to address potential reimbursement issues withthird-party payers. Ifphysicians are unable to obtain adequate reimbursement for procedures performedusing the NC-stat System, we may be unable to sell the NC-stat System and ourbusiness would suffer significantly. Additionally, even if these procedures arereimbursed by third-party payers, adverse changes in payers’ policies towardreimbursement for the procedures would harm our ability to market and sell theNC-stat System. Third-party payers include those governmental programs such asMedicare and Medicaid, workers’ compensation programs, private health insurersand other organizations. These third-party payers may deny coverage if theydetermine that a procedure was not reasonable or necessary, for example, if itsuse was not considered medically appropriate, or was experimental, or wasperformed for an unapproved indication. In addition, some health care systemsare moving towards managed care arrangements in which they contract to providecomprehensive healthcare for a fixed cost per person, irrespective of theamount of care actually provided. These providers, in an effort to controlhealthcare costs, are increasingly challenging the prices charged for medicalproducts and services and, in some instances, have pressured medical suppliersto lower their prices. If we are pressured to lower our prices, our revenuesmay decline and our profitability could be harmed. The Center for Medicare andMedicaid Services, or CMS, guidelines set the reimbursement rates forprocedures covered by Medicare. Future regulatory action by CMS or othergovernmental agencies or negative clinical results may diminish reimbursementpayments to physicians for performing procedures using the NC-stat System.Medicaid reimbursement differs from state to state, and some state Medicaidprograms may not reimburse physicians for performing procedures using theNC-stat System in an adequate amount, if at all. Additionally, some privatepayers do not follow the CMS and Medicaid guidelines and may reimburse for onlya portion of these procedures or not at all. We are unable to predict whatchanges will be made in the reimbursement methods used by private orgovernmental third-party payers. Additionally, we may be required to expendsubstantial resources to address potential reimbursement issues with thirdparty payers.

 

**We may be unable to expand the marketfor the NC-stat System, which would limit our ability to increase our revenues.**

 

We believe that the drawbacks of traditional nerve conduction studies,including those related to the referral process, and the limited treatmentoptions for diabetic peripheral neuropathy, or DPN, have limited the number ofnerve conduction studies that are performed. For our future growth, we arerelying, in part, on increased use of nerve conduction studies. A number offactors could limit the increased use of nerve conduction studies and theNC-stat System, including:

 

• third-party payers challenging, or the threat ofthird-party payers challenging, the necessity of increased levels of nerveconduction studies;

 

• third-party payers reducing or eliminatingreimbursement for procedures performed by physicians using the NC-stat System;

 

• unfavorable experiences by physicians using the NC-statSystem;

 

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• physicians’ reluctance to alter their existingpractices; and

 

• the failure of other companies’ existing drugdevelopment programs to produce an effective treatment for DPN, which may limitthe perceived need and the actual use of the NC-stat System in connection withthis disease, and thereby limit or delay our growth in the DPN market, which wehave estimated to be our largest potential market for our NC-stat System.

 

If we are unable to expand the market for the NC-stat System, ourability to increase our revenues will be limited and our business prospectswill be adversely affected.

 

**We may not be able to accuratelypredict the size of the market for our NC-stat System.**

 

We may not be able to accurately predict the size of the market forproducts used to diagnose neuropathies, such as our NC-stat System.Neuropathies traditionally have been diagnosed by an NCS/nEMG procedure,performed by a neurologist or physician in a related specialty. We estimatethat there are approximately two million traditional NCS/nEMG proceduresperformed each year in the United States; however, we anticipate that theadvantages and increased availability of the NC-stat System will significantlyincrease the number of nerve conduction studies performed. Based on ouranalysis of current data, we estimate that the potential market size for theNC-stat System in the diabetes, low back pain and carpal tunnel syndromemarkets in the aggregate could be as great as 9.5 million annual patient tests.This represents a more than four-fold increase in the size of the market fornerve conduction studies and is based upon a number of assumptions andestimates, which themselves may not be accurate. For example, we have assumedthat all initial office visits for low back pain may represent an opportunityfor use of the NC-stat System, and we have estimated that an annual testingrate of 33% for all individuals diagnosed with diabetes represents thepotential addressable market in diabetes. Market size is difficult to predict,and we cannot assure you that our assumptions or estimates will prove to becorrect. The industry and market data on which we have based our assumptionsand estimates of future market size, which is described in our annual report onForm 10-K for the year ended December 31, 2004, may be inaccurate orincomplete, and we have not independently verified those data. If our estimateof the size of the market for our NC-stat System is incorrect, our potentialrevenue growth may be limited.

 

**If we are unable to successfully sellthe NC-stat System to primary care physicians, our ability to increase ourrevenues will be limited.**

 

We are focusing our sales and marketing efforts for the NC-stat Systemon primary care physicians. As these physicians traditionally have not beentargeted by companies selling equipment used to perform nerve conductionstudies, we may face difficulties in selling our products to them.Particularly, we may be unable to convince these physicians that the NC-statSystem provides an effective alternative or useful supplement to existingtesting methods. In addition, these physicians may be reluctant to make thecapital investment to purchase the NC-stat System and alter their existingpractices. If we are unable to successfully sell the NC-stat System to primarycare physicians, our ability to increase our revenues will be severely limited.

 

**We are dependent on two single sourcemanufacturers to produce all of our current products, and any change in ourrelationship with either of these manufacturers could prevent us fromdelivering products to our customers in a timely manner and may adverselyimpact our future revenues or costs.**

 

