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**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

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**FORM 10-Q**

 

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**(Mark One)**

 
| **x**                                                   | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934**  |
|---------------------------------------------------------|----------------------------------------------------------------------------------------------------------|
|                                                    |
| **For the  quarterly period ended March 31, 2009** |
|                                                    |
| **OR**                                                  |
|                                                    |
| **o**                                                   | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |

 

**CommissionFile Number 001-33770**

 

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**Power MedicalInterventions, Inc.**

(Exact name of registrant as specified in itscharter)

 

| **Delaware**                     | ** ** | **23-3011410**                        |
|----------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of |       | (I.R.S. Employer  Identification No.) |
| incorporation or  organization)  |       |                                  |

 

**2021 CabotBoulevard, Langhorne, Pennsylvania 19047**

(Address of principal executive offices)

 

**(267)775-8100**

(Registrant’s telephone number, includingarea code)

 

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

 

Indicate by check mark whether the registrant hassubmitted electronically and posted on its corporate Web site, if any, everyInteractive Data File required to be submitted and posted pursuant to Rule 405of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (orfor such shorter period that the registrant was required to submit and postsuch files).  Yes  o      No  o.

 

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, a non-accelerated filer, or asmaller reporting company. See the definitions of “large accelerated filer,”“accelerated filer,” and “smaller reporting company” in Rule 12b-2 of theExchange Act. (Check one):

 

| Large accelerated  filer  o                                               |   | Accelerated  filer  o         |
|-------------------------------------------------------------------------------------|--------|-----------------------------------------|
|                                                                                |   |                                    |
| Non-accelerated  filer  o

(Do not check if a smaller  reporting company) |   | Smaller reporting  company  x |

 

Indicate by check mark whether the Registrant is ashell company (as defined in Rule 12b-2 of the ExchangeAct). Yes  o      No  x.

 

The number of shares outstanding of each of the registrant’s classes ofcommon stock, as of the latest practicable date, is as follows:

 

| **Class**                                | ** ** | **Outstanding  at May 8, 2009** |
|------------------------------------------|------------|--------------------------------------|
|                                     | ** ** |                                 |
| Common stock, par value $0.001 per share | ** ** | 17,152,465                           |

 

 

 

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**POWER MEDICAL INTERVENTIONS, INC.**

 
| ** **    | ** **                                                                                                | **PAGE** |
|---------------|-----------------------------------------------------------------------------------------------------------|----------|
| PART I:  | FINANCIAL INFORMATION                                                                                     | 1        |
|          |                                                                                                      |     |
| Item 1.  | Consolidated Financial  Statements (Unaudited)                                                            | 1        |
|          |                                                                                                      |     |
|          | Condensed  Consolidated Balance Sheets as of March 31, 2009 and December 31,  2008              | 1        |
|          |                                                                                                      |     |
|          | Condensed  Consolidated Statements of Operations for the Three Months Ended  March 31, 2009 and 2008 | 2        |
|          |                                                                                                      |     |
|          | Condensed  Consolidated Statements of Cash Flows for the Three Months Ended  March 31, 2009 and 2008 | 3        |
|          |                                                                                                      |     |
|          | Notes to Unaudited Condensed Consolidated Financial  Statements                                           | 4        |
|          |                                                                                                      |     |
| Item 2.  | Management’s  Discussion and Analysis of Financial Condition and Results of Operations               | 12       |
|          |                                                                                                      |     |
| Item 3.  | Quantitative  and Qualitative Disclosures About Market Risk                                               | 22       |
|          |                                                                                                      |     |
| Item 4.  | Controls and  Procedures                                                                                  | 23       |
|          |                                                                                                      |     |
| PART II: | OTHER INFORMATION                                                                                         | 24       |
|          |                                                                                                      |     |
| Item 1.  | Legal Proceedings                                                                                         | 24       |
|          |                                                                                                      |     |
| Item 1A. | Risk Factors                                                                                              | 25       |
|          |                                                                                                      |     |
| Item 2.  | Unregistered  Sales of Equity Securities and Use of Proceeds                                              | 46       |
|          |                                                                                                      |     |
| Item 3.  | Defaults  Upon Senior Securities                                                                          | 46       |
|          |                                                                                                      |     |
| Item 4.  | Submission  of Matters to a Vote of Security Holders                                                      | 46       |
|          |                                                                                                      |     |
| Item 5.  | Other Information                                                                                         | 46       |
|          |                                                                                                      |     |
| Item 6.  | Exhibits                                                                                                  | 47       |
|          |                                                                                                      |     |
|          | Signatures                                                                                                | 48       |

 

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PART I:                  FINANCIAL INFORMATION

 

**Item 1.                    Consolidated FinancialStatements (Unaudited)**

 

**PowerMedical Interventions, Inc.**

**CondensedConsolidated Balance Sheets**

**(Amounts inthousands, except share and per share data)**

 
| ** **                                                                                                                             | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                                                                                                             | ** ** | **2009**           | ** ** | **2008**              | ** ** |
| **ASSETS**                                                                                                                             | ** ** | ** **         | ** ** | ** **            | ** ** |
| Current assets:                                                                                                                        | ** ** | ** **         | ** ** | ** **            | ** ** |
| Cash and cash equivalents                                                                                                              |       | $                  | 4,713      |                  | $          | 8,384 |   |
| Restricted cash                                                                                                                        |       | —             |       | 875                   |       |
| Accounts receivable, net of allowance for  doubt accounts                                                                              |       | 1,736              |       | 1,290                 |       |
| Inventory                                                                                                                              |       | 7,536              |       | 8,354                 |       |
| Prepaid expenses and other current assets                                                                                              |       | 1,040              |       | 1,487                 |       |
| Total current assets                                                                                                                   |       | 15,025             |       | 20,390                |       |
|                                                                                                                                   |       |               |       |                  |       |
| Property and equipment, net                                                                                                            |       | 4,106              |       | 4,380                 |       |
| Intangibles, net                                                                                                                       |       | 1,207              |       | 1,192                 |       |
| Deferred financing fees                                                                                                                |       | 567                |       | 709                   |       |
| Other assets                                                                                                                           |       | 209                |       | 223                   |       |
| Restricted cash                                                                                                                        |       | 1,118              |       | 1,303                 |       |
| Total assets                                                                                                                           |       | $                  | 22,232     |                  | $          | 28,197 |   |
|                                                                                                                                   |       |               |       |                  |       |
| **LIABILITIES AND STOCKHOLDERS’ DEFICIT**                                                                                         |       |               |       |                  |       |
| Current liabilities:                                                                                                                   |       |               |       |                  |       |
| Accounts payable                                                                                                                       |       | $                  | 1,556      |                  | $          | 2,661 |   |
| Accrued expenses                                                                                                                       |       | 3,154              |       | 4,039                 |       |
| Long term debt, current portion                                                                                                        |       | 24,840             |       | 71                    |       |
| Total current liabilities                                                                                                              |       | 29,550             |       | 6,771                 |       |
|                                                                                                                                   |       |               |       |                  |       |
| Long-term debt, net of current portion                                                                                                 |       | 196                |       | 24,921                |       |
| Deferred revenue, long-term                                                                                                            |       | 15,000             |       | 12,500                |       |
| Deferred rent, net of current portion                                                                                                  |       | 443                |       | 493                   |       |
| Total liabilities                                                                                                                      |       | 45,189             |       | 44,685                |       |
|                                                                                                                                   |       |               |       |                  |       |
| Commitments and contingencies                                                                                                          |       |               |       |                  |       |
|                                                                                                                                   |       |               |       |                  |       |
| Stockholders’ deficit:                                                                                                            |       |               |       |                  |       |
| Common stock, $.001 par value, 200,000,000  shares authorized,  17,152,465 shares issued and outstanding, as of each respective period |       | 17                 |       | 17                    |       |
| Additional paid-in capital                                                                                                             |       | 200,266            |       | 199,740               |       |
| Accumulated other comprehensive loss                                                                                                   |       | (68                | )          | (20                   | )          |
| Accumulated deficit                                                                                                                    |       | (223,172           | )          | (216,225              | )          |
| Total stockholders’ deficit                                                                                                       |       | (22,957            | )          | (16,488               | )          |
| Total liabilities and stockholders’ deficit                                                                                       |       | $                  | 22,232     |                  | $          | 28,197 |   |

 

*See accompanying notes to these unaudited condensed consolidatedfinancial statements.*

 

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**PowerMedical Interventions, Inc.**

**CondensedConsolidated Statements of Operations**

**(Amounts inthousands, except share and per share data)**

 
| ** **                                                       | ** ** | **For the Three Months** | ** ** |
|------------------------------------------------------------------|------------|--------------------------|------------|
| ** **                                                       | ** ** | **Ended March 31,** | ** ** |
| ** **                                                       | ** ** | **2009**                 | ** ** | **2008** | ** ** |
|                                                             |       |                     |       |   |   |
| **Sales**                                                        |       | $                        | 2,743      |   | $ | 2,224 |   |
| **Cost of Sales**                                                |       | 2,161                    |       | 2,557 |   |
|                                                             |       | 582                      |       | (333 | ) |
|                                                             |       |                     |       |   |   |
| **Costs and expenses**                                           |       |                     |       |   |   |
| Research and development                                         |       | 804                      |       | 1,583 |   |
| Sales and marketing                                              |       | 3,494                    |       | 6,796 |   |
| General and administrative                                       |       | 2,625                    |       | 3,013 |   |
|                                                             |       | 6,923                    |       | 11,392 |   |
|                                                             |       |                     |       |   |   |
| Operating loss                                                   |       | (6,341                   | )          | (11,725 | ) |
|                                                             |       |                     |       |   |   |
| **Other income (expense)**                                       |       |                     |       |   |   |
| Interest and other income                                        |       | 44                       |       | 195 |   |
| Interest and other expense                                       |       | (650                     | )          | (650 | ) |
| **Total other income (expense)**                                 |       | (606                     | )          | (455 | ) |
|                                                             |       |                     |       |   |   |
| **Net loss**                                                     |       | $                        | (6,947     | ) | $ | (12,180 | ) |
|                                                             |       |                     |       |   |   |
| **Net loss per common stock share:**                             |       |                     |       |   |   |
| - Basic and diluted                                              |       | $                        | (0.41      | ) | $ | (0.71 | ) |
|                                                             |       |                     |       |   |   |
| **Weighted average number of common stock  shares outstanding:** |       |                     |       |   |   |
| - Basic and diluted                                              |       | 17,152,465               |       | 17,107,052 |   |

 

*See accompanying notes to these unaudited condensedconsolidated financial statements.*

 

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**PowerMedical Interventions, Inc.**

**CondensedConsolidated Statements of Cash Flows**

**(Amounts inthousands)**

 
| ** **                                                                  | ** ** | **For the Three Months** | ** ** |
|-----------------------------------------------------------------------------|------------|--------------------------|------------|
| ** **                                                                  | ** ** | **Ended March 31,** | ** ** |
| ** **                                                                  | ** ** | **2009**                 | ** ** | **2008** | ** ** |
| ** **                                                                  | ** ** | ** **               | ** ** | ** ** | ** ** |
| **CASH FLOWS FROM OPERATING ACTIVITIES:**                                   | ** ** | ** **               | ** ** | ** ** | ** ** |
| Net loss                                                                    |       | $                        | (6,947     | ) | $ | (12,180 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities |       |                     |       |   |   |
| Depreciation and amortization                                               |       | 472                      |       | 298 |   |
| Amortization of debt discount and deferred  financing fees                  |       | 204                      |       | 204 |   |
| Loss on disposal of property and equipment                                  |       | —                   |       | 16 |   |
| Share-based compensation                                                    |       | 525                      |       | 440 |   |
| Changes in operating assets and  liabilities:                               |       |                     |       |   |   |
| Accounts receivable                                                         |       | (485                     | )          | (70 | ) |
| Inventory                                                                   |       | 914                      |       | (1,632 | ) |
| Prepaid expenses and other assets                                           |       | 302                      |       | 152 |   |
| Accounts payable                                                            |       | (1,087                   | )          | 232 |   |
| Accrued expenses                                                            |       | (744                     | )          | (589 | ) |
| Deferred rent                                                               |       | (50                      | )          | (47 | ) |
| Deferred revenue                                                            |       | 2,500                    |       | — |   |
| Net cash used in operating activities                                       |       | (4,396                   | )          | (13,176 | ) |
|                                                                        |       |                     |       |   |   |
| **CASH FLOWS FROM INVESTING ACTIVITIES:**                                   |       |                     |       |   |   |
| Purchases of property and equipment                                         |       | (148                     | )          | (1,055 | ) |
| Proceeds from sale of property and  equipment                               |       | 3                        |       | — |   |
| Patent application costs                                                    |       | (74                      | )          | (19 | ) |
| Change in restricted cash                                                   |       | 1,016                    |       | 1,016 |   |
| Net cash provided by (used in) investing  activities                        |       | 797                      |       | (58 | ) |
| **CASH FLOWS FROM FINANCING ACTIVITIES:**                                   |       |                     |       |   |   |
| Repayments of long-term debt                                                |       | (18                      | )          | (17 | ) |
| Net cash used in financing activities                                       |       | (18                      | )          | (17 | ) |
|                                                                        |       |                     |       |   |   |
| Effect of exchange rate on cash and cash  equivalents                       |       | (54                      | )          | 132 |   |
| Net decrease in cash and equivalents                                        |       | (3,671                   | )          | (13,119 | ) |
| Cash and equivalents, beginning of period                                   |       | 8,384                    |       | 36,592 |   |
| Cash and equivalents, end of period                                         |       | $                        | 4,713      |   | $ | 23,473 |   |
|                                                                        |       |                     |       |   |   |
| **SUPPLEMENTAL DISCLOSURE OF CASH FLOW  INFORMATION**                       |       |                     |       |   |   |
| Cash paid for interest                                                      |       | $                        | 877        |   | $ | 884 |   |

 

*See accompanying notes to these unaudited condensedconsolidated financial statements.*

 

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**PowerMedical Interventions, Inc.**

 

**Notes toUnaudited Condensed Consolidated Financial Statements**

 

**March 31,2009**

 

**1.  Business**

 

Power Medical Interventions, Inc. (the Company), a Delawarecorporation, is a medical device company that designs, manufactures and marketsa family of computer-assisted, power-actuated endomechanical surgicalinstruments, referred to as Intelligent Surgical InstrumentsTM. Surgeons useIntelligent Surgical Instruments for cutting, stapling and tissue manipulationin a variety of procedures in open surgery, minimally invasive surgery, or MIS,and in the emerging field of natural orifice translumenal endoscopic surgery,or NOTES.

 

The Company has wholly owned subsidiaries in Germany, Power MedicalInterventions Deutschland GmbH; in France, Power Medical InterventionsFrance; and in Japan, Power Medical Interventions Japan, which conduct salesand marketing operations. The Company also has a dormant U.S. subsidiary, PowerMedical Vascular, Inc.

 

The consolidated financial statements of the Company have been preparedon a going-concern basis, which contemplates the realization of assets and thesatisfaction of liabilities in the normal course of business. Accordingly, thefinancial statements do not include any adjustments that might be necessaryshould the Company be unable to continue in existence. The Company incurred anet loss of approximately $6.9 million in the three months ended March 31,2009 and net losses of approximately $42.3 million and $36.8 millionfor the years ended December 31, 2008, and 2007, respectively, and has anaccumulated deficit of approximately $223.2 million at March 31,2009. Losses are expected to continue at least through 2009. The Companybelieves that its cash and cash equivalents, together with the Company’s futuresales and milestones, will be sufficient to meet its cash requirements through June 30,2009. These factors raise substantial doubt about the Company’s ability tocontinue as a going concern. The Company’s future cash requirements will dependon many factors, including its ability to increase its sales and improve itsgross margins, its ability to earn and receive additional payments under itsagreements with Intuitive Surgical, Inc. and the success of itsrestructuring initiative. The Company implemented this restructuring initiativein the fourth quarter of 2008 to reduce cash used in operations throughheadcount reductions and other spending programs. Examples of such costsinclude certain sales and marketing costs, product development costs, clinicalresearch costs, employee bonuses, and capital expenditures. The Company’sability to meet its obligations in the normal course of business will bedependent on its securing additional external financing which it is activelypursuing through various structures, increasing its customer and revenue base,and continuing to control expenses. Currently, the Company has no arrangementsto obtain additional financing, and there can be no assurance that suchfinancing will be available in amounts or on terms acceptable to the Company,if at all.

 

**2.  Summary of Significant Accounting Policies**

 

*Unaudited interim financial data*

 

The accompanying unaudited condensed consolidated financial statementshave been prepared in accordance with accounting principles generally acceptedin the United States and the requirements of Form 10-Q and Regulation S-X.

 

The accompanying condensed consolidated balance sheet as of March 31,2009, the condensed consolidated statements of operations for the three monthsended March 31, 2009 and 2008, and the condensed consolidated statementsof cash flows for the three months ended March 31, 2009 and 2008 areunaudited. The unaudited interim financial statements have been prepared on thesame basis as the annual financial statements and, in the opinion ofmanagement, reflect all adjustments, which include only normal recurring adjustments,necessary to state fairly the Company’s financial position as of March 31,2009 and the results of its operations and cash flows for the three monthsended March 31, 2009 and 2008. The financial data and other informationdisclosed in these notes to the financial statements are unaudited. The resultsfor the three months ended March 31, 2009 are not necessarily indicativeof the results to be expected for any future period.

 

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*Revenue recognition*

 

Most of the Company’s revenue historically has been derived from thesale of single-patient, disposable loading units and from the sale of reloadcartridges for reusable Intelligent Surgical Instruments. Revenue related tothe sale of such individual products is recognized when persuasive evidence ofan arrangement exists, delivery has occurred, the sales price is fixed anddeterminable, and collectibility is reasonable assured, which is generally atthe time of shipment upon delivery to a common carrier.

 

The Company also considers Emerging Issue Task Force, orEITF, 00-21, *Revenue Arrangements withMultiple Deliverables,* when recognizing its revenue. Under multiple-elementarrangements involving the sale of multiple products, services and/or rights touse assets, the multiple elements are divided into separate units of accountingwhen certain criteria are met, including whether the delivered items have standalone value to the customer and whether there is objective and reliableevidence of the fair value of the undelivered items. When separate units ofaccounting exist, consideration is allocated among the separate elements basedon their respective fair values. If such evidence of fair value for eachundelivered element of the arrangement does not exist, all revenue from thearrangement is deferred until such time that evidence of fair value for eachundelivered element does exist or until all elements of the arrangement aredelivered.

 

The Company’s Intelligent Surgical Instrument surgical platformincludes cutting and stapling devices in a variety of sizes and linear, rightangle and circular configurations designed for differing surgical needs. TheCompany’s Intelligent Surgical Instruments are available in a reusablemultiple-patient format which can be autoclaved and used in multiple cases. TheCompany’s reusable Intelligent Surgical Instruments use disposable cutting andstapling cartridges in various sizes, which the Company refers to as reloadcartridges and digital loading units.

 

The Company instituted a program in 2007 whereby it may providereusable Intelligent Surgical Instruments and FlexShafts to customers at nocost. In certain cases, the Company offers such Intelligent SurgicalInstruments and FlexShafts at no cost in exchange for higher unit pricing onthe sale of reload cartridges over a specified period of time. In these cases,the Company recognizes the revenue ratably over the period of delivery of thereload cartridges, as long as such revenue is not contingent on the delivery ofthe undelivered products. The Company has in certain cases agreed to transfertitle to such systems to the customer upon the customer’s purchase of aspecified number of disposable Intelligent Surgical Instruments although thecustomer is under no obligation to purchase the Intelligent SurgicalInstruments. In these instances, the Company recognizes revenue attributable tothe complete system as the Intelligent Surgical Instruments are delivered.

 

The Company currently makes its i60, i45 and iDrive instrumentsavailable to customers at no charge under an “in service under evaluation”program. The evaluation period is typically six months and the Company expectsto derive recurring revenues from sales of the reload cartridges necessary forthe evaluation instruments’ use. At the end of the evaluation period, customershave the option to (i) buy the equipment and continue to receive reloadcartridge pricing consistent with that of the evaluation period, (ii) keepthe equipment and agree to higher sales prices on the reload cartridge than wascharged during the evaluation period or (iii) return the equipment with nofurther obligation.

