**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,DC 20549**

**FORM 10-QSB**
| **x** | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|-------|------------|--------------------------------------------------------------------------------------------------------|

 

**FOR THE QUARTERLY PERIOD ENDED OCTOBER 31, 2006**
| **o** | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|-------|------------|---------------------------------------------------------------------------------------------------------|

 

**Commission File Number 000-33295**

**MedicalCV, Inc.**

(Exact Name of Small Business Issuer as Specified inIts Charter)

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

 

**9725South Robert Trail**

**InverGrove Heights, Minnesota 55077**

**(651)452-3000**

(Address ofPrincipal Executive Offices and Issuer’s

Telephone Number, including Area Code)

Checkwhether the issuer:  (1) filed all reports required to be filed bySection 13 or 15(d) of the Exchange Act during the past 12 months (orsuch shorter period that the registrant was required to file such reports), and(2) has been subject to such filing requirements for the past 90 days.

Yes  x No  o

Indicateby check mark whether the registrant is a shell company (as defined inRule 12b-2 of the Exchange Act).

Yes  o No  x

As ofDecember 4, 2006, the issuer had outstanding 9,837,224 shares of common stock,$0.01 par value.

TransitionalSmall Business Disclosure Format (check one)   oYes   x No

 

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**TABLE OF CONTENTS**
| PART I       | FINANCIAL  INFORMATION |                                                            |
|-------------------|------------------------|-----------------------------------------------------------------|
|              |                   |                                                            |   |
|              | ITEM 1                 | Condensed  Financial Statements                                 |   |
|              | ITEM 2                 | Management’s  Discussion and Analysis or Plan of Operation |   |
|              | ITEM 3                 | Controls and  Procedures                                        |   |
|              |                   |                                                            |   |
| PART II      | OTHER  INFORMATION     |                                                            |
|              |                   |                                                            |   |
|              | ITEM  1                | Legal  Proceedings                                              |   |
|              | ITEM 4                 | Submission of  Matters to a Vote of Security Holders            |   |
|              | ITEM 6                 | Exhibits                                                        |   |
|              |                   |                                                            |   |
| SIGNATURES        |                   |                                                            |   |
| INDEX TO EXHIBITS |                   |                                                            |

 

2

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**PART I**

**FINANCIALINFORMATION**

**ITEM 1****                                CONDENSEDFINANCIAL STATEMENTS**

**MEDICALCV, INC.**

**CONDENSED BALANCE SHEETS**
| ** **                                                                                                                                                         | ** ** | **October 31,  2006** | ** ** | **April 30,  2006** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|--------------------------|------------|
| ** **                                                                                                                                                         | ** ** | **(unaudited)**            | ** ** | ** **               | ** ** |
| **ASSETS**                                                                                                                                                         |       |                       |       |                     |       |
| CURRENT ASSETS                                                                                                                                                     |       |                       |       |                     |       |
| Cash and cash  equivalents                                                                                                                                         |       | $                          | 6,565,206  |                     | $          | 10,351,570 |   |
| Prepaid expenses  and other assets                                                                                                                                 |       | 111,992                    |       | 242,975                  |       |
| Current assets  of discontinued operations                                                                                                                         |       | 89,782                     |       | 89,782                   |       |
| TOTAL CURRENT  ASSETS                                                                                                                                              |       | 6,766,980                  |       | 10,684,327               |       |
|                                                                                                                                                               |       |                       |       |                     |       |
| PROPERTY, PLANT AND  EQUIPMENT, net                                                                                                                                |       | 750,678                    |       | 740,010                  |       |
| DEFERRED FINANCING  COSTS, net                                                                                                                                     |       | 47,300                     |       | 50,942                   |       |
| OTHER LONG-TERM ASSETS                                                                                                                                             |       | 23,400                     |       | 23,400                   |       |
| NON-CURRENT ASSETS OF  DISCONTINUED OPERATIONS                                                                                                                     |       | 42,431                     |       | 87,323                   |       |
| TOTAL ASSETS                                                                                                                                                       |       | $                          | 7,630,789  |                     | $          | 11,586,002 |   |
|                                                                                                                                                               |       |                       |       |                     |       |
| **LIABILITIES,  CONVERTIBLE PREFERRED STOCK AND   SHAREHOLDERS’ EQUITY**                                                                                      |       |                       |       |                     |       |
| CURRENT LIABILITIES                                                                                                                                                |       |                       |       |                     |       |
| Accounts payable                                                                                                                                                   |       | $                          | 747,827    |                     | $          | 605,313 |   |
| Current portion  of related party lease obligation                                                                                                                 |       | 328,549                    |       | 322,586                  |       |
| Accrued expenses                                                                                                                                                   |       | 400,402                    |       | 377,507                  |       |
| TOTAL CURRENT  LIABILITIES                                                                                                                                         |       | 1,476,778                  |       | 1,305,406                |       |
| RELATED PARTY LEASE  OBLIGATION, less current portion                                                                                                              |       | 2,376,453                  |       | 2,542,233                |       |
| TOTAL  LIABILITIES                                                                                                                                                 |       | 3,853,231                  |       | 3,847,639                |       |
|                                                                                                                                                               |       |                       |       |                     |       |
| COMMITMENTS AND  CONTINGENCIES                                                                                                                                     |       |                       |       |                     |       |
|                                                                                                                                                               |       |                       |       |                     |       |
| 5% SERIES A REDEEMABLE  CONVERTIBLE PREFERRED STOCK;   $.01 par value; stated value $10,000 per share; 1,900 shares authorized; no   shares issued and outstanding |       | —                     |       | —                   |       |
|                                                                                                                                                               |       |                       |       |                     |       |
| SHAREHOLDERS’ EQUITY                                                                                                                                          |       |                       |       |                     |       |
| Preferred stock;  $.01 par value; 998,100 shares authorized; no shares issued and outstanding                                                                      |       | —                     |       | —                   |       |
| Common stock;  $.01 par value; 24,000,000 shares authorized; 9,837,224   and 9,122,946 shares issued and outstanding                                               |       | 98,372                     |       | 91,229                   |       |
| Additional  paid-in capital                                                                                                                                        |       | 58,198,310                 |       | 55,088,734               |       |
| Deferred  stock-based compensation                                                                                                                                 |       | —                     |       | (98,512                  | )          |
| Accumulated  deficit                                                                                                                                               |       | (54,519,124                | )          | (47,343,088              | )          |
| TOTAL  SHAREHOLDERS’ EQUITY                                                                                                                                   |       | 3,777,558                  |       | 7,738,363                |       |
| TOTAL LIABILITIES,  CONVERTIBLE PREFERRED STOCK AND   SHAREHOLDERS’ EQUITY                                                                                    |       | $                          | 7,630,789  |                     | $          | 11,586,002 |   |

 

See notes to condensed financial statements.

3

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**MEDICALCV, INC.**

**CONDENSEDSTATEMENTS OF OPERATIONS**

**(UNAUDITED)**
| ** **                                                                                           | ** ** | **Three months ended October 31,** | ** ** | **Six months ended October 31,** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                                           | ** ** | **2006**                                               | ** ** | **2005**                                             | ** ** | **2006** | ** ** | **2005** | ** ** |
| OPERATING  EXPENSES, CONTINUING OPERATIONS                                                           |       |                                                   |       |                                                 |       |   |   |   |   |
| Sales and marketing                                                                                  |       | $                                                      | 406,192    |                                                 | $          | 28,617 |   | $ | 796,874 |   | $ | 133,834 |   |
| General and administrative                                                                           |       | 539,595                                                |       | 721,251                                              |       | 2,757,208 |   | 1,484,580 |   |
| Research and development                                                                             |       | 2,154,289                                              |       | 789,450                                              |       | 3,742,651 |   | 1,192,675 |   |
| TOTAL OPERATING EXPENSES                                                                             |       | 3,100,076                                              |       | 1,539,318                                            |       | 7,296,733 |   | 2,811,089 |   |
| LOSS FROM  OPERATIONS                                                                                |       | (3,100,076                                             | )          | (1,539,318                                           | )          | (7,296,733 | ) | (2,811,089 | ) |
|                                                                                                 |       |                                                   |       |                                                 |       |   |   |   |   |
| OTHER INCOME  (EXPENSE)                                                                              |       |                                                   |       |                                                 |       |   |   |   |   |
| Interest income                                                                                      |       | 73,022                                                 |       | 77,068                                               |       | 181,371 |   | 146,030 |   |
| Interest expense                                                                                     |       | (29,772                                                | )          | (21,043                                              | )          | (67,007 | ) | (100,079 | ) |
| Other income (expense)                                                                               |       | 798                                                    |       | (4,664                                               | )          | 19,725 |   | (3,604 | ) |
| Decrease in fair value of putable warrants                                                           |       | —                                                 |       | 822,164                                              |       | — |   | 7,276,102 |   |
| TOTAL OTHER INCOME (EXPENSE)                                                                         |       | 44,048                                                 |       | 873,525                                              |       | 134,089 |   | 7,318,449 |   |
|                                                                                                 |       |                                                   |       |                                                 |       |   |   |   |   |
| (LOSS) INCOME  FROM CONTINUING OPERATIONS                                                            |       | (3,056,028                                             | )          | (665,793                                             | )          | (7,162,644 | ) | 4,507,360 |   |
|                                                                                                 |       |                                                   |       |                                                 |       |   |   |   |   |
| LOSS FROM  DISCONTINUED OPERATIONS                                                                   |       | (22,446                                                | )          | (46,681                                              | )          | (13,392 | ) | (149,650 | ) |
| NET (LOSS)  INCOME                                                                                   |       | $                                                      | (3,078,474 | )                                                    | $          | (712,474 | ) | $ | (7,176,036 | ) | $ | 4,357,710 |   |
|                                                                                                 |       |                                                   |       |                                                 |       |   |   |   |   |
| NET (LOSS)  INCOME TO COMMON SHAREHOLDERS                                                            |       |                                                   |       |                                                 |       |   |   |   |   |
| Net (loss) income                                                                                    |       | $                                                      | (3,078,474 | )                                                    | $          | (712,474 | ) | $ | (7,176,036 | ) | $ | 4,357,710 |   |
| Redeemable convertible preferred stock cash  dividends                                               |       | —                                                 |       | (223,058                                             | )          | — |   | (441,691 | ) |
| NET (LOSS)  INCOME TO COMMON SHAREHOLDERS                                                            |       | $                                                      | (3,078,474 | )                                                    | $          | (935,532 | ) | $ | (7,176,036 | ) | $ | 3,916,019 |   |
|                                                                                                 |       |                                                   |       |                                                 |       |   |   |   |   |
| NET (LOSS)  EARNINGS PER COMMON SHARE – CONTINUING OPERATIONS,  AFTER PREFERRED  DIVIDENDS |       |                                                   |       |                                                 |       |   |   |   |   |
| Basic                                                                                                |       | $                                                      | (0.33      | )                                                    | $          | (0.78 | ) | $ | (0.78 | ) | $ | 3.62 |   |
| Diluted                                                                                              |       | (0.33                                                  | )          | (0.78                                                | )          | (0.78 | ) | (1.51 | ) |
|                                                                                                 |       |                                                   |       |                                                 |       |   |   |   |   |
| NET LOSS PER  COMMON SHARE – DISCONTINUED OPERATIONS                                            |       |                                                   |       |                                                 |       |   |   |   |   |
| Basic                                                                                                |       | $                                                      | (0.00      | )                                                    | $          | (0.04 | ) | $ | (0.00 | ) | $ | (0.13 | ) |
| Diluted                                                                                              |       | (0.00                                                  | )          | (0.04                                                | )          | (0.00 | ) | (0.07 | ) |
|                                                                                                 |       |                                                   |       |                                                 |       |   |   |   |   |
| NET (LOSS)  EARNINGS PER COMMON SHARE                                                                |       |                                                   |       |                                                 |       |   |   |   |   |
| Basic                                                                                                |       | $                                                      | (0.33      | )                                                    | $          | (0.82 | ) | $ | (0.78 | ) | $ | 3.49 |   |
| Diluted                                                                                              |       | (0.33                                                  | )          | (0.82                                                | )          | (0.78 | ) | (1.58 | ) |
|                                                                                                 |       |                                                   |       |                                                 |       |   |   |   |   |
| WEIGHTED AVERAGE  COMMON SHARES   OUTSTANDING                                                        |       |                                                   |       |                                                 |       |   |   |   |   |
| Basic                                                                                                |       | 9,262,690                                              |       | 1,141,181                                            |       | 9,192,815 |   | 1,121,811 |   |
| Diluted                                                                                              |       | 9,262,690                                              |       | 1,141,181                                            |       | 9,192,815 |   | 2,124,179 |   |

 

See notes to condensed financial statements.

