**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,  2008** |
|           |   |   |
|           |   | **OR** |
|           |   |   |
| **o**          | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |

 

**Commission File Number****001-33770**

 

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**Power Medical Interventions, Inc.**

(Exactname of registrant as specified in its charter)

 

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

 

**2021 Cabot Boulevard, Langhorne, Pennsylvania 19047**

(Address ofprincipal executive offices)

 

**(267)775-8100**

(Registrant’s telephone number, includingarea code)

 

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Indicateby check mark whether the Registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days. Yes  x    No  o.

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, anon-accelerated filer, or a smaller reporting company. See definitions of“large accelerated filer,” “accelerated filer,” and “smaller reporting company”in Rule 12b-2 of the Exchange Act. (Check one):

 

| Large accelerated filer  o                     |   | Accelerated filer o          |
|------------------------------------------------|--------|-----------------------------------|
|                                           |   |                              |
| Non-accelerated filer x                        |   | Smaller reporting  company o |
| (Do not check if a  smaller reporting company) |   |                              |

 

Indicateby check mark whether the Registrant is a shell company (as defined in Rule 12b-2of the Exchange Act). Yes  o.    No  x.

 

Indicatethe number of shares outstanding of each of the Registrant’s classes of CommonStock.

 

Asof May 12, 2008, 17,108,415 shares of the Registrant’s Common Stock,$0.001 par value, were outstanding.

 

 

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** **

**POWER MEDICAL INTERVENTIONS, INC.**

 
| ** **    | ** **                                                                                                            | **PAGE**   |
|---------------|-----------------------------------------------------------------------------------------------------------------------|------------|
| ** **    | ** **                                                                                                            | ** ** |
| PART I:  | FINANCIAL  INFORMATION                                                                                                | 1          |
|          |                                                                                                                  |       |
| Item 1.  | Financial  Statements                                                                                                 | 1          |
|          |                                                                                                                  |       |
|          | Condensed Consolidated Balance Sheets as of March 31, 2008  (Unaudited) and December 31, 2007               | 1          |
|          |                                                                                                                  |       |
|          | Condensed Consolidated Statements of  Operations for the Three Months Ended March 31, 2008 and 2007  (Unaudited) | 2          |
|          |                                                                                                                  |       |
|          | Condensed Consolidated Statements of Cash  Flows for the Three Months Ended March 31, 2008 and 2007 (Unaudited)  | 3          |
|          |                                                                                                                  |       |
|          | Notes to Unaudited Condensed Consolidated  Financial Statements                                                       | 4          |
|          |                                                                                                                  |       |
| Item 2.  | Management’s Discussion and Analysis of  Financial Condition and Results of Operations                           | 10         |
|          |                                                                                                                  |       |
| Item 3.  | Quantitative and Qualitative Disclosures  About Market Risk                                                           | 15         |
|          |                                                                                                                  |       |
| Item 4.  | Controls and Procedures                                                                                               | 16         |
|          |                                                                                                                  |       |
| PART II: | OTHER INFORMATION                                                                                                     | 16         |
|          |                                                                                                                  |       |
| Item 1.  | Legal Proceedings                                                                                                     | 16         |
|          |                                                                                                                  |       |
| Item 1A. | Risk Factors                                                                                                          | 16         |
|          |                                                                                                                  |       |
| Item 2.  | Unregistered Sales of Equity Securities and  Use of Proceeds                                                          | 36         |
|          |                                                                                                                  |       |
| Item 3.  | Defaults Upon Senior Securities                                                                                       | 37         |
|          |                                                                                                                  |       |
| Item 4.  | Submission of Matters to a Vote of Security  Holders                                                                  | 37         |
|          |                                                                                                                  |       |
| Item 5.  | Other Information                                                                                                     | 37         |
|          |                                                                                                                  |       |
| Item 6.  | Exhibits                                                                                                              | 37         |
|          |                                                                                                                  |       |
|          | Signatures                                                                                                            | 38         |

 

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| **PART I:** | **FINANCIAL INFORMATION** |
|------------------|---------------------------|
|             |                      |
| **Item 1.**      | **Financial Statements.** |

 

**Power Medical Interventions, Inc.**

**CondensedConsolidated Balance Sheets**

 
| ** **                                                                                                                                                                            | ** ** | **March 31, 2008** | ** ** | **December 31, 2007** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|---------------------------------|------------|
| ** **                                                                                                                                                                            | ** ** | **(unaudited)**              | ** ** | ** **                      | ** ** |
| ** **                                                                                                                                                                            | ** ** | ** **                   | ** ** | ** **                      | ** ** |
| **Assets**                                                                                                                                                                            |       |                         |       |                            |       |
| Current assets:                                                                                                                                                                       |       |                         |       |                            |       |
| Cash and cash  equivalents                                                                                                                                                            |       | $                            | 23,472,717 |                            | $          | 36,592,220 |   |
| Restricted cash                                                                                                                                                                       |       | 1,750,000                    |       | 1,750,000                       |       |
| Accounts  receivable less allowance of $104,000 and $120,000 in March 31, 2008 and  December 31, 2007, respectively                                                         |       | 1,600,081                    |       | 1,514,776                       |       |
| Inventory                                                                                                                                                                             |       | 9,003,350                    |       | 7,371,205                       |       |
| Prepaid expenses  and other current assets                                                                                                                                            |       | 1,058,561                    |       | 1,178,493                       |       |
| Total current  assets                                                                                                                                                                 |       | 36,884,709                   |       | 48,406,694                      |       |
| Property and  equipment, net                                                                                                                                                          |       | 5,523,988                    |       | 4,713,010                       |       |
| Intangible  assets, net                                                                                                                                                               |       | 939,993                      |       | 965,303                         |       |
| Deferred  financing fees                                                                                                                                                              |       | 1,134,231                    |       | 1,276,010                       |       |
| Other assets                                                                                                                                                                          |       | 257,609                      |       | 261,862                         |       |
| Restricted cash                                                                                                                                                                       |       | 1,388,078                    |       | 2,350,071                       |       |
| Total assets                                                                                                                                                                          |       | $                            | 46,128,608 |                            | $          | 57,972,950 |   |
| **Liabilities  and shareholders’ equity**                                                                                                                                        |       |                         |       |                            |       |
| Current  liabilities:                                                                                                                                                                 |       |                         |       |                            |       |
| Accounts payable                                                                                                                                                                      |       | 4,698,523                    |       | $                               | 4,422,198  |   |
| Accrued expenses                                                                                                                                                                      |       | 4,081,648                    |       | 4,506,748                       |       |
| Current portion  of long-term debt                                                                                                                                                    |       | 69,230                       |       | 69,230                          |       |
| Total current  liabilities                                                                                                                                                            |       | 8,849,401                    |       | 8,998,176                       |       |
|                                                                                                                                                                                  |       |                         |       |                            |       |
| Long-term debt,  net of current portion                                                                                                                                               |       | 24,788,030                   |       | 24,742,891                      |       |
| Deferred rent,  net of current portion                                                                                                                                                |       | 644,945                      |       | 691,873                         |       |
| Total  liabilities                                                                                                                                                                    |       | 34,282,376                   |       | 34,432,940                      |       |
|                                                                                                                                                                                  |       |                         |       |                            |       |
| **Shareholders’  equity:**                                                                                                                                                       |       |                         |       |                            |       |
| Common stock,  $.001 par value:                                                                                                                                                       |       |                         |       |                            |       |
| Authorized  shares—200,000,000 at March 31, 2008 and December 31, 2007;  issued and outstanding shares - 17,107,052 at March 31, 2008 and  December 31, 2007 |       | 17,107                       |       | 17,107                          |       |
| Additional  paid-in capital                                                                                                                                                           |       | 198,174,449                  |       | 197,733,981                     |       |
| Accumulated  other comprehensive loss                                                                                                                                                 |       | (254,633                     | )          | (300,184                        | )          |
| Accumulated  deficit                                                                                                                                                                  |       | (186,090,691                 | )          | (173,910,894                    | )          |
| Total  shareholders’ equity                                                                                                                                                      |       | 11,846,232                   |       | 23,540,010                      |       |
| Total  liabilities and shareholders’ equity                                                                                                                                      |       | $                            | 46,128,608 |                            | $          | 57,972,950 |   |

 

*See accompanying notes.*

 

1

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**Power Medical Interventions, Inc.**

**CondensedConsolidated Statements of Operations (Unaudited)**

 
| ** **                                                 | ** ** | **Three Months Ended March 31,** | ** **  |
|------------------------------------------------------------|------------|------------------------------------------------------|-------------|
| ** **                                                 | ** ** | **2008**                                             | ** **  | **2007** | ** ** |
| **Sales**                                                  |       | $                                                    | 2,224,206   |   | $ | 1,815,297 |   |
| **Cost of  sales**                                         |       | 2,557,169                                            |        | 1,351,264 |   |
|                                                       |       | (332,963                                             | )           | 464,033 |   |
| **Costs  and expenses:**                                   |       |                                                 |        |   |   |
| Research and  development                                  |       | 1,582,411                                            |        | 999,181 |   |
| Sales and  marketing                                       |       | 6,796,385                                            |        | 3,263,391 |   |
| General and  administrative                                |       | 3,013,277                                            |        | 2,216,906 |   |
|                                                       |       | 11,392,073                                           |        | 6,479,478 |   |
|                                                       |       |                                                 |        |   |   |
| Operating loss                                             |       | (11,725,036                                          | )           | (6,015,445 | ) |
|                                                       |       |                                                 |        |   |   |
| **Other  income (expense):**                               |       |                                                 |        |   |   |
| Interest income                                            |       | 194,829                                              |        | 71,333 |   |
| Interest expense                                           |       | (649,590                                             | )           | (5,795 | ) |
| **Total  other income (expense)**                          |       | (454,761                                             | )           | 65,538 |   |
| Net loss                                                   |       | $                                                    | (12,179,797 | ) | $ | (5,949,907 | ) |
|                                                       |       |                                                 |        |   |   |
| Accretion of  preferred stock                              |       | —                                               |        | (2,262,871 | ) |
| Net loss  applicable to common shares                      |       | $                                                    | (12,179,797 | ) | $ | (8,212,778 | ) |
| **Net  loss per common share:**                            |       |                                                 |        |   |   |
| Basic and  diluted                                         |       | $                                                    | (0.71       | ) | $ | (2.19 | ) |
| **Weighted  average number of common shares outstanding:** |       |                                                 |        |   |   |
| Basic and  diluted                                         |       | 17,107,052                                           |        | 3,758,171 |   |

 