 

The Company’s customers generally order product using standard purchaseorders and payment terms are 30 days. The Company provides discountedpricing to its customers based on volume and commitment levels. Allowance forproduct returns are estimated based on historical experience and provisions arerecorded at the time of shipment. The Company also provides limited warrantiesto its customers against material defects in materials and workmanship. Suchwarranties are generally for a one year period from the date of shipment.Historically, warranty costs have not been material.

 

The Company’s revenues were derived from customers located in thefollowing geographic regions:

 

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| ** **    | ** ** | **March 31,** | ** ** |
|---------------|------------|--------------------|------------|
| ** **    | ** ** | **2009**           | ** ** | **2008** | ** ** |
|          |       |               |       |   |   |
| North America |       | 69                 | %          | 85 | % |
| Europe        |       | 14                 | %          | 11 | % |
| Asia          |       | 17                 | %          | 4 | % |

 

Amounts billed to customers for product shipping and handling areincluded in sales. Costs incurred related to product shipping and handling areincluded in cost of sales.

 

*Revenue Recognition—Arrangement with IntuitiveSurgical, Inc.*

 

In September 2008, the Company entered into two agreements withIntuitive Surgical, Inc. The first agreement is a License and DevelopmentAgreement under which Intuitive expects to develop a surgical stapling devicewhich will attach to Intuitive’s da VinciTM Surgical Systems and will utilizeour patented technology. Once developed, this attachment will enable Intuitive’sda VinciTM Surgical Systems to cut and staple tissue in a broad array ofsurgical applications. The second agreement is an exclusive Reload SupplyAgreement whereby the Company will manufacture and will be the exclusivesupplier to Intuitive of staple reloads for the newly developed device atagreed upon prices. The Company refers to the License and Development Agreementand the Reload Supply Agreement collectively as the Intuitive Agreements.

 

Under the terms of the Intuitive Agreements, the Company received anupfront license payment of $12.5 million in September 2008. Inaddition, the Company received a payment $2.5 million in February 2009and may receive additional payments of up to $5.0 million based upon theachievement of agreed upon development milestones. The Company will also beresponsible for providing, at its expense, up to an aggregate of 3,900 manhours of engineering and technical support services to Intuitive to assistIntuitive in designing and developing the new device.

 

The Company has identified four deliverables within this arrangement: (i) thelicense to utilize its patented technology, (ii) consultative servicesduring Intuitive’s development of the new device, (iii) a six-year supplyarrangement to supply reload cartridges to Intuitive, including a minimumpurchase obligation during the first 18 months subsequent to the firstcommercial sale of the device by Intuitive to a third party and (iv) asignificant and incremental discount on the future purchases of reloadcartridges. The Company has concluded that these deliverables should beaccounted for as a single unit of accounting, with recognition of revenue for thesingle unit of accounting commencing upon the delivery of the final element inthe arrangement (i.e., commencement of delivery of the staple reloadcartridges contemplated by the Reload Supply Agreement). Accordingly, the$15.0 million the Company has received since September 2008 has beendeferred and is reported in the consolidated financial statements as deferredrevenue as of March 31, 2009. Additional milestone payments, if received,will also be deferred until the first commercial sale of the device to a thirdparty.

 

Should the project reach the first commercial sale, the$20.0 million of up-front and milestone payments, as well as theguaranteed minimum amount of reload sales, will begin to be recognized asrevenues over the term of the Reload Supply Arrangement (i.e., thesix-year period following the date of the first commercial sale of the deviceto a third party). Revenues from the sale of additional reloads beyond theminimum guaranteed quantity will be recognized as such reloads are shipped.

 

*Share-based compensation*

 

The Company’s share-based compensation is accounted for in accordancewith the fair value recognition provisions of Statements of FinancialAccounting Standards, or SFAS, No. 123 (revised 2004) *Share-BasedPayments*, or SFAS 123(R). In addition, the Company accounts for itsshare-based compensation to non-employees in accordance with EITF 96-18, *Accounting for Equity Investments that are Issued to Other ThanEmployees for Acquiring, or in connection with, Selling Goods or Services,*orEITF 96-18. The Company uses the Black-Scholes option-pricing model to estimatethe fair value its share-based awards as of the date of grant. TheBlack-Scholes model, by its design, is highly complex and dependent upon keydata inputs estimated by management. The primary

 

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datainputs with the greatest degree of judgment are generally the estimated livesof the share-based awards and the estimated volatility of the Company’s commonstock price. The Black-Scholes model is sensitive to changes to these two datainputs.

 

Beginning in fiscal year 2006, the Company calculated the estimatedlife of stock options granted using a “simplified” method, based upon guidancefrom the Securities and Exchange Commission, or SEC, as contained in StaffAccounting Bulletin, or SAB, No. 107 permitting the initial use of thismethod through 2007. In December 2007, the SEC issued SAB No. 110,which was effective January 1, 2008, expressing the expectation thatcompanies should be employing information from internal or external sourcesabout employee stock option exercise behavior when developing estimates ofexpected term as they relate to stock option valuations. SAB No. 110states that the SEC will continue to accept the use of the “simplified” method,under certain circumstances, beyond December 31, 2007. The Companyevaluated the exercise behavior of its employees and determined that theexercise history was an inadequate measure of the expected term of the Company’sstock options. Therefore, the Company has continued its use of the simplifiedmethod as prescribed in SAB No. 107. Expected stock price volatility istypically based on the daily historical trading data from an appropriate pointin time through the last day of the applicable period. Because the Company’shistorical trading data only dates back to October 26, 2007, the firsttrading date subsequent to our initial public offering, the expected volatilityof its common stock was calculated for each date of grant based on analternative method (defined as “calculated value”). The Company identifiedsimilar public entities for which share price information is available and haveconsidered the historical volatility of these entities’ share prices inestimating expected volatility.

 

*Net loss attributable to common shares*

 

The Company computes net loss per share in accordance with SFAS No. 128,*Earnings Per Share, or*SFAS No. 128.Under SFAS No. 128, basic net loss per share is computed by dividing netloss per share available to common stockholders by the weighted average numberof common shares outstanding for the period and excludes the effects of anypotentially dilutive securities. Diluted earnings per share, if presented,would include the dilution that would occur upon the exercise or conversion ofall potentially dilutive securities into common stock using the “treasury stock”and/or “if converted” methods as applicable.

 

The following summarizes the potential outstanding common stock of theCompany as of the end of each period (in thousands):

 

| ** **                               | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                               | ** ** | **2009**           | ** ** | **2008**              | ** ** |
| Convertible Notes                        |       | 2,599              |       | 2,643                 |       |
| Common stock warrants                    |       | 959                |       | 959                   |       |
| Common stock options outstanding         |       | 3,015              |       | 2,456                 |       |
| Common stock options available for grant |       | 285                |       | 844                   |       |
| Total                                    |       | 6,858              |       | 6,902                 |       |

 

If the outstanding options, warrants, and convertible notes wereexercised or converted into common stock, the result would be anti-dilutive.Accordingly, basic and diluted net loss attributable to common stockholders pershare are identical for all periods presented in the accompanying consolidatedstatements of operations.

 

*Recent Accounting Pronouncements*

 

The Company adopted SFAS No. 157,*Fair Value Measurements,*or SFAS No. 157,effective January 1, 2008, for financial assets and liabilities.  In addition, effective January 1, 2009,the Company adopted SFAS No. 157 as it relates to nonfinancial assets andliabilities that are not recognized or disclosed at fair value in the financialstatements on at least an annual basis. SFAS No. 157 defines fair value asthe price that would be received to sell an asset or paid to transfer aliability, referred to as the exit price, in an orderly transaction between marketparticipants at the measurement date. The standard outlines a valuationframework and creates a fair value hierarchy in order to increase theconsistency and comparability of fair value measurements and the relateddisclosures. In determining 

 

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fair value of financialassets, the Company primarily uses prices and other relevant informationgenerated by market transactions involving identical or comparable assets,called the market approach. As of March 31, 2009 and December 31,2008, the fair value of all of the Company’s financial assets is based on levelone observable inputs. The implementation of SFAS No. 157 fornonfinancial assets and liabilities did not have an impact on the Company’sconsolidated financial statements as of March 31, 2009. The provisions ofSFAS No. 157 will be applied at such time a fair value measurement of anonfinancial asset or liability is required, which may result in a fair valuethat is materially different than would have been calculated prior to theadoption of SFAS No. 157.

 

InFebruary 2007, the FASB issued SFAS No. 159, *Fair ValueOption for Financial Assets and Liabilities* or SFAS No. 159.  SFAS No. 159 allows companies to choose,at specific election dates, to measure eligible financial assets andliabilities that are not otherwise required to be measured at fair value, atfair value. Under SFAS No. 159, companies would report unrealized gainsand losses for which the fair value option has been elected in earnings at eachsubsequent reporting date, and recognize up-front costs and fees related tothose items in earnings as incurred. SFAS No. 159 became effective forfiscal years beginning after November 15, 2007.  The Company did not elect the fair valueoption for any financial assets or liabilities and, therefore, adoption of theprovisions of SFAS No. 159 did not have a material effect on itsconsolidated financial statements.

 

In May 2008, the Financial Accounting Standards Board, or FASB,issued Staff Position No. Accounting Principles Board 14-1, *or* FSP No. APB 14-1, *Accounting for Convertible Debt Instruments That May BeSettled in Cash upon Conversion (Including Partial Cash Settlement)*.FSP No. APB 14-1 requires that the liability and equity components ofconvertible debt instruments that may be settled in cash upon conversion(including partial cash settlement) be separately accounted for in a mannerthat reflects an issuer’s nonconvertible debt borrowing rate. The Companyadopted FSP No. APB 14-1 effective January 1, 2009. The adoptionof APB 14-1 did not have an impact on the Company’s consolidated financialstatements as of and for the three months ended March 31, 2009.

 

In June 2008, the FASB issued EITF 07-5, *Determining Whether an Instrument (or EmbeddedFeature) Is Indexed to an Entity’s Own Stock*, or EITF 07-5.EITF 07-5 provides guidance in assessing whether an equity-linkedfinancial instrument (or embedded feature) is indexed to an entity’s own stockfor purposes of determining whether the appropriate accounting treatment fallsunder the scope of SFAS No. 133, *Accounting For DerivativeInstruments and Hedging Activities*, or SFAS No. 133, and/or EITF 00-19,*Accounting For Derivative Financial InstrumentsIndexed to, and Potentially Settled in, a Company’s Own Stock*,**or EITF 00-19. EITF 07-5 is effective forfinancial statements issued for fiscal years beginning after December 15,2008. The Company adopted EITF 07-5 effective January 1, 2009. The fairvalue of certain of the Company’s outstanding warrants to which this guidanceapplies was not material as of March 31, 2009. As such, the Company’sadoption of EITF 07-5 did not have a material impact on its consolidatedfinancial statements as of and for the three months ended March 31, 2009.

 

**3.****   ****License, Development andSupply Agreement with Intuitive Surgical**

 

In September 2008, the Company entered into two agreements withIntuitive Surgical, Inc. The first agreement is a License and DevelopmentAgreement under which Intuitive expects to develop a surgical stapling devicethat will attach to Intuitive’s da VinciTM Surgical Systems and will utilize theCompany’s patented technology. Once developed, this attachment will enableIntuitive’s da VinciTM Surgical Systems to cut and staple tissue in a broadarray of surgical applications. The second agreement is an exclusive ReloadSupply Agreement whereby the Company will manufacture and be the exclusivesupplier to Intuitive of staple reloads for the newly developed device atagreed upon prices.

 

Under the terms of the Intuitive Agreements, the Company received anup-front license payment of $12.5 million in September 2008. Inaddition, the Company received a milestone payment of $2.5 million in February 2009and may receive additional payments of up to $5.0 million based upon theachievement of agreed upon development milestones. The Company will also beresponsible for providing at its expense up to an aggregate of 3,900 man hoursof engineering and technical support services to Intuitive to assist Intuitivein designing and developing the new device.

 

The Company has identified four deliverables within this arrangement: (i) thelicense to utilize its patented technology, (ii) consultative servicesduring Intuitive’s development of the new device, (iii) a six-year supply 

 

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arrangementto supply reload cartridges to Intuitive, including a minimum purchaseobligation during the first 18 months subsequent to the first commercialsale of the device to a third party, and (iv) a significant andincremental discount on the future purchases of reload cartridges. The Companyhas concluded that these deliverables should be accounted for as a single unitof accounting, with recognition of revenue for the single unit of accountingcommencing upon the delivery of the final element in the arrangement(i.e., commencement of delivery of the staple reload cartridgescontemplated by the Reload Supply Agreement). Accordingly, the $15.0 millionthe Company has received since September 2008 has been deferred and isreported as deferred revenue as of March 31, 2009. The remaining$5.0 million in milestone payments, if received, will also be deferreduntil the first commercial sale of the device to a third party.

 

Should the project reach the state of the first commercial sale, the$20.0 million of up-front and milestone payments, as well as theguaranteed minimum amount of reload sales, will begin to be recognized asrevenues over the term of the Reload Supply Arrangement (i.e., thesix-year period following the date of the first commercial sale of the deviceby Intuitive to a third party). Revenues from the sale of additional reloadsbeyond the guaranteed minimum quantity will be recognized as such reloads areshipped.

 

**4.  Long-TermDebt**

 

DuringMarch 2007, the Company sold $25.0 million of 7% Convertible Senior SecuredNotes, or Convertible Notes, which generated net proceeds to the Company of$23.3 million (net of financing fees). Of this amount, $3.5 million was placedin escrow to fund the first four interest payments on the Convertible Notes.The Convertible Notes accrue interest initially at the rate of 7% per annum,payable semiannually in arrears, and were subject to an increase to 8.5% per annumin the event that a qualified initial public offering, or a Convertible NoteQualified IPO, did not occur by December 31, 2007. The contingentadjustable interest feature in the Convertible Notes is a derivative requiringbifurcation under SFAS No. 133. The value of the derivative was not deemedmaterial during 2007 and the Company completed its initial public offering in October 2007,which met the requirements of a Convertible Note Qualified IPO. Interest thataccrued on or before March 31, 2009 was payable in cash, while interestaccruing after March 31, 2009 is payable, at the Company’s option, in cashor paid-in-kind in the form of additional notes, or the PIK Notes. Theprincipal amounts of any such PIK Notes would have the same maturity as the ConvertibleNotes. Should the Company elect to pay interest on the Convertible Notes in PIKNotes, the interest rate on such PIK Notes shall be equal to the thenapplicable interest rate plus 1.5%.

 

The Convertible Notes also require the payment of aterminal value that (i) will be due upon redemption or conversion of theConvertible Notes, (ii) will be considered part of the conversion amountfor purposes of determining the conversion rate (see below) or (iii) willbe due upon maturity as part of the principal amount. In each case, theterminal value payment which, as amended, is defined to equal 7% per annum ofthe applicable principal from the closing date of the Convertible Notes in March 2007to October 31, 2007, the date of the Company’s initial public offering).This amount totals approximately $1.0 million. There is no possible futurescenario in which the accrued terminal value would not be required to be paidto the holders of the Convertible Notes or realized by such holders uponconversion of the Convertible Notes. The accrued terminal value ofapproximately $1.0 million is included in accrued expenses in theaccompanying balance sheets at March 31, 2009 and December 31, 2008.

 

The Convertible Notes were not convertible until theoccurrence of a conversion event, which is defined as a Convertible NoteQualified IPO described above or a qualified sale of the Company. The Company’sinitial public offering constituted a Convertible Note Qualified IPO. Upon theoccurrence of the Company’s initial public offering, the Convertible Notes plusany accrued interest thereon as well as the accreted terminal value becameconvertible into the Company’s common stock at the option of the holder at anytime from the date of the conversion event through the maturity date of thenotes. In addition, upon the occurrence of the Convertible Note Qualified IPO, whichconstituted a conversion event, the Convertible Notes became unsecured byassets of the Company and subordinated to all existing and future indebtednessof the Company.

 

The conversion price of the notes was set at $10.01per share upon the completion of the Company’s initial public offering. Theconversion price is subject to adjustment from time to time as follows:

 

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i)  Upona stock dividend, stock distribution, stock split, reverse stock split orrecapitalization, the conversion price shall be adjusted so that the holder ofthe Convertible Notes will be entitled to receive the number of shares ofcommon stock that they would have owned if they had converted the noteimmediately prior to such event.

 

ii)  Upon a distribution of rights, options orwarrants to substantially all holders of common stock entitling them tosubscribe for or purchase shares of common stock for a period of time at aprice per share (or having a conversion, exercise or exchange price per share)less than the current market price per share of common stock, the conversionprice shall be adjusted so that the conversion price would be reduced to aprice equal to the conversion price currently in effect multiplied by afraction, the numerator of which is equal to the number of shares outstandingimmediately prior to the distribution of rights, options or warrants plus thenumber of shares of common stock which the aggregate offering price of thetotal number of shares of common stock so offered (or the aggregate conversion,exercise or exchange price so offered) would purchase at the current marketprice per share, and the denominator of which is equal to the number of sharesof common stock outstanding immediately prior to such adjustment plus thenumber of additional shares of common stock offered (or into which thesecurities so offered are convertible, exchangeable or exercisable).

 

iii)  Upona distribution to all or substantially all holders of common stock any sharesof capital stock of the Company (other than common stock), evidence ofindebtedness or other non-cash assets, the conversion price shall be adjustedso that the conversion price would be reduced to a price equal to theconversion price currently in effect multiplied by a fraction, the numerator ofwhich is equal to the current market price per share of the common stock on therecord date of the distribution, less the fair market value per share on suchrecord date of the capital stock, evidence of indebtedness or other non-cashassets distributed, and the denominator of which shall be the current marketprice per share of common stock on such record date.

 

iv)  Upona cash distribution to all or substantially all holders of common stock, theconversion price shall be decreased so that the conversion price would equalthe conversion price in effect multiplied by a fraction, the numerator of whichis equal to the current market price per share of the common stock on the dateof the distribution less the per share amount of the distribution, and thedenominator of which is the current market price per share of common stock onthe date of the distribution.

 

v)   Upon the purchase of any shares by theCompany or any of its subsidiaries by means of a tender offer, the conversionprice shall be decreased so that the conversion price would equal the conversionprice in effect immediately prior to the close of the tender offer, multiplieda fraction, the numerator of which is the product of the number of shares ofcommon stock outstanding immediately prior to the closing of the tender offermultiplied by the current market price per share of the common stock, and thedenominator of which shall be the sum of the aggregate consideration payable tothe stockholders based on the acceptance of the tender offer and the product ofthe number of shares of common stock outstanding immediately prior to the closeof the tender offer and the current market price per share of common stock.

 

Beginning on the date that is 180 daysfollowing the closing of a Convertible Note Qualified IPO, the Company may, atits option, redeem the Convertible Notes in whole at any time or in part fromtime to time, upon 15 days prior written notice to the holder, at aredemption price payable in cash, equal to the principal amount plus anyinterest (including the terminal value) accrued and unpaid, subject to thesatisfaction of the following conditions precedent:

 

(a) the declaration of effectivenessof a registration statement filed with the SEC for the resale of the underlyingshares;

 

(b) theaverage of the high and low sale price of the common stock, as reported on theprincipal securities exchange on which the common stock is listed, on each ofany 20 trading days during any period of 30 consecutive trading days endingwithin 45 days prior to the Redemption Date (so long as, during the entire30 trading day period, the aforementioned registration statement has beeneffective and there has been no suspension of trading of the common stock),having been equal to or greater than 140% of the initial public 

 

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offeringprice in the Convertible Notes Qualified IPO (in each case, with pricesadjusted for stock splits, reverse splits, stock dividends, share combinationand other antidilution events); and

 

(c) nomore than $12,500,000 of outstanding Convertible Notes may be redeemed pursuantto this provision in any period of 30 consecutive trading days; and

 

(d) anysuch redemption shall be effected on a pro rata basis with respect to all thenoutstanding Convertible Notes (including PIK Notes).