We rely on two third-party manufacturers to manufacture all of ourcurrent products. In the event that either of our manufacturers ceases tomanufacture sufficient quantities of our products in a timely manner and onterms acceptable to us, we would be forced to locate an alternate manufacturer.Additionally, if either of our manufacturers experiences a failure in itsproduction process, is unable to obtain sufficient quantities of the componentsnecessary to manufacture our products or otherwise fails to meet our qualityrequirements, we may be forced to delay the manufacture and sale of ourproducts or locate an alternative manufacturer. We may be unable to locatesuitable alternative manufacturers for our products, particularly our NC-stat biosensors,for which the manufacturing process is relatively specialized, on termsacceptable to us, or at all. Currently, we rely on a single manufacturer, ParlexPolymer Flexible Circuits, Inc., or PPFC, a wholly owned subsidiary of ParlexCorporation, for the manufacture of the NC-stat biosensors, and a singlemanufacturer, Advanced Electronics, Inc., or AEI, for the manufacture of ourNC-stat monitors and docking stations. We order all of our products from PPFCon a purchase order basis. Because we do not have a supply agreement in placewith PPFC, PPFC may cease manufacturing our products or increase the price itcharges us for our products at any time.  Johnson Electric, a Hong Kong basedmanufacturing company, announced in September 2005 their plans to acquireParlex Corporation, including PPFC, and that the acquisition is expected to becompleted in November 2005.  We cannotassure you that the acquisition will not have a material adverse impact on ourrelationship with PPFC or that Johnson Electric will remain committed to themanufacturing of our biosensors.  Themanufacturing of the NC-stat monitors and devices is being transitioned fromAEI to Sunburst EMS, Inc as a result of a decision by AEI to shut down itsoperations.  We expect this transition tobe completed in November 2005.  We cannotassure you that the transition will proceed smoothly or that Sunburst will beable to manufacture NC-stat monitors and docking stations with the same levelof quality and on the same delivery schedule as AEI.  We do occasionally experience transientinventory shortages, typically lasting less than one month, on new productsduring the initial production ramp-up phase. If any of the changes in ourrelationships with these manufacturers as described above occurs, our abilityto supply our customers will be severely limited until we are able to engage analternate manufacturer or, if applicable, resolve any quality issues with ourexisting manufacturer. This situation could

 

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prevent us from delivering products to our customers in a timelymanner, lead to decreased sales or increased costs, or harm our reputation withour customers.

 

**If our manufacturers are unable tosupply us with an adequate supply of products as we expand our markets, wecould lose customers, our growth could be limited and our business could beharmed.**

 

In order for us successfully to expand our business within the UnitedStates and internationally, our contract manufacturers must be able to provideus with the products that comprise the NC-stat System in substantialquantities, in compliance with regulatory requirements, in accordance withagreed upon specifications, at acceptable cost and on a timely basis. Ouranticipated growth may strain the ability of our manufacturers to deliver anincreasingly large supply of products and obtain materials and components insufficient quantities. Manufacturers often experience difficulties in scalingup production, including problems with production yields and quality controland assurance. If we are unable to obtain sufficient quantities of high qualityproducts to meet customer demand on a timely basis, we could lose customers,our growth may be limited and our business could be harmed.

 

**We currently rely entirely on salesof the products that comprise the NC-stat System to generate revenues, and anyfactors that negatively impact our sales of these products could significantlyreduce our ability to generate revenues.**

 

We introduced the NC-stat System tothe market in May 1999. We derive all of our revenues from sales of theproducts that comprise the NC-stat System, and we expect that sales of theseproducts will continue to constitute the substantial majority of our sales forthe foreseeable future. Accordingly, our ability to generate revenues isentirely reliant on our ability to market and sell the products that comprisethe NC-stat System, particularly the disposable biosensors, sales of whichaccounted for approximately 87.9% of our total revenues for the first ninemonths of 2005 and 87.6% and 85.8% of our total revenues in 2004 and 2003,respectively. Our sales of these products may be negatively impacted by manyfactors, including:

 

• changes in reimbursement rates or policies relating toour products by third-party payers;

 

• the failure of the market to accept our products;

 

• manufacturing problems;

 

• claims that our products infringe on patent rights orother intellectual property rights owned by other parties;

 

• adverse regulatory or legal actions relating to ourproducts;

 

• competitive pricing and related factors; and

 

• results of clinical studies relating to our products orour competitors’ products.

 

If any of these events occurs, our ability to generate revenues couldbe significantly reduced.

 

**The patent rights we rely upon toprotect the intellectual property underlying our products may not be adequate,which could enable third parties to use our technology and would harm ourability to compete in the market.**

 

Our success will depend in part on our ability to develop or acquirecommercially valuable patent rights and to protect these rights adequately. Ourpatent position is generally uncertain and involves complex legal and factualquestions. The risks and uncertainties that we face with respect to our patentsand other related rights include the following:

 

• the pending patent applications we have filed or towhich we have exclusive rights may not result in issued patents or may takelonger than we expect to result in issued patents;

 

• the claims of any patents that are issued may notprovide meaningful protection;

 

• we may not be able to develop additional proprietarytechnologies that are patentable;

 

• other parties may challenge patents, patent claims orpatent applications licensed or issued to us; and

 

• other companies may design around technologies we havepatented, licensed or developed.

 

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We also may not be able to protect our patent rights effectively insome foreign countries. For a variety of reasons, we may decide not to file forpatent protection. Our patent rights underlying our products may not beadequate, and our competitors or customers may design around our proprietarytechnologies or independently develop similar or alternative technologies orproducts that are equal or superior to our technology and products withoutinfringing on any of our patent rights. In addition, the patents licensed orissued to us may not provide a competitive advantage. If any of these events wereto occur, our ability to compete in the market would be harmed.

 

**Other rights and measures we havetaken to protect our intellectual property may not be adequate, which wouldharm our ability to compete in the market.**

 

In addition to patents, we rely on a combination of trade secrets,copyright and trademark laws, confidentiality, nondisclosure and assignment ofinvention agreements and other contractual provisions and technical measures toprotect our intellectual property rights. In particular, we have sought nopatent protection for the technology and algorithms we use in our onCallInformation System, and we rely on trade secrets to protect this information.While we currently require employees, consultants and other third parties toenter into confidentiality, non-disclosure or assignment of inventionagreements or a combination thereof where appropriate, any of the followingcould still occur:

 

• the agreements may be breached;

 

• we may have inadequate remedies for any breach;

 

• trade secrets and other proprietary information couldbe disclosed to our competitors; or

 

• others may independently develop substantiallyequivalent proprietary information and techniques or otherwise gain access toour trade secrets or disclose such technologies.

 

If, for any of the above reasons, our intellectual property isdisclosed or misappropriated, it would harm our ability to protect our rightsand our competitive position.