4

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**MEDICALCV,INC.**

**CONDENSEDSTATEMENTS OF CASH FLOWS**

**(UNAUDITED)**
| ** **                                                                              | ** ** | **Six months ended October 31,** | ** ** |
|-----------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                              | ** ** | **2006**                                             | ** ** | **2005** | ** ** |
| OPERATING  ACTIVITIES                                                                   |       |                                                 |       |   |   |
| Net (loss) income                                                                       |       | $                                                    | (7,176,036 | ) | $ | 4,357,710 |   |
| Adjustments to reconcile net (loss) income to net  cash used by operating   activities: |       |                                                 |       |   |   |
| Decrease in fair value of putable warrants                                              |       | —                                               |       | (7,276,102 | ) |
| Depreciation and amortization                                                           |       | 88,006                                               |       | 129,793 |   |
| Gain from the sales of property, plant and equipment                                    |       | (49,649                                              | )          | — |   |
| Stock-based compensation                                                                |       | 1,064,210                                            |       | — |   |
| Provision for doubtful accounts                                                         |       | —                                               |       | 23,935 |   |
| Changes in operating assets and liabilities:                                            |       |                                                 |       |   |   |
| Prepaid expenses and other assets                                                       |       | 175,875                                              |       | 889,783 |   |
| Accounts payable                                                                        |       | 142,514                                              |       | (150,596 | ) |
| Accrued expenses                                                                        |       | 22,895                                               |       | (157,980 | ) |
| NET CASH USED BY OPERATING ACTIVITIES                                                   |       | (5,732,185                                           | )          | (2,183,457 | ) |
| INVESTING  ACTIVITIES                                                                   |       |                                                 |       |   |   |
| Purchases of property, plant and equipment                                              |       | (96,051                                              | )          | (307,264 | ) |
| Proceeds from the sales of property, plant and  equipment                               |       | 50,668                                               |       | — |   |
| NET CASH USED BY INVESTING ACTIVITIES                                                   |       | (45,383                                              | )          | (307,264 | ) |
| FINANCING  ACTIVITIES                                                                   |       |                                                 |       |   |   |
| Principal payments under related party lease  obligation                                |       | (159,817                                             | )          | (116,653 | ) |
| Payments of fractional share interests                                                  |       | (229                                                 | )          | — |   |
| Proceeds from issuance of common stock and warrants                                     |       | 2,151,250                                            |       | — |   |
| Proceeds from exercise of stock options                                                 |       | —                                               |       | 660 |   |
| Preferred stock cash dividends                                                          |       | —                                               |       | (441,691 | ) |
| NET CASH PROVIDED (USED) BY FINANCING ACTIVITIES                                        |       | 1,991,204                                            |       | (557,684 | ) |
| NET DECREASE IN  CASH AND CASH EQUIVALENTS                                              |       | (3,786,364                                           | )          | (3,048,405 | ) |
|                                                                                    |       |                                                 |       |   |   |
| CASH AND CASH  EQUIVALENTS                                                              |       |                                                 |       |   |   |
| Beginning of year                                                                       |       | 10,351,570                                           |       | 10,637,796 |   |
| End of period                                                                           |       | $                                                    | 6,565,206  |   | $ | 7,589,391 |   |
| SUPPLEMENTAL  DISCLOSURE OF CASH FLOW INFORMATION                                       |       |                                                 |       |   |   |
|  Cash paid  for interest                                                           |       | $                                                    | 67,007     |   | $ | 105,667 |   |

 

See notes to condensed financial statements.

5

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**MEDICALCV, INC.**

**Notes to Condensed FinancialStatements**

**1.            Basis of Financial Statement Presentation**

Theaccompanying unaudited condensed financial statements included herein have beenprepared by MedicalCV, Inc. (the “Company”) in accordance with accountingprinciples generally accepted in the United States of America for interimfinancial information and pursuant to the rules and regulations of theSecurities and Exchange Commission (“SEC”).  Certain information andfootnote disclosures normally included in financial statements prepared inaccordance with accounting principles generally accepted in the United Statesof America have been condensed or omitted pursuant to such rules andregulations.  These interim financial statements should be read inconjunction with the financial statements and the notes thereto included in theCompany’s Annual Report on Form 10-KSB for the fiscal year endedApril 30, 2006.

Thebalance sheet as of October 31, 2006, the statements of operations for thethree and six months ended October 31, 2006 and 2005, and the statements ofcash flows for the six months ended October 31, 2006 and 2005 include, inthe opinion of management, all adjustments, consisting solely of normalrecurring adjustments, necessary for a fair presentation of the financialresults for the respective interim periods and are not necessarily indicativeof results of operations to be expected for the entire fiscal year endingApril 30, 2007.

**2.            Going Concern**

TheCompany’s financial statements as of and for the six months ended October 31,2006 have been prepared on a going concern basis, which contemplates therealization of assets and settlement of liabilities and commitments in thenormal course of business.  The Company has sustained losses and negativecash flows from operations in recent years and expects these conditions tocontinue in the foreseeable future.  At October 31, 2006, the Companyhad an accumulated deficit of $54,519,124.  The level of cash required foroperations during the remaining quarters of fiscal year 2007 is difficult topredict, and management anticipates that development and introduction of itsnew product will require additional capital.  These matters raisesubstantial doubt about the Company’s ability to continue as a goingconcern.  Management intends to seek additional debt or equity financingas it continues to develop and launch its new product.  However, theCompany may not be able to obtain such financing on acceptable terms or atall.  If the Company is unable to obtain such additional financing, itwill be required to significantly revise its business plan and drasticallyreduce operating expenditures such that it may not be able to develop orenhance its product, gain market share in the United States of America orrespond to competitive pressures or unanticipated requirements, which couldseriously harm its business, financial position and results ofoperations.  The financial statements do not include any adjustments thatmight result from the outcome of this uncertainty.

6

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**3.            Net (Loss) Earnings per Common Share**

Basicnet (loss) earnings per common share was computed by dividing the net (loss)income to common shareholders by the weighted average number of common sharesoutstanding.  Diluted net loss per common share reflects the potentialdilution that could occur if holders of warrants and options that are notanti-dilutive convert their holdings into common stock.  Diluted net lossper common share does not differ from basic net loss per common share in thethree and six months ended October 31, 2006 and the three months ended October31, 2005 due to the loss from continuing operations which would cause thepotentially dilutive shares to be anti-dilutive.  Certain warrants outstandingduring the six months ended October 31, 2005 were potentially dilutive andconsidered to be common stock equivalents.  The net earnings to commonshareholders for the six months ended October 31, 2005 was adjusted for thedecrease in fair value of putable warrants and the weighted average number ofshares used for the basic net earnings per share computation was increased bythe shares issuable under the warrants as follows:
| ** **                                                                                 | ** ** | **For the Periods Ended October 31,** | ** ** |
|--------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------|------------|
| ** **                                                                                 | ** ** | **Three Months**                                          | ** ** | **Six Months** | ** ** |
| ** **                                                                                 | ** ** | **2006**                                                       | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** |
| Numerator:                                                                                 |       |                                                           |       |   |   |   |   |   |   |
| Net (loss)  income to common shareholders for   basic net (loss) earnings per common share |       | $                                                              | (3,078,474 | ) | $ | (935,532 | ) | $ | (7,176,036 | ) | $ | 3,916,019 |   |
| Effect of  dilutive securities – decrease in fair   value of putable warrants         |       | —                                                         |       | — |   | — |   | (7,276,102 | ) |
| Net loss to common  shareholders for diluted   loss per common share                       |       | $                                                              | (3,078,474 | ) | $ | (935,532 | ) | $ | (7,176,036 | ) | $ | (3,360,083 | ) |

 
| ** **                                                                            | ** ** | **For the Periods Ended October 31,** | ** ** |
|---------------------------------------------------------------------------------------|------------|----------------------------------------------------------------|------------|
| ** **                                                                            | ** ** | **Three Months**                                          | ** ** | **Six Months** | ** ** |
| ** **                                                                            | ** ** | **2006**                                                       | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** |
| Denominator:                                                                          |       |                                                           |       |   |   |   |   |   |   |
| Weighted average  shares outstanding for basic   net (loss) earnings per common share |       | 9,262,690                                                      |       | 1,141,181 |   | 9,192,815 |   | 1,121,811 |   |
| Effect of  dilutive securities – shares issuable   under warrant agreements      |       | —                                                         |       | — |   | — |   | 1,002,368 |   |
| Weighted average shares  outstanding for diluted   net loss per common share          |       | 9,262,690                                                      |       | 1,141,181 |   | 9,192,815 |   | 2,124,179 |   |

 

Optionsand warrants outstanding to purchase 2,118,040 and 4,619,096 shares of commonstock were excluded from the computation for the three months ended October 31,2006 and 2005, respectively, because they were anti-dilutive.  Options and warrants outstanding to purchase2,139,239 and 1,091,751 shares of common stock were excluded from thecomputation for the six months ended October 31, 2006 and 2005, respectively,because they were anti-dilutive.