*See accompanying notes.*

 

2

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**Power Medical Interventions, Inc.**

**CondensedConsolidated Statements of Cash Flows (Unaudited)**

 
| ** **                                                                            | ** ** | **Three Months Ended March 31,** | ** **  |
|---------------------------------------------------------------------------------------|------------|------------------------------------------------------|-------------|
| ** **                                                                            | ** ** | **2008**                                             | ** **  | **2007** | ** ** |
| **Operating  activities**                                                             |       |                                                 |        |   |   |
| Net loss                                                                              |       | $                                                    | (12,179,797 | ) | $ | (5,949,907 | ) |
| Adjustments to  reconcile net loss to net cash used in operating activities:          |       |                                                 |        |   |   |
| Depreciation and  amortization                                                        |       | 297,652                                              |        | 560,929 |   |
| Amortization of  debt discount and deferred financing fees                            |       | 204,047                                              |        | — |   |
| Loss on the  disposal of property and equipment                                       |       | 15,597                                               |        | — |   |
| Stock-based  compensation                                                             |       | 440,470                                              |        | 100,613 |   |
| Changes in  operating assets and liabilities:                                         |       |                                                 |        |   |   |
| Accounts  receivable                                                                  |       | (69,823                                              | )           | 102,789 |   |
| Inventory                                                                             |       | (1,632,478                                           | )           | (569,259 | ) |
| Prepaid expenses  and other assets                                                    |       | 151,827                                              |        | (746,039 | ) |
| Accounts payable                                                                      |       | 232,308                                              |        | 787,436 |   |
| Accrued expenses                                                                      |       | (589,347                                             | )           | (152,383 | ) |
| Deferred rent                                                                         |       | (46,928                                              | )           | 76,026 |   |
| Net cash used in  operating activities                                                |       | (13,176,472                                          | )           | (5,789,795 | ) |
|                                                                                  |       |                                                 |        |   |   |
| **Investing  activities**                                                             |       |                                                 |        |   |   |
| Purchase of  property and equipment                                                   |       | (1,055,211                                           | )           | (670,532 | ) |
| Patent  application costs                                                             |       | (19,107                                              | )           | — |   |
| Change in  restricted cash                                                            |       | 1,015,690                                            |        | (3,359,310 | ) |
| Net cash used in  investing activities                                                |       | (58,628                                              | )           | (4,029,842 | ) |
|                                                                                  |       |                                                 |        |   |   |
| **Financing  activities**                                                             |       |                                                 |        |   |   |
| Repayments on  long-term debt                                                         |       | (17,130                                              | )           | (16,665 | ) |
| Proceeds of  long-term debt, net                                                      |       | —                                               |        | 23,396,373 |   |
| Principal  payments on capital lease obligations                                      |       | —                                               |        | (12,574 | ) |
| Net proceeds  from the issuance of common stock and exercise of common stock warrants |       | —                                               |        | 6,587 |   |
| Payment of  deferred equity financing costs                                           |       | —                                               |        | 84,417 |   |
| Net cash (used  in) provided by financing activities                                  |       | (17,130                                              | )           | 23,458,138 |   |
|                                                                                  |       |                                                 |        |   |   |
| Effect of  exchange rate changes on cash and cash equivalents                         |       | 132,727                                              |        | (116,609 | ) |
| Net (decrease)  increase in cash and equivalents                                      |       | (13,119,503                                          | )           | 13,521,892 |   |
| Cash and cash  equivalents, beginning of period                                       |       | 36,592,220                                           |        | 8,684,341 |   |
| Cash and  equivalents, end of period                                                  |       | $                                                    | 23,472,717  |   | $ | 22,206,233 |   |
| ** **                                                                            |       |                                                 |        |   |   |
| **Supplemental  disclosure of cash flow information**                                 |       |                                                 |        |   |   |
| Cash paid for  interest                                                               |       | $                                                    | 883,936     |   | $ | 3,827 |   |

 

*See accompanying notes.*

 

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** **

**PowerMedical Interventions, Inc.**

** **

**Notes toUnaudited Condensed Consolidated Financial Statements**

** **

**1.     Business**

 

PowerMedical Interventions, Inc. (the Company), a Delaware corporation, is amedical device company that designs, manufactures and markets the SurgASSIST®system 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. To date, the majority of the Company’s efforts have been devoted toresearch and development, raising capital, recruiting personnel, and thecommercialization of products and the commencement of manufacturing activities.

 

TheCompany has wholly owned subsidiaries in Germany, Power Medical InterventionsDeutschland GmbH; in France, Power Medical Interventions France; and in Japan,Power Medical Interventions Japan, which conduct sales and marketingoperations. The Company also has a dormant U.S. subsidiary, Power MedicalVascular, Inc.

 

**2.     Summary ofSignificant Accounting Policies**

** **

*Unaudited interim financial data*

* *

The accompanying unaudited condensed consolidatedfinancial statements have been prepared in accordance with accountingprinciples generally accepted in the United States and the requirements of Form 10-Qand Regulation S-X.

 

Theaccompanying condensed consolidated balance sheet as of March 31, 2008,the condensed consolidated statements of operations for the three months ended March 31,2008 and 2007, and the condensed consolidated statement of cash flows for thethree months ended March 31, 2008 and 2007 are unaudited. The unauditedinterim financial statements have been prepared on the same basis as the annualfinancial statements and, in the opinion of management, reflect alladjustments, which include only normal recurring adjustments, necessary tostate fairly the Company’s financial position as of March 31, 2008 and theresults of its operations and cash flows for the three months ended March 31,2008 and 2007. The financial data and other information disclosed in thesenotes to the financial statements related to the three periods are unaudited.The results for the three months ended March 31, 2008 are not necessarilyindicative of the results to be expected for any future period.

 

*Revenue recognition*

* *

TheCompany’s SurgASSIST surgical platform includes cutting and stapling devices ina variety of sizes and linear, right angle and circular configurations designedfor differing surgical needs. The Company’s Intelligent Surgical Instrumentsare available as disposable, single-patient devices as well as 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.

 

Inthe original configuration of the SurgASSIST system, Intelligent SurgicalInstruments are connected through a flexible shaft, or FlexShaft, to a powerconsole and, in some cases, a separate remote control unit. The Company’s nextgeneration products, beginning with the i60 linear stapler that the Companyintroduced in the fourth quarter of 2007, are self-contained hand heldinstruments that do not require a FlexShaft or separate power console.

 

Mostof the Company’s revenue is derived from the sale of single-patient, disposableIntelligent Surgical Instruments and from the sale of reload cartridges forreusable Intelligent Surgical Instruments. Revenue related to the sale of suchindividual products is recognized when persuasive evidence of an arrangementexists, delivery has occurred, 

 

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thesale price is fixed and determinable, and collectibility is reasonably assured,which is generally at the time of shipment upon delivery to a common carrier.

 

The Company hashistorically provided power consoles, FlexShafts, remote control units andmobile carts associated with its first-generation SurgASSIST system tocustomers at no cost as loaner equipment. In addition, the Company has 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 theIntelligent Surgical Instruments. In these instances, the Company recognizesrevenue attributable to the complete system as the Intelligent SurgicalInstruments are delivered, in accordance with EITF 00-21, *Revenue Arrangements with Multiple Deliverables.*

 

In 2007, the Companyinstituted a program whereby it may provide reusable Intelligent SurgicalInstruments and FlexShafts to customers at no cost.  In certain cases, the Company offers suchIntelligent Surgical Instruments and FlexShafts at no cost in exchange forhigher unit pricing on the sale of reload cartridges over a specified period oftime. In these cases, the Company recognizes the revenue ratably over theperiod of delivery of the reload cartridges in accordance with the guidance ofEITF 00-21, as long as such revenue is not contingent on the delivery of theundelivered products. The Company currently makes its i60 and iDriveinstruments available to customers at no cost without condition. The Companyrecognizes revenue related to reload cartridges for such instruments as reloadcartridges are delivered.

 

The Company’s customersgenerally order product using standard purchase orders and payment terms are 30days. The Company provides discounted pricing to its customers based on volumeand commitment levels. Allowances for product returns are estimated based onhistorical experience and provisions are recorded at the time of shipment. TheCompany also provides limited warranties to its customers against materialdefects in materials and workmanship. Such warranties are generally for aone-year period from the date of shipment. Historically, warranty costs havenot been material.

 

During the three monthsended March 31, 2008, the Company’s revenues were from customers locatedin North America (85%), Europe (11%) and Asia (4%). During the three monthsended March 31, 2007, the Company’s revenues were from customers locatedin North America (79%), Europe (16%) and Asia (5%).   Amounts billed to customers for shipping andhandling of products are included in sales. Costs incurred related to shippingand handling are included in cost of sales.

 

*Stock-based compensation*

* *

InDecember 2004, the Financial Accounting Standards Board (FASB) issued SFASNo. 123 (revised 2004), *Share-BasedPayment* (SFAS No. 123(R)), which replaces SFAS No. 123, *Accounting for Stock-Based Compensation*(SFAS 123), and supersedes Accounting Principles Board (APB) Opinion No. 25,*Accounting for Stock Issued to Employees*(APB 25). SFAS No. 123(R) requires all share-based payments toemployees, including grants of employee stock options, to be recognized in thefinancial statements based on their fair values beginning with the first annualperiod after December 15, 2005. SFAS No. 123(R) requires that anentity measure the cost of equity-based service awards based on the grant-datefair value of the award and recognize the cost of such award over the period duringwhich the employee is required to provide service in exchange for the award(vesting period). The pro forma disclosures previously permitted under SFAS No. 123are no longer an alternative to financial statement recognition. The Companyadopted SFAS No. 123(R) on January 1, 2006 using the prospectivetransition method, which required that all new stock-based awards grantedsubsequent to adoption be recognized in the financial statements at fair value.The Company accounts for equity issued to nonemployees in accordance with EITF96-18, *Accounting for Equity Investmentsthat are Issued to Other Than Employees for Acquiring, or in Conjunction with,Selling Goods or Services* (EITF 96-18).