 

**We may need to initiate lawsuits toprotect or enforce our patents and other intellectual property rights, whichcould be expensive and, if we lose, could cause us to lose some of ourintellectual property rights, which would harm our ability to compete in themarket.**

 

We rely on patents to protect a portion of our intellectual propertyand our competitive position. Patent law relating to the scope of claims in thetechnology fields in which we operate is still evolving and, consequently,patent positions in the medical device industry are generally uncertain. Inorder to protect or enforce our patent rights, we may initiate patentlitigation against third parties, such as infringement suits or interferenceproceedings. Litigation may be necessary to:

 

• assert claims of infringement;

 

• enforce our patents;

 

• protect our trade secrets or know-how; or

 

• determine the enforceability, scope and validity of theproprietary rights of others.

 

Any lawsuits that we initiate could be expensive, take significant timeand divert management’s attention from other business concerns. Litigation alsoputs our patents at risk of being invalidated or interpreted narrowly and ourpatent applications at risk of not issuing. Additionally, we may provoke thirdparties to assert claims against us. We may not prevail in any lawsuits that weinitiate and the damages or other remedies awarded, if any, may not becommercially valuable. The occurrence of any of these events could harm ourbusiness, our ability to compete in the market or our reputation.

 

**Claims that our products infringe onthe proprietary rights of others could adversely affect our ability to sell ourproducts and increase our costs.**

 

Substantial litigation over intellectual property rights exists in themedical device industry. We expect that our products could be increasinglysubject to third-party infringement claims as the number of competitors growsand the functionality of products and technology in different industry segmentsoverlap. Third parties may currently have, or may eventually be issued, patentson which our products or technologies may infringe. Any of these third partiesmight make a claim of infringement against us. Any litigation regardless of itsimpact would likely result in the expenditure of significant financialresources and the diversion of management’s time and resources. In addition,litigation in which we are accused of infringement may cause negativepublicity, adversely impact prospective customers, cause product shipmentdelays or require us to develop non-infringing technology, make substantialpayments

 

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to third parties, or enter into royalty or license agreements, whichmay not be available on acceptable terms, or at all. If a successful claim ofinfringement were made against us and we could not develop non-infringing technologyor license the infringed or similar technology on a timely and cost-effectivebasis, our revenues may decrease substantially and we could be exposed tosignificant liability.

 

**We are subject to extensiveregulation by the U.S. Food and Drug Administration, which could restrict thesales and marketing of the NC-stat System and could cause us to incursignificant costs.**

 

We sell medical devices that are subject to extensive regulation in theUnited States by the Food and Drug Administration, or FDA, for manufacturing,labeling, sale, promotion, distribution and shipping. Before a new medicaldevice, or a new use of or claim for an existing product, can be marketed inthe United States, it must first receive either 510(k) clearance, grant of a denovo classification or pre-marketing approval from the FDA, unless an exemptionapplies. We may be required to obtain a new 510(k) clearance or de novoclassification or pre-market approval for significant post-market modificationsto our products. Each of these processes can be expensive and lengthy. The FDA’sprocess for obtaining 510(k) clearance usually takes from three to twelvemonths, but it can last longer. The process for obtaining de novoclassification involves a level of scrutiny similar to the 510(k) clearanceprocess. The process for obtaining pre-market approval is much more costly anduncertain and it generally takes from one to three years, or longer, from thetime the application is filed with the FDA.

 

Medical devices may be marketed only for the indications for which theyare approved or cleared. We have obtained 510(k) clearance for the currentclinical applications for which we market our products. However, our clearancescan be revoked if safety or effectiveness problems develop. Further, we may notbe able to obtain additional 510(k) clearances or premarket approvals for newproducts or for modifications to, or additional indications for, our existingproducts in a timely fashion, or at all. Delays in obtaining future clearanceswould adversely affect our ability to introduce new or enhanced products in atimely manner, which in turn would harm our revenue and future profitability.We have made modifications to our devices in the past and may make additionalmodifications in the future that we believe do not or will not requireadditional clearances or approvals. If the FDA disagrees, and requires newclearances or approvals for the modifications, we may be required to recall andto stop marketing the modified devices. We also are subject to numerouspost-marketing regulatory requirements, including quality system regulations,which relate to the manufacturing of our products, labeling regulations andmedical device reporting regulations. Our failure or either contractmanufacturer’s failure to comply with applicable regulatory requirements couldresult in enforcement action by the FDA, which may include any of the followingsanctions:

 

• warning letters, fines, injunctions, consent decreesand civil penalties;

 

• requiring repair, replacement, refunds, recall orseizure of our products;

 

• imposing operating restrictions, suspension or shutdownof production;

 

• refusing our requests for 510(k) clearance orpre-market approval of new products, new intended uses, or modifications toexisting products;

 

• withdrawing 510(k) clearance or pre-market approvalsthat have already been granted; and

 

• criminal prosecution.

 

If any of these events were to occur, they could harm our reputation,our ability to generate revenues and our profitability.

 

**If we or our contract manufacturersfail to comply with the FDA’s quality system regulations, the manufacturing anddistribution of our products could be interrupted, and our product sales andoperating results could suffer.**

 

We and our contract manufacturers are required to comply with the FDA’squality system regulations, which is a complex regulatory scheme that coversthe procedures and documentation of the design, testing, production, control,quality assurance, labeling, packaging, sterilization, storage and shipping ofour devices. The FDA enforces its quality system regulations through periodicunannounced inspections. We cannot assure you that our facilities or ourcontract manufacturers’ facilities would pass any future quality systeminspection. If our or any of our contract manufacturers’ facilities fails aquality system inspection, the manufacturing or distribution of our productscould be interrupted and our operations disrupted. Failure to take adequate andtimely corrective action in response to an adverse quality system inspectioncould force a suspension or shutdown of our packaging and labeling operations,the manufacturing operations of our contract manufacturers or a recall of ourproducts. If any of these events occurs, we may not be able to provide ourcustomers with the quantity of products they require on a timely basis, ourreputation could be harmed, and we could lose customers and suffer reducedrevenues and increased costs.