 

Inaccounting for the Convertible Notes, the Company did not elect the fair valueoption for any financial assets or liabilities as permissible under the provisionsof SFAS No. 159. However, as of March 31, 2009 the fair value of the$25.0 million of Convertible Notes, which are due in March 2010 andare no longer secured by the assets of the Company, is significantly lower thanthe carrying amount due to the Company’s current liquidity issues.

 

**5.  Inventory**

 

Inventory is stated at thelower of cost or market value, with cost being determined on a first-in,first-out (FIFO) basis and market value based on the lower of replacement cost,or the estimated net realizable value, reduced by an allowance for normalprofit margin.  Inventory consists of the following (in thousands):

 

| ** **      | ** ** | **As of**               | ** **  | **As of**                  | ** ** |
|-----------------|------------|-------------------------|-------------|----------------------------|------------|
| ** **      | ** ** | **March 31, 2009** | ** **  | **December 31, 2008** | ** ** |
| Raw Materials   |       | $                       | 3,786       |                       | $          | 4,478 |   |
| Work in process |       | 884                     |        | 463                        |       |
| Finished goods  |       | 2,866                   |        | 3,413                      |       |
|            |       | $                       |  7,536 |                       | $          | 8,354 |   |

 

During the three months ended March 31, 2009 and 2008, the Companyrecorded inventory obsolescence charges in the amount of approximately $179thousand and $301 thousand, respectively, which included a charge ofapproximately $250 thousand related to a write-off of components inventory dueto a design enhancement of our i60 product in the first quarter of 2008. Suchcharges are reflected in cost of sales in the accompanying condensedconsolidated statements of operations.

 

**6.  Comprehensive Loss**

 

The Company’s comprehensiveloss was as follows (in thousands):

 

| ** **                              | ** ** | **Three Months Ended** | ** ** |
|-----------------------------------------|------------|----------------------------------|------------|
| ** **                              | ** ** | **March 31,**               | ** ** |
| ** **                              | ** ** | **2009**                         | ** ** | **2008** | ** ** |
| ** **                              | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Net loss                                |       | (6,947                           | )          | (12,180 | ) |
| Foreign currency translation adjustment |       | (47                              | )          | 46 |   |
| Comprehensive loss                      |       | (6,994                           | )          | (12,134 | ) |

 

**7. Contingencies**

 

The Company has, on occasion, been named as a defendant in lawsuitsalleging product failure, patent infringement, and breach of contract. Thesecases are routinely handled by external counsel. Based on the advice ofcounsel, management has provided reserves for the estimated potential losses,when such losses are deemed probable and estimable. The Company currently has apatent infringement case outstanding. The Company received 

 

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afavorable ruling from the German courts on two of the patent infringementclaims and an unfavorable ruling on one of the claims. However, the Company isin the process of appealing the ruling. The Company intends to defend thisclaim vigorously and has concluded it is too early to determine whether or notthe Company will incur any loss under this claim. As such, no amounts areaccrued in the accompanying consolidated balance sheets related to this claim.

 

The Company also has a product liability case outstanding which iscurrently suspended and the Company has continued to contest the claim. TheCompany has accrued $100,000 related to this matter which represents its bestestimate of the potential liability related to this claim.

 

In August 2008, theCompany’s former Belgian distributor, Duo-Med, S.A., initiated a breach ofcontract action against the Company in the Commercial Court of Brussels inBelgium. The complaint alleges that the Company breached its distributionagreement with Duo-Med by failing to provide proper notice when the Companyterminated that agreement in May 2007 and that, as the result of problemswith the Company’s products, Duo-Med was unable to sell its existing inventory.The complaint asserts damages totaling approximately €460,000. The Companybelieves that the allegations in this matter are without merit and intends tovigorously defend against them. The Company has not accrued any amount in itsfinancial statements as of March 31, 2009 for this matter.

 

**8.  Share-based Compensation**

 

The fair value of the Company’s equity awards were estimated at thedate of grant using the Black-Scholes option-pricing model with the followingassumptions:

 

| ** **              | ** ** | **Three Months Ended March 31,** | ** ** |
|-------------------------|------------|---------------------------------------|------------|
| ** **              | ** ** | **2009**                              | ** ** | **2008** | ** ** |
| Dividend yield          |       | 0                                     | %          | 0 | % |
| Expected volatility     |       | 61                                    | %          | 50 | % |
| Risk-free interest rate |       | 1.64                                  | %          | 3.01 | % |
| Expected life (years)   |       | 5.50                                  |       | 7.00 |   |

 

Compensation expense under SFAS No. 123(R) andEITF 96-18 for the three months ended March 31, 2009 and 2008 was$525 thousand and $440 thousand, respectively, and was recorded in theaccompanying condensed consolidated financial statements and as follows (inthousands):

 

| ** **                             | ** ** | **Three Months Ended March 31,** | ** ** |
|----------------------------------------|------------|---------------------------------------|------------|
| ** **                             | ** ** | **2009**                              | ** ** | **2008** | ** ** |
| Cost of sales                          |       | $                                     | 14         |   | $ | 10 |   |
| Research and development               |       | 56                                    |       | 46 |   |
| Sales and marketing                    |       | 105                                   |       | 66 |   |
| General and administrative             |       | 350                                   |       | 318 |   |
| Total share-based compensation expense |       | 525                                   |       | $ | 440 |   |
|                                        |            |                                       |            |  |  |  |  |

 

As of March 31, 2009, there was approximately $5.3 million ofunrecognized compensation costs, net of estimated forfeitures, related to stockoption grants which are expected to be recognized over a weighted averageperiod of 1.9 years. There were no cash proceeds from option exercisesduring the three months ended March 31, 2009 and 2008.

 

**Item 2.**      **Management’s Discussion and Analysis of FinancialCondition and Results of Operations**

 

*You shouldread the following discussion in conjunction with our consolidated financialstatements and notes thereto appearing elsewhere in this report. In addition tohistorical consolidated financial information, the following discussion andanalysis contains forward-looking statements that involve risks, uncertaintiesand*

 

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*assumptions. Our actual resultscould differ materially from those anticipated by these forward-lookingstatements as a result of many factors, including those discussed under “RiskFactors” and elsewhere in this report.*

 

**Overview**

 

We design, manufacture and market a family of computer-assisted,power-actuated endomechanical surgical instruments, which we refer to asIntelligent Surgical InstrumentsTM. Surgeons use our Intelligent SurgicalInstruments for cutting, stapling and tissue manipulation in a variety ofprocedures in open surgery, minimally invasive surgery, or MIS, and in theemerging field of natural orifice translumenal endoscopic surgery, or NOTES. Webelieve that, compared to conventional endomechanical devices, our IntelligentSurgical Instruments offer greater precision and consistency, superiorcompressive force, improved access to anatomical sites and enhanced ease ofuse. To our knowledge, we are the only company to apply digital technology tothe field of endomechanical surgical instruments. Endomechanical devices areused in millions of surgical procedures each year to cut tissue, close woundsand reconnect tubular anatomical structures. We believe that conventional,manually operated endomechanical devices have inherent shortcomings that canlimit their efficacy and adversely affect clinical outcomes. We founded ourcompany to address these shortcomings and to improve surgical outcomes byintroducing the next generation of endomechanical instruments, designedspecifically for the rapidly evolving field of minimally invasive surgery.

 

Our operations to date have required significant cash expenditures. Wehave incurred net losses in each year since our inception and have anaccumulated deficit at March 31, 2009 of $223.2 million.  We believe that our current cash and cashequivalents, together with our expected near-term future sales and milestones,will be sufficient to meet our anticipated cash requirements through June 30,2009. We must raise additional capital. We are actively pursuing initiatives toraise additional funds through license and development agreements withcorporate partners or public and private offerings of securities, includingdebt or equity financings. Given the recent and continued turmoil in thecapital markets, there are a number of risks and uncertainties related to ourattempts to complete a financing or strategic partnering arrangement that areoutside our control. There can be no assurance that such financing will beavailable in amounts or on terms acceptable to us, if at all. In addition, wemay enter into arrangements to extend the maturity of, purchase, redeem,replace or otherwise modify the terms of the Convertible Notes, and any sucharrangements may require us to expend additional cash. These conditions raisesubstantial doubt about our ability to continue as a going concern. Ourindependent registered public accounting firm has modified its audit report onour consolidated financial statements to include an explanatory paragraphregarding this contingency.

 

Historically, we have financed our operations and internal growthprimarily through private placements of equity securities and debt and, morerecently, our initial public offering. We cannot be certain that additionalpublic or private financing will be available in amounts acceptable to us, orat all. If we raise additional funds by issuing equity securities or debt,significant dilution may occur. Debt financing, if available, may involverestrictive covenants. Any debt financing or additional equity that we raisemay contain terms that are not favorable to us or our stockholders. Our abilityto obtain additional debt financing will be limited by certain covenants wehave made to holders of our Convertible Notes. In addition, if we default inthe payment of our obligations under our Convertible Notes, our noteholderswill be entitled to exercise their rights as creditors.

 

If we are unable to raise additional funds when needed, we will needto:

 

·                  delay,scale-back or eliminate some or all of our research and product developmentprograms;

 

·                  licensethird parties to develop and commercialize products or technologies that wewould otherwise seek to develop and commercialize ourselves;

 

·                  attemptto sell our company;

 

·                  ceaseoperations; or

 

·                  declarebankruptcy.

 

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Ifwe take any of the above actions, the value of your investment in us could bematerially impaired or eliminated.

 

Our first Intelligent Surgical Instruments were introduced during thefourth quarter of 2007. We introduced the i60 linear cutter and our iDriveChand-held power and control unit. The i60 offers precise control and powerful,consistent cutting and stapling action. The iDriveC and iDriveS power and controlour suite of linear cutter, right-angle linear cutter, and circular staplerinstruments. We also launched the i45 articulating 45mm linear stapler, and thei45V—an articulating linear stapler for vascular applications, in the thirdquarter of 2008. During the first quarter of 2009, we announced that wereceived FDA 510(k) marketing clearance for our patented i60R IntelligentSurgical Instrument. The i60R Intelligent Surgical Instrument is the world’sfirst reverse pivot linear cutter, designed to improve medical outcomes byproviding surgeons with greater access to important anatomical sites that arecurrently difficult to reach. This unique instrument will be used to addresssurgical procedures performed throughout the digestive tract.

 

We currently focus our marketing and sales efforts on selected surgicalprocedures in minimally invasive colorectal, bariatric and thoracic surgery. Wetarget those procedures in which we believe the limitations of existing cuttingand stapling technology are most acute, where the number of proceduresperformed is growing rapidly and where clinicians have readily recognized thebenefits of our Intelligent Surgical Instruments. We intend to promote the useof our Intelligent Surgical Instruments in other surgical specialties. In thefuture, as surgical techniques continue to evolve beyond current MIS proceduresto even less invasive techniques such as natural orifice translumenalendoscopic surgery, or NOTES, we believe our instruments may become a keyenabling technology.

 

In October 2008, wereceived a notification from The Nasdaq Stock Market, or NASDAQ, indicatingthat we were not in compliance with the NASDAQ Global Market’s continuedlisting requirements set forth in Marketplace Rule 4450(b)(1)(A) becausethe market value of our listed securities was below $50.0 million for 10consecutive trading days. In January 2009, we were the subject of ahearing before a NASDAQ listing qualifications panel to determine whether ourcommon stock’s continued listing was warranted. At the hearing, we requested atransfer of our listing from the NASDAQ Global Market to the NASDAQ CapitalMarket. On March 23, 2009, the NASDAQ notified us that our request hadbeen granted. The transfer took effect on March 25, 2009. Our common stockcontinues to trade under the symbol PMII. The NASDAQ Capital Market is acontinuous trading market that operates in the same manner as the NASDAQ GlobalMarket. The NASDAQ Capital Market includes the securities of approximately 450companies. All companies listed on the NASDAQ Capital Market must meet certainfinancial requirements and adhere to NASDAQ’s corporate governance standards.Our continued listing on the NASDAQ Capital Market is subject to compliancewith all requirements, including the $2.5 million stockholders’ equityrequirement for continued listing on that market by May 20, 2009. Weare currently pursuing strategic initiatives, including, but not limited to,raising capital, that if successful may enable us to comply with the NASDAQCapital Markets minimum stockholder’s equity requirement.  If we are unable to meet the continuedlisting requirements of the NASDAQ Capital Market and our common stock becomesdelisted, the ability of stockholders to sell our common stock and the liquidity,trading market and price of our common stock could be adversely affected.

 

**Financial Operations Overview**

 

The following is adescription of the principal components of our sales and expenses and ofsignificant trends and challenges that we believe are important to anunderstanding of our business and results of operations.

 

*Sales.*  Our first generation SurgASSISTsurgical platform includes cutting and stapling devices in a variety of sizesand linear, right angle and circular configurations designed for differing surgicalneeds. In the original configuration of our system, our Intelligent SurgicalInstruments were connected through a flexible shaft, or FlexShaft, to a powerconsole. Our next generation products, beginning with the i60 linear staplerthat we introduced in the fourth quarter of 2007, are self-contained hand-heldinstruments that do not require a FlexShaft or separate power console. In December 2007,we also introduced our self-contained, wireless handheld iDrive system, whichcan be used to power and control our linear, right angle and circular staplers,without the need for a separate FlexShaft or power console. Further, in thethird quarter of 2008, we introduced our i45 reusable, autoclavable linearstapler and reload cartridge.

 

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Our Intelligent Surgical Instruments are available as disposable,single-patient devices as well as in a reusable multiple-patient format, usingdisposable cutting and stapling cartridges in various sizes, which we refer toas reload cartridges and digital loading units.

 

Our revenue is derived from the sale of our single-patient, disposableIntelligent Surgical Instruments and from the sale of reload cartridges for ourreusable Intelligent Surgical Instruments. We expect that as our installed baseof reusable, multiple-patient Intelligent Surgical Instruments grows, sales ofreload cartridges will become the largest component of our total sales.

 

We currently make our i60, i45 and iDrive instruments available tocustomers at no charge under an “in service under evaluation” program. Theevaluation period is typically six months and we expect to derive recurringrevenues from sales of the reload cartridges necessary for their use. At theend of the evaluation period, customers have the option to (i) buy theequipment and continue to receive reload cartridge pricing consistent with thatof the evaluation period, (ii) keep the equipment and agree to highersales prices on the reload cartridge than was charged during the evaluationperiod or (iii) return the equipment with no further obligation.

 

Our future success will depend on our ability to achieve and sustainsignificant growth in our sales. In the immediate term, our ability to grow ourrevenues will depend on many factors, including:

 

·                  increasedusage of our installed base of multiple-use Intelligent Surgical Instruments,resulting in recurring purchases of our reload cartridges;

 

·                  continuedgrowth in market acceptance of our Intelligent Surgical Instruments;

 

·                  continuedimprovements in our supply chain and manufacturing operations to assure thequality and adequate supply of our products; and

 

·                  achievementof the development milestones under our License Agreement with Intuitive andsuccessful commercialization by Intuitive of the resulting device, enabling usto realize the benefits of the Supply Agreement whereby we will manufacture andbe the exclusive supplier to Intuitive of staple reloads for the device.

 

*Cost of sales.*  Costof sales includes the cost of raw materials and components that we purchasefrom third parties and use in the assembly and manufacturing of our products.Cost of sales also includes personnel costs and overhead related to ourassembly and test operations, related occupancy, equipment depreciation,shipping costs and charges for inventory obsolescence.

 

Our future success will depend on our ability to make significantimprovements in our cost of sales as a percentage of sales, or gross margins.In prior years, we experienced high cost of sales, which were attributable to anumber of factors, including product defects that have required rework by usand by our suppliers, a labor-intensive manual assembly process that hasresulted in high labor costs, and excess manufacturing capacity in relation toour sales, which has resulted in inefficient absorption of manufacturingoverhead. In 2008, we began to integrate our manufacturing operations byacquiring the automated equipment necessary to enable us to assemble the reloadcartridges used in our multiple-use linear staplers. This system has had, andis expected to continue to have, a positive effect on our ability to bettercontrol the quality, cost and supply of our products and to more rapidlydevelop, prototype and commercialize new products.

 

Charges associated with write-offs of excess and obsolete inventoryhave also contributed to our high cost of sales. During the three months ended March 31,2009 and 2008, we recorded inventory obsolescence charges of approximately $179thousand and $301 thousand, respectively, which included a charge ofapproximately $250 thousand related to a write-off of components inventory dueto a design enhancement of our i60 product in the first quarter of 2008. Ourproduct development plans sometimes include introductions of new products thatoverlap functionally with existing products, while offering new or improvedcapabilities. We anticipate that in some cases, this may lead to a reduction indemand for, or discontinuation of, an existing product. In these circumstanceswe must carefully manage our finished goods inventory so that we havequantities of the existing product that are 

 

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sufficientto meet customer demand pending introduction of the new product, but that donot leave us holding excess or obsolete inventory when a new product supplantsthe existing one.

 

In order to facilitate market acceptance of our first generationIntelligent Surgical Instruments, in certain circumstances, we made the powerconsoles and certain related accessories necessary for the use of ourinstruments available to institutions at no charge. We included deprecationexpense in cost of sales for power consoles and related accessories loaned tocustomers for their use at no charge. In addition, we currently make our i60,i45 and iDrive products available to our customers at no cost under our “inservice under evaluation” program. The cost for these instruments is amortizedto cost of sales over the evaluation period, which is generally six months.

 

In order to achieve and sustain profitability, we will need to continueto improve our procurement and manufacturing processes, upgrade our managementinformation systems, and implement new quality assurance, inventory and costcontrols in order to further reduce the cost of the components we purchase fromthird party vendors and improve the efficiency of our manufacturing operations.

 

*Research and development expenses.* Research and development expenses consist primarily of salaries andrelated expenses and overhead for our research, development and engineeringpersonnel, prototype materials and research studies.  In October 2008, as part of acost-reducing restructuring initiative, we reduced our headcount in this areaand our research and development efforts have been redeployed with a focus onfulfilling our obligations under our agreements with Intuitive. We expense ourresearch and development costs as incurred.

 

*Sales and marketing expenses.*  Salesand marketing expenses consist primarily of salaries and related expenses,sales commissions and overhead for personnel performing sales and marketingfunctions. Other significant sales and marketing expenses include travel andentertainment expense, costs of attending medical conferences and trade shows,clinician training and other promotional costs and costs of demonstrationsystems and samples.

 

Our sales and marketing expenses have substantially exceeded our salesin each year since 2004, as we have invested in building the sales andmarketing organization and administrative infrastructure necessary to supportour planned sales growth. During 2008, we took steps, including theimplementation of a restructuring plan in October 2008, to reduce ourfuture sales and marketing expenses through a reduction in the number of ourdirect sales personnel, and as a result we do not expect these expenses to growin 2009 at the same rate they have in recent years.

 

*General and administrative expenses.* General and administrative expenses consist primarily of salaries andrelated expenses and overhead for personnel performing executive, finance,information technology and human resource functions. Other significant generaland administrative expenses include consulting fees and professional fees forlegal services (including services related to obtaining and maintainingprotection of our intellectual property) and accounting services.

 

*Interest income.* Interest income consists of interest earned on our cash and cashequivalents.

 

*Interest expense.* Interest expense consists primarily of interest costs incurred on ourConvertible Notes that we issued in March 2007.

 

**Liquidity and Capital Resources**

 

Since our inception, we have financed our operations primarily throughprivate placements of equity securities, unsecured borrowings from ourstockholders, a credit facility and, more recently, the issuance in March 2007of our Convertible Notes in the aggregate principal amount of$25.0 million, and our initial public offering in October 2007, whichgenerated proceeds of approximately $42.0 million. In addition, we havereceived $15.0 million under our agreements with Intuitive.  Our principal source of liquidity as of March 31,2009 consisted of our cash and cash equivalents of $4.7 million and ouraccounts receivable balance of approximately $1.7 million.