 

*Net loss attributable to common shares*

* *

TheCompany computes net loss per share in accordance with SFAS No. 128, *Earnings Per Share* (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 

 

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ofany potentially 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 thepotential outstanding common stock of the Company as of the end of each period:

 
| ** **                                   | ** ** | **March 31, 2008** | ** ** | **December 31, 2007** | ** ** |
|----------------------------------------------|------------|------------------------------|------------|---------------------------------|------------|
| Convertible  senior secured promissory notes |       | 2,599,951                    |       | 2,643,175                       |       |
|                                         |       |                         |       |                            |       |
| Common stock  warrants                       |       | 1,137,864                    |       | 1,137,864                       |       |
|                                         |       |                         |       |                            |       |
| Common stock  options outstanding            |       | 2,138,125                    |       | 1,728,844                       |       |
|                                         |       |                         |       |                            |       |
| Common stock  options available for grant    |       | 234,229                      |       | 643,510                         |       |
|                                         |       |                         |       |                            |       |
| Total                                        |       | 6,110,169                    |       | 6,153,393                       |       |

 

Ifthe outstanding options, warrants, and preferred stock were exercised orconverted into common stock, the result would be anti-dilutive. Accordingly,basic and diluted net loss attributable to common stockholders per share areidentical for all periods presented in the accompanying consolidated statementsof operations.

 

*RecentAccounting Pronouncements*

* *

The Company adoptedFinancial Accounting Standards Board Statement No. 157, *Fair Value Measurements*, or SFAS 157, effective January 1,2008.  SFAS 157 defines fair value as the price that would be received tosell an asset or paid to transfer a liability, referred to as the exit price,in an orderly transaction between market participants at the measurement date. The standard outlines a valuation framework and creates a fair valuehierarchy in order to increase the consistency and comparability of fair valuemeasurements and the related disclosures.  In determining fair value, theCompany primarily use prices and other relevant information generated by markettransactions involving identical or comparable assets, called the marketapproach. As of March 31, 2008, the fair value of all of the Company’sfinancial assets are based on level one observable inputs.  We have determined that our fair valuemeasurements are in accordance with the requirements of SFAS 157, therefore,the implementation of SFAS 157 did not have any impact on our consolidated financialcondition or results of operations.

 

**3.**     **Long-Term Debt**

** **

During March 2007,the Company sold $25.0 million of convertible senior secured promissorynotes due March 2010 (the “Convertible Notes”) which generated netproceeds to the Company of $23,298,654 ($25,000,000 less financing fees of$1,701,346). Of this amount, $3,500,000 was placed in escrow to fund the firstfour interest payments on the Convertible Notes. These notes are secured bysubstantially all of the Company’s assets and accrue interest at the rate of 7%per annum, payable semiannually in arrears. Interest accruing on or before March 31, 2009 is payable in cash,while interest accruing after March 31, 2009 is payable, at the Company’soption, in cash or paid-in-kind in the form of additional notes (“PIK Notes”).The principal amounts of such PIK Notes will have the same maturity as theConvertible Notes. Should the Company elect to pay interest on the ConvertibleNotes in PIK Notes, the interest rate on such PIK Notes shall be equal to thethen applicable interest rate plus 1.5%.

 

The ConvertibleNotes also require the payment of a terminal value that (i) will be dueupon redemption or conversion of the Convertible Notes, (ii) will beconsidered part of the conversion amount for purposes of determining theconversion rate (see below) or (iii) will be due upon maturity as part ofthe principal amount. In 

 

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each case, the terminalvalue payment, as amended, is defined to equal 7% per annum of the applicableprincipal from the closing date of the Convertible Notes in March 2007 tothe first Conversion Event (which the parties acknowledged and agreed occurredon October 31, 2007, the date of the Company’s initial public offering).  There is no possible future scenario in whichthe accrued terminal value would not be required to be paid to the holders ofthe Convertible Notes or realized by such holders upon conversion of theConvertible Notes.

 

Upon the occurrence ofthe Company’s initial public offering, the Convertible Notes plus any accruedinterest thereon as well as the accreted terminal value became convertible intothe Company’s Common Stock at the option of the holder at any time through thematurity date of the Convertible Notes. The conversion price of the ConvertibleNotes was set at $10.01 per share upon the completion of the Company’s initialpublic offering.

 

Beginning on the datethat is 180 days following the closing of a Convertible Note Qualified IPO, theCompany may, at its option, redeem the Convertible Notes in whole at any timeor in part from time to time, upon 15 days prior written notice to the holder,at a redemption 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 effectiveness of aregistration statement filed with the SEC for the resale of the underlyingshares;

 

(b)           the average of the high and low saleprice of the Common Stock, as reported on the principal securities exchange onwhich the Common Stock is listed, on each of any 20 trading days during anyperiod of 30 consecutive trading days ending within 45 days prior to theRedemption Date (so long as, during the entire 30 trading day period, theaforementioned registration statement has been effective and there has been nosuspension of trading of the Common Stock), having been equal to or greaterthan 140% of the initial public offering price in the Convertible NotesQualified IPO (in each case, with prices adjusted for stock splits, reversesplits, stock dividends, share combination and other antidilution events);

 

(c)           no more than $12,500,000 ofoutstanding Convertible Notes may be redeemed pursuant to this provision in anyperiod of 30 consecutive trading days; and

 

(d)           any such redemptionshall be effected on a pro rata basis with respect to all then outstandingConvertible Notes (including PIK Notes).

** **

**4.     Inventory**

 

Inventory is stated at the lower of cost or marketvalue, with cost being determined on a first-in, first-out (FIFO) basis andmarket value based on the lower of replacement cost, or the estimated netrealizable value, reduced by an allowance for normal profit margin.  Inventory consists of the following:

 
| ** **      | ** ** | **March 31, 2008** | ** ** | **December 31, 2007** | ** ** |
|-----------------|------------|------------------------------|------------|---------------------------------|------------|
| Raw Materials   |       | $                            | 4,582,415  |                            | $          | 3,861,162 |   |
| Work in process |       | 1,463,197                    |       | 1,066,864                       |       |
| Finished goods  |       | 2,957,738                    |       | 2,443,179                       |       |
|            |       | $                            | 9,003,350  |                            | $          | 7,371,205 |   |

 

During the three months ended March 31, 2008,and for the year ended December 31, 2007, the Company recorded inventoryobsolescence charges in the amount of approximately $301,000,  and $506,000 respectively.  Such charges are reflected in cost of salesin the accompanying condensed consolidated statements of operations.

 

7

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**5.****             ****Comprehensive Loss**

** **

TheCompany’s comprehensive loss was as follows:

 
| ** **                               | ** ** | **Three Months ended  March 31,** | ** **  |
|------------------------------------------|------------|--------------------------------------------------|-------------|
| ** **                               | ** ** | **2008**                                         | ** **  | **2007** | ** ** |
| Net loss  applicable to common shares    |       | $                                                | (12,179,797 | ) | $ | (8,212,778 | ) |
| Foreign currency  translation adjustment |       | 45,551                                           |        | 44,871 |   |
| Comprehensive  loss                      |       | $                                                | (12,134,246 | ) | $ | (8,167,907 | ) |

** **

**6.****             ****Contingencies**

** **

The Company has, on occasion, been named as adefendant in lawsuits alleging product failure, patent infringement, and breachof contract.  Management has providedreserves for the estimated potential losses, when such losses are deemedprobable and estimable.  The Companycurrently has a patent infringement case outstanding.  The Company received a favorable ruling fromthe German courts on two of the patent infringement claims and an unfavorableruling on one of the claims.  However,the Company is in the process of appealing the unfavorable ruling.  The Company intends to defend this claimvigorously and has concluded it is too early to determine whether or not theCompany will incur any loss under this claim. As such, no amounts are accrued in the accompanying consolidated balancesheets related to this claim.

 

The Company also has a product liability caseoutstanding which is currently suspended and the Company has continued tocontest the claim.  The Company hasaccrued $100,000 related to this matter which represents its best estimate ofthe potential liability related to this claim.

 

**7.****             ****Stock-based Compensation**

** **

Asa private company during 2007, the Company estimated the fair value of itscommon stock by utilizing a contemporaneous third party valuation. There wereno stock option grants during the first quarter of 2007. Grants issued duringthe first quarter of 2008 were valued at the closing price of the Company’spublicly traded stock on the date of grant. The per-share weighted average fairvalue on the date of grant of the options granted was $5.59****duringthe first quarter of 2008 using the Black-Scholes option-pricing model with thefollowing weighted average assumptions, which are based upon Company history orindustry comparative information:

 
| ** **                | ** ** | **Three Months  Ended  March 31, 2008** | ** ** |
|---------------------------|------------|--------------------------------------------------------|------------|
| ** **                | ** ** | ** **                                             | ** ** |
| Expected  dividend yield  |       | 0                                                      | %          |
| Expected  volatility      |       | 50.2                                                   | %          |
| Risk-free  interest rates |       | 3.01                                                   | %          |
| Expected life             |       | 7 years                                                |       |

 

Theexpected volatility 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 andconsidered the historical volatility of these entities’ share prices inestimating expected volatility. The Company used the average volatility ofthese guideline companies over a seven year period, consistent with theexpected term calculated pursuant to Staff Accounting Bulletin No. 107.  Compensation expense under SFAS No. 123(R) andEITF 96-18 for the three months ended March 31, 2008 related toshare-based service awards was $440,470, of which $10,347 is included in costof sales, $46,523 is included in research and development, $65,974 is includedin sales and marketing and $317,626 is included in general and administrativeexpense in the accompanying consolidated statements of operations.  Compensation expense under SFAS No. 123(R) andEITF 96-18 for the three months ended March 31, 2007 related toshare-based service awards was $100,613, of which $616 is included in 

 

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costof sales, $15,250 is included in sales and marketing and $84,747 is included ingeneral and administrative expense in the accompanying consolidated statementsof operations.  The Company recognizesthe compensation expense of such share-based service awards on a straight-linebasis. Total unrecognized compensation cost of options granted but not yetvested as of March 31, 2008 was $5,790,965, net of estimated forfeitures,which is expected to be recognized over the weighted average period of 2.19years. The Company utilized an estimated forfeiture rate of 15% for the 2006,2007  and 2008 grants, based on theCompany’s historical forfeiture rate as well as an analysis of current marketconditions.

 

Thefollowing table summarizes stock option activity for the three months ended March 31,2008:

 
| ** **                           | ** ** | **Number  of  Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|--------------------------------------|------------|------------------------|------------|----------------------------------------|------------|
| Outstanding, December 31,  2007 |       | 1,728,844              |       | $                                      | 8.69       |   |
| Options granted                      |       | 527,320                |       | $                                      | 10.24      |   |
| Options  cancelled/forfeited         |       | (118,039               | )          | $                                      | 11.22      |   |
| Options  exercised                   |       | —                 |       | —                                 |       |
| Outstanding,  March 31, 2008    |       | 2,138,125              |       | $                                      | 8.93       |   |
| Exercisable,  March 31, 2008    |       | 977,934                |       | $                                      | 7.10       |   |

 

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

** **

*You should read the following discussion inconjunction with our consolidated financial statements and notes theretoappearing elsewhere in this report. In addition to historical consolidatedfinancial information, the following discussion and analysis containsforward-looking statements that involve risks, uncertainties and assumptions.Our actual results could differ materially from those anticipated by theseforward-looking statements as a result of many factors, including thosediscussed under “Risk Factors” and elsewhere in this report.*

** **

**Overview**

** **

We design, manufacture and market the SurgASSIST® system 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.Our SurgASSIST system has been used in an estimated 30,000 surgical proceduresin more than 350 hospitals and medical institutions worldwide.