 

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**Our products are subject to recallseven after receiving FDA clearance or approval, which would harm ourreputation, business and financial results.**

 

We are subject to the medical device reporting regulations, whichrequire us to report to the FDA if our products cause or contribute to a deathor serious injury, or malfunction in a way that would likely cause orcontribute to a death or serious injury. The FDA and similar governmentalbodies in other countries have the authority to require the recall of ourproducts if we or our contract manufacturers fail to comply with relevantregulations pertaining to manufacturing practices, labeling, advertising orpromotional activities, or if new information is obtained concerning the safety or efficacy of ourproducts. A government-mandated or voluntary recall by us could occur as aresult of manufacturing defects, labeling deficiencies, packaging defects orother failures to comply with applicable regulations. Any recall would divertmanagement attention and financial resources and harm our reputation withcustomers. A recall involving the NC-stat System would be particularly harmfulto our business and financial results because the products that comprise theNC-stat System are currently our only products.

 

**We are subject to federal and statelaws prohibiting “kickbacks” and false or fraudulent claims, which, ifviolated, could subject us to substantial penalties. Additionally, anychallenge to or investigation into our practices under these laws could causeadverse publicity and be costly to respond to, and thus could harm ourbusiness.**

 

A federal law commonly known as the Medicare/Medicaid anti-kickbacklaw, and several similar state laws, prohibit payments that are intended toinduce physicians or others either to refer patients or to acquire or arrangefor or recommend the acquisition of healthcare products or services. These lawsconstrain our sales, marketing and other promotional activities by limiting thekinds of financial arrangements, including sales programs, we may have withhospitals, physicians or other potential purchasers of medical devices. Otherfederal and state laws generally prohibit individuals or entities fromknowingly presenting, or causing to be presented, claims for payment fromMedicare, Medicaid or other third-party payers that are false or fraudulent, orfor items or services that were not provided as claimed. Because we may providesome coding and billing information to purchasers of our products, and becausewe cannot assure that the government will regard any billing errors that may bemade as inadvertent, these laws are potentially applicable to us. Anti-kickbackand false claims laws prescribe civil and criminal penalties for noncompliance,which can be substantial. Even an unsuccessful challenge or investigation intoour practices could cause adverse publicity, and be costly to respond to, andthus could harm our business and results of operations.

 

**If we are found to have violated lawsprotecting the confidentiality of patient health information, we could besubject to civil or criminal penalties, which could increase our liabilitiesand harm our reputation or our business.**

 

There are a number of federal and state laws protecting theconfidentiality of certain patient health information, including patientrecords, and restricting the use and disclosure of that protected information.In particular, the U.S. Department of Health and Human Services promulgatedpatient privacy rules under the Health Insurance Portability and AccountabilityAct of 1996, or HIPAA. These privacy rules protect medical records and otherpersonal health information by limiting their use and disclosure, givingindividuals the right to access, amend and seek accounting of their own healthinformation and limiting most use and disclosures of health information to theminimum amount reasonably necessary to accomplish the intended purpose.Although we do not believe that we are subject to the HIPAA rules because wereceive patient data in our onCall Information System on an anonymous basis,the exact scope of these rules has not been clearly established. If we arefound to be in violation of the privacy rules under HIPAA, we could be subjectto civil or criminal penalties, which could increase our liabilities and harmour reputation or our business.

 

**The use of the NC-stat System couldresult in product liability claims that could be expensive, damage ourreputation and harm our business.**

 

Our business exposes us to an inherent risk of potential productliability claims related to the manufacturing, marketing and sale of medicaldevices. The medical device industry historically has been litigious, and weface financial exposure to product liability claims if the use of our productswere to cause or contribute to injury or death. In particular, the NC-statSystem may be susceptible to claims of injury because it involves the electricstimulation of a patient’s nerves. Although we maintain product liabilityinsurance for our products, the coverage limits of these policies may not beadequate to cover future claims. As sales of our products increase, we may beunable to maintain sufficient product liability insurance on acceptable termsor at reasonable costs, and this insurance may not provide us with adequatecoverage against potential liabilities. A successful claim brought against usin excess of, or outside of, our insurance coverage could have a materialadverse effect on our financial condition and results of operations. A productliability claim, regardless of its merit or eventual outcome, could result insubstantial costs to us, a substantial diversion of management attention andadverse publicity. A product liability claim could also harm our reputation andresult in a decline in revenues and an increase in expenses.

 

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**Our products are complex in design,and defects may not be discovered prior to shipment to customers, which couldresult in warranty obligations or product liability claims, reducing ourrevenues and increasing our costs and liabilities.**

 

We depend upon third parties for the manufacture of our products. Ourproducts, particularly our NC-stat biosensors, require a significant degree oftechnical expertise to produce. If our manufacturers fail to produce ourproducts to specification, or if the manufacturers use defective materials orworkmanship in the manufacturing process, the reliability and performance ofour products will be compromised.

 

If our products contain defects that cannot be repaired quickly, easilyand inexpensively, we may experience:

 

• loss of customer orders and delay in order fulfillment;

 

• damage to our brand reputation;

 

• increased cost of our warranty program due to productrepair or replacement;

 

• inability to attract new customers;

 

• diversion of resources from our manufacturing andresearch and development departments into our service department; and

 

• legal action.

 

The occurrence of any one or more of the foregoing could harm ourreputation and materially reduce our revenues and increase our costs andliabilities.

 

**If we lose any of our officers or keyemployees, our management and technical expertise could be weakenedsignificantly.**

 

Our success largely depends on the skills, experience and efforts ofour officers, including Shai N. Gozani, M.D., Ph.D., our founder and Presidentand Chief Executive Officer; Gary L. Gregory, our Chief Operating Officer; GuyDaniello, our Senior Vice President of Information Technology; MichaelWilliams, Ph.D., our Senior Vice President of Engineering; W. Bradford Smith,Chief Financial Officer; and our other key employees. We maintain a $5.0million key person life insurance policy on Dr. Gozani, for which the Companyis the beneficiary, but do not maintain key person life insurance policiescovering any of our other employees. The loss of any of our officers or keyemployees could weaken our management and technical expertise significantly andharm our business.