7

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**4.            Stock-Based Compensation**

On May1, 2006, the Company adopted Statement of Financial Accounting Standards (“SFAS”)No. 123R (revised 2004), *Share-BasedPayment,*and elected the modified prospective application transitionmethod.  SFAS No. 123R is a revision of SFAS No. 123, *Accounting for Stock-Based Compensation*,and supersedes Accounting Principles Board (“APB”) Opinion No. 25, *Accounting for Stock Issued to Employees*,and its related guidance.  As required by SFAS No. 123R, the Companyrecognizes compensation expense during the service period of stock-based awardsthat are granted, modified, repurchased, or cancelled after May 1, 2006 usingthe grant-date fair value of the award.  In addition, compensation expenseis recognized for awards granted prior to, but not yet vested as of May 1,2006, based on the grant-date fair value of the award.  In accordance withthe modified prospective application transition method of SFAS No. 123R, prior periodresults were not restated.  Incremental compensation cost for amodification of the terms or conditions of an award is measured by comparingthe fair value of the modified award with the fair value of the awardimmediately before the modification.  The Company has also implemented theSEC interpretations in Staff Accounting Bulletin (“SAB”) No. 107, *Share-Based Payments,*in connection withthe adoption of SFAS No. 123R.

*Stock-Based Compensation Expense*

Stock-basedcompensation expense is classified in the same expense lines as cashcompensation in accordance with SAB No. 107.  Stock-based compensationexpense included in the statement of operations as a result of adopting SFASNo. 123R is as follows:  
| ** **                                                                           | ** ** | **Three months  ended October 31, 2006** | ** ** | **Six months  ended October 31, 2006** | ** ** |
|--------------------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|------------------------------------------------------------|------------|
| Sales and  marketing                                                                 |       | $                                                            | 23,318     |                                                       | $          | 45,372 |   |
| General and  administrative                                                          |       | 246,227                                                      |       | 777,068                                                    |       |
| Research and  development (1)                                                        |       | 121,425                                                      |       | 241,770                                                    |       |
| Total  stock-based compensation                                                      |       | $                                                            | 390,970    |                                                       | $          | 1,064,210 |   |
|                                                                                 |       |                                                         |       |                                                       |       |
| Impact of adopting SFAS  No. 123R on reported basic and   diluted net loss per share |       | $                                                            | (0.04      | )                                                          | $          | (0.12 | ) |

 

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(1)Includes $16,571 and $31,481 of stock-based compensation expense related tonon-employees serving on the Company’s scientific advisory board in the threeand six months ended October 31, 2006, respectively.

TheCompany recognizes compensation expense for stock options on a straight-linebasis over the requisite service period of the award.  The amount ofstock-based compensation recognized is based on the value of the portions ofthe awards that are ultimately expected to vest.  SFAS No. 123R requiresforfeitures to be estimated at the time of grant and revised, if necessary, insubsequent periods if actual forfeitures differ from those estimates.  Nocompensation cost is recognized for unvested awards that employees forfeitbecause the requisite service is not rendered.  Previously recognizedcompensation cost is not reversed if an employee stock option for which therequisite service has been rendered expires unexercised.  The Company useshistorical forfeitures and employee turnover to estimate the number of optionsthat will actually vest.  The Company reevaluates this estimateperiodically and adjusts the forfeiture rate on a prospective basis asnecessary.

8

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Priorto the adoption of SFAS No. 123R, the Company accounted for stock optionsgranted to employees using the intrinsic value method under the guidance of APBNo. 25, and provided pro forma disclosure as required by SFAS No. 123.  Under the intrinsic value method of accounting,no compensation expense is recognized in the statement of operations when theexercise price of the employee stock option award equals or is greater than themarket price of the underlying common stock at the date of grant, and themeasurement date of the option grant is certain.  The measurement date is certain when the dateof grant is fixed and determinable. Compensation cost for employee stock options is measured as the excess,if any, of the quoted market price of the stock at the date of grant over theamount that the employee is required to pay for the stock.

Nostock-based compensation cost was recognized in the statement of operations forthe three and six months ended October 31, 2005 as all options granted had anexercise price equal to the market value of the underlying common stock of theCompany at the date of grant.

Inaccordance with the modified prospective application transition method of SFASNo. 123R, financial results for prior periods have not been restated.  Forpurposes of the pro forma disclosures required by SFAS No. 123, the Companyamortized the grant-date fair value of employee stock options over the vestingperiod and accounted for forfeitures as they occurred.  The followingtable illustrates the effect on net (loss) income and net (loss) earnings pershare as if the Company had recorded compensation expense for employee stockoptions under the fair value based method for the three and six months endedOctober 31, 2005:  
| ** **                                                                                    | ** ** | **Three months  ended October 31, 2005** | ** ** | **Six months  ended October 31, 2005** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|------------------------------------------------------------|------------|
| Net (loss)  income to common shareholders – as reported                                  |       | $                                                            | (935,532   | )                                                          | $          | 3,916,019 |   |
| Less:  Stock-based compensation determined under the fair   value based method for all awards |       | (419,096                                                     | )          | (801,277                                                   | )          |
| Net (loss)  income to common shareholders – pro forma                                    |       | $                                                            | (1,354,628 | )                                                          | $          | 3,114,742 |   |
|                                                                                          |       |                                                         |       |                                                       |       |
| Basic net (loss)  earnings per common share                                                   |       |                                                         |       |                                                       |       |
|  As reported                                                                             |       | $                                                            | (0.82      | )                                                          | $          | 3.49 |   |
|  Pro forma                                                                               |       | (1.19                                                        | )          | 2.78                                                       |       |
|                                                                                          |       |                                                         |       |                                                       |       |
| Diluted net loss  per common share                                                            |       |                                                         |       |                                                       |       |
|  As reported                                                                             |       | $                                                            | (0.82      | )                                                          | $          | (1.58 | ) |
|  Pro forma                                                                               |       | (1.19                                                        | )          | (1.96                                                      | )          |

 

As ofOctober 31, 2006, there was $3,597,121 of total unrecognized stock-basedcompensation cost and the Company expects that cost to be recognized over aweighted-average recognition period of 2.7 years.

9

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*Stock Option Activity*

At October31, 2006, 340,653 shares remain available for grant under the Company’s fiveauthorized stock option plans.  Of the 927,437 options outstanding atOctober 31, 2006, 513,715 have been issued outside of the Company’s authorizedplans.  Generally, the exercise price of an option is set at the closingmarket price of the Company’s common stock on the grant date.  Optionstypically vest over four years and have a maximum contractual term of tenyears.  Certain option awards provide for accelerated vesting if there isa change in control.

Thefollowing table summarizes information about stock options for the six monthsended October 31, 2006:
| ** **                                               | ** ** | **Options** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted Average  Remaining  Contractual Term  (in years)** | ** ** | **Aggregate  Intrinsic  Value (1)** | ** ** |
|----------------------------------------------------------|------------|-------------|------------|----------------------------------------|------------|------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| Outstanding,  April 30, 2006                             |       | 903,253     |       | $                                      | 9.70       |                                                                         |       |                                     |       |   |
| Granted                                                  |       | 146,229     |       | 7.66                                   |       |                                                                         |       |                                     |       |
| Forfeited/Expired                                        |       | (99,947     | )          | 10.23                                  |       |                                                                         |       |                                     |       |
| Outstanding,  July 31, 2006                              |       | 949,535     |       | 9.33                                   |       |                                                                         |       |                                     |       |
| Granted                                                  |       | 26,000      |       | 4.05                                   |       |                                                                         |       |                                     |       |
| Forfeited/Expired                                        |       | (48,098     | )          | 10.22                                  |       |                                                                         |       |                                     |       |
| Outstanding,  October 31, 2006                           |       | 927,437     |       | 9.13                                   |       | 6.8                                                                          |       | $                                        | 1,300      |   |
| Vested and  expected to vest, October 31, 2006 |       | 819,560     |       | 9.21                                   |       | 6.8                                                                          |       | $                                        | 1,116      |   |
| Exercisable,  October 31, 2006                           |       | 347,681     |       | 10.13                                  |       | 6.6                                                                          |       | $                                        | —     |   |
|                                                          |            |             |            |                                        |            |                                                                              |            |                                          |            |  |  |

 

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(1) This disclosure excludes those options that have no intrinsic value (i.e. thoseoptions that are out of the money using the closing market price of the Company’scommon stock on October 31, 2006 of $4.10 per share).

On May10, 2006, the Company awarded non-qualified stock options for the purchase of5,000 shares of common stock to each of the Company’s six non-employeedirectors.  These options vested immediately, are exercisable at $10.50per share, and expire on May 10, 2016.  In addition, the Company awarded anon-qualified stock option for the purchase of 25,000 shares of common stock tothe Vice President, Marketing.  This option vests over 4 years, isexercisable at $10.50 per share, and expires on May 10, 2016.

On June21, 2006, the Company awarded a non-qualified stock option for the purchase of91,229 shares of common stock to the Vice President, Finance and ChiefFinancial Officer.  This option vests over 4 years, is exercisable at$5.95 per share, and expires on June 21, 2016.

OnOctober 19, 2006, the Company awarded non-qualified stock options for thepurchase of 5,000 shares of common stock to each of the Company’s fivenon-employee directors. The options vest over 1 year, are exercisable at $4.05per share, and expire on October 19, 2016.

10

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Netcash proceeds from the exercise of stock options for 375 shares of common stockwere $1,125 in the six months ended October 31, 2005.  The aggregateintrinsic value of the options exercised (the amount by which the market priceof the stock on date of exercise exceeded the market price of the stock on thedate of grant) was $2,063 during the six months ended October 31, 2005. Due to the Company’s tax position, no tax benefit was recognized as a result ofoption exercises.  There were no stockoptions exercised during the three and six months ended October 31, 2006 andthree months ended October 31, 2005.  The Company issues new shares forstock options exercised.

*Stock Option Valuation*

TheCompany uses the Black-Scholes-Merton formula to estimate the grant date fairvalue of its stock options using the following assumptions:
| ** **                              | ** ** | **Three months ended October 31,** | ** ** | **Six months ended October 31,** | ** ** |
|-----------------------------------------|------------|--------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                              | ** ** | **2006**                                               | ** ** | **2005**                                             | ** ** | **2006** | ** ** | **2005** | ** ** |
| Options granted                         |       | 26,000                                                 |       | 63,096                                               |       | 172,229 |   | 83,596 |   |
| Weighted average  exercise price        |       | $                                                      | 4.05       |                                                 | $          | 7.36 |   | $ | 7.12 |   | $ | 7.39 |   |
| Weighted average  grant-date fair value |       | $                                                      | 3.31       |                                                 | $          | 7.15 |   | $ | 5.81 |   | $ | 7.19 |   |
| Expected  dividend rate (1)             |       | 0                                                      | %          | 0                                                    | %          | 0 | % | 0 | % |
| Risk free  interest rate (2)            |       | 4.8                                                    | %          | 4.2                                                  | %          | 4.8 to 5.1 | % | 4.2 | % |
| Expected term  (3)                      |       | 5.5 to 6.3 years                                       |       | 4.0 to 10.0 years                                    |       | 5.0 to 6.3 years |   | 4.0 to 10.0 years |   |
| Expected volatility  (4)                |       | 107.5                                                  | %          | 136.0                                                | %          | 107.5 to 111.2 | % | 136.0 | % |
| Weighted-average  volatility            |       | 107.5                                                  | %          | 136.0                                                | %          | 110.6 | % | 136.0 | % |

 

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**(1) Expected dividend rate** – The Company has not historicallypaid a cash dividend to common shareholders and does not intend to pay dividendsin the future.  Therefore, the Company has assumed an expected dividendrate of zero.