 

Since our inception, we have devoted substantially all our resources tothe development and commercialization of our SurgASSIST system and, morerecently, to the expansion of our manufacturing and direct sales and marketingoperations. We currently outsource the manufacture of components such asmachined and molded parts, mechanical sub-assemblies and circuit boards andperform the final assembly and testing of our products in our Langhorne,Pennsylvania facility. We sell our Intelligent Surgical Instruments through ourdirect sales force in the United States, parts of Europe and Japan and throughdistributors in other parts of Europe.

 

We have incurred net losses in each year since our inception and havean accumulated deficit at March 31, 2008 of $186.1 million. We expect ourlosses to continue through at least 2008 as we develop and introduce our nextgeneration of Intelligent Surgical Instruments and build the infrastructurenecessary to support our anticipated sales growth. To date, we have financedour operations primarily through the initial public offering of our commonstock, private placements of our preferred stock and the issuance of debt.

 

**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 SurgASSIST surgical platform includescutting and stapling devices in a variety of sizes and linear, right angle andcircular configurations designed for differing surgical needs. In the originalconfiguration of our system, our Intelligent Surgical Instruments are connectedthrough a flexible shaft, or FlexShaft, to a power console. Our next generationproducts, beginning with the i60 linear stapler that we introduced in thefourth quarter of 2007, are self-contained hand-held instruments that do notrequire a FlexShaft or separate power console. In December 2007, weintroduced our self-contained, wireless handheld iDrive system, which can beused to power and control our other linear, right angle and circular staplers,without the need for a separate FlexShaft or power console.

 

Our Intelligent SurgicalInstruments are available as disposable, single-patient devices as well as in areusable multiple-patient format, using disposable cutting and staplingcartridges in various sizes, which we refer to as reload cartridges.

 

To date, most of ourrevenue 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, sales of reload cartridges will become the largest componentof our total sales.

 

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We make power consolesand related accessories such as remote control units used with our first-generationSurgASSIST system available to institutions at no charge. We instituted aprogram in 2007 to make our PLC 60 instrument or FlexShaft available tothe customer at no cost, in certain cases in exchange for a commitment by thecustomer to purchase a minimum number of reload cartridges at a higher unitprice. We currently make our i60 and iDrive instruments available to customersat no charge, with the expectation that we will derive revenues from sales ofthe reload cartridges necessary for their use.

 

Our future success willdepend on our ability to achieve and sustain significant growth in our sales.Our ability to grow our revenues will depend on many factors, including:

 

·continued growth in market acceptance of our SurgASSIST system;

 

·continued introduction of our next generation Intelligent Surgical Instrumentson a timely basis;

 

·increased usage of our installed base of multiple-use Intelligent SurgicalInstruments, resulting in recurring purchases of our reload cartridges;

 

·expansion of our sales and marketing organization and recruitment and retentionof a sufficient number of qualified sales consultants;

 

·continued improvements in our supply chain and manufacturing operations toassure the quality and adequate supply of our products; and

 

·the availability of clinical data to substantiate the long term efficacy andsafety of our products, which has not been collected to date.

 

*Cost ofsales.*  Cost of salesincludes the cost of supplies, components and sub-assemblies that we purchase fromthird parties and use in the assembly of our products. Cost of sales alsoincludes personnel costs and overhead related to our assembly and testoperations, related occupancy, equipment depreciation, shipping costs andcharges for inventory obsolescence.

 

Our future success willdepend on our ability to make significant improvements in our cost of sales asa percentage of sales, or gross margins. Since the introduction of ourSurgASSIST system in 2001, our gross margins have ranged from a negative grossmargin of (56.9)% in 2002 to a positive gross margin of 25.6 % for the quarterended March 31, 2007. Our high cost of sales has been 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.

 

Charges associated withwrite-offs of excess and obsolete inventory have also contributed to our highcost of sales. Our product development plans sometimes include introductions ofnew products that overlap functionally with existing products, while offeringnew or improved capabilities. We anticipate that in some cases, this may leadto a reduction in demand for, or discontinuation of, an existing product. Inthese circumstances, we must carefully manage our finished goods inventory toensure that we have quantities of the existing product that are sufficient tomeet customer demand pending introduction of the new product, but that do notleave us holding excess or obsolete inventory when a new product supplants theexisting one.  Changes in the design ofour products can also result in the obsolescence of our inventory of componentsthat are not used in redesigned products.

 

Historically, our cost ofsales has included the substantial cost of our power consoles and relatedaccessories and more recently of Intelligent Surgical Instruments that we placewith customers at no charge, which has had a significant adverse effect on ourgross margins.  The cost of the i60 andiDrive instruments that we currently make available to customers at no chargeis recorded as a charge to cost of sales when the units are shipped to thecustomer.

 

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In order to achieve andsustain profitability, we will need to devote substantial resources toimproving our procurement and manufacturing processes, upgrading our managementinformation systems, and implementing new quality assurance, inventory and costcontrols in order to reduce the cost of the components we purchase from thirdparty vendors and improve the efficiency of our manufacturing operations. Wealso intend to increase the integration of our manufacturing operations, forexample, by acquiring the capital equipment necessary to enable us to moreefficiently assemble critical components such as the reload cartridges that areused in our reusable multiple-patient linear staplers. We believe this willenable us to significantly reduce the cost of these components, while alsoenabling us to better control their supply and quality. However, we cannotassure you that manufacturing yields or costs will not be adversely affected,at least initially, by the transition to in-house production or to newproduction processes. Because we have limited experience in manufacturing ourproducts in commercial quantities, increasing our manufacturing capacity tosupport our planned sales growth while significantly improving our grossmargins and maintaining product quality will involve significant challenges.

 

*Researchand 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. We expense our researchand development costs as incurred.

 

Our research anddevelopment expenses have fluctuated significantly in dollar amount and as apercentage of sales in the last five years, due primarily to the timing ofresearch and development efforts associated with significant new productintroductions. We anticipate that our research and development expenses willincrease as we continue to invest in the development of new products andtechnologies.

 

*Salesand marketing expenses.* Sales and marketing expenses consist primarily of salaries and relatedexpenses, sales commissions and overhead for personnel performing sales andmarketing functions. Other significant sales and marketing expenses includetravel and entertainment expense, costs of attending medical conferences andtrade shows, clinician training and other promotional costs and costs ofdemonstration systems and samples.

 

Our sales and marketingexpenses have substantially exceeded our sales in each year since 2004, as wehave invested in building the sales and marketing organization andadministrative infrastructure necessary to support our planned sales growth.During the first quarter of 2008, we have taken steps to reduce our sales andmarketing expenses through a reduction in the number of our direct salespersonnel, and as a result we do not expect these expenses to grow in 2008 atthe same rate they have in recent years.

 

*Generaland 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.

 

*Interestincome.*  Interestincome consists of interest earned on our cash and cash equivalents.

 

*Interestexpense.*  Interestexpense consists of interest expense on our revolving line of credit, termloans, bridge financing and equipment loans.

 

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**Internal Control over Financial Reporting**

** **

Our management determined that as of March 31, 2008 and December 31,2007 we had a material weakness in our internal control over financialreporting related to our financial statement close process that, until remediated,results in more than a remote likelihood that a material misstatement to theannual or interim consolidated financial statements could occur and not beprevented or detected by our internal controls in a timely manner. We concludedthat there is a material weakness in our internal control over financialreporting because we do not have a sufficient number of personnel with theappropriate level of experience and technical expertise to appropriatelyresolve non-routine and complex accounting matters or to evaluate the impact ofnew and existing accounting pronouncements on our consolidated financialstatements while completing the financial statement close process. The materialweakness resulted in the identification of adjustments during the financial statementclose process during 2007 that have been recorded in the consolidated financialstatements.  In order to remediate thismaterial weakness, we are taking the following actions:

 

·                  weare actively seeking additional accounting and finance staff members to augmentour current staff and to improve the effectiveness of our financial statementclose process; and

 

·                  weare expanding the training and education of our accounting and finance staffmembers in an effort to improve their effectiveness.

 

Notwithstanding the material weakness that existed as of March 31,2008 and December 31, 2007, our management has concluded that theconsolidated financial statements included elsewhere in this prospectus presentfairly, in all material respects, our financial position, results of operationand cash flows in conformity with U.S. generally accepted accountingprinciples.

 

**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 arereasonable under the circumstances, the results of which form the basis formaking the judgments about the carrying values of assets and liabilities thatare not readily apparent from other sources. Actual results could differ fromthose estimates, and material effects on our operating results and financialposition could result.

 

For a description of those of our accounting policies that, 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, see “Management’sDiscussion and Analysis of Financial Condition and Results of Operations—CriticalAccounting Policies and Estimates” in our Annual Report on Form 10-K,filed with the SEC on March 31, 2008.

 

**RecentAccounting Pronouncements**

** **

We adopted FinancialAccounting Standards Board Statement No. 157, *Fair ValueMeasurements*, or SFAS 157, effective January 1, 2008. SFAS 157 defines fair value as the price that would be received to sellan asset or paid to transfer a liability, referred to as the exit price, in anorderly transaction between market participants at the measurement date. The standard outlines a valuation framework and creates a fair valuehierarchy in order to increase the consistency and comparability of fair valuemeasurements and the related disclosures.  In determining fair value, weprimarily use prices and other relevant information generated by market transactionsinvolving identical or comparable assets, called the market approach. As of March 31,2008, the fair value of all of our financial assets is based on Level 1observable inputs.  We have determinedthat our

 

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fair value measurementsare in accordance with the requirements of SFAS 157, therefore, theimplementation of SFAS 157 did not have any impact on our consolidatedfinancial condition or results of operations.

 

**Results of Operations**

 

**Three month period ended March 31, 2008 and March 31,2007**

 

*Sales.*  Our sales in the three months ended March 31,2008 increased by 23%, to $2.2 million compared with $1.8 million during thecorresponding period in 2007, due to approximately $478,000 of revenueattributable to sales of reload cartridges for our new i60 wireless handheldlinear stapler.