 

**If we are unable to recruit, hire andretain skilled and experienced personnel, our ability to manage and expand ourbusiness will be harmed, which would impair our future revenues andprofitability.**

 

We are a small company with only 89 employees as of September 30, 2005,and our ability to retain our skilled labor force and our success in attractingand hiring new skilled employees will be a critical factor in determining ourfuture performance. We may not be able to meet our future hiring needs orretain existing personnel. We will face challenges and risks in hiring,training, managing and retaining engineering and sales and marketing employees,as well as independent regional sales agencies and sales representatives, mostof whom are geographically dispersed and must be trained in the use andbenefits of our products. Failure to attract and retain personnel, particularlytechnical and sales and marketing personnel, would materially harm our abilityto compete effectively and grow our business.

 

**If we do not effectively manage ourgrowth, our business resources may become strained, we may not be able todeliver the NC-stat System in a timely manner and our results of operations maybe adversely affected.**

 

We have recently significantly increased our sales force and our totalheadcount. This growth, as well as any other growth that we may experience in thefuture, will provide challenges to our organization and may strain ourmanagement and operations. We may misjudge the amount of time or resources thatwill be required to effectively manage any anticipated or unanticipated growthin our business or we may not be able to attract, hire and retain sufficientpersonnel to meet our needs. If we cannot scale our business appropriately,maintain control over expenses or otherwise adapt to anticipated andunanticipated growth, our business resources may become strained, we may not beable to deliver the NC-stat System in a timely manner and our results ofoperations may be adversely affected.

 

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**If we are unable to successfullyexpand, develop and retain our sales force and maintain our independent salesagent network, our revenues may decline, our future revenue growth may belimited and our expenses may increase.**

 

As of September 30, 2005, we employ 31 regional sales managers andutilize a network of over 450 independent sales agents. We are highly dependenton our regional sales managers and independent sales agents to generate ourrevenues. We have recently significantly increased our sales force and expectto add 10-15 additional regional sales managers with the hiring process plannedfor the first quarter of 2006. Our ability to build and develop a strong salesforce will be affected by a number of factors, including:

 

• our ability to attract, integrate and motivate salespersonnel;

 

• our ability to effectively train our sales force;

 

• the ability of our sales force to sell an increasednumber of products;

 

• the length of time it takes new sales personnel tobecome productive;

 

• the competition we face from other companies in hiringand retaining sales personnel;

 

• our ability to effectively manage a multi-locationsales organization;

 

• our ability to enter into agreements with prospectivemembers of our sales force on commercially reasonable terms; and

 

• our ability to get our independent sales agencies, whomay sell products of multiple companies, to commit the necessary resources toeffectively market and sell our products.

 

If we are unable to successfully build, develop and retain a strongsales force, our revenues may decline, our revenue growth may be limited andour expenses may increase.

 

**Failure to develop products otherthan the NC-stat System and enhance the NC-stat System could have an adverseeffect on our business prospects.**

 

All of our current revenues are derived from selling the NC-stat System.Our future business and financial success will depend, in part, on our abilityto continue to introduce new products and upgraded products into themarketplace. Developing new products and upgrades to existing and futureproducts imposes burdens on our research and development department and ourmanagement. This process is costly, and we cannot assure you that we will beable to successfully develop new products or enhance the NC-stat System or anyfuture products. In addition, as we develop the market for point-of-servicenerve conduction studies, future competitors may develop desirable productfeatures earlier than we do, which could make our competitors’ products lessexpensive or more effective than our products and could render our productsobsolete or unmarketable. If our product development efforts are unsuccessful,we will have incurred significant costs without recognizing the expectedbenefits and our business prospects may suffer.

 

**We currently compete, and may in thefuture need to compete, against other medical device companies with potentiallygreater resources, more established distribution channels and other competitiveadvantages, and the success of these competitors may harm our ability togenerate revenues.**

 

We currently do, and in the future may need to, compete directly andindirectly with a number of other companies that enjoy significant competitiveadvantages over us. Currently, in the point-of-service market, we indirectlycompete with companies that sell traditional NCS/nEMG equipment. In thismarket, these companies are indirect competitors because the equipment theysell traditionally has been used by neurologists, who rely upon and seek toobtain referrals from primary care physicians to perform the same types oftests that may be performed by primary care physicians using the NC-statSystem. Additionally, in selling the NC-stat System to neurologists, which isnot a market we historically have focused on, we compete directly with thecompanies that sell traditional NCS/nEMG equipment. There are a number ofcompanies that sell traditional NCS/nEMG equipment including Viasys HealthcareInc., Medtronic, Inc., and Cadwell Laboratories, Inc. Additionally, we areaware of one company, Neumed Inc., that markets a nerve conduction study systemto the point-of-service market. Of these companies, Viasys Healthcare andMedtronic, in particular, enjoy significant competitive advantages, including:

 

• greater resources for product development, sales andmarketing;

 

• more established distribution networks;

 

• greater name recognition;

 

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• more established relationships with health careprofessionals, customers and third-party payers; and

 

• additional lines of products and the ability to offerrebates or bundle products to offer discounts or incentives.

 

Other than Neumed, we do not know if these companies or others areengaged in research and development efforts to develop products to performpoint-of-service nerve conduction studies that would be directly competitivewith the NC-stat System. As we develop the market for point-of-service nerveconduction studies, we may be faced with competition from these companies orothers that decide and are able to enter this market. Some or all of our futurecompetitors in the point-of-service market may enjoy competitive advantagessuch as those described above. If we are unable to compete effectively againstexisting and future competitors, our sales will decline and our business willbe harmed.

 

**We are dependent upon the computerand communications infrastructure employed and utilized by our onCallInformation System, and any failures or disruptions in this infrastructurecould impact our revenues and profit margins or harm our reputation.**

 

We are dependent upon the computer and communications infrastructureemployed and utilized by our onCall Information System. Our computer andcommunications infrastructure consists of standard hardware, off-the-shelfsystem software components, database servers, proprietary application servers,a modem bank and desktop applications. Our future success in selling theNC-stat System will depend, in part, upon the maintenance and growth of thisinfrastructure. Any failures or outages of this infrastructure as a result of acomputer virus, intentional disruption of our systems by a third party,manufacturing failure, telephone system failure, fire, storm, flood, power lossor other similar events, could prevent or delay the operation of our onCallInformation System, which could result in increased costs to eliminate theseproblems and address related security concerns and harm our reputation with ourcustomers. In addition, if our infrastructure fails to accommodate growth incustomer transactions, customer satisfaction could be impaired, we could losecustomers, our ability to add customers could be impaired or our costs could beincreased, any of which would harm our business.