**(2) Risk free interest rate** – For fiscal year 2007, the Companyuses yield rates on U.S. Treasury securities for a period approximating theexpected term of the award to estimate the risk-free interest rate in itsgrant-date fair value assessment.  For fiscal year 2006, the rate wasbased on the U.S. Treasury interest rate for the term consistent with thematurity of the option.

**(3) Expected term** – Due to the limited number of stock optionsexercised historically, the Company has elected to use the “simplified” methodfor estimating the expected terms of options in fiscal year 2007 as allowedunder SAB 107.  Under this approach, the expected term was calculated bytaking the average of the vesting term and the original contract term.  Infiscal year 2006, the Company used the contractual life of the option as theexpected term.

**(4)  Expected volatility** – For stockoption grants in fiscal year 2007, the Company uses at least three years ofhistorical monthly price observations to estimate volatility.  For stockoption grants in fiscal year 2006, the Company used weekly price observationsbeginning in August 2003, the date of acquisition of certain technology used incontinuing operations.

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**5.            Shareholders’ Equity**

**Reverse Stock Split**

On May31, 2006, the Company effected a reverse stock split pursuant to which everyten shares of common stock and every ten shares of preferred stock werecombined into one share of common stock and one share of preferred stock,respectively, without any change in the par value of the shares.  Theauthorized capital stock was reduced in a like manner.  No fractionalshares were issued as a result of the reverse split, and $229 has been paid forfractional share interests.  The reverse split was approved by the Company’sboard of directors without shareholder approval in accordance with therequirements of Minnesota law.  Historical share data presented hereingives retroactive effect to this reverse stock split.

**Registration Statement for Public Offering of Common Stock**

OnAugust 8, 2006, the Company requested withdrawal of its registration statementon Form SB-2 originally filed with the SEC on May 19, 2006 related to aproposed public offering of common stock.  Due to unsettled conditions inthe equity markets, the Company decided not to pursue a public offering at thattime.

**Private Placement of Common Stock and Warrants**

OnOctober 13, 2006, pursuant to the terms of a securities purchase agreement, theCompany issued 714,286 shares of common stock to accredited investors andwarrants for the purchase of an aggregate of 178,571 shares of common stock tosuch investors.  Gross proceeds of $2,500,000from the private placement were reduced by offering costs of $348,750 resultingin $2,151,250 of net proceeds.  Thewarrants are exercisable for five years at an exercise price of $4.365 pershare, subject to basic, and for 9 months, full-ratchet anti-dilutionadjustments.

Inconnection with the securities purchase agreement, the Company granted theinvestors a 12-month right of participation in subsequent financings.  The Company agreed not to create or authorizeany senior securities or undertake a reverse or forward stock split or reclassification,without the consent of the purchasers of a majority of the shares, for 18months.  The Company also agreed not toenter into any variable rate transactions for 18 months.

In addition, the Companyentered into a registration rights agreement which required the Company to filea registration statement to register for resale the shares of common stockissued in this transaction and the shares of common stock issuable uponexercise of the warrants.  The Companyfiled such registration statement on November 17, 2006 and it was declaredeffective on November 30, 2006.

If the registrationstatement ceases to be effective for more than an aggregate of 75 calendar daysin any 12-month period, the Company has agreed to pay each holder an amount asliquidated damages equal to 1.5% of the aggregate investment amount then heldby the holder of the shares purchased pursuant to the securities purchaseagreement and on each monthly anniversary of the failure to effect suchregistration, provided however that such liquidated damages will not exceed 10%of the aggregate purchase price paid by all holders.  The Company is required to use itscommercially reasonable efforts to keep the registration statement effectiveuntil all registered securities covered by the registration statement have beensold or may be sold without volume restrictions pursuant to Rule 144(k).  The Company has determined that thepossibility of failing to maintain the effectiveness of the registration statementfor more than an aggregate of 75 calendar days in any 12-month period is notprobable and has not recorded a liability in the financial statements forliquidated damages.

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In addition, if theregistration statement permitting the resale of the shares issuable upon theexercise of the warrants is required to be effective but is not then effectiveor the prospectus forming a part thereof is not then available for the resaleof the shares, then each warrant allows the holder to convert the warrants intocommon stock without any cash consideration in exchange for the surrender ofthe remaining shares of common stock otherwise purchasable upon the exercise ofthe warrant.

**Warrants**

TheCompany had warrants outstanding to purchase 1,303,638 shares of the Company’scommon stock at prices ranging from $3.25 to $67.50 per share at October 31,2006.  The warrants expire at various dates through March 2015.  
|                                                | ** ** | **Warrants** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|------------------------------------------------|------------|--------------|------------|----------------------------------------|------------|
| Outstanding,  April 30, 2006 and July 31, 2006 |       | 1,168,498    |       | $                                      | 11.24      |   |
| Granted                                        |       | 178,571      |       | 4.37                                   |       |
| Impact of anti-dilution features               |       | 6,569        |       | 0.07                                   |       |
| Forfeited/Expired                              |       | (50,000      | )          | 65.00                                  |       |
| Outstanding,  October 31, 2006                 |       | 1,303,638    |       | 8.18                                   |       |
|                                                |            |              |            |                                        |            |  |

 

**6.            Employment Agreements**

**Current Vice President, Finance and Chief Financial Officer**

In May2006, the Company entered into an employment agreement with Eapen Chacko, whojoined the Company on June 21, 2006, as Vice President, Finance and ChiefFinancial Officer.  Mr. Chacko assumed the roles of principal financialofficer and principal accounting officer effective at the close of business onJuly 31, 2006.  Mr. Chacko receives an annual base salary of $200,000 andis eligible to receive performance-based cash bonuses.  The employmentagreement provides that a severance payment will be made if the employment isterminated by the Company without cause, or by the employee for good reason,including, but not limited to, a reduction of the employee’s compensation; areduction of authority and responsibility; a relocation of place of employment;or a breach of the employment agreement by the Company.  The severancepayment would be six months of base salary and, if at the end of such six-monthperiod, Mr. Chacko is not employed or engaged as an independent contractor, theCompany would pay him up to an additional six months of base salary until he isemployed or engaged as an independent contractor.  In addition to paymentsof base salary, the Company has agreed to pay or reimburse Mr. Chacko formedical (COBRA) benefits for the periods covered by the severancepayments.  In addition, Mr. Chacko has agreed to certain nondisclosure andinvention provisions and certain noncompetition and nonrecruitment provisionsduring the term of employment and for a period of one year after termination ofemployment.

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**Former Vice President, Finance and Chief Financial Officer**

InApril 2006, the Company entered into an amendment to the employment agreement(the “First Amendment”) with John H. Jungbauer, then the Company’s VicePresident, Finance and Chief Financial Officer, to reflect the mutual decisionreached concerning Mr. Jungbauer’s departure from the Company.  Mr.Jungbauer’s employment ceased effective at the close of business on July 31,2006.  A severance payment of $100,000 was paid on July 31, 2006 and anadditional $100,000 will be paid to Mr. Jungbauer in January 2007.  Inaddition to these severance payments, the Company has agreed to pay orreimburse Mr. Jungbauer for medical (COBRA) benefits.  The Companyrecorded $94,291 in the first quarter of fiscal year 2007 and $131,793 infiscal year 2006 related to the severance payments, related payroll taxes, andmedical benefits.

Inconnection with the First Amendment, the Company agreed to amend Mr. Jungbauer’sstock option agreements to provide that his options, to the extent vested onthe termination date, would be exercisable for a period of twelve monthsfollowing the termination of Mr. Jungbauer’s employment.  The originalterms of Mr. Jungbauer’s stock option agreements for the purchase of 144,012shares of the Company’s common stock provided that he had three monthsfollowing termination of employment to exercise the vested portions.  TheCompany accounted for the modification in accordance with the provisions of APBNo. 25 and recorded stock-based compensation expense of $87,353 in fiscal year2006 to reflect the intrinsic value of the excess of the market price of theCompany’s common stock at the date of modification over the exercise price ofthe vested stock options.

In July2006, the Company entered into a second amendment to the employment agreement(the “Second Amendment”) with Mr. Jungbauer to retroactively rescind theprovision in the First Amendment that provided Mr. Jungbauer twelve monthsfollowing termination of employment to exercise the vested portions of hisstock options and revert to the original terms of the stock option agreementsthat provide Mr. Jungbauer three months following termination of employment toexercise the vested portions thereof.  Options to purchase 44,065 sharesof the Company’s common stock had vested as of July 31, 2006.  The Companyaccounted for the subsequent modification of the exercise period in fiscal year2007 in accordance with the provisions of SFAS No. 123R.  Accordingly, noincremental compensation was recorded in fiscal year 2007 as the fair value ofthe modified stock option agreements was less than the fair value immediatelybefore the modification.  The optionsexpired unexercised on October 31, 2006.

**Other Separation**

Duringthe six months ended October 31, 2005, the Company entered into a separationagreement with an employee, resulting in a charge to general and administrativeexpense for severance pay of $40,382.

Thefollowing table summarizes the severance charges: 
| Balance as of April 30, 2005                                 |   | $        | 24,834  |   |
|--------------------------------------------------------------|--------|----------|---------|--------|
| Severance  charges in fiscal year 2006                       |   | 172,175  |    |
| Cash usage in  fiscal year 2006                              |   | (65,216  | )       |
| Balance as of  April 30, 2006                                |   | 131,793  |    |
| Severance  charges in the first quarter of fiscal year 2007  |   | 94,291   |    |
| Cash usage in  the first quarter of fiscal year 2007         |   | (100,000 | )       |
| Balance as of  July 31, 2006                                 |   | 126,084  |    |
| Severance  charges in the second quarter of fiscal year 2007 |   | —   |    |
| Cash usage in  the second quarter of fiscal year 2007        |   | (5,958   | )       |
| Balance as of October  31, 2006                              |   | $        | 120,126 |   |

 

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**7.****                                           Litigation**

OnMarch 10, 2006, J Giordano Securities LLC (d/b/a J Giordano SecuritiesGroup) (“JGSG”) filed suit against the Company in U.S. District Court for theDistrict of Connecticut. JGSG, which acted as a private placement agent for theCompany in connection with sales of the Company’s securities to privateinvestors in April 2005, asserts claims for breach of contract, unjustenrichment and quantum meruit. JGSG contends it is owed certain fees as aresult of “follow on transactions” executed by investors identified by JGSG,pursuant to the engagement agreement, as amended, between the Company and JGSGor, in the alternative, that it should be awarded such fees on an equitablebasis. In particular, JGSG originally claimed that the exercise of outstandingwarrants for the purchase of common stock by certain JGSG-identified investorsand the Company’s purchase of outstanding shares of 5% Series A RedeemableConvertible Preferred Stock from certain JGSG-identified investors inDecember 2005 and January 2006 entitled JGSG to damages no less than$1,431,769. JGSG originally sought (a) $279,191 in cash commissions,(b) warrants for the purchase of 85,905 shares at $3.25 per share,(c) lost profits of $751,669 on the argument that JGSG would have exercisedthe foregoing warrant and sold 85,905 shares on December 30, 2005, at aprice of $12.00 per share, and (d) $400,909 in cash commissions theCompany paid C.E. Unterberg, Towbin, LLC (“CEUT”).