 

*Cost of sales and gross profit.*  Our costof sales in the three months ended March 31, 2008 increased by 89%, to$2.6 million compared with $1.4 million during the corresponding period in2007.  Our gross profit decreased to$(0.3) million, or (15)% of sales, in the three months ended March 31,2008 from $0.4 million, or 26% of sales, during the corresponding period in2007.  The decrease in our gross profitand our gross margin percentage reflects approximately $250,000 of costs of thei60 and iDrive devices that we placed with hospitals during the first quarterand approximately $250,000 associated with the write-off of componentsinventory that became obsolete due to a design enhancement of the i60 device.Our gross margins may experience fluctuations from period to period until weare able to realize further economies of scale in our purchasing andmanufacturing process through increased manufacturing capacity utilization and automation.

 

*Research and development expenses.*  Ourresearch and development expenses in the three months ended March 31, 2008increased by 58%, to $1.6 million compared with $1.0 million during thecorresponding period in 2007.  Researchand development costs increased as a percentage of sales to 71% in the threemonths ended March 31, 2008, compared with 55% of sales during thecorresponding period in 2007.  Theexpense increase in both dollars and percentage of sales was due to increasedinvestment in product line extensions and product derivatives, as well asapproximately $325,000 of development component costs, primarily for the i60green reload cartridges which were launched in April 2008.

 

*Sales and marketing expenses.*  Ourdomestic and international sales and marketing expenses in the three monthsended March 31, 2008 increased by 108%, to $6.8 million, compared with$3.3 million during the corresponding period in 2007, and increased as apercentage of sales to 306% of sales in the three months ended March 31,2008.  This compares to 180% of salesduring the corresponding period in 2007. The increase in both dollar amount and percentage of sales was due tosales force expansion, training and planned increases in marketing expenseassociated with trade shows and conventions.

 

*General and administrative expenses.*  Ourgeneral and administrative expenses in the three months ended March 31,2008 increased by 36%, to $3.0 million compared with $2.2 million during thecorresponding period in 2007, and increased as a percentage of sales to 135% inthe three months ended March 31, 2008, compared to 122% during thecorresponding period in 2007.  Theincrease in dollar amount and percentage of sales was due to higher salaries,stock-based compensation expense and other personnel related expenses.

 

*Interest income.*  Our interest income in the threemonths ended March 31, 2008 increased by 173%, to $0.2 million comparedwith $71,000 during the corresponding period in 2007, due to investment ofhigher average cash balances resulting from our convertible debt issuance in March 2007and our initial public offering in October 2007.

 

*Interest expense.*  Our interest expense in thethree months ended March 31, 2008 increased to $0.6 million compared with$6,000 during the corresponding period in 2007. The increase was the result ofinterest expense related to our convertible debt issued in March 2007.

 

**Liquidity and Capital Resources**

 

Since our inception, we have financed our operations primarily throughprivate placements of our preferred stock, 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,

 

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inwhich we received net proceeds, after underwriting discounts and offeringexpenses, of approximately $42 million. Our principal source of liquidity as ofMarch 31, 2008 consisted of our cash and cash equivalents of $23.5 millionand our accounts receivable balance of $1.6 million.

 

In the first three months of 2008, our operating activities used $13.2million in cash, due primarily to our net operating loss of $12.2 million. Weused cash of $0.6 million to pay down accrued expenses and we used cash of $1.6million to increase inventory, primarily raw materials and components requiredfor assembly of our newly introduced i60and iDrive instruments and related reload cartridges, to support expected demandfor these products. These uses were partially offset by a $0.4 million increasein accounts payable and prepaid expense and other assets. Of our non-cashexpenses of approximately $1.0 million, the largest component was stockcompensation expense of $0.4 million. We used $58,000 in our investingactivities, primarily consisting of purchases of property and equipment of $1.1million, related primarily to the purchase of our automated reload machine,offset by a decrease in restricted cash of $1.0 million.  Our financing activities used $17,000 forrepayment on our long-term debt.

 

We believe that our cash and cash equivalentswill be sufficient to meet our anticipated cash requirements through at leastJanuary 1, 2009, however, there can be no assurance in this regard. Ifnecessary, we have the intent and ability to reduce spending in 2008 bycontrolling costs that are within management's discretion. Such costs includecertain sales and marketing costs, clinical research costs, employee bonuses,professional education, and capital expenditures. Our future cash requirementswill depend on many factors, including our rate of sales growth, if any, thetiming and extent of spending to support new product development efforts, theexpansion of our sales and marketing activities, the timing and introductionsof new products and the amount and timing of capital investments we make andcost we incur to expand our manufacturing capacity. Our ability to meet ourobligations in the normal course of business beyond January 1, 2009 willbe dependent on our increasing our customer and revenue base, controllingexpenses and securing additional external financing. We have made noarrangements to obtain additional financing, and there can be no assurance thatsuch financing, if required or desired, will be available in amounts or onterms acceptable to us, if at all. 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.

 

**Item 3.****            Quantitativeand Qualitative Disclosures About Market Risk.**

 

We do not utilize derivativefinancial instruments, derivative commodity instruments or other market risksensitive instruments, positions or transactions.

 

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.*  At March 31,2008, we had $23.5 million of cash and cash equivalents. These amounts wereinvested primarily in certificates of deposit. The primary objective of ourinvestment activity is to preserve principal, provide liquidity and maximizeincome without increasing risk.  Ourinvestments have limited exposure to market risk. The interest rates arevariable and fluctuate with current market conditions. The risk associated withfluctuating interest rates is limited to our investments in certificates ofdeposit, and we do not believe that a 10% change in interest rates would have amaterial impact on our financial position or results of operations.

 

The interest rate on our 7% convertible senior secured promissory notesis fixed and therefore exposes us to limited market risk.

 

*Foreign currency risk.*  Todate, our international customer agreements have been denominated primarily inthe local currency of the international customer.  The functional currency of our foreignoperations in Europe and Japan is the local currency and, as a result, anyfluctuation in the exchange rates of these net assets, denominated in localcurrency, would be reflected in the translation gains or losses, which areaccounted for in other comprehensive income in our statements of changes inequity. We do not believe that a change of 10% in the foreign currency exchangerates would have a material impact on our financial position or results ofoperations.

 

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**Item 4.****            Controlsand Procedures.**

 

Our chief executive officer and chief financialofficer have performed an evaluation of the effectiveness of the design andoperation of our disclosure controls and procedures as of March 31,2008.  Based on that evaluation, ourchief executive officer and chief financial officer concluded that, as of March 31,2008, our disclosure controls and procedures were ineffective, due to thematerial weaknesses in our internal control over financial reporting previouslydescribed in our Annual Report on Form 10-K for the year ended December 31,2007, filed with the SEC on March 31, 2008, which identified the followingmaterial weakness that has not been fully remediated as of March 31, 2008:

 

Our management hasdetermined that we have a material weakness in our internal control overfinancial reporting related to our financial statement close process that,until remediated, results in a reasonable possibility that a materialmisstatement to the annual or interim consolidated financial statements couldoccur and not be prevented or detected by our internal controls in a timelymanner. We have concluded that there is a material weakness in our internalcontrol over financial reporting because we do not have a sufficient number ofpersonnel with the appropriate level of experience and technical expertise toappropriately resolve non-routine and complex accounting matters or to evaluatethe impact of new and existing accounting pronouncements on our consolidatedfinancial statements while completing the financial statement close process.The material weakness resulted in the identification of adjustments during thefinancial statement close process during 2007 that have been recorded in theconsolidated financial statements. In order to remediate this materialweakness, we are taking the following actions:

 

·we are actively seeking additional accounting and finance staff members toaugment our current staff and to improve the effectiveness of our financialstatement close process; and

 

·we are expanding the training and education of our accounting and finance staffmembers in an effort to improve their effectiveness.

 

There was no change inour internal control over financial reporting during our most recent fiscalquarter that has materially affected, or is reasonably likely to materiallyaffect, our internal control over financial reporting.

 

**PART II:****                                            OTHERINFORMATION**

 

**Item 1:****   LegalProceedings.**

 

Not applicable

 

**Item 1A.****                 RiskFactors.**

 

In addition to the other information set forth in this report, youshould carefully consider the factors discussed in Part I, “Item 1A. RiskFactors” in our Annual Report on Form 10-K for the year ended December 31,2007, which could materially affect our business, financial condition or futureresults and could cause actual events to differ materially from theforward-looking statements in this report. There has been no material change inthe risk factors described in that Annual Report on Form 10-K, except asfollows:

 

Therisk factors under the headings “Wemust upgrade and correct deficiencies in our regulatory compliance operations,and our failure to do so could impair our ability to market our products orlead to regulatory enforcement action against us” and “Our failure to meet strict regulatoryrequirements could require us to pay fines, incur other costs or even close ourfacilities” have been expanded to disclose that the FDA is currentlyconducting an inspection of our facilities in Langhorne, Pennsylvania which isnot yet completed.

 

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**Risks Related to Our Business**

 

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

 

We are a company with a limited operating history and have sustainednet losses since our inception, including a net loss of $36.8 million for theyear ended December 31, 2007 and a net loss of $12.2 million for the threemonths ended March 31, 2008. We have an accumulated deficit of $186.1million at March 31, 2008. We expect to continue to incur significantoperating losses at least through 2008, as we invest in the development of ourbusiness. Our losses have had and will continue to have an adverse effect onour stockholders’ equity and working capital.

 

**We are dependent on the success of our SurgASSIST platformand, in particular, of the next generation wireless handheld technologyincorporated in our recently released i60 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, most of our revenue has been derived from the sale of oursingle-patient, disposable Intelligent Surgical Instruments and, to a lesserextent, from the sale of reload cartridges for our reusable IntelligentSurgical Instruments. We expect that sales of our first generation productswill continue to account for most of our sales for at least the next sixmonths. However, we expect that, as our installed base of reusable,multiple-patient Intelligent Surgical Instruments grows and the number offirings of our instruments increases, sales of reload cartridges will becomethe largest component of our total sales. It is difficult to predict thepenetration, future growth rate or size of the market for our SurgASSISTplatform or the rate at which our installed base of instruments will be fired.