 

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**Net cash used in operating activities**

 

Net cash used in operating activities for the three months ended March 31,2009 were primarily related to cash used to fund our efforts to expand ourcustomer base and our products’ acceptance within that customer base, todevelop and introduce our next generation of Intelligent Surgical Instruments,and to further integrate our manufacturing processes, offset by $2.5 million inmilestone payments we received under our agreements with Intuitive in February 2009.Had we not received this milestone payment, our net cash used in operatingactivities would have been approximately $6.9 million.

 

**Net cash provided by investing activities**

 

Net cash provided by investing activities for the three months ended March 31,2009 was primarily attributable to reductions in restricted cash balances as ofMarch 31, 2009 offset by cash used for capital expenditures related to theintegration of our manufacturing process and patent application costs.

 

**Net cash used in financing activities**

 

Net cash used in financing activities was primarily attributable todebt repayments on equipment loans during the three months ended March 31,2009.

 

**Liquidity Capital Resources Outlook**

 

As of March 31, 2009, we had cash and cash equivalents ofapproximately $4.7 million. In addition, as of March 31, 2009, we hadtotal liabilities of $45.2 million, including $25.0 million ofConvertible Notes due to be paid in March 2010.

 

Our operations to date have required significant cash expenditures.Although we significantly reduced our operating expenses through therestructuring plan we implemented in the fourth quarter of 2008, our operationscontinue to require significant cash expenditures, and we must raise additionalcapital to be able to fund them. We believe that our current cash and cashequivalents, together with our future sales and milestones will be sufficientto meet our anticipated cash requirements through June 30, 2009. We needto raise funds not only to continue our operations at their current levels pastJune 30, 2009, but also to satisfy our obligations under the ConvertibleNotes. We are actively pursuing initiatives to raise funds through license anddevelopment agreements with corporate partners or public and private offeringsof securities, including debt or equity financings. We may enter intoarrangements to extend the maturity of, purchase, redeem, replace or otherwisemodify the terms of the Convertible Notes, and any such arrangements mayrequire us to expend additional cash. Given the recent and continued turmoil inthe capital markets, there are a number of risks and uncertainties related toour attempts to complete a financing or strategic partnering arrangement thatare outside our control. There can be no assurance that such financing will beavailable in amounts or on terms acceptable to us, if at all. These conditionsraise substantial doubt about our ability to continue as a going concern. Ourindependent registered public accounting firm has modified its audit report onour consolidated financial statements for the year ended December 31, 2008to include an explanatory paragraph regarding this contingency.

 

Historically, we have financed our operations and internal growthprimarily through private placements of equity securities and debt and, morerecently, our initial public offering. We cannot be certain that additionalpublic or private financing will be available in amounts acceptable to us, orat all. If we raise additional funds by issuing equity securities or debt,significant dilution may occur. Debt financing, if available, may involverestrictive covenants. Any debt financing or additional equity that we raisemay contain terms that are not favorable to us or our stockholders. Our abilityto obtain additional debt financing will be limited by certain covenants wehave made to holders of our Convertible Notes. In addition, if we default inthe payment of our obligations under our Convertible Notes, our noteholderswill be entitled to exercise their rights as creditors.

 

If we are unable to raise additional funds when needed, we will needto:

 

·                  delay,scale-back or eliminate some or all of our research and product developmentprograms;

 

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·                  licensethird parties to develop and commercialize products or technologies that wewould otherwise seek to develop and commercialize ourselves;

 

·                  attemptto sell our company;

 

·                  ceaseoperations; or

 

·                  declarebankruptcy.

 

Ifwe take any of the above actions, the value of your investment in us could bematerially impaired or eliminated.

 

Additionally, if we default in the payment of our Convertible Notes,our noteholders will be entitled to exercise their rights under the ConvertibleNotes and immediately accelerate repayment of the Convertible Notes, whichcould materially impair our ability to continue to operate our business.

 

In October 2008, we received a notification from the NASDAQindicating that we were not in compliance with the NASDAQ Global Market’scontinued listing requirements set forth in Marketplace Rule 4450(b)(1)(A) becausethe market value of our listed securities was below $50.0 million for 10consecutive trading days. In January 2009, we were the subject of ahearing before a NASDAQ listing qualifications panel to determine whether ourcommon stock’s continued listing was warranted. At the hearing we requested atransfer of our listing from the NASDAQ Global Market to the NASDAQ CapitalMarket. On March 23, 2009, the NASDAQ notified us that our request hadbeen granted. The transfer took effect on March 25, 2009. Our common stockcontinues to trade under the symbol PMII. The NASDAQ Capital Market is acontinuous trading market that operates in the same manner as the NASDAQ GlobalMarket. The NASDAQ Capital Market includes the securities of approximately 450companies. All companies listed on the NASDAQ Capital Market must meet certainfinancial requirements and adhere to NASDAQ’s corporate governance standards.Our continued listing on the NASDAQ Capital Market is subject to compliancewith all requirements, including the $2.5 million stockholders equityrequirement, for continued listing on that market by May 20, 2009. We arecurrently pursuing strategic initiatives, including, but not limited to,raising capital, that if successful may enable us to comply with the NASDAQCapital Markets minimum stockholder’s equity requirement.  If we are unable to meet the continuedlisting requirements of the NASDAQ Capital Market and our common stock becomesdelisted, the ability of stockholders to sell our common stock and the liquidity,trading market and price of our common stock could be adversely affected.

 

If we are unable to raise additional funds when needed, we may have todelay or reduce the scope of or eliminate some or all of our developmentprograms or we may be forced to seek protection under applicable bankruptcylaws. Any restructuring or bankruptcy could materially impair your investment.

 

**Results of Operations**

 

**Three month periods ended March 31,2009 and 2008**

 

*Sales.*   Our sales in the three months ended March 31,2009 increased by 23% to $2.7 million compared with $2.2 million during thecorresponding period in 2008. This increase related primarily to increasedsales in Japan, which accounted for 17% of sales in the three months ended March 31,2009 compared with 4% of sales in the corresponding period  in 2008. Sales of reload cartridges totaledapproximately $1.3 million during the three months ended March 31, 2009compared to approximately $0.5 million during the three months ended March 31,2008.

 

*Cost of sales and gross profit.*   Our cost of sales in the three monthsended March 31, 2009 decreased by 15%, to $2.2 million compared with $2.6million during the corresponding period in 2008.  Our gross margin was$0.6 million, or 21% of sales, in the three months ended March 31, 2009compared to a gross margin of ($0.3 million) or (15%) of sales, during thecorresponding period in 2008.  Our gross margins in 2009 improved versus2008 due to improvements in our manufacturing process, including our ReloadAutomation Machine, or RAM.  However, gross margins are likely tofluctuate from period to period until we are able to realize further 

 

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economiesof scale in our purchasing and manufacturing process through increasedmanufacturing capacity utilization and automation.

 

*Researchand development expenses.*   Our research and development expenses in the three months endedMarch 31, 2009 decreased by 49% to $0.8 million, compared with $1.6million during the corresponding period in 2008 due to our restructuringinitiative that was implemented in the fourth quarter of 2008.  The restructuring initiative includedheadcount reductions and a redeployment of much of our available resources toour engineering and technical support obligations under the Intuitive Agreements.  Research and development costs decreased as apercentage of sales to 29% in the three months ended March 31, 2009,compared with 71% of sales during the corresponding period in 2008.  

 

*Sales andmarketing expenses.*  Our domestic and international sales and marketing expenses in the threemonths ended March 31, 2009 decreased by 49%, to $3.5 million, comparedwith $6.8 million during the corresponding period in 2008, and decreased as apercentage of sales to 127% of sales in the three months ended March 31,2009, compared with 306% of sales during the corresponding period in2008.  The decrease in dollar amount in 2009 was primarily due to areduction in our sales force and improved efficiencies in our sales andmarketing department.

 

*Generaland administrative expenses.*   Our general and administrative expenses in the three monthsended March 31, 2009 decreased by 13%, to $2.6 million, compared with $3.0million during the corresponding period in 2008, and decreased as a percentageof sales to 96% in the three months ended March 31, 2009, compared to 135%during the corresponding period in 2008. The decrease in general andadministrative expenses related primarily to the restructuring initiative thatwas implemented in the fourth quarter of 2008, offset by an increase inshare-based compensation expense.

 

*Interestand other income.* Our interest and other income in the three months ended March 31, 2009decreased by 77% to $44 thousand compared with $195 thousand during thecorresponding period in 2008, due to significantly lower average cash balancesand lower interest rates.

 

*Interestexpense.*  Ourinterest expense in the three months ended March 31, 2009 and 2008 totaledapproximately  $0.7 million for eachperiod and relates primarily to our Convertible Notes issued in March 2007.

 

**Critical Accounting Policies and Estimates**

 

The preparation of financial statements in conformity with accountingprinciples generally accepted in the United States requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and disclosure of contingent assets and liabilities at the date ofthe financial statements and the reported amounts of revenue and expensesduring the reporting period. These estimates and judgments are inherentlysubject to uncertainty. On an ongoing basis, we re-evaluate our judgments andestimates, including those related to uncollectible accounts receivable,inventories, recoverability of long-lived assets, stock-based compensation,accrued expenses and other contingencies. We base our estimates and judgmentson our historical experience and on other assumptions that we believe are reasonableunder the circumstances, the results of which form the basis for making thejudgments about the carrying values of assets and liabilities that are notreadily apparent from other sources. Actual results could differ from thoseestimates, and material effects on our operating results and financial positioncould result. The accounting policies described below are those which, in ouropinion, involve the most significant application of judgment or involvecomplex estimation, and which could, if different judgments or estimates weremade, materially affect our reported results of operations.

 

*Revenue recognition.*  Mostof our revenue historically has been derived from the sale of single-patient,disposable loading units and from the sale of reload cartridges for reusableIntelligent Surgical Instruments. Revenue related to the sale of suchindividual products is recognized when persuasive evidence of an arrangementexists, delivery has occurred, the sales price is fixed and determinable, andcollectibility is reasonably assured, which is generally at the time ofshipment upon delivery to a common carrier.

 

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We also consider the provisions of EITF, 00-21, *Revenue Arrangements with Multiple Deliverables*,when recognizing revenue. Under multiple-element arrangements involving thesale of multiple products, services and/or rights to use assets, the multipleelements are divided into separate units of accounting when certain criteriaare met, including whether the delivered items have stand alone value to thecustomer and whether there is objective and reliable evidence of the fair valueof the undelivered items. When separate units of accounting exist,consideration is allocated among the separate elements based on theirrespective fair values. If such evidence of fair value for each undeliveredelement of the arrangement does not exist, all revenue from the arrangement isdeferred until such time that evidence of fair value for each undeliveredelement does exist or until all elements of the arrangement are delivered.

 

Our Intelligent Surgical Instrument surgical platform includes cuttingand stapling devices in a variety of sizes and linear, right angle and circularconfigurations designed for differing surgical needs. Our Intelligent SurgicalInstruments are available in a reusable multiple-patient format which can beautoclaved and used in multiple cases. Our reusable Intelligent SurgicalInstruments use disposable cutting and stapling cartridges in various sizes,which we refer to as reload cartridges and digital loading units.

 

We instituted a program in 2007 whereby we may provide reusableIntelligent Surgical Instruments and FlexShafts to customers at no cost. Incertain cases, we offer such Intelligent Surgical Instruments and FlexShafts atno cost in exchange for higher unit pricing on the sale of reload cartridgesover a specified period of time. In these cases, we recognize revenue ratablyover the period of delivery of the reload cartridges, as long as such revenueis not contingent on the delivery of the undelivered products. We have incertain cases agreed to transfer title to such systems to the customer upon thecustomer’s purchase of a specified number of disposable Intelligent SurgicalInstruments although the customer is under no obligation to purchase the IntelligentSurgical Instruments. In these instances, we recognize revenue attributable tothe complete system as the Intelligent Surgical Instruments are delivered.

 

We currently make our i60, i45 and iDrive instruments available tocustomers at no charge under an “in service under evaluation” program. Theevaluation period is typically six months and we expect to derive recurringrevenues from sales of the reload cartridges necessary for the evaluationinstruments’ use. At the end of the evaluation period, customers have theoption to (i) buy the equipment and continue to receive reload cartridgepricing consistent with that of the evaluation period, (ii) keep theequipment and agree to higher sales prices on the reload cartridge than wascharged during the evaluation period or (iii) return the equipment with nofurther obligation.

 

*Revenue Recognition—Arrangement with IntuitiveSurgical, Inc.*

 

In September 2008, we entered into two agreements with Intuitive.The first agreement is a License and Development Agreement under whichIntuitive expects to develop a surgical stapling device which will attach to itsda VinciTM Surgical Systems and will utilize our patented technology. Oncedeveloped, this attachment will enable the da VinciTM Surgical System to cut andstaple tissue in a broad array of surgical applications. The second agreementis an exclusive Reload Supply Agreement whereby we will manufacture and be theexclusive supplier to Intuitive of staple reloads for the newly developeddevice at agreed upon prices.

 

Under the terms of the Intuitive agreements, we received an upfrontlicense payment of $12.5 million in September 2008. In addition, wereceived a payment $2.5 million in February 2009 and may receiveadditional payments of up to $5.0 million based upon the achievement ofagreed upon development milestones. We will also be responsible for providing,at our expense, up to an aggregate of 3,900 man hours of engineering andtechnical support services to Intuitive to assist Intuitive in designing anddeveloping the new device.

 

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We have identified four deliverables within this arrangement: (i) thelicense to utilize our patented technology, (ii) consultative servicesduring Intuitive’s development of the new device, (iii) a six-year supplyarrangement to supply reload cartridges to Intuitive, including a minimumpurchase obligation during the first 18 months subsequent to the firstcommercial sale of the device by Intuitive to a third party and (iv) asignificant and incremental discount on the future purchases of reloadcartridges. We have concluded that these deliverables should be accounted foras a single unit of accounting, with recognition of revenue for the single unitof accounting commencing upon the delivery of the final element in thearrangement (i.e., commencement of delivery of the staple reloadcartridges contemplated by the Reload Supply Agreement). Accordingly, the $15.0 millionwe have received since September 2008 has been deferred and is reported inthe consolidated financial statements as deferred revenue as of March 31,2009. Additional milestone payments, if received, will also be deferred untilthe first commercial sale of the device to a third party.

 

Should the project reach the first commercial sale, the$20.0 million of up-front and milestone payments, as well as theguaranteed minimum amount of reload sales, will begin to be recognized asrevenues over the term of the Reload Supply Arrangement (i.e., thesix-year period following the date of the first commercial sale of the deviceto a third party). Revenues from the sale of additional reloads beyond theminimum guaranteed quantity will be recognized as such reloads are shipped.

 

*Share-based compensation*

 

Our share-based compensation is accounted for in accordance with thefair value recognition provisions of SFAS No. 123 (revised 2004) *Share-Based Payments*, or SFAS 123(R). In addition, weaccount for our share-based compensation to non-employees in accordance withEITF 96-18. We use the Black-Scholes option-pricing model to estimate thefair value our share-based awards as of the date of grant. The Black-Scholesmodel, by its design, is highly complex and dependent upon key data inputsestimated by management. The primary data inputs with the greatest degree ofjudgment are generally the estimated lives of the share-based awards and theestimated volatility of the our common stock price. The Black-Scholes model issensitive to changes to these two data inputs.

 

Beginning in fiscal year 2006, we calculated the estimated life ofstock options granted using a “simplified” method, based upon guidance from theSEC as contained in SAB No. 107 permitting the initial use of this methodthrough 2007. In December 2007, the SEC issued SAB No. 110, which waseffective January 1, 2008, expressing the expectation that companiesshould be employing information from internal or external sources aboutemployee stock option exercise behavior when developing estimates of expectedterm as they relate to stock option valuations. SAB No. 110 states thatthe SEC will continue to accept the use of the “simplified” method, undercertain circumstances, beyond December 31, 2007. We evaluated the exercisebehavior of our employees and determined that the exercise history was aninadequate measure of the expected term of our stock options. Therefore, wehave continued our use of the simplified method as prescribed in SAB No. 107.Expected stock price volatility is typically based on the daily historicaltrading data from an appropriate point in time through the last day of theapplicable period. Because our historical trading data only dates back to October 26,2007, the first trading date subsequent to our initial public offering, theexpected volatility of our common stock was calculated for each date of grantbased on an alternative method (defined as “calculated value”). We identifiedsimilar public entities for which share price information is available and haveconsidered the historical volatility of these entities’ share prices inestimating expected volatility.

 

**Recent Accounting Pronouncements**

 

We adopted SFAS No. 157,effective January 1, 2008, for financial assets and liabilities.  In addition, effective January 1, 2009,we adopted SFAS No. 157 as it relates to nonfinancial assets andliabilities that are not recognized or disclosed at fair value in the financialstatements on at least an annual basis. SFAS No. 157 defines fair value asthe price that would be received to sell an asset or paid to transfer aliability, referred to as the exit price, in an orderly transaction betweenmarket participants at the measurement date. The standard outlines a valuationframework and creates a fair value hierarchy in order to increase theconsistency and comparability of fair value measurements and the relateddisclosures. In determining fair value of financial assets, we primarily useprices and other relevant information generated by market transactionsinvolving identical or comparable assets, called the 

 

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market approach. As of March 31,2009 and December 31, 2008, the fair value of all of our financial assetsis based on level one observable inputs. The implementation of SFAS No. 157 fornonfinancial assets and liabilities did not have an impact on the Company’sconsolidated financial statements as of March 31, 2009. The provisions ofSFAS No. 157 will be applied at such time a fair value measurement of anonfinancial asset or liability is required, which may result in a fair valuethat is materially different than would have been calculated prior to theadoption of SFAS No. 157.

 

InFebruary 2007, the FASB issued SFAS No. 159, *Fair ValueOption for Financial Assets and Liabilities* or SFAS No. 159.  SFAS No. 159 allows companies to choose,at specific election dates, to measure eligible financial assets andliabilities that are not otherwise required to be measured at fair value, at fairvalue. Under SFAS No. 159, companies would report unrealized gains andlosses for which the fair value option has been elected in earnings at eachsubsequent reporting date, and recognize up-front costs and fees related tothose items in earnings as incurred. SFAS No. 159 became effective forfiscal years beginning after November 15, 2007.  We did not elect the fair value option forany financial assets or liabilities and, therefore, adoption of the provisionsof SFAS No. 159 did not have a material effect on our consolidatedfinancial statements.

 

In May 2008, the FASB issued Staff Position No. AccountingPrinciples Board 14-1, *or* FSP No. APB 14-1,*Accounting for Convertible Debt InstrumentsThat May Be Settled in Cash upon Conversion (Including Partial CashSettlement)*. FSP No. APB 14-1 requires that the liabilityand equity components of convertible debt instruments that may be settled incash upon conversion (including partial cash settlement) be separatelyaccounted for in a manner that reflects an issuer’s nonconvertible debtborrowing rate. We adopted FSP No. APB 14-1 effective January 1,2009. The adoption of APB 14-1 did not have an impact on our consolidatedfinancial statements as of and for the three months ended March 31, 2009.

 

In June 2008, the FASB issued EITF 07-5, *Determining Whether an Instrument (or EmbeddedFeature) Is Indexed to an Entity’s Own Stock*, or EITF 07-5.EITF 07-5 provides guidance in assessing whether an equity-linkedfinancial instrument (or embedded feature) is indexed to an entity’s own stockfor purposes of determining whether the appropriate accounting treatment fallsunder the scope of SFAS No. 133 and/or EITF 00-19. EITF 07-5 iseffective for financial statements issued for fiscal years beginning after December 15,2008. We adopted EITF 07-5 effective January 1, 2009. The fair value ofcertain of our outstanding warrants to which this guidance applies was notmaterial as of March 31, 2009. As such, our adoption of EITF 07-5 did nothave a material impact on our consolidated financial statements as of and forthe three months ended March 31, 2009.