OnSeptember 22, 2006, the Company asserted a counterclaim against JGSG forfraud and breach of contract based upon JGSG’s misrepresentations to induce theCompany to enter the engagement agreement and JGSG’s failure to perform itspromised services thereunder. The Company seeks damages of (a) the $30,000retainer and $543,000 cash paid to JGSG; (b) the value of the Company’swarrants for 114,600 shares of common stock issued to JGSG; (c) the$445,328 fee and $27,016 expense reimbursement that the Company paid CEUT forits advisory services in December 2005 and January 2006; (d) the$3.7 million cash the Company did not obtain on investor warrant exercises dueto the reduced warrant exercise price the Company was required to accept duringthose months; and (e) the value of the additional 1.9 million shares ofcommon stock the Company was required to issue to effectuate the preferredstock purchase during those months. As a result, the Company counterclaims inexcess of $5.0 million.

OnNovember 20, 2006, JGSG filed an amended statement of claim. JGSG addednew claims for additional compensation based upon the issuance of additionalcommon stock to preferred stock holders in the alleged “follow-on transactions,”the Company’s alleged failure to timely file a resale registration statementfor JGSG, and for additional compensation based upon the October 2006private placement. JGSG currently seeks alleged damages of $3,346,565 asfollows: (a) $279,191 in cash commissions; (b) warrants for thepurchase of 85,905 shares at $3.25 per share; (c) lost profits of $751,669on the argument that JGSG would have exercised the foregoing warrant and sold85,905 shares on December 30, 2005, at a price of $12.00 per share;(d) $249,690 in cash pursuant to the alleged failure to timely file theresale registration statement for JGSG; (e) $6,726 in liquidated damagesbased upon the Company’s alleged failure to timely file the resale registrationstatement for JGSG; (f) $556,214 in cash commissions that JGSG claims itwas entitled to based upon preferred stock holders’ receipt of additionalcommon stock in the alleged “follow-on transactions”; (g) warrants for thepurchase of 171,142 shares at $3.25 per share; (h) lost profits of$952,166 on the argument that JGSG would have exercised the foregoing warrantand sold 171,142 shares on January 3, 2006, at a price of $11.00 pershare; (i) $400,909 in cash commissions the Company paid to CEUT; and(j) $150,000 based upon the fee the Company paid to CEUT for theOctober 2006 private placement. JGSG also seeks reimbursement forreasonable expenses, interest, costs and attorneys’ fees. The U.S. DistrictCourt for the District of Connecticut has referred the matter to NASDarbitration. The Company believes that JGSG’s lawsuit is without merit andintends to vigorously defend itself.

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**8.****                                           DiscontinuedOperations**

On November 17,2004, the Company’s board of directors authorized management to ceaseproduction of heart valves but to continue marketing the valves while exploringthe merits of possible strategic alternatives for the heart valve business,including, but not limited to, a joint venture with another party or the saleof the business.  Following exploration of a number of alternatives,management concluded in April 2005 that an orderly winding up of the valvebusiness was the Company’s best alternative.  On April 6, 2005, theCompany’s board authorized management to discontinue sales and marketing ofheart valves effective April 30, 2005, and to seek a buyer for the relatedproduction equipment.

As aresult of the Company’s discontinuance of the heart valve business, the Companymade a determination during the fourth quarter of fiscal year 2005 that theremaining assets of the heart valve operations should be considered “held forsale” pursuant to SFAS No. 144, *Accounting for Impairmentor Disposal of Long-Lived Assets*.  Pursuant to SFASNo. 144, the Company ceased depreciation of property and equipment heldfor sale and evaluated whether any of the long-lived assets of the discontinuedheart valve business were impaired.  Based upon the estimated sellingprices of these assets, management concluded that the carrying value of theseassets was not impaired.  The Company has sold or disposed of the majorityof the equipment and the carrying value of the remaining net assets of theheart valve business are reported as assets of discontinued operations on theCompany’s balance sheet.

 

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**ITEM 2   MANAGEMENT’SDISCUSSION AND ANALYSIS OR PLAN OF OPERATION**

*The following discussion contains variousforward-looking statements within the meaning of Section 21E of theExchange Act.  Although we believe that, in making any such statement, ourexpectations are based on reasonable assumptions, any such statement may beinfluenced by factors that could cause actual outcomes and results to bematerially different from those projected.  When used in the followingdiscussion, the words “anticipates,” “believes,” “expects,” “intends,” “plans,”“estimates” and similar expressions, as they relate to us or our management,are intended to identify such forward-looking statements.  Theseforward-looking statements are subject to numerous risks and uncertainties thatcould cause actual results to differ materially from those anticipated. Factors that could cause actual results to differ materially from thoseanticipated, certain of which are beyond our control, are set forth in thisdocument and in our Annual Report on Form 10-KSB for the fiscal year endedApril 30, 2006, under the caption “Management’s Discussion and Analysis orPlan of Operation — Cautionary Statement.”*

*Our actual results, performance or achievements could differmaterially from those expressed in, or implied by, forward-lookingstatements.  Accordingly, we cannot be certain that any of the eventsanticipated by forward-looking statements will occur or, if any of them dooccur, what impact they will have on us.  We caution you to keep in mindthe cautions and risks described in this document and in our CautionaryStatement and to refrain from attributing undue certainty to anyforward-looking statements, which speak only as of the date of the document inwhich they appear.  We do not undertake to update any forward-lookingstatement.*

**Overview**

OurATRILAZETM surgical ablation system utilizes laser energy to ablate cardiac andsoft tissue.  We acquired the initial technology in August 2003 andwe have developed several generations of products beyond the initial technologypurchase.  We received FDA 510(k) clearances for the first generationproduct in November 2004 and the second generation product in October2005.  In addition, we received a third 510(k) clearance in April 2006which covered an additional laser wavelength.

TheATRILAZE system with its laser technology platform is currently being utilizedto ablate cardiac tissue concomitantly, or in conjunction, with open-heartsurgical procedures, such as mitral valve surgery.  Ablating cardiac tissue creates preciselesions, or scars, which can block abnormal electrical impulses that causeatrial fibrillation (“AF”).  AF is themost commonly occurring cardiac arrhythmia. It reduces cardiac output, is a major precursor to congestive heartfailure and is associated with an increased incidence of stroke.

In May2006, we submitted an application for FDA 510(k) clearance of our minimallyinvasive system for cardiac tissue ablation. We define a minimally invasive treatment as being one in which theprocedure is performed on a beating heart in a closed-chest setting.  In December 2006, we announced that, as aconsequence of continued review by the FDA of our application, we no longerexpect to receive 510(k) clearance on a timeline that would permit commerciallaunch of our minimally invasive system in calendar year 2006.  We intend to respond to the FDA and, subjectto FDA 510(k) clearance, to introduce our minimally invasive system in calendaryear 2007.

Beyondthe use of our cleared devices for cardiac ablation in concomitant proceduresand the pending FDA 510(k) application for our minimally invasive system, it isour long-range goal to leverage our existing laser technology to develop astand-alone, minimally invasive treatment for AF.  However, specific labeling of our product forAF would require a premarket approval, the most stringent form of FDA review,which would entail a clinical trial.  Asof October 31, 2006, no company had received FDA approval or clearance tomarket an ablation system for use as a treatment for AF.

Ourcompany was incorporated in Minnesota on March 30, 1992, under the name CVDynamics, Inc.  In April 1992, we acquired all of the tangible andintangible assets of Omnicor, Inc.  Omnicor resulted from the corporateand financial restructuring of a predecessor company called MedicalIncorporated, which was organized in 1971 to develop and market theLillehei-Kaster heart valve, licensed from the University of Minnesota.

UntilNovember 2004, we developed and marketed mechanical heart valves known as theOmnicarbon® 3000 and 4000 heart valves.  In November 2004, after anexhaustive evaluation of the heart valve business, we discontinued all heartvalve related production.  In April 2005, we announced that ourefforts to find a buyer for the heart valve business had been unsuccessful andthat we would stop selling heart valves and were exiting the heart valvebusiness.  At that time, we also determined to direct all of our resourcesto the development and introduction of our laser technology platform for tissueablation.

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**Critical Accounting Policies and Estimates**

Forfurther discussion of our critical accounting policies and estimates, see ourAnnual Report on Form 10-KSB for the fiscal year ended April 30,2006.  Also, see Note 4 in Part I, Item 1“Condensed Financial Statements” for additional information.

**Recent Accounting Pronouncements**

In June2006, the Financial Accounting Standards Board (“FASB”) issued Interpretation (“FIN”)No. 48, *Accounting for Uncertainty in IncomeTaxes – an interpretation of FASB Statement No. 109*.  ThisInterpretation prescribes a recognition threshold and measurement attribute forthe financial statement recognition and measurement of a tax position taken orexpected to be taken in a tax return, and provides guidance on derecognition,classification, interest and penalties, accounting in interim periods,disclosure, and transition. We do not anticipate the adoption of FIN 48 on May1, 2007 to have a material impact on our financial statements due to our taxloss carryforwards and related valuation allowance.

In September 2006, theFASB issued SFAS No. 157, *Fair Value Measurements*,which defines fair value, establishes a framework for measuring fair value ingenerally accepted accounting principles, and expands disclosures about fairvalue measurements.  We do not anticipatethe adoption of SFAS No. 157 on May 1, 2008 to have a material impact on ourfinancial statements.

In September 2006, theSEC issued SAB No. 108, *Considering the Effects ofPrior Year Misstatements When Quantifying Misstatements in Current YearFinancial Statements*, which provides interpretive guidance on howthe effects of the carryover or reversal of prior year misstatements should beconsidered in quantifying a current year misstatement. The SEC staff believesthat registrants should quantify errors using both a balance sheet and anincome statement approach and evaluate whether either approach results inquantifying a misstatement that, when all relevant quantitative and qualitativefactors are considered, is material. This pronouncement is effective for fiscal years ending after November15, 2006.  We do not anticipate theadoption of SAB No. 108 to have a material impact on our financial statements.

**Results of Operations for the Three Months Ended October 31,2006 and 2005**

*Sales and Marketing*.  Sales andmarketing expenses increased from $28,617 in the three months ended October 31,2005 to $406,192 in the three months ended October 31, 2006.  The $377,575increase was primarily due to expanding our sales and marketing efforts inpreparation for launch of our minimally invasive system.  The significant components of sales andmarketing expenses in the three months ended October 31, 2006 included $151,221in payroll and related costs, $142,108 in costs to conduct a scientificadvisory board conference in September 2006, $52,071 in travel and entertainment,and $23,318 in employee stock-based compensation as a result of SFAS No. 123R.

*General and Administrative*.  Generaland administrative expenses decreased from $721,251 in the three months endedOctober 31, 2005 to $539,595 in the three months ended October 31, 2006. The $181,656 decrease was primarily due to a $272,034 reversal of an accrual ofconsulting expenses related to a proposed public offering of our common stockthat we subsequently decided not to pursue. This credit was partially offset by expenses of $205,237 in employeestock-based compensation and $40,990 in director stock-based compensation as aresult of SFAS No. 123R.