 

The commercial success of our various Intelligent Surgical Instrumentswill require broad acceptance of the SurgASSIST platform by the surgeons whospecialize in the procedures we target, a limited number of whom may be able toinfluence device selection and purchasing decisions. If the concept ofcomputer-assisted power-actuated devices for tissue manipulation, cutting andstapling is not broadly accepted and perceived as having significant advantagesover manually-actuated devices, then we will not meet our business objectives.Broad acceptance of our SurgASSIST platform will require a determination byhospitals and surgeons that our products are safe, cost-effective and representacceptable methods of treatment. In addition, certain components of ourSurgASSIST platform in its current configuration may be considered to becapital purchases that require administrative procedures and approvals fromsenior hospital management, the result of which can be an extended sales cyclerequiring multiple individuals to believe in the advantages of our products. Wecannot assure that our existing relationships and arrangements with hospitalsand surgeons can be maintained or that new relationships will be established insupport of our products. In addition, our competitors may develop newtechnology 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.

 

**The success of our business is dependent on our ability todevelop new and innovative products and to enhance our existing products. Weexperienced significant delays in new product introduction in 2006 and 2007,and if we do not achieve our current development goals in the time frames weexpect, the commercialization of our new products may be delayed and, as aresult, our operations may be adversely affected.**

 

The success of our business is dependent on our ability to develop newproducts, to introduce enhancements to our existing products and to developthese new technologies within targeted time frames. These target estimates arebased on a variety of assumptions. The actual timing of these milestones canvary dramatically compared to our estimates for reasons that may or may not bewithin our control. For example, the commercial release of our PLC 60linear stapler in 2006 was delayed almost nine months due to product designflaws and supply chain problems, and our ability to generate revenue fromthe PLC 60 staplers that we placed in hospitals beginning in December 2006was adversely affected due to the unavailability in 2007 of certain reloadcartridges for the

 

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device.  Similarly, our ability to generate revenuefrom the new i60 liner stapler that we introduced in September 2007 hasbeen adversely affected by the unavailability of green reload cartridges forthe device and by problems with the initial quality of units delivered tocustomers and other issues. Design and materials engineering problems affectinga key component of the green reloads, which is manufactured for us by a thirdparty, have required us to redesign the part. We currently expect theredesigned green reloads to be available in commercial quantities in the secondquarter of 2008.  Some early users of ouri60 instrument have experienced difficulties, such as problems in consistentlyoperating its articulation feature and in properly seating reload cartridges.Although these difficulties may in part be attributable to inadequate trainingor incorrect technique, they have led in some cases to a negative perception ofproduct quality. Additionally, training of our sales force and the clinicalpersonnel of our customers has taken longer than expected. Our inability tosupply green reloads for the i60 has resulted in lost revenue opportunities andtogether with the other factors described above, has slowed the rate ofadoption of our i60 instrument. Further delays in the availability of greenreload cartridges, or in other planned product releases, or our inability toquickly resolve perceived quality issues and other factors affecting thesuccess of our i60 product launch, 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.

 

**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 of our products is a complex and costly operationinvolving a number of separate processes and components. To date, ourmanufacturing activities have consisted primarily of assembling limitedquantities of our products. We have considered, and will continue to consideras appropriate, manufacturing components that are currently provided by thirdparties, as well as implementing new production processes. We do not haveexperience in manufacturing our products in the commercial quantities thatmight be required to market our products in the United States, Europe andJapan. During 2006, we experienced significant difficulties in our supply chainand manufacturing operations, which impaired our ability to ship our productson a timely basis and had a material adverse impact on our results ofoperations for 2006.  Manufacturing ofour products in commercial quantities will require us to expand ourmanufacturing capabilities and to hire and train additional personnel. Weexpect that any expansion would be achieved through modified space utilizationin our current leased facilities, improved efficiencies, increased automationand acquisition of additional tooling and equipment. We may encounterdifficulties in increasing our manufacturing capacity and in manufacturingcommercial 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.

 

Difficulties encountered in increasing our manufacturing capacity couldimpact our ability to adequately supply our customers.

 

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

 

The historical unit costs for our products, based on limitedmanufacturing volumes, have been very high in relation to our sales, resultingin low or negative gross margins. It will be necessary for us to achievesubstantial further reductions in our cost of sales as a percentage of sales inorder to become profitable. The transition to in-house production or to newproduction processes may initially have a negative effect on our manufacturingyields or

 

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costs,which would materially and adversely affect our business, financial conditionand results of operations. Certain of our manufacturing processes are laborintensive, and achieving significant cost reductions will depend in part uponreducing the time required to perform these processes. We cannot assure youthat 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 and effectivealternative to existing technologies, we will not be commercially successful.**

 

Our Intelligent Surgical Instruments rely on new technology, and oursuccess depends upon acceptance of this technology by the medical community assafe, clinically effective and cost effective and a preferred device ascompared to products of our competitors. We have not collected, and are notaware that others have collected, long-term data regarding efficacy, safety andclinical outcomes associated with the use of our products. Any data that isgenerated in the future may not be positive or consistent with our current,largely anecdotal data, which would negatively affect market acceptance and therate at which our Intelligent Surgical Instruments are adopted. Equallyimportant will be physicians’ perceptions of the safety of our products. Ourtechnology is relatively new in surgery, and the results of short-term clinicalexperience with our SurgASSIST system do not necessarily predict long-termclinical benefits as compared to the products of our competitors. If, over thelong term, our SurgASSIST system does not meet surgeons’ expectations as tosafety, efficacy and ease of use, the SurgASSIST system may not become widelyadopted.

 

Even if the data collected from future clinical studies or clinicalexperience indicates positive results, each surgeon’s actual experience withour device outside the clinical study setting may vary. Consequently, bothshort- and long-term results reported in any future clinical studies may besignificantly more favorable than typical results of other practicing surgeons,which could negatively affect rates of adoption and negatively affect ourresults.

 

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

 

Our SurgASSIST system is a new technology and must compete with themore established manual devices of our competitors, such as Covidien andEthicon Endo-Surgery, Inc. Conventional manual devices are widely acceptedin the medical community, have a long history of use and do not require thepurchase of additional, expensive capital equipment. We cannot be certain thatsurgeons will use our products to replace or supplement established treatmentsor that our products will be competitive with current or future products andtechnologies.

 

Most of our competitors enjoy competitive advantages over us,including:

 

·significantly greater name recognition;

 

·longer operating histories;

 

·established relationships with healthcare professionals, customers and third-partypayors;

 

·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;

 

·greater experience in conducting research and development, manufacturing,clinical trials, obtaining regulatory clearance for products and marketingapproved products; and

 

·greater financial and human resources for product development, sales andmarketing and patent litigation.

 

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In addition, our SurgASSIST system in its original configuration hascertain perceived disadvantages compared to conventional manual endomechanicaldevices. Prior to the introduction of our new i60 linear stapler 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 success depends upon maintaining a competitive position inthe development of products and technologies in our areas of focus. Ourcompetitors may:

 

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

 

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

 

·obtain regulatory approval for the commercialization of their products morerapidly or effectively than we do.

 

Additional competitors also may enter our market. As a result, we cannotassure you that we will be able to compete successfully against existing or newcompetitors. Our sales would be reduced or eliminated if our competitorsdevelop and market products that are more effective and less expensive than ourproducts. Volatility in the demand for our products could, among other things,make it more difficult to gauge the manufacturing capacity necessary to meetour demand, decrease our manufacturing efficiency and increase our workingcapital requirements. If any of these occur, your investment in our commonstock may decrease in value.

 

**We assemble our Intelligent Surgical Instruments using ourown customized equipment and plan to undertake a new manufacturing process,making us vulnerable to production and supply problems that could negativelyimpact our sales.**

 

We presently use customized equipment for certain steps in the assemblyof our Intelligent Surgical Instruments. Because of the customized nature ofour equipment, we cannot rely on third parties to find new parts or replace theequipment. As a result, we are responsible for maintaining the equipment andfor locating spare parts. If the equipment malfunctions and we are unable tolocate spare parts or hire qualified personnel to repair the equipment, we mayencounter delays in the manufacture of our Intelligent Surgical Instruments andreloads and may not have sufficient inventory to meet our customers’ demands,which could adversely affect our business, financial condition and results ofoperations.

 

We have engaged a third party to develop and fabricate an automatedsystem to enable us to assemble the reload cartridges for our PLC 60 andi60 linear staplers, which we currently assemble manually. We expect the systemto be operational in the second quarter of 2008.  While we believe the use of this new systemshould reduce our risk of supply problems, the automated system must be capableof manufacturing at our anticipated volume. However, there is no guarantee thatthe automated system will function at the capacity we require. The automatedsystem will be located at our facility in Langhorne, Pennsylvania, whichrequires us to be responsible for the day-to-day control and protection of thesystem. Delay in the availability of, or unanticipated problems in ourutilization of, this automated system could jeopardize our initiatives toimprove our gross margins.

 

**We are dependent upon a number of key suppliers, includingsole source suppliers, the loss of which would materially harm our business.**

 

We rely upon sole source suppliers for a number of key components andservices used in manufacturing our products and, in general, we do not havelong-term contracts with these suppliers. We cannot assure you that we

 

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willbe able to obtain sufficient quantities of such components or services 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, our reliance on third parties involves a number of risks,including, among other things:

 

·suppliers may fail to comply with regulatory requirements or make errors inmanufacturing components that could negatively affect the efficacy or safety ofour 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-term supplyarrangements for key components;

 

·we may experience delays in delivery by our suppliers due to changes in demandfrom 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;

 

·fluctuations in demand for products that our suppliers manufacture for othersmay affect their ability or willingness to deliver components to us in a timelymanner;

 

·our suppliers may wish to discontinue supplying components or services to usfor risk management reasons;

 

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

 

·our suppliers may encounter financial hardships unrelated to our demand forcomponents, which could inhibit their ability to fulfill our orders and meetour requirements.

 

If any of these risks materialize, it could significantly increase ourcosts and impact our ability to meet demand for our products.

 

We cannot quickly replace suppliers or establish additional newsuppliers for some of these components, due to both the complex nature of themanufacturing process used by our suppliers and the time and effort that may berequired to obtain regulatory clearance or approval to use materials fromalternative suppliers. Any significant supply interruption or capacityconstraints affecting our facilities or those of our suppliers would impair ourability to manufacture our products.

 

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

 

As of March 31, 2008, we had approximately 175 employees, comparedwith 227 at December 31, 2007. We will need to expand our managerial,operational, financial and other resources to manage and fund our operations,continue our research and development activities, increase the sales force anddevelop our products.** **It is possible that ourmanagement, finance, technical and regulatory personnel, systems and facilitiescurrently in place may not be adequate to support the recent rapid growth inour operations, and our expected future growth. Our need to effectively manageour operations, growth and programs requires that we continue to improve oursystems and procedures in each of these areas and to attract and retain sufficientnumbers of talented employees. We may be unable to successfully implement thesetasks on a larger scale and, accordingly, may not achieve our research,development and growth goals. In March 2008, our chief operations officer,Alex Bourdon, resigned. Mr. Bourdon was one of our three executiveofficers and was responsible for our manufacturing operations as well as forour regulatory compliance operations. We have hired Michael M. Fard as vicepresident of operations, effective March 24, 2008.