 

**Item 3.****           Quantitative and Qualitative Disclosures About Market Risk.**

 

We are exposed to market risk in the ordinary course of business, whichconsists primarily of interest rate risk associated with our cash and cashequivalents and debt and foreign exchange rate risk.

 

*Interest rate risk.*  Theprimary objective of our investment activity is to preserve principal, provideliquidity and maximize income without increasing risk. Our investments havelimited exposure to market risk. To minimize this risk, we maintain ourportfolio of cash and cash equivalents in a variety of investments, consistingprimarily of bank deposits, money market funds and short-term government funds.The interest rates are variable and fluctuate with current market conditions.The risk associated with fluctuating interest rates is limited to thisinvestment portfolio, and we do not believe that a 10% change in interest rateswould have a material impact on our financial position or results ofoperations.

 

The interest rates on our Convertible Notes are not subject to marketfluctuations and therefore our market risk is limited.

 

*Foreign currency risk.*  Todate, our international customer agreements have been denominated primarily inthe local currency of the international customer. The functional currency ofour foreign operations in Europe and Japan is the local currency and, as aresult, any fluctuation in the exchange rates of these net assets, denominatedin local 

 

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currency,would be reflected in the translation gains or losses, which are accounted for inother comprehensive income in our statements of changes in equity. We do notbelieve that a change of 10% in the foreign currency exchange rates would havea material impact on our financial position or results of operations.

 

**Item 4.****           Controls and Procedures.**

 

**Evaluation of Disclosure Controls and Procedures**

 

Our management, with the participation of our chief executive officerand chief financial officer, evaluated the effectiveness of our disclosurecontrols and procedures (as defined in Rules 13a-15(e) and 15d-15(e) underthe Exchange Act) as of March 31,2009. Based on that evaluation, our chief executive officer and chieffinancial officer concluded that, as of March 31, 2009, our disclosurecontrols and procedures were ineffective due to the material weaknessesdescribed in our Annual Report on Form 10-K, as amended, for the yearended December 31, 2008, filed with the SEC on April 9, 2009, whichidentified the material weakness listed below that had not been fullyremediated at March 31, 2009.

 

Our management determined that we have a material weakness in ourinternal control over financial reporting related to not having a sufficientnumber of personnel with the appropriate level of experience and technicalexpertise to appropriately resolve non-routine and complex accounting mattersor to evaluate the impact of new and existing accounting pronouncements on ourconsolidated financial statements while completing the financial statementclose process. The material weakness resulted in the identification ofadjustments during the financial statement close process in 2008 that have beenrecorded in the consolidated financial statements. Until this design deficiencyin our internal control over financial reporting is remediated, there is a reasonablepossibility that a material misstatement to our annual or interim consolidatedfinancial statements could occur and not be prevented or detected by ourinternal controls in a timely manner.

 

Our efforts to remediate this material weakness in our internalcontrols over financial reporting through the hiring and training of additionalqualified financial and accounting personnel are currently in process, andconsist of the following:

 

·                  inaddition to our hiring of Brian Posner, an experienced chief financial officerin January 2009, we hired a vice president of financial reporting withexperience preparing SEC reports for a publicly traded company required tocomply with Section 404 of the Sarbanes-Oxley Act of 2002 and further, wehired a director of financial planning and analysis in the first quarter of2009; and

 

·                  wewill also expand the training and education of our accounting and finance staffmembers, including Sarbanes-Oxley compliance training, in an effort to improvetheir effectiveness.

 

In addition, our management determined that we have a material weaknessin our entity-level controls as we did not have a control to prevent loans toexecutive officers. In connection with the review of our internal controls,management noted that in October 2008 we made an advance of salary ofapproximately $24,000 to our president and chief executive officer, MichaelWhitman. Such advance was made by us on Mr. Whitman’s behalf to Mr. Whitman’sbrokerage account to enable Mr. Whitman to satisfy a margin call requirementin cash rather than in shares of our common stock, which would have resulted insales of our stock during a restricted trading period. This advance wasapproved by our then chief financial officer and was repaid by Mr. Whitmanin full in December 2008.

 

Following an investigation by the Audit Committee of the Board ofDirectors, our Board of Directors, with our chief executive officer andpresident having removed himself from its deliberations, determined that theadvance was an inadvertent violation of Section 402 of the Sarbanes-OxleyAct of 2002 which our internal controls and procedures did not prevent. Ourthen chief financial officer, did not consider that short term salary advancesare deemed to be loans under the provisions of Section 402 of theSarbanes-Oxley Act and therefore was unaware of the Section’s prohibitions onsuch advances to executive officers. Our Board of Directors determined thatthis matter was an isolated incident and required the payment of imputedinterest calculated based on an annual interest rate of 2.19% on the amounts ofsalary advanced, which Mr. Whitman has paid. In addition, the Board ofDirectors has terminated our consulting arrangement with our former chieffinancial officer. Our chief executive officer and president is now aware ofthis requirement of the

 

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Sarbanes-Oxley Act of2002 and will ensure that he avoids any violation thereof in the future. Inresponse to this matter, the Board of Directors has instructed our currentchief financial officer to undertake a thorough review of our internal controlsand procedures with the intention of expanding and formalizing our policies andprocedures to avoid future violations of the Sarbanes-Oxley Act of 2002, andother applicable laws, rules and regulations. This review by our chieffinancial officer is in process. The Board of Directors intends to institutemandatory corporate governance and Sarbanes-Oxley Act of 2002 training formanagement and our accounting staff.

 

**Changesin Internal Control Over Financial Reporting**

 

There was nochange in our internal control over financial reporting during our most recentfiscal quarter that has materially affected, or is reasonably likely tomaterially affect, our internal control over financial reporting.

 

**PART II:**                                               **OTHER INFORMATION**

 

**Item 1:**   **Legal Proceedings.**

 

*Productliability suit in Belgium.*    In early December 2004,we were made a party to a lawsuit filed in a Belgian court on September 30,2004 by a patient and his co-habitating female partner against the insurer fora Belgian surgeon and hospital as well as against PMI’s former Belgiandistributor. The complaint alleged that the patient suffered injuries as aresult of a surgery performed using one of our surgical instruments. Thecomplaint alleged that our instrument was “deficient” and claimed estimateddamages in the amount of €100,000 with “reservation for modification during theproceedings.” We have notified our insurance carrier of the lawsuit and thecarrier has not disclaimed coverage. We intend to continue to contest the claimwith the assistance of U.S. and Belgian counsel. We have accrued $100,000 inour consolidated financial statements as of March 31, 2009 for thismatter, which represents our best estimate of the potential liability relatedto this claim.

 

*Patentlitigation against Ethicon Endo-Surgery in Germany.*    In March 2005,Ethicon Endo-Surgery initiated three patent infringement lawsuits against usand our German subsidiary in district court in Düsseldorf, Germany. Thelawsuits allege that certain of our products infringe the German parts of threeEuropean patents owned by Ethicon Endo-Surgery, which we refer to as theHooven, Clark and Rothfuss patents. We hired German counsel to defend thepatent infringement cases and to seek revocation of Ethicon Endo-Surgery’spatents in nullity proceedings before a separate court in Munich, Germany.

 

We prevailed in theHooven patent infringement action, and the products in question were found notto infringe this patent. Ethicon Endo-Surgery did not appeal the infringementdecision and the case is closed. In the related nullity action, the Hoovenpatent was upheld in a modified form. No appeal was taken and the case is nowclosed.

 

We prevailed in both theinfringement and nullity actions related to the Clark patent. The products inquestion were found not to infringe this patent and the nullity court declaredthe asserted patent revoked. Ethicon Endo-Surgery is appealing both theinfringement and nullity decisions. The infringement appeal has been stayed bythe appellate court until the final outcome of the nullity proceedings, whichis not expected before 2010. We lost the infringement action related to theRothfuss patent, which concerns a particular stapling cartridge that can beused in our surgical instruments. We are appealing that infringement decision.We prevailed in the nullity action related to the Rothfuss patent and thenullity court declared the asserted patent revoked. Ethicon has appealed thisdecision.

 

In the Rothfussinfringement action, Ethicon Endo Surgery asserts that it is entitled tocollect damages of approximately €526,000 and has instituted damagesproceedings for part of its claim, asking the Düsseldorf court for a partialdamages award of at least €142,000, or alternatively, €263,000.

 

We introduced aredesigned stapling product that would not infringe the Rothfuss patent even ifthe patent and the infringement decision were upheld. Subsequently, the appealcourt stayed the provisional enforcement of the 

 

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district court ruling inEthicon Endo-Surgery’s favor in the Rothfuss patent infringement litigation andwe re-introduced the product accused of infringement in that case.

 

Ethicon Endo-Surgery isappealing the Rothfuss patent nullity decision. The courts before which theRothfuss infringement appeal and the damages action are pending stayed thoseproceedings until final resolution of the Rothfuss nullity action, which is notexpected before 2010.

 

In the event EthiconEndo-Surgery was to prevail in its appeals of the Clark patent decisions or inits appeal of the Rothfuss nullity action decision, we may be precluded fromselling certain of our products in Germany.

 

We have not accrued anyamount in our consolidated financial statements as of March 31, 2009 forthese matters.

 

*Duo-Medlitigation in Belgium.*    In August 2008, our former Belgian distributor,Duo-Med, S.A., initiated a breach of contract action against us in theCommercial Court of Brussels in Belgium. The complaint alleges that we breachedour distribution agreement with Duo-Med by failing to provide proper noticewhen we terminated that agreement in May 2007 and that, as the result ofproblems with our products, Duo-Med was unable to sell its existing inventory.The complaint asserts damages totaling approximately €460,000. We believe thatthe allegations in this matter are without merit and intend to vigorouslydefend against them. We have not accrued any amount in our consolidated financialstatements as of March 31, 2009 for this matter.

 

 **Item 1A.**                **Risk Factors.**

 

**RisksRelated to Our Business**

 

***We will be required to raise additional capital. If wecannot raise such capital, we will be forced to curtail operations,******consummate transactionswith respect to our assets that we might not otherwise enter into, attempt tosell our company, cease operations or declare bankruptcy******.***

 

As March 31,2009, we had cash and cash equivalents of approximately $4.7 million. Inaddition, as of March 31, 2009, we had total liabilities of approximately$45.2 million, including approximately $25.0 million of ConvertibleNotes due to be paid in March 2010.

 

Our operations todate have required significant cash expenditures. We have incurred net lossesin each year since our inception and have an accumulated deficit at March 31,2009 of $223.2 million. We believe that our current cash and cash equivalents,together with our expected near-term future sales and milestones, will besufficient to meet our anticipated cash requirements through June 30,2009. We must raise additional capital. We are actively pursuing initiatives toraise additional funds through license and development agreements withcorporate partners or public and private offerings of securities, includingdebt or equity financings. Given the recent and continued turmoil in thecapital markets, there are a number of risks and uncertainties related to ourattempts to complete a financing or strategic partnering arrangement that are outsideour control. There can be no assurance that such financing will be available inamounts or on terms acceptable to us, if at all. In addition, we may enter intoarrangements to extend the maturity of, purchase, redeem, replace or otherwisemodify the terms of the Convertible Notes, and any such arrangements mayrequire us to expend additional cash. These conditions raise substantial doubtabout our ability to continue as a going concern. Our independent registeredpublic accounting firm has modified its audit report on our consolidatedfinancial statements to include an explanatory paragraph regarding thiscontingency.

 

Our actual capitalrequirements will depend on many factors, many of which are outside ourcontrol, including:

 

·                  future revenue generation;

 

·                  the cost of filing and prosecuting patent applications and defendingand enforcing our patent and other intellectual property rights;

 

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·                  the cost of defending, in litigation or otherwise, any claims that weinfringe third party patent or other intellectual property rights;

 

·                  the cost and timing of regulatory approvals;

 

·                  expenses of future clinical studies, if any;

 

·                  the effect of competing technological and market developments; and

 

·                  licensing technologies for future development.

 

Historically, wehave financed our operations and internal growth primarily through privateplacements of equity securities and debt and, more recently, our initial publicoffering. We cannot be certain that additional public or private financing willbe available in amounts acceptable to us, or at all. If we raise additionalfunds by issuing equity securities or debt, significant dilution may occur.Debt financing, if available, may involve restrictive covenants. Any debtfinancing or additional equity that we raise may contain terms that are notfavorable to us or our stockholders. Our ability to obtain additional debtfinancing will be limited by certain covenants we have made to holders of ourConvertible Notes. In addition, if we default in the payment of our obligationsunder our Convertible Notes, our noteholders will be entitled to exercise theirrights as creditors.

 

If we are unableto raise additional funds when needed, we will need to:

 

·                  delay, scale-back or eliminate some or all of our research and productdevelopment programs;

 

·                  license third parties to develop and commercialize products ortechnologies that we would otherwise seek to develop and commercializeourselves;

 

·                  attempt to sell our company;

 

·                  cease operations; or

 

·                  declare bankruptcy.

 

If we take any of theabove actions, the value of your investment in us could be materially impairedor eliminated.

 

As of March 31,2009, there were approximately 3.0 million stock options and approximately1.0 million warrants outstanding. These equity instruments representapproximately 23% of our shares outstanding at March 31, 2009. Thesignificant dilution represented by our outstanding warrants and equitycompensation awards may make it more difficult for us to raise additionalcapital.

 

***We have incurred losses since inception and anticipate thatwe will incur continued losses for the foreseeable future.***

 

We are a companywith a limited operating history and have sustained net losses since ourinception, including a net loss of $6.9 million in the three months ended March 31,2009 and net losses of $42.3 million and $36.8 million for the yearsended December 31, 2008 and 2007, respectively. We had an accumulateddeficit of $223.2 million at March 31, 2009. We expect to continue toincur significant operating losses at least through 2009. Our losses have hadand will continue to have an adverse effect on our stockholders’ equity andworking capital and could cause us to take actions that could materially impairor eliminate the value of your investment in us.

 

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***We are dependent on our next generation wireless handheldtechnology incorporated in our i60, i45 and iDrive products, and we cannot becertain that our technology and our products will achieve the broad marketacceptance necessary to develop a sustainable, profitable business.***

 

Historically, mostof our revenue has been derived from the sale of our single-patient, disposableIntelligent Surgical Instruments and, to a lesser extent, from the sale ofreload cartridges for our reusable Intelligent Surgical Instruments. We expectthat as our installed base of reusable, multiple-patient Intelligent SurgicalInstruments grows and the number of firings of our instruments increases, salesof reload cartridges will become the largest component of our total sales. Itis difficult to predict the penetration, future growth rate or size of themarket for our next generation of wireless handheld products.

 

The commercialsuccess of our various Intelligent Surgical Instruments will require broadacceptance of our technology platform by the surgeons who specialize in theprocedures we target, a limited number of whom may be able to influence deviceselection and purchasing decisions. If the concept of computer-assistedpower-actuated devices for tissue manipulation, cutting and stapling is notbroadly accepted and perceived as having significant advantages overmanually-actuated devices, then we will not meet our business objectives. Suchbroad acceptance will require a determination by hospitals and surgeons thatour products are safe, cost-effective and represent acceptable methods oftreatment. We cannot assure that our existing relationships and arrangementswith hospitals and surgeons can be maintained or that new relationships will beestablished in support of our products. In addition, our competitors may developnew technology for tissue manipulation, cutting and stapling that is moreattractive to surgeons and hospitals. If surgeons do not consider our productsto be suitable for application in the procedures we are targeting and animprovement over the use of competing products, our business goals will not berealized.

 

***Our Convertible Notes contain certain covenants that, if weviolate, could result in an event of default. If we are in default, ournoteholders will be entitled to exercise their rights under the ConvertibleNotes and immediately accelerate payment, which could materially impair ourability to continue to operate our business.***

 

Our ConvertibleNotes include certain covenants that, among other things, require that wematerially comply with all applicable laws; pay all material taxes, assessmentsand governmental levies; furnish certain financial statements to ournoteholders; and maintain insurance in the amounts customarily maintained bycompanies in the same or similar businesses. Our ability to comply with theseand other provisions of the Convertible Notes may be impacted by changes ineconomic or business conditions, results of operations or events beyond ourcontrol. The breach of any of these covenants could result in an event of default.Upon an event of default, our noteholders will be entitled to exercise theirrights under the Convertible Notes and immediately accelerate repayment of theConvertible Notes, which could materially impair our ability to continue tooperate our business.

 

***The success of our business is dependent on our ability todevelop new and innovative products and to enhance our existing products. Inrecent years, we experienced significant delays in the introduction of our newproducts, and if we do not achieve our current development goals in the timeframes we expect, the commercialization of our new products may be delayed and,as a result, our operations may be adversely affected.***

 

The success of ourbusiness is dependent on our ability to develop new products, to introduceenhancements to our existing products and to develop these new technologieswithin targeted timeframes. These target estimates are based on a variety ofassumptions. The actual timing of these milestones can vary dramaticallycompared to our estimates for reasons that may or may not be within ourcontrol. Delays in product releases, or our inability to quickly resolvequality issues, both real and perceived, and other factors affecting thesuccess of our product launches, could have a material adverse effect on ourrevenues and results of operations. Customers may forego purchases of ourexisting products and purchase our competitors’ products as a result of delaysin the introduction of our new products and enhancements, failure by us tochoose correctly among technical alternatives or failure by us to offerinnovative products or enhancements at competitive prices and in a timelymanner. In addition, announcements of new products by us or by competitors mayresult in a delay in or cancellation of purchasing decisions in anticipation ofsuch new products. Any such losses could impair the value of your investment.

 

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***We have limited manufacturing experience, have experiencedsignificant manufacturing problems in the past and may encounter difficultiesin increasing production to provide an adequate supply to customers.***

 

The manufacture ofour products is a complex and costly operation involving a number of separateprocesses and components. To date, our manufacturing activities have consistedprimarily of assembling limited quantities of our products. We have considered,and will continue to consider as appropriate, manufacturing components that arecurrently provided by third parties, as well as implementing new productionprocesses. We do not have experience in manufacturing our products in thecommercial quantities that might be required to market our products in theUnited States, Europe and Japan. Manufacturing of our products in commercialquantities will require us to expand our manufacturing capabilities and to hireand train additional personnel. We expect that any expansion would be achievedthrough modified space utilization in our current leased facilities, improvedefficiencies, increased automation and acquisition of additional tooling andequipment. We may encounter difficulties in increasing our manufacturingcapacity and in manufacturing commercial quantities, including:

 

·                  maintaining product yields;

 

·                  maintaining quality control and assurance;

 

·                  providing component and service availability;

 

·                  maintaining adequate control policies and procedures; and

 

·                  hiring and retaining qualified personnel.

 

Difficultiesencountered in increasing our manufacturing capacity could impact our abilityto adequately supply our customers.

 

***In order to achieve and sustain profitability, we mustsubstantially improve our gross margins.***

 

The historicalunit costs for our products, based on limited manufacturing volumes, have beenvery high in relation to our sales, resulting in low or negative gross margins.It will be necessary for us to achieve substantial reductions in our cost ofsales as a percentage of sales in order to become profitable. The transition toin-house production or to new production processes initially had a negativeeffect on our manufacturing yields or costs, which adversely affected our grossmargins in the first half of 2008. While we saw improvements to our grossmargins in the second half of 2008 and the first quarter of 2009, due to thesenew production processes, we may not be able to maintain such margins as newproducts are introduced to the market. Certain of our manufacturing processes arelabor intensive, and achieving significant cost reductions will depend in partupon reducing the time required to perform these processes. We cannot assureyou that we will be able to achieve the significant cost reductions in themanufacture of our products necessary for our business to achieveprofitability.

 

***If our products are not considered to be a safe andeffective alternative to existing technologies, we will not be commerciallysuccessful.***

 

Our successdepends upon acceptance of our technology by the medical community as safe,clinically effective and cost effective and a preferred device as compared toproducts of our competitors. We have not collected, and are not aware thatothers have collected, long-term data regarding efficacy, safety and clinicaloutcomes associated with the use of our products. Any data that is generated inthe future may not be positive or consistent with our current, largelyanecdotal data, which would negatively affect market acceptance and the rate atwhich our Intelligent Surgical Instruments are adopted. Equally important willbe physicians’ perceptions of the safety of our products. Our technology isrelatively new in surgery, and the results of short-term clinical experiencewith our Intelligent Surgical Instruments do not necessarily predict long-termclinical benefits as compared to the products of our competitors. If, over thelong term, our Intelligent Surgical Instruments do not meet surgeons’expectations as to safety, efficacy and ease of use, our Intelligent SurgicalInstruments may not become widely adopted.