*Research and Development.*  Researchand development expenses increased from $789,450 in the three months endedOctober 31, 2005 to $2,154,289 in the three months ended October 31,2006.  The $1,364,839 increase was primarily due to development of ourminimally invasive system.  During thethree months ended October 31, 2006, we incurred $698,280 in externaldevelopment of our controller component of the system, $319,582 in externaldevelopment of our laser component of the system, and $211,393 in materials andtemporary labor to build pre-clinical disposable delivery system prototypes tobe tested as part of the development process. Stock based compensation to employees as a result of SFAS No. 123R was$104,854 and stock-based compensation to non-employees serving on ourscientific advisory board was $16,571 in the three months ended October 31,2006.

18

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*Other Income (Expense)*.  Total otherincome (expense) decreased from $873,525 in the three months ended October 31,2005 to $44,048 in the three months ended October 31, 2006.  The threemonths ended October 31, 2005 included a $822,164 reduction in the fair value ofthe putable warrants issued in connection with 1,803 shares of 5% Series ARedeemable Convertible Preferred Stock (“Preferred Stock”) issued on April 1,2005 discussed more fully in Note 9 of the financial statements included in ourAnnual Report on Form 10-KSB for the fiscal year ended April 30, 2006.

*Discontinued Operations.*  The lossfrom discontinued operations consisted primarily of the amortization of aprepaid insurance policy related to the heart valve business.  The lossfrom discontinued operations decreased from $46,681 in the three months endedOctober 31, 2005 to $22,446 in the three months ended October 31, 2006.  The $24,235 decrease was due primarily to baddebt expense recorded in the three months ended October 31, 2005.

*Dividends on Preferred Stock. *Duringthe three months ended October 31, 2005, we paid cash dividends of $223,058related to the Preferred Stock.  As discussed in Note 9 of our financialstatements included in our Annual Report on Form 10-KSB for the fiscal yearended April 30, 2006, these shares are no longer outstanding.

*Income Tax Provision*.  We have noincome tax provision in the three months ended October 31, 2006 and 2005 due tothe net operating losses generated for income tax reporting purposes.  Wehave established a valuation allowance to fully offset tax assets due to theuncertainty about our ability to generate the future taxable income necessaryto realize these deferred tax assets, particularly in light of our history ofsignificant operating losses.  In addition, future utilization ofavailable net operating loss carryforwards may be limited under InternalRevenue Code Section 382 as a result of changes in ownership that have or mayresult from the issuance of common stock, redeemable convertible preferredstock or common stock options and warrants.

**Results of Operations for the Six Months Ended October 31,2006 and 2005**

*Sales and Marketing*.  Sales andmarketing expenses increased from $133,834 in the six months ended October 31,2005 to $796,874 in the six months ended October 31, 2006.  The $663,040increase was primarily due to expanding our sales and marketing efforts inpreparation for launch of our minimally invasive system.  The significant components of the increase insales and marketing expenses in the six months ended October 31, 2006 included$244,164 in additional payroll and related costs, $142,108 in costs to conducta scientific advisory board conference in September 2006, $111,654 inadditional travel and entertainment, $65,000 in relocation costs, and $45,372in employee stock-based compensation as a result of SFAS No. 123R.

*General and Administrative*.  Generaland administrative expenses increased from $1,484,580 in the six months endedOctober 31, 2005 to $2,757,208 in the six months ended October 31, 2006. A majority of the $1,272,628 increase was due to the adoption of SFAS No.123R.  Employee and director stock-basedcompensation was $431,622 and $345,446, respectively, in the six months endedOctober 31, 2006 as a result of SFAS No. 123R. In addition, we incurred increases of $124,633 in legal services,$117,253 in accounting services, and $162,778 in printing expenses relatedprimarily to a proposed public offering of our common stock that wesubsequently decided not to pursue.

*Research and Development.*  Researchand development expenses increased from $1,192,675 in the six months endedOctober 31, 2005 to $3,742,651 in the six months ended October 31, 2006. The $2,549,976 increase was primarily due to development of our minimallyinvasive system.  During the six monthsended October 31, 2006, we incurred $1,271,156 in external development of ourcontroller component of the system, $375,886 in external development of ourlaser component of the system, and $327,250 in materials and temporary labor tobuild pre-clinical disposable delivery system prototypes to be tested as partof the development process.  Stock basedcompensation to employees as a result of SFAS No. 123R was $210,289 andstock-based compensation to non-employees serving on our scientific advisoryboard was $31,481 in the six months ended October 31, 2006.

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*Other Income (Expense)*.  Total otherincome (expense) decreased from $7,318,449 in the six months ended October 31,2005 to $134,089 in the six months ended October 31, 2006.  The six monthsended October 31, 2005 included a $7,276,102 reduction in the fair value of theputable warrants issued in connection with 1,803 shares of Preferred Stockissued on April 1, 2005 discussed more fully in Note 9 of the financialstatements included in our Annual Report on Form 10-KSB for the fiscal yearended April 30, 2006.

*Discontinued Operations.*  The lossfrom discontinued operations decreased from $149,650 in the six months endedOctober 31, 2005 to $13,392 in the six months ended October 31, 2006.  The loss in the six months ended October 31,2005 included revenue of $338,333, cost of goods sold of $441,302, insuranceexpense of $22,446, and bad debt expense of $24,235.  The loss in the six months ended October 31,2006 consisted of $44,892 in amortization of a prepaid insurance policypartially offset by $31,500 in the gain on the sale of fixed assets.

*Dividends on Preferred Stock. *Duringthe six months ended October 31, 2005, we paid cash dividends of $441,691related to the Preferred Stock.  As discussed in Note 9 of our financialstatements included in our Annual Report on Form 10-KSB for the fiscal yearended April 30, 2006, these shares are no longer outstanding.

*Income Tax Provision*.  We have noincome tax provision in the six months ended October 31, 2006 and 2005 due tothe net operating losses generated for income tax reporting purposes.  Wehave established a valuation allowance to fully offset tax assets due to theuncertainty about our ability to generate the future taxable income necessaryto realize these deferred tax assets, particularly in light of our history ofsignificant operating losses.  In addition, future utilization ofavailable net operating loss carryforwards may be limited under InternalRevenue Code Section 382 as a result of changes in ownership that have or mayresult from the issuance of common stock, redeemable convertible preferredstock or common stock options and warrants.

**Liquidity and Capital Resources**

Cash and cash equivalentsdecreased from $10,351,570 at April 30, 2006 to $6,565,206 at October 31, 2006due to the following:
| ** **                                 | ** ** | **Six months   ended  October 31, 2006** | ** ** |
|--------------------------------------------|------------|--------------------------------------------------------------|------------|
| Net cash used by operating activities      |       | $                                                            | (5,732,185 | ) |
| Net cash used by investing activities      |       | (45,383                                                      | )          |
| Net cash provided by financing activities  |       | 1,991,204                                                    |       |
| Net decrease in  cash and cash equivalents |       | $                                                            | (3,786,364 | ) |

 

*Operating Activities. *The net cashused by operating activities of $5,732,185 in the six months ended October 31,2006 resulted primarily from the net loss of $7,176,036 being partially offsetby non-cash charges of $1,064,210 related to stock-based compensation and$341,284 in net changes in operating assets and liabilities primarily due to adecrease in prepaid expenses and an increase in accounts payable.  The netcash used by operating activities of $2,183,457 in the six months ended October31, 2005 resulted primarily from the net income of $4,357,710 less non-cashcharges of $7,276,102 related to the change in fair value of putable warrants.

*Investing Activities. *The net cashused by investing activities of $45,383 in the six months ended October 31,2006 resulted from purchases of property, plant and equipment of $96,051 beingpartially offset by cash proceeds from the sales of property, plant andequipment of $50,668.  The net cash usedby investing activities of $307,264 in the six months ended October 31, 2005resulted from purchases of property, plant and equipment.

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*Financing Activities. *The net cashprovided by financing activities of $1,991,204 in the six months ended October31, 2006 resulted primarily from the $2,151,250 in net cash proceeds obtainedfrom the October 13, 2006 private placement being partially offset by principalpayments required by the related party lease obligation.  The net cash used by financing activities of$557,684 in the six months ended October 31, 2005 resulted primarily from the$441,691 in preferred stock cash dividends and principal payments required bythe related party lease obligation.

OnOctober 13, 2006, pursuant to the terms of a securities purchase agreement, weissued 714,286 shares of common stock to accredited investors and warrants forthe purchase of an aggregate of 178,571 shares of common stock to suchinvestors.  Gross proceeds of $2,500,000 fromthe private placement were reduced by offering costs of $348,750 resulting in$2,151,250 of net proceeds.  The warrantsare exercisable for five years at an exercise price of $4.365 per share,subject to basic, and for 9 months, full-ratchet anti-dilution adjustments.

Inconnection with the securities purchase agreement, we granted the investors a12-month right of participation in subsequent financings.  We agreed not to create or authorize anysenior securities or undertake a reverse or forward stock split orreclassification, without the consent of the purchasers of a majority of theshares, for 18 months.  We also agreednot to enter into any variable rate transactions for 18 months.

In addition, we enteredinto a registration rights agreement which required us to file a registrationstatement to register for resale the shares of common stock issued in thistransaction and the shares of common stock issuable upon exercise of thewarrants.  We filed such registrationstatement on November 17, 2006 and it was declared effective on November 30,2006.

If the registrationstatement ceases to be effective for more than an aggregate of 75 calendar daysin any 12-month period, we have agreed to pay each holder an amount asliquidated damages equal to 1.5% of the aggregate investment amount then heldby the holder of the shares purchased pursuant to the securities purchaseagreement and on each monthly anniversary of the failure to effect suchregistration, provided however that such liquidated damages will not exceed 10%of the aggregate purchase price paid by all holders.  We are required to use our commerciallyreasonable efforts to keep the registration statement effective until allregistered securities covered by the registration statement have been sold ormay be sold without volume restrictions pursuant to Rule 144(k).  We have determined that the possibility offailing to maintain the effectiveness of the registration statement for morethan an aggregate of 75 calendar days in any 12-month period is not probableand have not recorded a liability in the financial statements for liquidateddamages.

Inaddition, if the registration statement permitting the resale of the sharesissuable upon the exercise of the warrants is required to be effective but isnot then effective or the prospectus forming a part thereof is not thenavailable for the resale of the shares, then each warrant allows the holder toconvert the warrants into common stock without any cash consideration inexchange for the surrender of the remaining shares of common stock otherwisepurchasable upon the exercise of the warrant.

Throughoutfiscal year 2006 and 2005, we entered into a number of other financingtransactions to provide funds necessary to meet our working capital and capitalexpenditure needs and to meet other obligations.  Details of theseactivities are contained in our Annual Report on Form 10-KSB for the fiscalyear ended April 30, 2006.