 

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Thistransition in our senior management team may in the near term impair ourability to effectively manage our growing operations and to implement requiredsystems improvements.

 

**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 to extensive regulation in the United States and othercountries, including by the United States Food and Drug Administration, or FDA.We maintain an organization of managers, engineers and administrativepersonnel, consisting of 22 persons at December 31, 2007, whoseresponsibility it is to ensure that our products, facilities and operationscomply with applicable regulatory requirements. However, during 2007 weexperienced shortages of qualified regulatory compliance staff due to turnoverand illness, among other factors, and we need to upgrade and carefully manage ourregulatory compliance operations in order to accommodate our expected growth.Additionally, the senior vice president of regulatory affairs and qualityassurance whom we hired in the fourth quarter of 2007, resigned in January 2008.We currently are not seeking to recruit a successor for him, and have dividedhis responsibilities among several of our current employees. Our chiefoperations officer, Alex Bourdon, to whom our senior vice president ofregulatory affairs and quality assurance reported, also resigned in March 2008.

 

In April 2007, following an inspection of our facilities, the FDAissued a Notice of Inspectional Observations, or Form 483, which included24 inspectional observations. We were also inspected by the FDA in 2002, 2003and 2005, and some of the observations in the FDA’s April 2007 Form 483are similar to those we received in earlier inspections. As a result of theseevents, we concluded that there are significant deficiencies in our regulatorycompliance operations, and are taking steps to rectify these deficiencies. Wealso have begun the process of making needed improvements in our corrective andpreventive action, complaint handling and medical device reporting procedures,in our processes for compliance with other requirements of the FDA’s qualitysystem regulations and in our related controls and internal audit functions. Inlate 2007 we engaged an independent consultant to audit our compliance withcertain aspects of the FDA’s quality system regulations. The consultant notedimprovements in our complaint management, failure investigation, medical devicereport reporting, management review, internal audit and corrective andpreventative action processes, but also identified areas for improvement in ourFDA quality system regulations in each of these areas, some of which related tooccurrences after the FDA’s April 2007 Form 483.

 

As of the date of this report, the FDA is conducting an inspection ofour facilities in Langhorne, Pennsylvania which is not yet completed.

 

If we are not successful in identifying and recruiting qualifiedpersonnel to manage and staff our regulatory compliance operations or inimplementing necessary process improvements on a timely basis, we could besubject to regulatory enforcement actions which could damage our reputation,impair our ability to obtain regulatory clearances for new products, prevent usfrom manufacturing and selling our products and harm our business.

 

**We have a material weakness in our internal control overfinancial reporting, and if we are unable to achieve and maintain effectiveinternal control over financial reporting, investors could lose confidence inour financial statements and our company, which could have a material adverseeffect on our business and stock price.**

 

We have concluded that there is a material weakness in our internalcontrol over financial reporting because we do not have a sufficient number ofpersonnel with the appropriate level of experience and technical expertise toappropriately resolve non-routine and complex accounting matters or to evaluatethe impact of new and existing accounting pronouncements on our consolidatedfinancial statements while completing the financial statement close process.The material weakness resulted in the identification of adjustments during thefinancial statement close process in 2007 that have been recorded in ourconsolidated financial statements. A material weakness is a control deficiency,or a combination of control deficiencies, in internal control over financialreporting, such that there is a reasonable possibility that a materialmisstatement of annual or interim financial statements would not be preventedor detected. Until this design deficiency in our internal control overfinancial reporting is remediated, there is reasonable possibility that amaterial misstatement to our annual or interim

 

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consolidatedfinancial statements could occur and not be prevented or detected by ourinternal controls in a timely manner.

 

Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, when wefile our Annual Report on Form 10-K for the fiscal year ending December 31,2008, we must assess the effectiveness of our internal control over financialreporting as of the end of our 2008 fiscal year. This assessment must includedisclosure of any material weaknesses in our internal control over financialreporting that are identified by management. The report must also contain astatement that our independent registered public accounting firm has issued anattestation report on management’s assessment of such internal controls.

 

If we are unable at that time to assert that our internal control overfinancial reporting is effective because the material weakness identified abovehas not been remediated, or for any other reason, or if our independentregistered public accounting firm is unable to express an opinion on theeffectiveness of our internal controls, 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 critical component of our sales and marketing efforts is the trainingof a sufficient number of surgeons, other clinicians and hospital staff toproperly use our SurgASSIST system. In order to operate effectively, ourinternal sales force must also be trained on the benefits and properutilization of our technology, including newly introduced products. Inconnection with the introduction of our i60 and iDrive products, we have foundthat it takes longer than we expected to adequately train our internal salesforce and customers’ clinical personnel on the use and care of theseinstruments, due in part to their novelty and to the need to employ newsterilization techniques. Additionally, the number of i60 and iDrivedemonstration units available for use by our sales force was limited during theearly phases of our i60 product launch. As a result, it has taken longer forour sales force to become fully effective in selling these new products, andthe rate of adoption of our new technology has been adversely affected. Anyfurther delays in adequately training our internal sales force or our customers’clinical personnel on these or other products could harm our business.

 

Additionally, we rely on clinicians and hospital staff to devoteadequate time to learn to use our products. If surgeons or hospital staff arenot properly trained in the use of our Intelligent Surgical Instruments, theymay misuse or ineffectively use our products. For example, during 2007, wereceived reports of incomplete firings of our reusable PLC 60 instrumentthat we believed were attributable to improper installation of reloadcartridges by our customers’ medical personnel. More recently, we have receivedsimilar reports relating to the seating of reload cartridges in our i60and PLC 75 linear staplers. We initiated improvements in our trainingprocedures to alert customers to the need to properly seat the reloadcartridges, and designed a new version of the reload cartridge to incorporate apositive locking feature to make this error less likely to occur.  However, insufficient training may result inunsatisfactory patient outcomes, patient injury and related liability ornegative publicity, which could have an adverse effect on our product sales.

 

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

 

Our business exposes us to significant risks of product liabilityclaims that are inherent in the testing, manufacturing and marketing of medicaldevices. The medical device industry has historically been subject to extensiveproduct liability litigation. We have in the past been, and in the future maybe, subject to claims by consumers, healthcare providers, third-party payors orothers selling our products if the use of our products were to cause, or merelyappear to cause, injury or death. We are currently the subject of a productliability suit in Belgium. Any weakness in training and service associated withour products may also result in product liability lawsuits. Additionally, wemay be unable to maintain our existing product liability insurance in thefuture at satisfactory rates or adequate amounts. A product liability claim,regardless of its merit or eventual outcome or the availability of insurancecoverage, could result in:

 

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·decreased demand for our products;

 

·injury to our reputation;

 

·diversion of management’s attention;

 

·significant costs of related litigation;

 

· substantialmonetary 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 manufacturing and marketing of our products involve an inherentrisk of product liability claims. In addition, our product development andproduction processes are complex and could expose our products to defects.Additionally, problems experienced by our customers, such as difficulty inconsistently seating our reload cartridges may be perceived by them as qualitydefects. Our SurgASSIST system also incorporates sophisticated computersoftware. Complex software frequently contains errors, especially when firstintroduced. We cannot assure you that our software will not experience errorsor performance problems in the future. If our products have, or are perceivedto have, mechanical defects or software errors or have performance problems, wewould likely 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.

 

**We may need substantial additional funding and we may beunable to raise capital when needed, which would force us to delay, reduce oreliminate our product development programs or commercialization efforts.**

 

We believe that our existing cash and cash equivalent balances and interestwe earn on these balances will be sufficient to meet our anticipated cashrequirements through January 1, 2009. We have made no arrangements toobtain additional financing, and there can be no assurance that such financing,if required or desired, will be available in amounts or on terms acceptable tous, if at all. These conditions raise substantial doubt about our ability tocontinue as a going concern. Our independent registered public accounting firmhas modified its audit report on our consolidated financial statements toinclude an explanatory paragraph regarding this contingency. However, ouractual capital requirements will depend on many factors, many of which areoutside our control, including:

 

·future revenue generation;

 

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·the cost of filing and prosecuting patent applications and defending andenforcing our patent and other intellectual property rights;

 

·the cost of defending, in litigation or otherwise, any claims that we infringethird 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;

 

·licensing technologies for future development; and

 

·the extent to which we acquire or invest in businesses, products andtechnologies, although we currently have no commitments or agreements relatingto any of these types of transactions.

 

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, dilution mayoccur. Debt financing, if available, may involve restrictive covenants. Anydebt financing or additional equity that we raise may contain terms that arenot favorable to us or our stockholders. Substantially all our assets aresubject to a security interest in favor of the holders of our convertiblenotes, which may limit our ability to obtain additional debt financing.Additionally, if we default in the payment of our convertible notes, ournoteholders will be entitled to exercise their rights as secured creditors,which include the right to foreclose on the assets we have provided ascollateral, which could materially impair our ability to continue to operateour business.

 

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.

 

**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 three months ended March 31, 2008, 85% of our saleswere derived from customers located in North America and 15% were derived fromcustomers in Europe and Asia. During the three months ended March 31,2007, 79% of our sales were derived from customers located in North America and21% were derived from customers in Europe and Asia.  For the years ended December 31, 2007and 2006, sales occurring in international markets were 18% and 21%,respectively.  By doing business ininternational markets, we are exposed to risks separate and distinct from thosewe face in our domestic operations. Our international business may be adverselyaffected by changing economic conditions in foreign countries. Because most ofour international sales are denominated in the functional currency of thecountry where the product is being shipped, increases or decreases in the valueof the U.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 regulatory requirementsand laws;

 

·laws and business practices favoring local companies;

 

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·longer payment cycles;

 

·difficulties in enforcing agreements and collecting receivables through certainforeign 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 to each of these risks may increase our costs, impair ourability to market and sell our products and require significant managementattention. We cannot assure you that one or more of these factors will not harmour business.

 

**If we choose to acquire or invest in new and complementarybusinesses, products or technologies instead of developing them ourselves, suchacquisitions or investments could disrupt our business.**

 

We may attempt to expand our business through acquisitions. To theextent we grow our business through acquisitions, our future success may bepartially dependent upon our ability to effectively integrate acquiredbusinesses with our own. There can be no assurance that our acquisitions willbe successfully integrated or that any such acquisitions will otherwise besuccessful. If our acquisitions are unsuccessful for any reason, our businessmay be harmed and the value of your investment may decline.