 

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Even if the datacollected from future clinical studies or clinical experience indicatespositive results, each surgeon’s actual experience with our device outside theclinical study setting may vary. Consequently, both short- and long-termresults reported in any future clinical studies may be significantly morefavorable than typical results of other practicing surgeons, which couldnegatively affect rates of adoption and negatively affect our results.

 

***Because our markets are highly competitive, customers maychoose to purchase our competitors’ products, which would result in reducedsales and harm our financial results.***

 

Our IntelligentSurgical Instruments rely on new technology and must compete with the moreestablished manual devices of our competitors, such as Covidien and EthiconEndo-Surgery, Inc. Conventional manual devices are widely accepted in themedical community, have a long history of use and do not require the purchaseof additional, expensive capital equipment. We cannot be certain that surgeonswill use our products to replace or supplement established treatments or thatour products will be competitive with current or future products andtechnologies.

 

The medicalindustry is highly competitive. In recent years, there has been changes intechnological innovation achieved in short periods of time, and it is possiblethat future technological change and discoveries by others could negativelyimpact our products. Most of our competitors enjoy competitive advantages overus, including:

 

·                  significantly greater name recognition;

 

·                  greater financial and human resources for product development, salesand marketing and patent litigation;

 

·                  longer operating histories;

 

·                  established relationships with healthcare professionals, customers andthird-party payors;

 

·                  established distribution networks;

 

·                  additional lines of products and the ability to offer rebates or bundleproducts to offer higher discounts or incentives to gain a competitiveadvantage; and

 

·                  greater experience in conducting research and development,manufacturing, clinical trials, obtaining regulatory clearance for products andmarketing approved products.

 

In addition, ourfirst generation SurgASSIST system in its original configuration had certainperceived disadvantages compared to conventional manual endomechanical devices.Prior to the introduction of our new i60 and i45 linear staplers and our iDrivewireless handheld power and control system, our Intelligent SurgicalInstruments had to be tethered by a flexible shaft to a power console which islocated outside the sterile field. Some surgeons and operating room personnelfound this to be cumbersome and not well suited for all procedures. This factormay initially have limited market acceptance of our SurgASSIST platform. Ournext generation untethered self-contained Intelligent Surgical Instruments aredesigned to eliminate this disadvantage of our SurgASSIST system, but we mayneed to overcome an initial negative perception by clinicians of ourfirst-generation tethered technology.

 

Our future successdepends upon maintaining a competitive position in the development of productsand technologies in our areas of focus. Our competitors may:

 

·                  develop technologies and products that are more effective than ourproducts or that render our technologies or products obsolete or noncompetitive;

 

·                  obtain patent protection or other intellectual property rights thatwould prevent us from developing or enhancing our products; or

 

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·                  obtain regulatory approval for the commercialization of their productsmore rapidly or effectively than we do.

 

Additionalcompetitors also may enter our market. As a result, we cannot assure you thatwe will be able to compete successfully against existing or new competitors.Our sales would be reduced or eliminated if our competitors develop and marketproducts that are more effective and less expensive than our products.Volatility in the demand for our products could, among other things, make itmore difficult to gauge the manufacturing capacity necessary to meet ourdemand, decrease our manufacturing efficiency and increase our working capitalrequirements. If any of these occur, your investment in our common stock maydecrease in value.

 

***We assemble our Intelligent Surgical Instruments using ourown customized equipment and are currently implementing a new manufacturingprocess, making us vulnerable to production and supply problems that couldnegatively impact our sales.***

 

We presently usecustomized equipment for certain steps in the assembly of our IntelligentSurgical Instruments. Because of the customized nature of our equipment, wecannot rely on third parties to find new parts or replace the equipment. As aresult, we are responsible for maintaining the equipment and for locating spareparts. If the equipment malfunctions and we are unable to locate spare parts orhire qualified personnel to repair the equipment, we may encounter delays inthe manufacture of our Intelligent Surgical Instruments and reloads and may nothave sufficient inventory to meet our customers’ demands, which could adverselyaffect our business, financial condition and results of operations.

 

We integrated anautomated system that enables us to assemble the reload cartridges forour PLC 60 and i60 linear staplers. There is no guarantee that theautomated system will function at the capacity we require. The automated systemis located at our facility in Langhorne, Pennsylvania, which requires us to beresponsible for the day-to-day control and protection of the system. While weexpect this automated system to manufacture at our anticipated volume,unanticipated problems in our utilization of this automated system couldjeopardize our initiatives to improve our gross margins.

 

***We are dependent upon a number of key suppliers, includingcertain sole source suppliers, the loss of which would materially harm ourbusiness.***

 

While we generallyno longer rely upon sole source suppliers for key components and services usedin manufacturing our products, we do not have long-term contracts with oursuppliers. We cannot assure you that we will be able to obtain sufficientquantities of the components or services we use in our manufacturing in thefuture. Because we do not have long-term contracts, our suppliers generally arenot required to provide us with any guaranteed minimum production levels.

 

In addition, ourreliance on third parties involves a number of risks, including, among otherthings:

 

·                  suppliers may fail to comply with regulatory requirements or makeerrors in manufacturing components that could negatively affect the efficacy orsafety of our products or cause delays in shipments of our products;

 

·                  we may not be able to respond to unanticipated changes and increases incustomer orders;

 

·                  we may be subject to price fluctuations due to a lack of long-termsupply arrangements for key components;

 

·                  we may experience delays in delivery by our suppliers due to changes indemand from us or their other customers;

 

·                  we may lose access to critical services and components, resulting in aninterruption in the manufacture, assembly and shipment of our systems;

 

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·                  fluctuations in demand for products that our suppliers manufacture forothers may affect their ability or willingness to deliver components to us in atimely manner;

 

·                  our suppliers may wish to discontinue supplying components or servicesto us for risk management reasons;

 

·                  we may not be able to find new or alternative components or reconfigureour system and manufacturing processes in a timely manner if the necessarycomponents become unavailable; and

 

·                  our suppliers may encounter financial hardships unrelated to our demandfor components, which could inhibit their ability to fulfill our orders andmeet our requirements.

 

If any of theserisks materialize, it could significantly increase our costs and impact ourability to meet demand for our products.

 

We cannot quicklyreplace suppliers or establish additional new suppliers for some of thesecomponents, due to both the complex nature of the manufacturing process used byour suppliers and the time and effort that may be required to obtain regulatoryclearance or approval to use materials from alternative suppliers. Anysignificant supply interruption or capacity constraints affecting ourfacilities or those of our suppliers would impair our ability to manufactureour products.

 

***If we are unable to manage our expected growth, ourperformance may suffer.***

 

In October 2008,we implemented a restructuring plan aimed at reducing costs, primarily throughheadcount reductions. As of March 31, 2009, we had approximately 127employees globally, compared with 177 in March 2008. It is possible thatour management, finance, technical and regulatory personnel, systems andfacilities currently in place may not be adequate to support our expectedfuture growth. Our need to effectively manage our operations, growth andprograms requires that we continue to improve our systems and procedures ineach of these areas and to attract and retain sufficient numbers of talentedemployees. We may be unable to successfully implement these tasks on a largerscale and, accordingly, may not achieve our research, development and growthgoals.

 

***We have concluded that there are material weaknesses in ourinternal controls over financial reporting, and if we are unable to achieve andmaintain effective internal controls over financial reporting, investors couldlose confidence in our financial statements and our company, which could have amaterial adverse effect on our business and stock price.***

 

We determined thatwe have a material weakness in our internal control over financial reportingrelated to not having a sufficient number of personnel with the appropriatelevel of experience and technical expertise to appropriately resolvenon-routine and complex accounting matters or to evaluate the impact of new andexisting accounting pronouncements on our consolidated financial statementswhile completing the financial statement close process. The material weaknessresulted in the identification of adjustments during the financial statementclose process in 2008 that have been recorded in the consolidated financialstatements. Until this design deficiency in our internal control over financialreporting is remediated, there is a reasonable possibility that a materialmisstatement to our annual or interim consolidated financial statements couldoccur and not be prevented or detected by our internal controls in a timelymanner.

 

Our efforts toremediate this material weakness in our internal controls over financialreporting through the hiring and training of additional qualified financial andaccounting personnel are currently in process, and consist of the following:

 

·                  in addition to our hiring of Brian Posner, an experienced chieffinancial officer in January 2009, we hired a vice president of financialreporting with experience preparing SEC reports for a publicly traded companyrequired to comply with Section 404 of the Sarbanes-Oxley Act of 2002 andfurther, we hired a director of financial planning and analysis in the firstquarter of 2009; and

 

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·                  we will also expand the training and education of our accounting andfinance staff members, including Sarbanes-Oxley compliance training, in aneffort to improve their effectiveness.

 

In addition, wedetermined that we have a material weakness in our entity-level controls as wedid not have a control to prevent loans to executive officers. In connectionwith the review of our internal controls, we noted that in October 2008 wemade an advance of salary of approximately $24,000 to our president and chief executiveofficer, Michael Whitman. Such advance was made by us on Mr. Whitman’sbehalf to Mr. Whitman’s brokerage account to enable Mr. Whitman tosatisfy a margin call requirement in cash rather than in shares of our commonstock, which would have resulted in sales of our stock during a restrictedtrading period. This advance was approved by our then chief financial officerand was repaid by Mr. Whitman in full in December 2008.

 

Following aninvestigation by the Audit Committee of the Board of Directors, our Board ofDirectors, with our chief executive officer and president having removedhimself from its deliberations, determined that the advance was an inadvertentviolation of Section 402 of the Sarbanes-Oxley Act of 2002 which ourinternal controls and procedures did not prevent. Our then chief financialofficer, did not consider that short term salary advances are deemed to beloans under the provisions of Section 402 of the Sarbanes-Oxley Act andtherefore was unaware of the Section’s prohibitions on such advances toexecutive officers. Our Board of Directors determined that this matter was anisolated incident and required the payment of imputed interest calculated basedon an annual interest rate of 2.19% on the amounts of salary advanced, which Mr. Whitmanhas paid. In addition, the Board of Directors has terminated our consultingarrangement with our former chief financial officer. Our chief executiveofficer and president is now aware of this requirement of the Sarbanes-OxleyAct of 2002 and will ensure that he avoids any violation thereof in the future.In response to this matter, the Board of Directors has instructed our currentchief financial officer to undertake a thorough review of our internal controlsand procedures with the intention of expanding and formalizing our policies andprocedures to avoid future violations of the Sarbanes-Oxley Act of 2002, andother applicable laws, rules and regulations. This review by our chieffinancial officer is in process. The Board of Directors intends to institutemandatory corporate governance and Sarbanes-Oxley Act of 2002 training formanagement and our accounting staff.

 

Pursuant to Section 404of the Sarbanes-Oxley Act of 2002, we must assess the effectiveness of ourinternal control over financial reporting. This assessment must includedisclosure of any material weaknesses in our internal control over financialreporting that are identified by management. If we are unable at that time toassert that our internal control over financial reporting is effective becausethe material weakness identified above has not been remediated, or for anyother reason, or if our independent registered public accounting firm is unableto express an opinion on the effectiveness of our internal controls when it isrequired to do so in the future, investors could lose confidence in theaccuracy and completeness of our financial reports, which could have an adverseeffect on our stock price.

 

***Any failure in our training efforts could result in lowerthan expected product sales and potential liabilities.***

 

A criticalcomponent of our sales and marketing efforts is the training of a sufficientnumber of surgeons, other clinicians and hospital staff to properly use ourIntelligent Surgical Instruments. In order to operate effectively, our internalsales force must also be trained on the benefits and proper utilization of ourtechnology, including newly introduced products. In connection with theintroduction of our i60, i45, i45v and iDrive products, we have found that ittakes longer than we expected to adequately train our internal sales force andcustomers’ clinical personnel on the use and care of these instruments, due inpart to their novelty and to the need to employ new sterilization techniques.Additionally, the number of i60 and iDrive demonstration units available foruse by our sales force was limited during the early phases of our i60 productlaunch. As a result, it has taken longer for our sales force to become fullyeffective in selling these new products, and the rate of adoption of our newtechnology has been adversely affected. Any further delays in adequatelytraining our internal sales force or our customers’ clinical personnel on theseor other products could harm our business.

 

Additionally, werely on clinicians and hospital staff to devote adequate time to learn to useour products. If surgeons or hospital staff are not properly trained in the useof our Intelligent Surgical Instruments, they may misuse or ineffectively useour products. Insufficient training may result in unsatisfactory patientoutcomes, patient injury and related liability or negative publicity, whichcould have an adverse effect on our product sales.

 

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***The use of our products could result in product liabilityclaims that could be expensive, divert management’s attention and harm ourreputation and business.***

 

Our businessexposes us to significant risks of product liability claims that are inherentin the testing, manufacturing and marketing of medical devices. The medicaldevice industry has historically been subject to extensive product liabilitylitigation. We have in the past been, and in the future may be, subject toclaims by consumers, healthcare providers, third-party payors or others sellingour products if the use of our products were to cause, or merely appear tocause, injury or death. We are currently the subject of a product liabilitysuit in Belgium. Any weakness in training and service associated with ourproducts may result in other product liability lawsuits. Additionally, we maybe unable to maintain our existing product liability insurance in the future atsatisfactory rates or adequate amounts. A product liability claim, regardlessof its merit or eventual outcome or the availability of insurance coverage,could result in:

 

·                  decreased demand for our products;

 

·                  injury to our reputation;

 

·                  diversion of management’s attention;

 

·                  significant costs of related litigation;

 

·                  substantial monetary awards to patients;

 

·                  product recalls or market withdrawals;

 

·                  loss of sales; and

 

·                  the inability to successfully commercialize our products that are underdevelopment.

 

***If we deliver products with defects, our credibility may beharmed and market acceptance of our products may decrease.***

 

The manufacturingand marketing of our products involve an inherent risk of product liabilityclaims. In addition, our product development and production processes arecomplex and could expose our products to defects. Additionally, problemsexperienced by our customers, such as difficulty in consistently seating ourreload cartridges, may be perceived by them as quality defects. Our IntelligentSurgical Instruments also incorporate sophisticated computer software. Complexsoftware frequently contains errors, especially when first introduced. Wecannot assure you that our software will not experience errors or performanceproblems in the future. If our products have, or are perceived to have,mechanical defects or software errors or have performance problems, we wouldlikely experience:

 

·                  loss of sales;

 

·                  delay in market acceptance of our products;

 

·                  damage to our reputation;

 

·                  additional regulatory filings;

 

·                  product recalls;

 

·                  increased service or warranty costs; or

 

·                  product liability claims.

 

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***We sell our systems internationally and are subject tovarious risks relating to these international activities, which could adverselyaffect our business, financial condition and results of operations.***

 

During the threemonths ended March 31, 2009 and 2008, sales in international marketstotaled 31% and 15%, respectfully. By doing business in international markets,we are exposed to risks separate and distinct from those we face in ourdomestic operations. Our international business may be adversely affected bychanging economic conditions in foreign countries. Because most of ourinternational sales are denominated in the functional currency of the countrywhere the product is being shipped, increases or decreases in the value of theU.S. dollar relative to foreign currencies could affect our results ofoperations. Engaging in international business inherently involves a number ofother difficulties and risks, including:

 

·                  export restrictions and controls relating to technology and governmentregulation;

 

·                  the availability and level of reimbursement within prevailing foreignhealthcare payment systems;

 

·                  pricing pressure that we may experience internationally;

 

·                  required compliance with existing and changing foreign regulatoryrequirements and laws;

 

·                  laws and business practices favoring local companies;

 

·                  longer payment cycles;

 

·                  difficulties in enforcing agreements and collecting receivables throughcertain foreign legal systems;

 

·                  political and economic instability;

 

·                  potentially adverse tax consequences, tariffs and other trade barriers;

 

·                  international terrorism and anti-American sentiment;

 

·                  difficulties and costs of staffing and managing foreign operations; and

 

·                  difficulties in enforcing intellectual property rights.

 

Our exposure toeach of these risks may increase our costs, impair our ability to market andsell our products and require significant management attention. We cannotassure you that one or more of these factors will not harm our business.

 

***We are dependent upon key personnel, the loss of any ofwhich could harm our business.***

 

Our futurebusiness and operating results depend significantly on the continuedcontributions of our key technical personnel and senior management,particularly those of Mr. Whitman. These individuals and the services theyprovide would be difficult to replace. While we are subject to certainseverance obligations to Mr. Whitman, either he or we may terminate his employmentat any time and for any lawful reason or for no reason. Our business and futureoperating results also depend significantly on our ability to attract andretain qualified management, manufacturing, technical, regulatory, marketing,sales and support personnel for our operations. Competition for such personnelis intense, and there can be no assurance that we will be successful inattracting or retaining such personnel.

 

Although we havekey-person life insurance in the amount of $2.0 million on the life of Mr. Whitman,this amount would not fully compensate us for the loss of Mr. Whitman’sservices. The loss of key employees, the failure of any key employee to performor our inability to attract and retain skilled employees, as needed, could harmour business.

 

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***Lack of third-party coverage and reimbursement for ourproducts could delay or limit their adoption.***

 

We may experiencelimited sales growth resulting from limitations on reimbursements made topurchasers of our products by third-party payors, and we cannot assure you thatour sales will not be impeded and our business harmed if third-party payorsfail to provide reimbursement that hospitals view as adequate.

 

In the UnitedStates, our products are purchased primarily by medical institutions, whichthen bill various third-party payors, such as the Centers for Medicare andMedicaid Services, or CMS, which administers the Medicare and Medicaidprograms, and other government programs and private insurance plans, for thehealthcare services provided to their patients. The process involved inapplying for coverage and incremental reimbursement from CMS is lengthy andexpensive.

 

Moreover, manyprivate payors look to CMS in setting their reimbursement policies and amounts.If CMS or other agencies limit coverage for procedures utilizing ourIntelligent Surgical Instruments or decrease or limit reimbursement paymentsfor doctors and hospitals, this may affect coverage and reimbursementdeterminations by many private payors.

 

If a medicaldevice does not receive incremental reimbursement from CMS, then a medicalinstitution would have to absorb the cost of our products as part of the costof the procedure in which the products are used. Acute care hospitals are nowgenerally reimbursed by CMS for inpatient operating costs under a Medicarehospital inpatient prospective payment system. Under the Medicare hospitalinpatient prospective payment system, acute care hospitals receive a fixedpayment amount for each covered hospitalized patient based upon theDiagnosis-Related Group, or DRG, to which the inpatient stay is assigned,regardless of the actual cost of the services provided. At this time, we do notknow the extent to which medical institutions would consider insurers’ paymentlevels adequate to cover the cost of our products. Failure by hospitals andsurgeons to receive an amount that they consider to be adequate reimbursementfor procedures in which our products are used could deter them from purchasingour products and limit our sales growth. In addition, pre-determined DRGpayments may decline over time, which could deter medical institutions frompurchasing our products. If medical institutions are unable to justify thecosts of our products, they may refuse to purchase them, which wouldsignificantly harm our business.

 

***Our operations are currently conducted primarily at a singlelocation that may be at risk from fire, earthquakes, terror attacks or otherdisasters.***

 

We currentlyconduct all of our manufacturing and management activities and certain researchand development activities at a single location in Langhorne, Pennsylvania. Wehave taken precautions to safeguard our facilities, including insurance, healthand safety protocols and off-site storage of computer data. However, a casualtydue to fire or natural disaster, such as an earthquake, storm or terroristattack, could cause substantial delays in our operations, damage or destroy ourequipment or inventory and cause us to incur additional expenses. A disastercould seriously harm our business and results of operations. Our insurance doesnot cover earthquakes and floods and may not be adequate to cover our losses inany particular case.