 

**If future clinical studies or otherarticles are published, or physician associations or other organizationsannounce positions, that are unfavorable to the NC-stat System, our salesefforts and revenues may be negatively affected.**

 

Future clinical studies or other articles regarding our existingproducts or any competing products may be published that either support aclaim, or are perceived to support a claim, that a competitor’s product is moreaccurate or effective than our products or that our products are not asaccurate or effective as we claim or previous clinical studies have concluded.Additionally, physician associations or other organizations that may be viewedas authoritative or have an economic interest in nerve conduction studies andin related electrodiagnostic procedures could endorse products or methods thatcompete with the NC-stat System or otherwise announce positions that areunfavorable to the NC-stat System. Any of these events may negatively affectour sales efforts and result in decreased revenues.

 

**Our future capital needs areuncertain and we may need to raise additional funds in the future, and thesefunds may not be available on acceptable terms or at all.**

 

We believe that our current cash and cash equivalents together with ourshort-term and long-term investments and the cash to be generated from expectedproduct sales will be sufficient to meet our projected operating requirementsfor at least the next 12 months. However, we may seek additional funds frompublic and private stock offerings, borrowings under credit lines or othersources. Our capital requirements will depend on many factors, including:

 

• the revenues generated by sales of the NC-stat Systemand any other products that we develop;

 

• the costs associated with expanding our sales andmarketing efforts;

 

• the expenses we incur in manufacturing and selling ourproducts;

 

• the costs of developing new products or technologiesand enhancements to existing products;

 

• the cost of obtaining and maintaining FDA approval orclearance of our products and products in development;

 

• costs associated with any expansion;

 

• the costs associated with capital expenditures; and

 

• the number and timing of any acquisitions or otherstrategic transactions.

 

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As a result of these factors, we may need to raise additional funds,and these funds may not be available on favorable terms, or at all.Furthermore, if we issue equity or debt securities to raise additional funds,our existing stockholders may experience dilution, and the new equity or debtsecurities may have rights, preferences and privileges senior to those of ourexisting stockholders. In addition, if we raise additional funds throughcollaboration, licensing or other similar arrangements, it may be necessary torelinquish valuable rights to our potential products or proprietarytechnologies, or grant licenses on terms that are not favorable to us. If wecannot raise funds on acceptable terms, we may not be able to develop orenhance our products, execute our business plan, take advantage of futureopportunities, or respond to competitive pressures or unanticipated customerrequirements. If any of these events occurs, our ability to achieve ourdevelopment and commercialization goals would be adversely affected.

 

**If we choose to acquire or invest innew businesses, products or technologies, instead of developing them ourselves,these acquisitions or investments could disrupt our business and could resultin the use of significant amounts of equity, cash or a combination of both.**

 

From time to time we may seek to acquire or invest in businesses,products or technologies, instead of developing them ourselves. Acquisitionsand investments involve numerous risks, including:

 

• the inability to complete the acquisition orinvestment;

 

• disruption of our ongoing businesses and diversion ofmanagement attention;

 

• difficulties in integrating the acquired entities,products or technologies;

 

• difficulties in operating the acquired businessprofitably;

 

• the inability to achieve anticipated synergies, costsavings or growth;

 

• potential loss of key employees, particularly those ofthe acquired business;

 

• difficulties in transitioning and maintaining keycustomer, distributor and supplier relationships;

 

• risks associated with entering markets in which we haveno or limited prior experience; and

 

• unanticipated costs.

 

In addition, any future acquisitions or investments may result in oneor more of the following:

 

• issuances of dilutive equity securities, which may besold at a discount to market price;

 

• the use of significant amounts of cash;

 

• the incurrence of debt;

 

• the assumption of significant liabilities;

 

• increased operating costs or reduced earnings;

 

• financing obtained on unfavorable terms;

 

• large one-time expenses; and

 

• the creation of certain intangible assets, includinggoodwill, the write-down of which may result in significant charges toearnings.

 

Any of these factors could materially harm our stock price, ourbusiness or our operating results.

 

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**If we expand, or attempt to expand,into foreign markets, we will be affected by new business risks that mayadversely impact our financial condition or results of operations.**

 

If we expand, or attempt to expand, into foreign markets, we will besubject to new business risks, including:

 

• failure to fulfill foreign regulatory requirements tomarket the NC-stat System or other future products;

 

• availability of, and changes in, reimbursement withinprevailing foreign health care payment systems;

 

• adapting to the differing business practices and lawsin foreign countries;

 

• difficulties in managing foreign relationships andoperations, including any relationships that we establish with foreigndistributors or sales or marketing agents;

 

• limited protection for intellectual property rights insome countries;

 

• difficulty in collecting accounts receivable and longercollection periods;

 

• costs of enforcing contractual obligations in foreignjurisdictions;

 

• recessions in economies outside of the United States;

 

• political instability and unexpected changes indiplomatic and trade relationships;

 

• currency exchange rate fluctuations; and

 

• potentially adverse tax consequences.

 

If we are successful in introducing our products into foreign markets,we will be affected by these additional business risks, which may adverselyimpact our financial condition or results of operations. In addition, expansioninto foreign markets imposes additional burdens on our executive andadministrative personnel, research and sales departments, and generalmanagerial resources. Our efforts to introduce our products into foreignmarkets may not be successful, in which case we may have expended significantresources without realizing the expected benefit. Ultimately, the investmentrequired for expansion into foreign markets could exceed the revenues generatedfrom this expansion.

 

**Our operating results may fluctuatedue to various factors and, as a result, period-to-period comparisons of ourresults of operations will not necessarily be meaningful.**

 

Factors relating to our business make our future operating resultsuncertain and may cause them to fluctuate from period to period. These factorsinclude:

 

• changes in the availability of third-partyreimbursement in the United States or other countries;

 

• the timing of new product announcements andintroductions by us or our competitors;

 

• market acceptance of new or enhanced versions of ourproducts;

 

• changes in manufacturing costs or other expenses;

 

• competitive pricing pressures;

 

• the gain or loss of significant distribution outlets orcustomers;

 

• increased research and development expenses;

 

• the timing of any future acquisitions; or

 

• general economic conditions.