Weexpect that our operating losses and negative operating cash flow will continueas we continue to support the development and launch of our minimally invasiveproduct.  We anticipate that our sales and marketing, general andadministrative and research and development expenses will continue toconstitute a material use of our cash resources.  The actual amounts andtiming of our capital expenditures will vary significantly depending upon theprogress of our product development and the availability of financing. Our cash balance of $6,565,206 at October 31, 2006 is expected to last throughMarch 2007.

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Ourcapital requirements may vary depending upon the timing and the success of theimplementation of our business plan, regulatory, technological and competitivedevelopments, or if:

·              sales of our product are notachieved;

·              operating losses exceed ourexpectations;

·              our manufacturing and developmentcosts or estimates prove to be inaccurate; or

·              we acquire, license or developadditional technologies.

Wecannot, however, assure you that our efforts to enter the market for treatingatrial fibrillation through laser ablation will:

·              be attainable;

·              be profitable;

·              reduce our reliance upon financingtransactions; or

·              enable us to continue operations.

**Commitments and Contingent Liabilities**

*Product Liability Contingency.*  InMarch 2005, we became aware that a patient who was utilizing our heartvalve had died.  We have not received any claims related to this matterbut believe that any such claim would be covered by our existing liabilityinsurance.  Based upon the expectation that insurance will cover the costof any claims after our payment of the deductible, we do not expect theultimate resolution of this matter to have a material effect on our business,financial condition, operating results or cash flows.

*Related Party Lease Obligation. * OnApril 4, 2003, we sold our corporate headquarters, manufacturing facilityand surrounding land in Inver Grove Heights, Minnesota, to PKM Properties, LLC(“PKM”), an entity controlled by Paul K. Miller.  Mr. Miller is one of ourdirectors and one of the largest beneficial owners of our securities.  Inconnection with the transaction, we received total consideration of $3.84million consisting of (1) $1.0 million in cash, (2) PKM’s assumptionof our $2.5 million outstanding indebtedness to Associated Bank, and(3) PKM’s assumption of our promissory note with Dakota ElectricAssociation and land special assessments payable to Dakota County aggregating$336,105.

Simultaneouswith the sale of the facility, we entered into a lease with PKM to lease backthe facility and a portion of the land.  The lease has a ten-year initialterm with options for us to extend the lease up to ten additional years. Under certain conditions, we also have an option to purchase the building atthe end of the initial ten-year term at the fair value at that time.  We also pay maintenance and operating costs,utilities and real estate taxes under the lease.  In addition, the lease makes it ourresponsibility for any construction costs deemed necessary or required by thelandlord in connection with the relocation or removal of the private septicsystem and/or drain field as well as costs associated with responding to anyrelease of hazardous materials at the property.

*Operating Lease.*  We have anoperating lease for a certain piece of office equipment, which expires infiscal year 2011.  At the end of the initial lease term, we have theoption to purchase the equipment at the fair market value, renew the lease, orreturn the equipment.

*Severance Contingencies.*  Employmentagreements with seven officers contain a provision for lump sum payments of upto twelve months severance if the officer is terminated without cause by us orfor good reason by the officer (as defined in the agreements).

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*Severance Contract.*  In April 2006,we entered into an amendment to the employment agreement (the “First Amendment”)with John H. Jungbauer, then our Vice President, Finance and Chief FinancialOfficer, to reflect the mutual decision reached concerning Mr. Jungbauer’sdeparture from our company.  Mr. Jungbauer’s employment ceased effectiveat the close of business on July 31, 2006.  A severance payment of$100,000 was paid on July 31, 2006 and an additional $100,000 will be paid toMr. Jungbauer in January 2007.  In addition to these severance payments,we have agreed to pay or reimburse Mr. Jungbauer for medical (COBRA)benefits.  We recorded an expense of $94,291 in the first quarter offiscal year 2007 and $131,793 in fiscal year 2006 related to the severancepayments, related payroll taxes, and medical benefits.

Inconnection with the First Amendment, we agreed to amend Mr. Jungbauer’s stockoption agreements to provide that his options, to the extent vested on thetermination date, would be exercisable for a period of twelve months followingthe termination of Mr. Jungbauer’s employment.  The original terms of Mr.Jungbauer’s stock option agreements for the purchase of 144,012 shares of ourcommon stock provided that he had three months following termination ofemployment to exercise the vested portions thereof.  We accounted for themodification in accordance with the provisions of APB No. 25 and recordedstock-based compensation expense of $87,353 in fiscal year 2006 to reflect theintrinsic value of excess of the market price of our stock at the date ofmodification over the exercise price of the vested stock options.

In July2006, we entered into a second amendment to the employment agreement (the “SecondAmendment”) with Mr. Jungbauer to retroactively rescind the provision in theFirst Amendment that provided Mr. Jungbauer twelve months following terminationof employment to exercise the vested portions thereof and revert to theoriginal terms of the stock option agreements that provide Mr. Jungbauer threemonths following termination of employment to exercise the vested portionsthereof.  Options to purchase 44,065 shares of our common stock had vestedas of July 31, 2006.  We accounted for the subsequent modification of theexercise period in fiscal year 2007 in accordance with the provisions of SFASNo. 123R.  Accordingly, no incremental compensation was recorded in fiscalyear 2007 as the fair value of the modified stock option agreements was lessthan the fair value immediately before the modification.  The options expired unexercised on October31, 2006.

*Laser Probe Technology Purchase Agreement. *In August 2003, we entered into a technology purchase agreement withLightWave Ablation Systems, Inc. (“LightWave”) and its principals, one of whombecame an employee of our company, relating to the acquisition of LightWave’sinterests in technology consisting of a catheter/probe containing elements ofoptical fiber, coolant passages and other features for the purpose ofdelivering laser energy to the epicardial surface of the heart for treatment ofatrial fibrillation.  We paid LightWave an initial standstill paymentconsisting of 1,500 shares of our common stock, $10,000 upon closing and anadditional $30,000 to LightWave in installments in 2004 and 2005.  Anadditional $125,000 was paid to LightWave in January 2006.  We will be obligatedto pay an additional $385,000 within 45 days following our achievement of$1,500,000 of cumulative gross sales of disposable products.  In addition,at closing, during fiscal year 2004, we issued to LightWave a warrant for thepurchase of 2,500 shares of common stock at $14.60 per share and, during fiscalyear 2005, a warrant for the purchase of 2,500 shares of common stock at $14.60per share upon receiving an FDA 510(k) clearance.  In addition, we areobligated to issue a warrant for the purchase of 2,500 shares of common stockupon a receipt of a U.S. utility patent covering the product and a warrant forthe purchase of 2,500 shares of common stock upon the first commercial sale ofthe product.

Followingthe first commercial sale, we have agreed to make payments to LightWave for tenyears equal to six percent of net sales of the LightWave product in countriesin which we obtain patent protection and four percent of net sales of theLightWave product in territories in which there is no patent protection. Commencing with the second year following our first commercial sale, we haveagreed to make minimum annual payments as follows:

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| Year Following  Commercialization | ** ** | **Minimum Annual  Payment** | ** ** |
|----------------------------------------|------------|----------------------------------|------------|
| 2                                      |       | $                                | 50,000     |   |
| 3                                      |       | 75,000                           |       |
| 4                                      |       | 100,000                          |       |
| 5                                      |       | 200,000                          |       |
| 6                                      |       | 300,000                          |       |
| 7                                      |       | 350,000                          |       |
| 8                                      |       | 350,000                          |       |
| 9                                      |       | 400,000                          |       |
| 10                                     |       | 500,000                          |       |
|                                   |       |                             |       |
|                                        |            |                                  |            |  |

 

LightWaveand two of its principals have agreed to certain noncompetition obligations,nondisclosure obligations, and certain obligations to assign new developments orinventions relating to the acquired technology to our company.  We haveagreed to use our reasonable commercial efforts to commercialize the technologywithin three years following the acquisition of the technology from LightWave.

If we fail in any year topay minimum annual payments, we may be obligated to grant LightWave anonexclusive right to use the technology acquired from LightWave, or payLightWave the difference between payments actually made and minimum paymentsdue for a given year.

The following table summarizes our contractualobligations as of October 31, 2006, excluding product liability contingencies,severance contingencies and payments that are contingent upon achievement offuture development of sales milestones, as described above:
| ** **                                            | ** ** | **Payments Due By Period** | ** ** |
|-------------------------------------------------------|------------|-------------------------------------------|------------|
| **Summary of Contractual Obligations** | ** ** | **TOTAL**                                 | ** ** | **Less than One   Year** | ** ** | **Two to Three   Years** | ** ** | **Four or More   Years** | ** ** |
| Related Party Lease Obligation(1)      |       | $                                         | 2,697,542  |   | $ | 431,384 |   | $ | 872,908 |   | $ | 1,393,250 |   |
| Accrued  Severance                                    |       | 120,126                                   |       | 120,126 |   | — |   | — |   |
| Operating Lease                                       |       | 19,815                                    |       | 5,530 |   | 11,059 |   | 3,226 |   |
| Total Contractual  Obligations                        |       | $                                         | 2,837,483  |   | $ | 557,040 |   | $ | 883,967 |   | $ | 1,396,476 |   |

 

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(1)          Future payments include interest due.

**Qualitative and Quantitative Disclosures about Market Risk**

We arefocusing all of our resources on the development and introduction of ourminimally invasive system.  Sales in fiscal year 2007 are not expected tobe material, and we expect that any sales will be in the United Statesdenominated in U.S. dollars.  Our interest income and expenses aresensitive to changes in the general level of U.S. interest rates, particularlysince our investments are in short-term instruments.  At October 31, 2006,we held a majority of our cash in a money market account.  Based on thecurrent nature and levels of our investments we believe that we currently haveno material market risk exposure.

Ourgeneral investing policy is to limit market and credit risk and the risk ofprincipal loss.  All liquid investments with maturities of three months orless are considered to be cash equivalents.

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**ITEM 3   CONTROLS ANDPROCEDURES**

**Evaluation of Disclosure Controls and Procedures**

Wemaintain disclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934, as amended (the “ExchangeAct”)) that are designed to ensure that information required to be disclosed byus in the reports we file or submit under the Exchange Act is recorded,processed, summarized, and reported, within the time periods specified in theSecurities and Exchange Commission’s rules and forms, and that such informationis accumulated and communicated to our management, including our principalexecutive officer and principal financial officer, to allow timely decisionsregarding required disclosure.

Ourmanagement, with the participation of our Chief Executive Officer and ChiefFinancial Officer, evaluated the effectiveness of our Company’s disclosurecontrols and procedures as of the end of the period covered in this QuarterlyReport on Form 10-QSB.  Based on this evaluation and because of thematerial weakness described below, our Chief Executive Officer and ChiefFinancial Officer have concluded that our disclosure controls and procedureswere not effective as of the end of the period covered in this Quarterly Reporton Form 10-QSB.  To address the material weakness described below, we haveexpanded our disclosure controls and procedures to include additional analysisand other procedures over the preparation of the financial statements includedin this report.  Accordingly, our management has concluded that thefinancial statements included in this report fairly present in all materialrespects our financial position, results of operations and cash flows for theperiods presented in conformity with accounting principles generally acceptedin the United States of America.