 

***Risks Related to Ownership of Our Common Stock***

 

***We expect that the price of our common stock will fluctuatesubstantially based on a number of factors, many of which are beyond ourcontrol.***

 

Until our initialpublic offering in October 2007, there was no public market for shares ofour common stock. Since our initial public offering, the closing market priceof our common stock has ranged from $0.22 at its low point in December 2008to $14.40 at its high point in February 2008. The closing market price ofour common stock during the first quarter of 2009 ranged from $0.24 at its lowpoint in January 2009 to $0.69 at its high point in February 2009.The market price for our common stock is likely to continue to fluctuate as aresult of a number of factors, including:

 

·                  developments relating to our efforts to obtain additional financing tofund our operations or our issuance of additional debt or equity securities;

 

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·                  if we are unable to obtain such additional financing or issue such debtor equity securities, our consequent need to:

 

·                  delay, scale-back or eliminate some or all of ourresearch and product development programs;

 

·                  license third parties to develop and commercialize products ortechnologies that we would otherwise seek to develop and commercializeourselves;

 

·                  attempt to sell our company;

 

·                  cease operations; or

 

·                  declare bankruptcy;

 

·                  actual or anticipated announcements of technological innovations;

 

·                  introduction by us or by others of new commercial products;

 

·                  actual or anticipated changes in laws and governmental regulations;

 

·                  disputes relating to patents or proprietary rights;

 

·                  changes in business practices;

 

·                  announcements by us regarding transactions with potential strategicpartners;

 

·                  changes in industry trends or conditions;

 

·                  trading volume of our common stock;

 

·                  changes in earnings estimates or recommendations by securitiesanalysts, failure to obtain analyst coverage of our common stock or our failureto achieve analysts’ earnings estimates;

 

·                  developments in our industry; and

 

·                  general market conditions and other factors unrelated to our operatingperformance or the operating performance of our competitors or potentialcompetitors.

 

Stock prices ofmany companies in the medical device industry have experienced widefluctuations that have often been unrelated to the operating performance ofthese companies. In the past, securities class action litigation often has beeninitiated against a company following a period of volatility in the marketprice of the company’s securities. If securities class action litigation isinitiated against us, we will incur substantial costs and our management’sattention will be diverted from our operations. All of these factors maymaterially and adversely affect the market price of our common stock, and youmay lose some or all of your investment.

 

***Our common stock may be delisted from the NASDAQ CapitalMarket stock exchange.***

 

Our common stockmay be subject to delisting from the NASDAQ Capital Market. In October 2008,we received a notification from the NASDAQ indicating that we were not incompliance with the NASDAQ Global Market’s continued listing requirements setforth in Marketplace Rule 4450(b)(1)(A) because the market value ofour listed securities was below $50.0 million for 10 consecutive tradingdays. In January 2009, we were the subject of a hearing before a NASDAQlisting qualifications panel to determine whether our common stock’s continuedlisting was warranted. At the hearing, we requested a transfer of our listingfrom the NASDAQ Global Market to the NASDAQ Capital Market. On March 23,2009, the NASDAQ notified us that our request had been granted. The transfertook effect on March 25, 2009. Our common stock continues to trade underthe symbol PMII. The 

 

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NASDAQ Capital Market isa continuous trading market that operates in the same manner as the NASDAQGlobal Market. The NASDAQ Capital Market includes the securities ofapproximately 450 companies. All companies listed on the NASDAQ Capital Marketmust meet certain financial requirements and adhere to NASDAQ’s corporategovernance standards. Our continued listing on the NASDAQ Capital Market issubject to compliance with all requirements, including the $2.5 millionstockholders’ equity requirement, for continued listing on that market by May 20,2009. We are currently pursuing strategic initiatives, including, but notlimited to, raising capital, that if successful may enable us to comply withthe NASDAQ Capital Markets minimum stockholder’s equity requirement. If we areunable comply with the requirements for continued listing on the NASDAQ CapitalMarket and our common stock becomes delisted from that exchange, we will makeevery possible effort to have it listed on the Over the Counter Bulletin Board,or the OTC Bulletin Board. If our common stock were to be traded on the OTCBulletin Board, the Securities Exchange Act of 1934, as amended, and relatedSEC rules would impose additional sales practice requirements onbroker-dealers that sell our securities. These rules may adversely affectthe ability of stockholders to sell our common stock and otherwise negativelyaffect the liquidity, trading market and price of our common stock.

 

If our commonstock would not be able to be traded on the OTC Bulletin Board, we would makeevery effort to have it available for trading on the National Quotation Bureau’sPink Sheets, or the Pink Sheets. The Pink Sheets market consists of securityfirms who act as market makers in the stocks, usually, of very small companies.The bid and asked prices are not quoted electronically, but are quoted daily in“hard copy,” which is delivered to firms that subscribe. Stocks that trade inthe Pink Sheets are usually not as liquid as those that trade in electronicmarkets and, often times, the difference between the bid and the asked pricesare substantial. As a result, if our common stock were traded on the PinkSheets, there would likely be a further negative effect on the liquidity, tradingmarket and price of our common stock even compared to that we might suffer ifwe were traded on the OTC Bulletin Board.

 

As a result of theabove, we cannot assure you that our common stock will continue to be listed ona national securities exchange, a national quotation service, the OTC BulletinBoard or the Pink Sheets or, if it is to be listed, whether or not there wouldbe an interruption in the trading of our common stock. We believe that thelisting of our stock on a recognized national trading market, such as theNASDAQ Capital Market, is an important part of our business and strategy. Sucha listing helps our stockholders by providing a readily available tradingmarket with current quotations. Without that, stockholders may have a difficulttime getting a quote for the sale or purchase of our stock, the sale orpurchase of our stock would likely be made more difficult and the tradingvolume and liquidity of our stock would likely decline. The absence of such alisting may adversely affect the acceptance of our common stock as currency orthe value accorded it by other parties. In that regard, listing on a recognizednational trading market will also affect our ability to benefit from the use ofour operations and expansion plans, including for use in licensing agreements,joint ventures, the development of strategic relationships and acquisitions,which are critical to our business and strategy and none of which is currentlythe subject of any agreement, arrangement or understanding, with respect to anyfuture financing or strategic relationship we may undertake. The delisting fromthe NASDAQ Capital Market would result in negative publicity and wouldnegatively impact our ability to raise capital in the future.

 

***Securities analysts may not initiate or continue coveragefor our common stock or may issue negative reports, and this may have anegative impact on the market price of our common stock.***

 

Securitiesanalysts may elect not to provide research coverage of our common stock, and ifa sufficient number of securities analysts do not cover our common stock, thelack of research coverage may adversely affect the market price of our commonstock. The trading market for our common stock may be affected in part by theresearch and reports that industry or financial analysts publish about us orour business. If one or more of the analysts who elect to cover us downgradesour stock, our stock price could decline. If one or more of these analystsceases coverage of our company, we could lose visibility in the market, whichin turn could cause our stock price to decline. In addition, rules mandatedby the Sarbanes-Oxley Act and a global settlement reached in 2003 between theSEC, other regulatory agencies and a number of investment banks have led to anumber of fundamental changes in how analysts are reviewed and compensated. Inparticular, many investment banking firms will be required to contract withindependent financial analysts for their stock research. It may be difficultfor companies such as ours, with smaller market capitalizations, to attractindependent financial analysts that will cover our common stock. This couldhave a negative effect on the market price of our stock.

 

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***Our principal stockholders, directors and management own alarge percentage of our voting stock, which allows them to exercise significantinfluence over matters subject to stockholder approval.***

 

Our executiveofficers, directors and stockholders holding 5% or more of our outstandingcommon stock beneficially own or control approximately 45% of the outstandingshares of our common stock, assuming no exercise of outstanding options andwarrants or conversion of our Convertible Notes. Accordingly, these executiveofficers, directors and principal stockholders, acting as a group, will havesubstantial influence over the outcome of corporate actions requiringstockholder approval, including the election of directors, any merger,consolidation or sale of all or substantially all of our assets or any othersignificant corporate transaction. These stockholders may also delay or preventa change of control or otherwise discourage a potential acquirer fromattempting to obtain control of our company, even if such a change of controlwould benefit our other stockholders. This significant concentration of stockownership may adversely affect the trading price of our common stock due toinvestors’ perception that conflicts of interest may exist or arise.

 

***Anti-takeover provisions in our charter documents andDelaware law could prevent or delay a change in control of our company.***

 

Provisions in ouramended and restated certificate of incorporation and amended and restatedbylaws, as well as provisions of Delaware law, may discourage, delay or preventa merger, acquisition or change of control. These provisions could alsodiscourage proxy contests and make it more difficult for stockholders to electdirectors and take other corporate actions. These provisions include:

 

·                  advance notice requirements for stockholder proposals and nominations;

 

·                  limitations on convening stockholder meetings;

 

·                  the elimination of stockholder action by written consent;

 

·                  the elimination of cumulative voting; and

 

·                  a classified board of directors.

 

In addition, we are subject to Section 203 of theDelaware General Corporation Law, which imposes certain restrictions on mergersand other business combinations between us and any holder of 15% or more of ourcommon stock.

 

***Risks Related to Our Intellectual Property***

 

***If we fail to adequately enforce or defend our intellectualproperty rights, our business may be harmed.***

 

Much of thetechnology used in the markets in which we compete is covered by patents. Ourcommercial success will depend in large part on our ability to obtain andmaintain patent and trade secret protection for our products and methods. Wecurrently hold 24 issued United States patents, five granted European patents, morethan 100 pending United States and foreign patent applications and two licensedpatents that cover key aspects of our technology. Our issued patents expire atvarious dates beginning in 2019. The loss of our patents could reduce the valueof the related products. In addition, the cost to litigate infringements of ourpatents or the cost to defend ourselves against patent infringement actions byothers could be substantial.

 

Our ability toobtain additional patents is uncertain and the legal protection afforded bythese patents is limited and may not adequately protect our rights or permit usto gain or keep any competitive advantage. In addition, the specific contentrequired of patents and patent applications that is necessary to support andinterpret patent claims is highly uncertain due to the complex nature of therelevant legal, scientific and factual issues. Changes in either patent laws orin interpretations of patent laws in the United States or elsewhere maydiminish the value of our intellectual property or narrow the scope of ourpatent protection. Even if patents are issued regarding 

 

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our products and methods,our competitors may challenge the validity of those patents. Patents also willnot protect our products and methods if competitors devise ways of makingcompetitive products without infringing our patents.

 

Proprietary tradesecrets and unpatented know-how are also very important to our business. Werely on trade secrets to protect certain aspects of our technology, especiallywhere we do not believe that patent protection is appropriate or obtainable.However, trade secrets are difficult to protect. Our employees, consultants,contractors, outside clinical collaborators and other advisors mayunintentionally or willfully disclose our confidential information tocompetitors, and confidentiality agreements may not provide an adequate remedyin the event of unauthorized disclosure of confidential information. Enforcinga claim that a third party illegally obtained and is using our trade secrets isexpensive and time consuming, and the outcome is unpredictable. Moreover, ourcompetitors may independently develop equivalent knowledge, methods andknow-how. Failure to obtain or maintain trade secret protection could adverselyaffect our competitive business position.

 

***If we infringe intellectual property rights of thirdparties, it may increase our costs or prevent us from being able to sell ourexisting products or commercialize new products.***

 

There is a riskthat we are infringing the proprietary rights of third parties under patentsand pending applications belonging to third parties that may exist in theUnited States and elsewhere in the world and that relate to the products wemarket and develop. Because the patent application process can take severalyears to complete, there may be currently pending applications, unknown to us,which may result in issued patents that cover the production, manufacture,commercialization or use of our products. In addition, the production,manufacture, commercialization or use of our product candidates may infringeexisting patents of which we are not aware.

 

There has beensubstantial litigation and other proceedings regarding patent and otherintellectual property rights in the medical device industry. Defendingourselves against third-party claims, including litigation in particular, wouldbe costly and time consuming and would divert management’s attention from ourbusiness, which could lead to delays in our development or commercializationefforts. Currently, we are involved in two appeal proceedings in Germany inconnection with two of three patent-infringement lawsuits against us. Thelawsuits alleged that certain of our products infringe three European patentsheld by Ethicon Endo-Surgery. We prevailed in two of the three infringementactions and the products in question were found not to infringe the Ethicon Endo-Surgerypatents, and Ethicon Endo-Surgery is appealing one of those decisions. We lostthe other infringement action and are appealing that decision. If third partiesare successful in their claims, we might have to pay substantial damages ortake other actions that are adverse to our business. As a result ofintellectual property infringement claims, or to avoid potential claims, wemight:

 

·                  be prohibited from selling or licensing any of our current products orany product that we may develop unless the patent holder licenses the patent tous, which it is not required to do;

 

·                  be required to pay substantial royalties or grant a cross license toour patents to another patent holder; or

 

·                  be required to redesign a product so it does not infringe, which maynot be possible or could require substantial funds and time.

 

***We may be subject to damages resulting from claims that ouremployees or we have wrongfully used or disclosed alleged trade secrets oftheir former employers.***

 

Many of ouremployees were previously employed at universities or other medical devicecompanies, including our competitors or potential competitors. We could in thefuture be subject to claims that these employees, or we, have inadvertently orotherwise used or disclosed trade secrets or other proprietary information oftheir former employers. Litigation may be necessary to defend against theseclaims. If we fail in defending against such claims, a court could order us topay substantial damages and prohibit us from using technologies or featuresthat are essential to our products, if such technologies or features are foundto incorporate or be derived from the trade secrets or other proprietaryinformation of the former employers. In addition, we may lose valuableintellectual property rights or personnel. A loss of key research personnel ortheir work product could hamper or prevent our 

 

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ability to commercializecertain potential products, which could severely harm our business. Even if weare successful in defending against these claims, such litigation could resultin substantial costs and be a distraction to management.

 

***Risks Related to Regulatory Compliance***

 

***Our failure to meet strict regulatory requirements couldrequire us to pay fines, incur other costs or even close our facilities.***

 

Our facilities andmanufacturing techniques generally must conform to standards that areestablished by the United States Food and Drug Administration, or FDA, andother government agencies, including those of European and other foreigngovernments. These regulatory agencies may conduct periodic audits orinspections of our facilities or our processes to monitor our compliance withapplicable regulatory standards. If a regulatory agency finds that we havefailed to comply with the appropriate regulatory standards, it may impose fineson us, delay or withdraw pre-market clearances or other regulatory approvalsor, if such a regulatory agency determines that our non-compliance is severe,it may close our facilities. Any adverse action by an applicable regulatoryagency could impair our ability to produce our products in a cost-effective andtimely manner in order to meet our customers’ demands. We may also be requiredto bear other costs or take other actions that may have a negative impact onour future sales and our ability to generate profits.

 

Between February 2007and May 2008, the FDA conducted two inspections of our facilities. Each ofthose inspections resulted in the issuance of a Notice of InspectionalObservations, or Form 483. Certain observations regarding our processesfor handling customer complaints and submitting medical device reports wereidentified by the FDA as areas of possible non-compliance with the FDAregulations. For each of the Form 483s issued by the FDA, we submitted atimely response which identified our proposed corrective action plans toaddress these inspectional observations. The FDA has not issued anEstablishment Inspection Report, or EIR, which officially closes an inspection,for either the 2007 or 2008 inspections. Regarding the most recent inspection,which occurred from April 7, through May 21, 2008, we submitted tothe FDA a written response to the Form 483 on May 30, 2008. Thatresponse described the corrective actions that we were taking to address theinspectional observations identified in the Form 483. We also submittedvarious follow up letters to the FDA regarding the status of our ongoingcorrective actions. On October 21, 2008, the FDA issued a warning letterto us. The warning letter listed the same inspectional observations identifiedin the Form 483. The warning letter also acknowledged the FDA’s receipt ofour Form 483 response and indicated that the agency would verify that wehave taken such corrective actions during a future inspection. On November 5,2008, we submitted a written response to the warning letter which updated theagency on the status of our ongoing corrective actions. The FDA acknowledgedreceipt of our warning letter response on January 27, 2009. In thatletter, the FDA stated that the adequacy of our corrective actions will bedetermined during the FDA’s next inspection. We also have provided the FDA withregular updates regarding the status of our corrective actions. We expect to bere-inspected by the FDA in 2009. If the FDA finds additional inspectionalobservations, or if the FDA is not satisfied with our corrective actions to the2008 inspection and warning letter, we could be subject to sanctions,including:

 

·                  untitled letters, warning letters, fines, injunctions, consent decreesand civil penalties;

 

·                  unanticipated expenditures to address or defend such actions;

 

·                  customer notifications for repair, replacement, refunds;

 

·                  recall, detention or seizure of our products;

 

·                  operating restrictions or partial suspension or total shutdown ofproduction;

 

·                  refusing or delaying our requests for 510(k) clearance orpremarket approval of new products or modified products;

 

·                  withdrawing 510(k) clearances on PMA approvals that have alreadybeen granted;

 

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·                  refusal to grant export approval for our products; and

 

·                  criminal prosecution.

 

***We must upgrade and correct deficiencies in our regulatorycompliance operations and our failure to do so could impair our ability tomarket our products or lead to regulatory enforcement action against us.***

 

We are subject toextensive regulatory compliance in the United States and other countries,including by the FDA. In 2007 we experienced shortages of qualified regulatorycompliance staff due to turnovers in regulatory staff and senior management,among other factors. We recently enhanced the regulatory and quality assurancefunctions of our organization by hiring personnel with appropriate regulatorycompliance experience.

 

To address the FDA’sinspectional observations made during on-site inspections of the Langhorne,Pennsylvania facility, we have begun the process of improving our complainthandling and medical device reporting procedures to ensure our compliance withthe FDA’s quality system regulations and our related controls and internalaudit functions. In 2008 we engaged an independent consultant to audit ourcompliance with certain aspects of the FDA’s quality system regulations. Whilecertain improvements were noted, further improvements are necessary in ourcorrective action and preventative action processes. We also have engaged athird-party to supervise our MDR decision making process, which will continueuntil the FDA clears the Warning letter it issued to us in October 2008.

 

If we are notsuccessful in retaining qualified personnel to manage and staff our regulatorycompliance operations or in implementing necessary process improvements on atimely basis, we could be subject to regulatory enforcement actions which coulddamage our reputation, impair our ability to obtain regulatory clearances fornew products, prevent us from manufacturing and selling our products and harmour business.

 

***Modifications to our products may require new regulatoryclearances or approvals or may require us to recall or cease marketing ourproducts until clearances or approvals are obtained.***

 

Modifications toour products may require new regulatory approvals or clearances, including 510(k) clearanceto market or premarket approvals, or require us to recall or cease marketingthe modified devices until these clearances or approvals are obtained. The FDArequires device manufacturers to initially make and document a determination ofwhether or not a modification requires a new approval, supplement or clearance.A manufacturer may determine that a modification could not significantly affectsafety or efficacy and does not represent a major change in its intended use,so that no new 510(k) clearance is necessary. However, the FDA can reviewa manufacturer’s decision and may disagree. The FDA may also on its owninitiative determine that a new clearance or approval is required. We have mademodifications to our products in the past and may make additional modificationsin the future that we believe do not or will not require additional clearancesor approvals. If the FDA disagrees and requires new clearances or approvals forthe modifications, we may be required to recall and to stop marketing ourproducts as modified, which could require us to redesign our products and harmour operating results. In these circumstances, we may be subject to significantenforcement actions.

 

If a manufacturerdetermines that a modification to an FDA-cleared device could significantlyaffect its safety or efficacy, or would constitute a major change in itsintended use, then the manufacturer must file for a new 510(k) clearanceor possibly a premarket approval application. Where we determine that modificationsto our products require a new 510(k) clearance or premarket approvalapplication, we may not be able to obtain those additional clearances orapprovals for the modifications or additional indications in a timely manner,or at all. For those products sold in the European Union, we must notify OrionRegistrar, Inc., or Orion, our E.U. Notified Body, if significant changesare made to the products or if there are substantial changes to our qualityassurance systems affecting those products. Obtaining clearances and approvalscan be a time consuming process, and failure to obtain or delays in obtainingrequired future clearances or approvals would adversely affect our ability tointroduce new or enhanced products in a timely manner, which in turn would harmour future growth.