 

Because our operating results may fluctuate from quarter to quarter, itmay be difficult for us or our investors to predict our future performance byviewing our historical operating results.

 

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**Our principal stockholders havesignificant voting power and may take actions that may not be in the bestinterests of our other stockholders.**

 

Based on most recent information, our officers, directors and principalstockholders together controlled a significant portion of our outstandingcommon stock.  If some or all of these stockholders act together, they maybe able to exercise significant control over our management and affairs inmatters requiring stockholder approval, including the election of directors andapproval of significant corporate transactions.  This concentration ofownership may have the effect of delaying or preventing a change in control andmight adversely affect the market price of our common stock.  In addition,this significant concentration of share ownership may adversely affect the tradingprice of our common stock because investors often perceive disadvantages toowning stock in companies with controlling stockholders.

 

**The sale or expected sale of asubstantial number of shares of our common stock may cause the price of ourcommon stock to decline.**

 

Sales or the expectation of sales of a substantial number of shares ofour common stock in the public market could harm the market price of our commonstock.  As additional shares of our common stock become available forresale in the public market, the supply of our common stock will increase,which could decrease the price.  Moreover, the holders of shares of ourcommon stock, comprised of shares issued upon conversion of our preferred stockhave rights, subject to various conditions and limitations, to require us tofile registration statements covering their shares or to include their sharesin registration statements that we may file for ourselves or otherstockholders.  Immediately following our initial public offering, thesestockholders held 7,488,758 shares of our common stock that had theseregistration rights.  Also, shares ofcommon stock that we may issue under our existing Amended and Restated 1998Equity Incentive Plan, our 2004 Stock Option and Incentive Plan and 2004Employee Stock Purchase Plan may be freely sold.  If any of these holderscause a large number of securities to be sold in the public market, the salescould reduce the trading price of our common stock.  These sales alsocould impede our ability to raise future capital.

 

**We will incur increased expenses as aresult of recently enacted laws and regulations affecting public companies.**

 

Recently enacted laws and regulations affecting public companies,including the provisions of the Sarbanes-Oxley Act of 2002 and rules adopted bythe Securities and Exchange Commission and by the National Association ofSecurities Dealers, Inc., will result in increased expenses to us.  Thenew rules could make it more difficult or more costly for us to obtain sometypes of insurance, including directors’ and officers’ liability insurance, andwe may be forced to accept reduced policy limits and coverage or incursubstantially higher costs to obtain the same or similar coverage.  Theimpact of these events also could make it more difficult for us to attract andretain qualified persons to serve on our board of directors, on our boardcommittees or as executive officers.  We will incur increased expenses inorder to comply with these new rules, and we may not be able to accuratelypredict the timing or amount of these expenses.

 

**Anti-takeover provisions in ourorganizational documents and Delaware law may discourage or prevent a change ofcontrol, even if an acquisition would be beneficial to our stockholders, whichcould affect our stock price adversely and prevent attempts by our stockholdersto replace or remove our current management.**

 

Our certificate of incorporation and bylaws contain provisions thatcould delay or prevent a change of control of our company or changes in ourboard of directors that our stockholders might consider favorable.  Someof these provisions:

 

•                                          authorizethe issuance of preferred stock which can be created and issued by the board ofdirectors without prior stockholder approval, with rights senior to those ofour common stock;

 

•                                          providefor a classified board of directors, with each director serving a staggeredthree-year term;

 

•                                          prohibitour stockholders from filling board vacancies, calling special stockholdermeetings, or taking action by written consent;

 

•                                          providefor the removal of a director only with cause and by the affirmative vote ofthe holders of 75% or more of the shares then entitled to vote at an electionof our directors; and

 

•                                          requireadvance written notice of stockholder proposals and director nominations.

 

In addition, we are subject to the provisions of Section 203 of theDelaware General Corporation Law, which may prohibit certain businesscombinations with stockholders owning 15% or more of our outstanding votingstock.  These and other provisions in our certificate of incorporation,bylaws and Delaware law could make it more difficult for stockholders orpotential acquirers to obtain control of our board of directors or initiateactions that are opposed by our then-current board of directors, including amerger, tender offer, or proxy contest involving our company.  Any delayor prevention of a change of control transaction or changes in our board ofdirectors could cause the market price of our common stock to decline.

 

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**We do not intend to pay cashdividends.**

 

We have never declared or paid cash dividends on our capitalstock.  We currently intend to retain all available funds and any futureearnings for use in the operation and expansion of our business and do notanticipate paying any cash dividends in the foreseeable future.  Inaddition, the terms of any future debt or credit facility may preclude us frompaying any dividends. As a result, capital appreciation, if any, of our commonstock will be our stockholders sole source of potential gain for theforeseeable future.

 

**CAUTIONARYNOTE REGARDING FORWARD-LOOKING STATEMENTS**

 

The statements contained in this quarterly report on Form 10-Q,including under the section titled “Management’s Discussion and Analysisof Financial Condition and Results of Operations” and other sections of thisquarterly report, include forward-looking statements within the meaning ofSection 27A of the Securities Act of 1933, as amended, andSection 21E of the Securities Exchange Act of 1934, as amended, including,without limitation, statements regarding our or our management’s expectations,hopes, beliefs, intentions or strategies regarding the future.  The words “believe,”“may,” “will,” “estimate,” “continue,” “anticipate,” “intend,” “expect,” “plan”and similar expressions may identify forward-looking statements, but theabsence of these words does not mean that a statement is notforward-looking.  The forward-looking statements contained in thisquarterly report are based on our current expectations and beliefs concerningfuture developments and their potential effects on us.  There can be noassurance that future developments affecting us will be those that we haveanticipated.  These forward-looking statements involve a number of risks,uncertainties (some of which are beyond our control) or other assumptions thatmay cause actual results or performance to be materially different from thoseexpressed or implied by these forward-looking statements.  These risks anduncertainties include, but are not limited to, those factors described in thesection titled “Management’s Discussion and Analysis of FinancialCondition and Results of Operations-Important Factors that May Affect FutureOperating Results.”  Should one or more of these risks or uncertaintiesmaterialize, or should any of our assumptions prove incorrect, actual resultsmay vary in material respects from those projected in these forward-lookingstatements.  We undertake no obligation to update or revise any forward-lookingstatements, whether as a result of new information, future events or otherwise,except as may be required under applicable securities laws.