**Material Weakness in Internal Control Over FinancialReporting**

Amaterial weakness is a control deficiency or a combination of controldeficiencies that result in more than a remote likelihood that a materialmisstatement of the annual or interim financial statements will not beprevented or detected.  Our management has concluded that, as of October31, 2006 and April 30, 2006, we did not maintain effective controls over thepreparation, review, presentation and disclosure of our financialstatements.  Additionally, this control deficiency could result in amisstatement of the presentation and disclosure of our statement of operationsthat would result in a material misstatement in our annual or interim financialstatements that would not be prevented or detected.  Accordingly,management determined that this control deficiency constitutes a materialweakness in our internal control over financial reporting as of October 31,2006 and April 30, 2006.

**Changes in Internal Control Over Financial Reporting**

Therewas no change in our internal control over financial reporting, other thanthose noted below, that occurred during our quarter ended October 31, 2006 thathas materially affected, or is reasonably likely to materially affect, ourinternal control over financial reporting.

**Plan for Remediation of Material Weakness**

We havedeveloped a plan to address the above-referenced material weakness thatincludes adding additional professional accounting personnel.  In April2006, we hired a full-time controller with national public accounting firmexperience.  We will continue to assess the adequacy and appropriatenessof our financial staff and adjust accordingly as changes in our businesswarrant.  Management believes that our plan to address this materialweakness, when fully implemented, will remediate it.  Although we are notcertain when the material weakness will be remediated, we will need a period oftime over which to demonstrate that these controls are functioningappropriately to conclude that we have adequately remediated it.

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**PART II**

**OTHER INFORMATION**

**ITEM 1****          LEGAL PROCEEDINGS**

On March 10, 2006, J Giordano Securities LLC(d/b/a J Giordano Securities Group) (“JGSG”) filed suit against our company inU.S. District Court for the District of Connecticut. JGSG, which acted as aprivate placement agent for our company in connection with sales of oursecurities to private investors in April 2005, asserts claims for breachof contract, unjust enrichment and quantum meruit. JGSG contends it is owedcertain fees as a result of “follow on transactions” executed by investorsidentified by JGSG, pursuant to the engagement agreement, as amended, betweenus and JGSG or, in the alternative, that it should be awarded such fees on anequitable basis. In particular, JGSG originally claimed that the exercise ofoutstanding warrants for the purchase of common stock by certainJGSG-identified investors and our purchase of outstanding shares of 5%Series A Redeemable Convertible Preferred Stock from certainJGSG-identified investors in December 2005 and January 2006 entitledJGSG to damages no less than $1,431,769. JGSG originally sought(a) $279,191 in cash commissions, (b) warrants for the purchase of85,905 shares at $3.25 per share, (c) lost profits of $751,669 on theargument that JGSG would have exercised the foregoing warrant and sold 85,905shares on December 30, 2005, at a price of $12.00 per share, and(d) $400,909 in cash commissions we paid C.E. Unterberg, Towbin, LLC (“CEUT”).

On September 22, 2006, we asserted a counterclaimagainst JGSG for fraud and breach of contract based upon JGSG’smisrepresentations to induce us to enter the engagement agreement and JGSG’sfailure to perform its promised services thereunder. We seek damages of(a) the $30,000 retainer and $543,000 cash paid to JGSG; (b) thevalue of our warrants for 114,600 shares of common stock issued to JGSG;(c) the $445,328 fee and $27,016 expense reimbursement that we paid CEUTfor its advisory services in December 2005 and January 2006;(d) the $3.7 million cash we did not obtain on investor warrant exercisesdue to the reduced warrant exercise price we were required to accept duringthose months; and (e) the value of the additional 1.9 million shares ofcommon stock we were required to issue to effectuate the preferred stockpurchase during those months. As a result, we counterclaim in excess of $5.0million.

On November 20, 2006, JGSG filed an amendedstatement of claim. JGSG added new claims for additional compensation basedupon the issuance of additional common stock to preferred stock holders in thealleged “follow-on transactions,” our alleged failure to timely file a resaleregistration statement for JGSG, and for additional compensation based upon ourOctober 2006 private placement. JGSG currently seeks alleged damages of$3,346,565 as follows: (a) $279,191 in cash commissions; (b) warrantsfor the purchase of 85,905 shares at $3.25 per share; (c) lost profits of$751,669 on the argument that JGSG would have exercised the foregoing warrantand sold 85,905 shares on December 30, 2005, at a price of $12.00 pershare; (d) $249,690 in cash pursuant to the alleged failure to timely filethe resale registration statement for JGSG; (e) $6,726 in liquidateddamages based upon our alleged failure to timely file the resale registrationstatement for JGSG; (f) $556,214 in cash commissions that JGSG claims itwas entitled to based upon preferred stock holders’ receipt of additionalcommon stock in the alleged “follow-on transactions”; (g) warrants for thepurchase of 171,142 shares at $3.25 per share; (h) lost profits of$952,166 on the argument that JGSG would have exercised the foregoing warrantand sold 171,142 shares on January 3, 2006, at a price of $11.00 pershare; (i) $400,909 in cash commissions we paid to CEUT; and(j) $150,000 based upon the fee we paid to CEUT for our October 2006private placement. JGSG also seeks reimbursement for reasonable expenses, interest,costs and attorneys’ fees. The U.S. District Court for the District ofConnecticut has referred the matter to NASD arbitration. We believe that JGSG’slawsuit is without merit and intend to vigorously defend ourselves.

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

The Company’s 2006 Annual Meeting of Shareholders washeld on October 19, 2006.  Two proposalswere submitted to shareholders for approval, each of which passed with votingresults as follows:

(1)           Toelect six directors for the ensuing year and until their successors shall beelected and duly qualified.  Each of thenominees for directors, as listed in the proxy statement, was elected with thenumber of votes set forth below:
| Name                   | ** ** | **For**   | ** ** | **Withhold** | ** ** |
|------------------------|------------|-----------|------------|--------------|------------|
| Susan L. Critzer       |       | 6,848,658 |       | 93,272       |       |
|                   |       |      |       |         |       |
| Marc P. Flores         |       | 6,848,658 |       | 93,272       |       |
|                   |       |      |       |         |       |
| Larry G.  Haimovitch   |       | 6,848,658 |       | 93,272       |       |
|                   |       |      |       |         |       |
| David B. Kaysen        |       | 6,848,658 |       | 93,272       |       |
|                   |       |      |       |         |       |
| Paul K. Miller         |       | 6,848,658 |       | 93,272       |       |
|                   |       |      |       |         |       |
| J. Robert Paulson, Jr. |       | 6,848,658 |       | 93,272       |       |

 

(2)           To ratify the appointment of LurieBesikof Lapidus & Company, LLP as our independent registered publicaccounting firm for the fiscal year ending April 30, 2007
| For       | ** ** | **Against** | ** ** | **Abstain** | ** ** |
|-----------|------------|-------------|------------|-------------|------------|
| 6,819,542 |       | 19,465      |       | 102,923     |       |

 

**ITEM 6****            EXHIBITS**

See “Index to Exhibits.”

27

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**SIGNATURES**

Inaccordance with the requirements of the Exchange Act, the registrant causedthis report to be signed on its behalf by the undersigned, thereunto dulyauthorized.
|                              | MedicalCV, Inc. |
|------------------------------|----------------------|
|                         |                 |   |   |
|                         |                 |   |   |
| Date: December 14, 2006 | By                   | /s/ Marc P. Flores |   |
|                         |                 | Marc P. Flores |   |
|                         |                 | President and Chief Executive Officer |
|                         |                 |   |   |
|                         | By                   | /s/ Eapen Chacko |   |
|                         |                 | Eapen Chacko |   |
|                         |                 | Vice President, Finance and Chief Financial Officer |

 

28

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**INDEX TOEXHIBITS**
| Exhibit  Number | ** ** | **Description**                                                                                                                                                                                                                               |
|-----------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|            |       |                                                                                                                                                                                                                                          |   |   |
| 3.1             |       | Restated Articles of Incorporation of the  Registrant, as Amended (incorporated by reference to Amendment No. 1 to our  Registration Statement on Form SB-2, filed on June 6, 2006 (File No.  333-134315)).                                   |
|            |       |                                                                                                                                                                                                                                          |   |   |
| 3.2             |       | Bylaws of the Registrant (incorporated by reference  to our Registration Statement on Form SB-2, filed on August 31, 2001 (File  No. 333-68884)).                                                                                             |
|            |       |                                                                                                                                                                                                                                          |   |   |
| 4.1             |       | Reference is made to Exhibits 3.1 and 3.2.                                                                                                                                                                                                    |
|            |       |                                                                                                                                                                                                                                          |   |   |
| 4.2             |       | Specimen Common Stock Certificate (incorporated by  reference to Amendment No. 1 to our Registration Statement on Form SB-2,  filed on June 6, 2006 (File No. 333-134315)).                                                                   |
|            |       |                                                                                                                                                                                                                                          |   |   |
| 10.1            |       | Securities Purchase Agreement between MedicalCV,  Inc. and the Investors named as signatories thereto, dated October 13, 2006  (incorporated by reference to our Current Report on Form 8-K filed on October  16, 2006 (File No. 000-33295)). |
|            |       |                                                                                                                                                                                                                                          |   |   |
| 10.2            |       | Registration Rights Agreement between MedicalCV,  Inc. and the Investors named as signatories thereto, dated October 13, 2006  (incorporated by reference to our Current Report on Form 8-K filed on October  16, 2006 (File No. 000-33295)). |
|            |       |                                                                                                                                                                                                                                          |   |   |
| 10.3            |       | Form of 2006 Private Placement Warrant (incorporated  by reference to our Current Report on Form 8-K filed on October 16, 2006  (File No. 000-33295)).                                                                                        |
|            |       |                                                                                                                                                                                                                                          |   |   |
| 10.4            |       | Non-Employee Director Compensation Policy  (incorporated by reference to our Current Report on Form 8-K filed on October  25, 2006 (File No. 000-33295)).                                                                                     |
|            |       |                                                                                                                                                                                                                                          |   |   |
| 10.5            |       | Form of Non-Employee Director Stock Option Agreement  issuable under the 2005 Director Stock Option Plan (incorporated by reference  to our Current Report on Form 8-K filed on September 23, 2005 (File No.  000-33295)).                    |
|            |       |                                                                                                                                                                                                                                          |   |   |
| 31.1            |       | Chief Executive Officer Certification pursuant to  Exchange Act Rule 13a-14(a).                                                                                                                                                          |
|            |       |                                                                                                                                                                                                                                          |   |   |
| 31.2            |       | Chief Financial Officer Certification pursuant to  Exchange Act Rule 13a-14(a).                                                                                                                                                          |
|            |       |                                                                                                                                                                                                                                          |   |   |
| 32.1            |       | Chief Executive Officer Certification pursuant to 18  U.S.C. Section 1350.                                                                                                                                                               |
|            |       |                                                                                                                                                                                                                                          |   |   |
| 32.2            |       | Chief Financial Officer Certification pursuant to 18  U.S.C. Section 1350.                                                                                                                                                               |

 

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