 

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***There is no guarantee that the FDA will grant 510(k) clearanceor PMA approval of our emerging technologies and failure to obtain necessaryclearances or approvals for our future products would adversely affect ourability to grow our business.***

 

Certain of our newproducts will require FDA 510(k) clearance to market or may even requireFDA approval of a PMA. We will need to develop our regulatory strategies forobtaining clearance or approval of new products, as necessary. The FDA may notapprove or clear such products for the indications that are necessary ordesirable for successful commercialization. In addition, the FDA may refuse ourrequests for 510(k) clearance to market or premarket approval of newproducts, new intended uses or modifications to existing products. Failure toreceive clearance or approval for our new products would have an adverse effecton our ability to expand our business.

 

***If we or our contract manufacturers fail to comply with theFDA’s Quality System Regulations, our manufacturing operations could beinterrupted and our product sales and operating results could suffer.***

 

Our finished goodsmanufacturing processes, and those of some of our contract manufacturers, arerequired to comply with the FDA’s Quality System Regulations, or QSRs, whichcover the procedures and documentation of the design, testing, production,control, quality assurance, labeling, packaging, sterilization, storage andshipping of our devices. The FDA enforces its QSRs through periodic inspectionsof manufacturing facilities. We and our contract manufacturers have been, andanticipate continuing to be, subject to such inspections. If our manufacturingfacilities or those of any of our contract manufacturers fail to takesatisfactory corrective action in response to an adverse QSR inspection, theFDA could take enforcement action, including any of the following sanctions,which could have a material impact on our operations:

 

·                  untitled letters, warning letters, fines, injunctions, consent decreesand civil penalties;

 

·                  unanticipated expenditures to address or defend such actions;

 

·                  customer notifications for repairs, replacements or refunds;

 

·                  recall, detention or seizure of our products;

 

·                  operating restrictions or partial suspension or total shutdown ofproduction;

 

·                  refusing or delaying our requests for 510(k) clearance orpremarket approval of new or modified products;

 

·                  withdrawing 510(k) clearances on PMA approvals that have alreadybeen granted;

 

·                  refusal to grant export approval for our products; and

 

·                  criminal prosecution.

 

Between February 2007and May 2008, the FDA conducted two inspections of our facilities. Each ofthose inspections resulted in the issuance of a Notice of InspectionalObservations, or Form 483. Certain observations regarding our processesfor handling customer complaints and submitting medical device reports wereidentified by the FDA as areas of possible non-compliance with FDA regulations.For each of the Form 483s issued by the FDA, we submitted a timelyresponse, which identified our proposed corrective action plans to addressthese inspectional observations. The FDA has not issued an EstablishmentInspection Report, or EIR, which officially closes an inspection, for eitherthe 2007 or 2008 inspections. Regarding the most recent inspection, whichoccurred from April 7, 2008 through May 21, 2008, we submitted to theFDA a written response to the Form 483 on May 30, 2008. That responsedescribed the corrective actions that we were taking to address theinspectional observations identified in the Form 483. We also submittedvarious follow up letters to the FDA regarding the status of our ongoingcorrective actions. On October 21, 2008, the FDA issued a warning letterto us. The warning letter listed the same inspectional observations identifiedin the Form 483. The warning letter also acknowledged the FDA’s receipt ofour 

 

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Form 483 responseand indicated that the agency would verify that we have taken such correctiveactions during a future inspection. On November 5, 2008, we submitted awritten response to the warning letter which updated the agency on the statusof our ongoing corrective actions. The FDA acknowledged receipt of our warningletter response in a January 23, 2009. In that letter, the FDA stated thatthe adequacy of our corrective actions will be determined during the FDA’s nextinspection. We also have provided the FDA with regular updates regarding thestatus of our corrective actions. We expect to be re-inspected by the FDA in2009. If the FDA finds additional inspectional observations, or if the FDA isnot satisfied with our corrective actions to the 2008 inspection and warningletter, we could be subject to various enforcement actions as identified above.

 

***Our products may in the future be subject to product recallsthat could harm our reputation, business and financial results.***

 

The FDA andsimilar foreign governmental authorities have the authority to require therecall of commercialized products in the event of material deficiencies ordefects in design or manufacture. In the case of the FDA, the authority torequire a recall must be based on an FDA finding that there is a reasonableprobability that the device would cause serious injury or death. In addition,foreign governmental bodies have the authority to require the recall of our productsin the event of material deficiencies or defects in design or manufacture.Manufacturers may, under their own initiative, voluntarily recall a product ifany material deficiency in a device is found. A government-mandated orvoluntary recall by us or one of our distributors could occur as a result ofcomponent failures, manufacturing errors, design or labeling defects or otherdeficiencies and issues. Recalls of any of our products would divert managerialand financial resources and have an adverse effect on our financial conditionand results of operations. The FDA requires that certain classifications ofrecalls be reported to FDA within 10 working days after the recall isinitiated. Companies are required to maintain certain records of recalls, evenif they are not reportable to the FDA. We have initiated certain voluntaryrecalls involving products that have been distributed to our customers and maytake additional such actions in the future. We believe that certain of thoserecalls do not require notification of the FDA. If the FDA disagrees with ourdeterminations, they could require us to report those actions as recalls. Afuture recall announcement could harm our reputation with customers andnegatively affect our sales. In addition, the FDA could take enforcementaction, including any of the following sanctions for failing to report therecalls when they were conducted:

 

·                  untitled letters, warning letters, fines, injunctions, consent decreesand civil penalties;

 

·                  unanticipated expenditures to address or defend such actions

 

·                  customer notifications for repairs, replacements or refunds;

 

·                  recall, detention or seizure of our products;

 

·                  operating restrictions or partial suspension or total shutdown ofproduction;

 

·                  refusing or delaying our requests for 510(k) clearance orpremarket approval of new or modified products;

 

·                  withdrawing 510(k) clearances on PMA approvals that have alreadybeen granted;

 

·                  refusal to grant export approval for our products; and

 

·                  criminal prosecution.

 

***If our products cause or contribute to a death or seriousinjury, or malfunction in certain ways, we will be subject to medical devicereporting regulations, which can result in voluntary corrective actions oragency enforcement actions.***

 

Under the FDAmedical device reporting regulations, or MDR, medical device manufacturers arerequired to report to the FDA information that a device has or may have causedor contributed to a death or serious injury or

 

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has malfunctioned in away that would likely cause or contribute to a death or serious injury if themalfunction of the device or one of our similar devices were to recur. Allmanufacturers placing medical devices in the market in the European Union arelegally bound to report any serious or potentially serious incidents involvingdevices they produce or sell to the Competent Authority in whose jurisdictionthe incident occurred. Were this to happen to us, the relevant CompetentAuthority would file an initial report, and there would then be a furtherinspection or assessment if there are particular issues. This would be carriedout either by the Competent Authority or it could require that Orion, as theNotified Body, carry out the inspection or assessment.

 

Any such adverseevent involving our products could result in future voluntary correctiveactions, such as recalls or customer notifications, or agency action, such asinspection or enforcement action. Adverse events involving our products havebeen reported to us in the past, and we cannot guarantee that they will notoccur in the future. Any corrective action, whether voluntary or involuntary,as well as defending ourselves in a lawsuit, will require the dedication of ourtime and capital, distract management from operating our business, and may harmour reputation and financial results. Failure to report such adverse events toappropriate government authorities on a timely basis, or at all, could resultin an enforcement action against us.

 

***Failure to obtain regulatory approval in additional foreignjurisdictions will prevent us from expanding the commercialization of ourproducts abroad.***

 

We currentlymarket our products and intend to market our future products in a number ofinternational markets. Although certain of our products have been approved forcommercialization in Japan and CE market in the European Union, in order tomarket our products in other foreign jurisdictions we must obtain separateregulatory approvals. The approval procedure varies among jurisdictions and caninvolve substantial additional testing. Approval or clearance by the FDA doesnot ensure approval by regulatory authorities in other jurisdictions, andapproval by one foreign regulatory authority does not ensure approval byregulatory authorities in other foreign jurisdictions or by the FDA. Theforeign regulatory approval process may include all of the risks associatedwith obtaining FDA approval in addition to other risks. In addition, the timerequired to obtain foreign approval may differ from that required to obtain FDAclearance or approval, and we may not obtain foreign regulatory approvals on atimely basis, if at all. We may not be able to file for regulatory approvalsand may not receive necessary approvals to commercialize our products in anyforeign market other than our current authorizations in the European Union andJapan.

 

***We may be subject to fines, penalties or injunctions if weare determined to be promoting the use of our products for unapproved or “off-label”uses.***

 

Our promotionalmaterials and training methods for surgeons must comply with FDA and otherapplicable laws and regulations. Many of our products are cleared by the FDAfor use in various surgical applications. We believe that the specific surgicalprocedures for which our products are marketed fall within the scope of thesurgical applications that have been cleared by the FDA. However, the FDA coulddisagree and require us to stop promoting our products for those specificprocedures until we obtain FDA clearance or approval for them. In addition, ifthe FDA determines that our promotional materials or training constitutespromotion of an unapproved use, it could request that we modify our training orpromotional materials or subject us to regulatory or enforcement actions,including the issuance of an untitled letter, a warning letter, injunction,seizure, civil fine and criminal penalties. It is also possible that otherfederal, state or foreign enforcement authorities might take action if theyconsider our promotional or training materials to constitute promotion of anunapproved use, which could result in significant fines or penalties underother statutory authorities, such as laws prohibiting false claims forreimbursement. In that event, our reputation could be damaged and adoption ofthe products would be impaired.

 

***Legislative and regulatory changes in the health care andmedical devices industry could have a negative impact on our financialperformance.***

 

*Healthcare*

 

Changes in thehealth care industry in the United States and elsewhere could adversely affectthe demand for our products as well as the way in which we conduct ourbusiness. Significantly, the new administration and Congressional and stateleaders have expressed a strong desire to reform the U.S. health care system.Included in 

 

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this reform could be lawsthat narrow Medicare coverage or reduce reimbursement levels for healthcareservices or items provided by physicians and hospitals. Furthermore, manyprivate payors look to Medicare’s coverage and reimbursement policies insetting their coverage policies and reimbursement amounts such that federalreforms could influence the private sector as well. Finally, many states alsomay attempt to reform their Medicaid programs such that either coverage forcertain items or services may be narrowed or reimbursement for them could bereduced. These healthcare reforms may adversely affect our business.

 

Consistent with orin addition to Congressional or state reforms, CMS could change its currentpolicies that affect reimbursement for our products.  Each year, CMS re-examines the reimbursementrates for hospital inpatient and outpatient and physician office settings andcould either increase or decrease the reimbursement rate for proceduresutilizing our products. Overall, we are unable to predict when legislation orregulation that affects our business may be proposed or enacted in the futureor what effect any such legislation or regulation would have on our business.Any such legislation, regulation or policies that affect the coverage andreimbursement of our current or future products, or the procedures utilizingour current or future products, could cause our sales to decrease and, as aresult, our revenue to decline.

 

In addition, therequirements or restrictions imposed on us or our products may change, eitheras a result of administratively adopted policies or regulations or as a resultof the enactment of new laws. Such changes are particular possibilities inlight of the 2008 elections in the United States.  There may be heightened scrutiny by federaland state regulators and legislators of the FDA’s device approval process, theagency’s efforts to assure the safety of marketed devices, and physicianpayments and promotional activities by manufacturers. Any new regulations orstatutory provisions could result in delays or increased costs during theperiod of product development, clinical trials, and regulatory review andapproval, as well as increased costs to assure compliance.

 

Further, oursuccess in international markets also depends upon the eligibility ofreimbursement for our products through government-sponsored health care paymentsystems and other third-party payers. Outside of the United States,reimbursement systems vary by country. These systems are often subject to thesame pressures to curb rising health care costs and control health careexpenditures as those in the United States. In addition, as economies ofemerging markets develop, these countries may implement changes in their healthcare delivery and payment systems. If adequate levels of reimbursement fromthird-party payers outside of the United States are not obtained, sales of ourproducts outside of the United States may be adversely affected.

 

*MedicalDevices*

 

From time to time,legislation is drafted and introduced in Congress that could significantlychange the statutory provisions governing the clearance or approval,manufacture and marketing of a medical device. In addition, FDA regulations andguidance are often revised or reinterpreted by the agency in ways that maysignificantly affect our business and our products. It is impossible to predictwhether legislative changes will be enacted or FDA regulations, guidance orinterpretations changed, and what the impact of such changes, if any, may be.

 

Without limitingthe generality of the foregoing, in 2007, the Food and Drug AdministrationAmendments Act of 2007, or the Amendments, were enacted. The Amendmentsrequire, among other things, that the FDA propose, and ultimately implement,regulations that will require manufacturers to label medical devices withunique identifiers unless a waiver is received from the FDA. Once implemented,compliance with those regulations may require us to take additional steps inthe manufacture of our products and labeling. These steps may requireadditional resources and could be costly.

 

***We may be subject, directly or indirectly, to federal andstate healthcare fraud and abuse laws and regulations and could facesubstantial penalties if we are unable to fully comply with such laws.***

 

The federalanti-kickback law and several similar state laws prohibit payments that areintended to induce physicians or others either to refer patients for, orrecommend the acquisition of, healthcare products or services. These lawsaffect our sales, marketing and other promotional activities by limiting thekinds of financial arrangements and sales programs we may have with hospitals,physicians or other potential purchasers or users of medical devices. Inparticular, these laws influence how we structure our sales, customer support,education and 

 

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training programs andphysician consulting and other service arrangements. Although we seek tostructure such arrangements in compliance with applicable requirements, theselaws are broadly written and it is difficult to determine precisely how theselaws will be applied in specific circumstances. We could be subject to a claimunder these anti-kickback laws for our consulting arrangements with surgeons,grants for training and other education, grants for research and otherinteractions with doctors which have come under scrutiny by federal and stateregulators and law enforcement entities. Anti-kickback laws prescribe civil,criminal and administrative penalties for noncompliance, which can besubstantial. Due to the breadth of the statutory provisions and the lack ofguidance in the form of regulations or court decisions addressing some industryactivities, it is possible that our sales, marketing and promotional activitiesand practices might be challenged under anti-kickback or related laws. Even anunsuccessful challenge to or investigation into our practices could causeadverse publicity and thus could harm our business and results of operations.

 

Foreign sales ofour products also subject us to similar fraud and abuse laws, includingapplication of the U.S. Foreign Corrupt Practices Act. If our operations,including any consulting arrangements we may enter into with physicians who useour products, are found to be in violation of these laws, we or our officersmay be subject to civil or criminal penalties, including large monetarypenalties, damages, fines, imprisonment and exclusion from Medicare andMedicaid program participation. If enforcement action were to occur, ourbusiness and financial condition would be harmed.

 

**Item 2.****                                       ****Unregistered Sales ofEquity Securities and Use of Proceeds.**

 

None.

 

**Item 3.****                                       ****Defaults Upon SeniorSecurities.**

 

None.

 

**Item 4.****                                       ****Submission of Matters toa Vote of Security Holders.**

 

None.

 

**Item 5.****                                       ****Other Information.**

 

On May 14,2009, the Company, and Michael P. Whitman entered into a Third Amendment to theSecond Amended and Restated Employment Agreement pertaining to Mr. Whitman’sservice to the Company as its Chief Executive Officer (the “Third Amendment”). The Company and Mr. Whitman had previously entered into a Second Amendedand Restated Employment Agreement, dated as of March 23, 2007, as amendedby the First Amendment to Second Amended and Restated Employment Agreement,dated as of February 8, 2008, and the Second Amendment to Second Amendedand Restated Employment Agreement, dated as of February 6, 2009(collectively with the Third Amendment, the “Agreement”).

 

The Third Amendment addedclarifying language to the definition of Change of Control in the Agreement toremove a provision from an earlier agreement that stated that a transactionvaluing the Company at less than $175.0 million would not constitute a Changeof Control under the Agreement.  The Third Amendment also corrected theprovision in the Agreement related to the payment of 2009 base salary to Mr. Whitmanto state that such annual base salary under the Agreement is $385,000,increased by the October 2008 percentage increase in the U.S. Departmentof Labor Statistics Consumer Price Index for Urban Wage Earners and ClericalWorkers.  Both such changes to theAgreement had been agreed by Mr. Whitman and the Compensation Committee ofthe Board of Directors of the Company at the time of execution of the SecondAmendment to Second Amended and Restated Employment Agreement but were notincorporated in the Second Amendment.

 

The Third Amendment is filedas Exhibit 10.1 to this Report on Form 10-Q.

 

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**Item 6.****                                       ****Exhibits.**

 
| 10.1   |   | Third Amendment to  Second Amended and Restated Employment Agreement, dated May 14, 2009 by  and between Power Medical Interventions, Inc. and Michael P. Whitman (1)                                                                                                                   |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                              |
| 31.1   |   | Certification of the  Principal Executive Officer of Power Medical Interventions, Inc.  pursuant to Rule 13a-l4(a) of the Securities Exchange Act of 1934,  as amended, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act  of 2002(1)                              |
|   |   |                                                                                                                                                                                                                                                                                              |
| 31.2   |   | Certification of the  Principal Financial Officer and Chief Accounting Officer of Power Medical  Interventions, Inc. pursuant to Rule 13a-14(a) of the  Securities Exchange Act of 1934, as amended, as adopted pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002(1) |
|   |   |                                                                                                                                                                                                                                                                                              |
| 32.1   |   | Certification of the  Principal Executive Officer of Power Medical Interventions, Inc.  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002(1)                                                                               |
|   |   |                                                                                                                                                                                                                                                                                              |
| 32.2   |   | Certification of the  Principal Financial Officer and Chief Accounting Officer of Power Medical  Interventions, Inc. to 18 U.S.C. Section 1350, as adopted pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002(1)                                                           |

 

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| (1) Filed herewith |
|--------------------|

 

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**SIGNATURES**

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 
|               |   | POWER  MEDICAL INTERVENTIONS, INC.     |
|--------------------|--------|----------------------------------------|
|               |   | (Registrant)                           |
|               |   |                                   |
| May 14,  2009 | By:    | /s/  Michael P. Whitman                |
|               |   | Michael  P. Whitman                    |
|               |   | President  and Chief Executive Officer |
|               |   |                                   |
|               |   | POWER  MEDICAL INTERVENTIONS, INC.     |
|               |   | (Registrant)                           |
|               |   |                                   |
| May 14,  2009 | By:    | /s/  Brian M. Posner                   |
|               |   | Brian  M. Posner                       |
|               |   | Chief  Financial Officer               |

 

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**Exhibit Index**

 
| 10.1   |   | Third Amendment to  Second Amended and Restated Employment Agreement, dated May 14, 2009 by  and between Power Medical Interventions, Inc. and Michael P. Whitman (1)                                                                                                                   |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                              |
| 31.1   |   | Certification of the  Principal Executive Officer of Power Medical Interventions, Inc.  pursuant to Rule 13a-l4(a) of the Securities Exchange Act of 1934,  as amended, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act  of 2002(1)                              |
|   |   |                                                                                                                                                                                                                                                                                              |
| 31.2   |   | Certification of the  Principal Financial Officer and Chief Accounting Officer of Power Medical  Interventions, Inc. pursuant to Rule 13a-14(a) of the  Securities Exchange Act of 1934, as amended, as adopted pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002(1) |
|   |   |                                                                                                                                                                                                                                                                                              |
| 32.1   |   | Certification of the  Principal Executive Officer of Power Medical Interventions, Inc.  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002(1)                                                                               |
|   |   |                                                                                                                                                                                                                                                                                              |
| 32.2   |   | Certification of the  Principal Financial Officer and Chief Accounting Officer of Power Medical  Interventions, Inc. to 18 U.S.C. Section 1350, as adopted pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002(1)                                                           |

 

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(1) Filedherewith

 

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