 

**Item3.     Quantitative and Qualitative Disclosures AboutMarket Risk**

 

We do not use derivative financial instruments in our investmentportfolio and have no foreign exchange contracts.  Our financialinstruments consist of cash, cash equivalents, short-term investments, accountsreceivable, accounts payable, accrued expenses and long-term obligations. We consider investments that, when purchased, have a remaining maturity of90 days or less to be cash equivalents.  The primary objectives ofour investment strategy are to preserve principal, maintain proper liquidity tomeet operating needs, and maximize yields. To minimize our exposure to anadverse shift in interest rates, we invest mainly in cash equivalents andshort-term investments and long-term investments with a maturity of eighteenmonths or less and maintain an average maturity of twelve months or less. We do not believe that a 10% change in interest rates would have a materialimpact on the fair value of our investment portfolio or our interest income.

 

**Item4.     Controls and Procedures**

 

(a)                                                          Evaluationof disclosure controls and procedures.

 

Our management carried out an evaluation, with the participation of ourChief Executive Officer and our Chief Financial Officer, of the effectivenessof our disclosure controls and procedures (as defined in Rules 13a-15(e) or15d-15(e) under the Securities Exchange Act of 1934, as amended (the “ExchangeAct”)) as of September 30, 2005.  Based upon that evaluation, our ChiefExecutive Officer and our Chief Financial Officer concluded that our disclosurecontrols and procedures are effective to ensure that information required to bedisclosed by us in reports that we file or submit under the Exchange Act, isrecorded, processed, summarized and reported, within the time periods specifiedin the Securities and Exchange Commission’s rules and forms.  In designingand evaluating our disclosure controls and procedures, we and our managementrecognize that any controls and procedures, no matter how well designed andoperated, can provide only reasonable assurance of achieving the desiredcontrol objectives, and our management necessarily was required to apply itsjudgment in evaluating and implementing possible controls and procedures. We continue to review and document our disclosure controls and procedures,including our internal controls and controls over financial reporting, and mayfrom time to time make changes aimed at enhancing their effectiveness and toensure that our systems evolve with our business.

 

(b)                                                         Changesin internal control over financial reporting.

 

There was no change in our internal control over financial reportingidentified in connection with our evaluation of our disclosure controls andprocedures that occurred during the period covered by this quarterly report onForm 10-Q that has materially affected, or is reasonably likely tomaterially affect, our internal control over financial reporting.

 

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**Part IIOther Information**

 

**Item 1.    LegalProceedings**

 

None.

 

**Item2.    Unregistered Sales of Equity Securities and Use ofProceeds**

 

On July 21, 2004, the Securities and ExchangeCommission declared effective our registration statement on Form S-1 (File No.333-115440), relating to the initial public offering of our common stock. Weexpect to continue to use the net proceeds from the initial public offering forgeneral corporate purposes, including to expand our selling and marketing andservices organizations, develop new distribution channels, expand our researchand development efforts, improve our operational and financial systems and forother working capital purposes. We may also use a portion of the net proceedsto acquire or invest in complementary businesses, products or technologies. Wehave no specific understandings, commitments or agreements with respect to anysuch acquisition or investment. Except as set forth below, we have notallocated any portion of the net proceeds for any specific purpose. Theaggregate price of the offering amount registered on our behalf was$27.6 million.  In connection with the offering, we paid approximately$1.9 million in underwriting discounts and commissions to the underwritersand incurred an estimated $1.7 million in other offering expenses. None of the underwriting discounts and commissions or offering expenses wereincurred or paid to directors or officers of ours or their associates or topersons owning 10 percent or more of our common stock or to any affiliatesof ours.  After deducting the underwriting discounts and commissions andoffering expenses, we received net proceeds from the offering of approximately$24.0 million.  From July 21, 2004, the effective date of theregistration statement, to September 30, 2005 we have used (i) $3.1 million ofthe net proceeds to repay in full the outstanding balance under our securedline of credit with Lighthouse Capital Partners, (ii) an estimated 3,604,200 ofthe net proceeds to fund cash spending of our research and developmentactivities, (iii) an estimated $4,979,300 of the net proceeds to fund theexpansion of our sales and marketing efforts and (iv) an estimated $356,200 forthe purchase of capital equipment.** **The remainder of the net proceeds have been invested in marketable, investmentgrade, interest-bearing securities pending their use. Our use of the proceedsfrom our initial public offering does not represent a material change from thedescription provided in our prospectus.

 

**Item3.    Defaults Upon Senior Securities**

 

None.

 

**Item4.    Submission of Matters to a Vote of Security Holders.**

 

None.

 

**Item 5.    OtherInformation**

 

None.

 

**Item6.    Exhibits**

 

See the Exhibit Index on the page immediately preceding the exhibitsfor a list of exhibits filed as part of this quarterly report, which ExhibitIndex is incorporated herein by this reference.

 

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**SIGNATURES**

 

Pursuant to the requirements of the Securities Exchange Act of 1934,the registrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 
| ** **             | ** ** | **NEUROMETRIX, INC.**                 |
|------------------------|------------|---------------------------------------|
| ** **             | ** ** | ** **                            |
| ** **             | ** ** | ** **                            |
| Date: November 9, 2005 | /s/        | Shai N. Gozani, M.D., Ph. D.          |   |
|                   |       | Shai N. Gozani, M.D., Ph. D.          |
|                   |       | Chief Executive Officer and President |
|                   |       |                                  |
|                   |       |                                  |
| Date: November 9, 2005 | /s/        | W. Bradford Smith                     |   |
|                   |       | W. Bradford Smith                     |
|                   |       | Chief Financial Officer               |

 

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Exhibit Index

 
| *31.1 |   | Certification of Principal Executive Officer  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                  |
|-------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------|
| *31.2 |   | Certification of Principal Financial Officer  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                  |
| *32   |   | Certification of Principal Executive Officer and  Principal Financial Officer pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002 |

 

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* Filed herewith

 

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