 

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

 

Our future business and operating results depend significantly on thecontinued contributions of our key technical personnel and senior management,particularly those of our co-founder, Chief Executive Officer and President,Michael P. Whitman. These individuals and the services they provide would bedifficult or impossible to replace. While we are subject to certain severanceobligations 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 have key-person life insurance in the amount of$2.0 million on the life of Mr. Whitman, this amount would not fullycompensate us for the loss of Mr. Whitman’s services. The loss of keyemployees, the failure of any key employee to perform or our inability to attractand retain skilled employees, as needed, could harm our business.

 

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

 

We may experience limited sales growth resulting from limitations onreimbursements made to purchasers of our products by third-party payors, and wecannot assure you that our sales will not be impeded and our business harmed ifthird-party payors fail to provide reimbursement that hospitals view asadequate.

 

In the United States, our products are purchased primarily by medicalinstitutions, which then bill various third-party payors, such as the Centersfor Medicare and Medicaid Services, or CMS, which administers the Medicareprogram, and other government programs and private insurance plans, for thehealthcare services provided

 

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totheir patients. The process involved in applying for coverage and incrementalreimbursement from CMS is lengthy and expensive.

 

Moreover, many private payors look to CMS in setting theirreimbursement policies and amounts. If CMS or other agencies limit coverage forprocedures utilizing our SurgASSIST system or decrease or limit reimbursementpayments for doctors and hospitals, this may affect coverage and reimbursementdeterminations by many private payors.

 

If a medical device does not receive incremental reimbursement fromCMS, then a medical institution would have to absorb the cost of our productsas part of the cost of the procedure in which the products are used. Acute carehospitals are now generally reimbursed by CMS for inpatient operating costsunder a Medicare hospital inpatient prospective payment system. Under theMedicare hospital inpatient prospective payment system, acute care hospitalsreceive a fixed payment amount for each covered hospitalized patient based uponthe Diagnosis-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 currently conduct all of our manufacturing and management activitiesand certain research and development activities at a single location inLanghorne, Pennsylvania. We have taken precautions to safeguard our facilities,including insurance, health and safety protocols and off-site storage ofcomputer data. However, a casualty due to fire or natural disaster, such as anearthquake, storm or terrorist attack, could cause substantial delays in ouroperations, damage or destroy our equipment or inventory and cause us to incuradditional expenses. A disaster could seriously harm our business and resultsof operations. Our insurance does not cover earthquakes and floods and may notbe adequate to cover our losses in any particular case.

 

**Risks Related to Our Intellectual Property**

 

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

 

Much of the technology used in the markets in which we compete iscovered by patents, and our commercial success will depend in large part on ourability to obtain and maintain patent and trade secret protection for ourproducts and methods. We currently hold 24 issued United States patents, fivegranted European patents, more than 100 pending United States and foreignpatent applications and two licensed patents that cover key aspects of ourtechnology. Our issued patents expire at various dates beginning in 2019. Theloss of our patents could reduce the value of the related products. Inaddition, the cost to litigate infringements of our patents or the cost todefend ourselves against patent infringement actions by others could besubstantial.

 

Our ability to obtain additional patents is uncertain and the legalprotection afforded by these patents is limited and may not adequately protectour rights or permit us to gain or keep any competitive advantage. In addition,the specific content required of patents and patent applications that isnecessary to support and interpret patent claims is highly uncertain due to thecomplex nature of the relevant legal, scientific and factual issues. Changes ineither patent laws or in interpretations of patent laws in the United States orelsewhere may diminish the value of our intellectual property or narrow thescope of our patent protection. Even if patents are issued regarding ourproducts and methods, our competitors may challenge the validity of thosepatents. Patents also will not protect our products and methods if competitorsdevise ways of making competitive products without infringing our patents.

 

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Proprietary trade secrets and unpatented know-how are also veryimportant to our business. We rely on trade secrets to protect certain aspectsof our technology, especially where we do not believe that patent protection isappropriate or obtainable. However, trade secrets are difficult to protect. Ouremployees, consultants, contractors, outside clinical collaborators and otheradvisors may unintentionally or willfully disclose our confidential informationto competitors, and confidentiality agreements may not provide an adequateremedy in the event of unauthorized disclosure of confidential information.Enforcing a claim that a third party illegally obtained and is using our tradesecrets is expensive and time consuming, and the outcome is unpredictable.Moreover, our competitors may independently develop equivalent knowledge,methods and know-how. Failure to obtain or maintain trade secret protectioncould adversely affect our competitive business position.

 

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

 

There is a risk that we are infringing the proprietary rights of thirdparties under patents and pending applications belonging to third parties thatmay exist in the United States and elsewhere in the world and that relate tothe products we market and develop. Because the patent application process cantake several years 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, theproduction, manufacture, commercialization or use of our product candidates mayinfringe existing patents of which we are not aware.

 

There has been substantial litigation and other proceedings regardingpatent and other intellectual property rights in the medical device industry.Defending ourselves against third-party claims, including litigation inparticular, would be costly and time consuming and would divert management’sattention from our business, which could lead to delays in our development orcommercialization efforts. Currently, we are involved in two appeal proceedingsin Germany in connection with two of three patent-infringement lawsuits againstus. The lawsuits alleged that certain of our products infringe three Europeanpatents held by Ethicon Endo-Surgery. We prevailed in two of the threeinfringement actions and the products in question were found not to infringethe Ethicon Endo-Surgery patents, and Ethicon Endo-Surgery is appealing one ofthose decisions. We lost the other infringement action and are appealing thatdecision. If third parties are successful in their claims, we might have to paysubstantial damages or take other actions that are adverse to our business. Asa result of intellectual property infringement claims, or to avoid potentialclaims, we might:

 

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

 

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

 

·be required to redesign a product so it does not infringe, which may not bepossible 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 our employees were previously employed at universities or othermedical device companies, including our competitors or potential competitors.We could in the future be subject to claims that these employees, or we, haveinadvertently or otherwise used or disclosed trade secrets or other proprietaryinformation of their former employers. Litigation may be necessary to defendagainst these claims. If we fail in defending against such claims, a courtcould order us to pay substantial damages and prohibit us from usingtechnologies or features that are essential to our products, if suchtechnologies or features are found to incorporate or be derived from the tradesecrets or other proprietary information of the former employers. In addition,we may lose valuable intellectual property rights or personnel. A loss of keyresearch personnel or their work product could hamper or prevent our ability tocommercialize certain potential products, which could severely harm ourbusiness. Even if we are successful in defending against these claims, suchlitigation could result in substantial costs and be a distraction tomanagement.

 

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**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 and manufacturing techniques generally must conform tostandards that are established by the United States Food and DrugAdministration, or FDA, and other government agencies, including those ofEuropean and other foreign governments. These regulatory agencies may conductperiodic audits or inspections of our facilities or our processes to monitorour compliance with applicable regulatory standards. If a regulatory agencyfinds that we have failed to comply with the appropriate regulatory standards,it may impose fines on us, delay or withdraw pre-market clearances or otherregulatory approvals or, if such a regulatory agency determines that ournon-compliance is severe, it may close our facilities. Any adverse action by anapplicable regulatory agency could impair our ability to produce our productsin a cost-effective and timely manner in order to meet our customers’ demands.We may also be required to bear other costs or take other actions that may havea negative impact on our future sales and our ability to generate profits.

 

Between May 2002 and June 2005, the FDA conducted threeinspections of our facilities. Each of those inspections resulted in theissuance of a Notice of Inspectional Observations, or Form 483. Certainobservations regarding our processes to handle customer complaints, submitmedical device reports, initiate corrective and preventive actions and toconduct internal quality audits were identified by the FDA as areas of possiblenon-compliance with FDA regulations. For each of those Form 483s issued bythe FDA, we submitted a response which identified our proposed correctiveaction plans to address the FDA’s inspectional observations. In each case, theFDA issued an Establishment Inspection Report, or EIR, which officially closedFDA’s inspection. From February 13 to April 26, 2007, the FDAconducted an additional inspection of our facility in Langhorne, Pennsylvania.A Form 483 was provided to us at the conclusion of the inspection. As ofthe date of this report, the FDA is conducting an inspection of our facilitiesin Longhorne, Pennsylvania which is not yet completed. In the FDA’s most recentForm 483, 24 inspectional observations were identified, including thefailure to properly process customer complaints, failure to submit to the FDAmedical device reports or to submit them within regulatory timeframes, and thelack of reporting a field action. Certain of the FDA’s inspectionalobservations are similar to observations identified in the prior Form 483sissued to us. We prepared and submitted a response to the FDA, which includedour proposed corrective actions to address the FDA’s observations. Whether theFDA will accept our response is uncertain, particularly in light of the similarnature of the current inspectional observations to the previous observations.If the FDA does not agree with our proposed corrective actions, or accepts thembut finds that we have not implemented them adequately, if the FDA is concernedabout the repetitive nature of the inspectional observations, or if weotherwise fail to comply with applicable regulatory requirements, the FDA couldinitiate an enforcement action, including any of the following sanctions:

 

·untitled letters, warning letters, fines, injunctions, consent decrees andcivil penalties;

 

·customer notifications or repair, replacement, refunds, recall, detention orseizure of our products;

 

·operating restrictions or partial suspension or total shutdown of production;

 

·refusing or delaying our requests for 510(k) clearance or premarketapproval, or PMA, of new products or modified products;

 

·withdrawing 510(k) clearances or PMA approvals that have already beengranted;

 

·refusal to grant export approval for our products; or

 

·criminal prosecution.

 

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**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 federal anti-kickback laws and several similar state laws prohibitpayments that are intended to induce physicians or others either to referpatients to acquire or arrange for or recommend the acquisition of healthcareproducts or services. These laws affect our sales, marketing and otherpromotional activities by limiting the kinds of financial arrangements andsales programs we may have with hospitals, physicians or other potentialpurchasers or users of medical devices. In particular, these laws influence howwe structure our sales, customer support, education and 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 activitiespractices might be challenged under anti-kickback or related laws. Even anunsuccessful challenge to or investigation into our practices could cause adversepublicity and thus could harm our business and results of operations.

 

Foreign sales of our products also subject us to similar fraud andabuse laws, including application of the U.S. Foreign Corrupt Practices Act. Ifour operations, including any consulting arrangements we may enter into withphysicians who use our products, are found to be in violation of these laws, weor our officers may be subject to civil or criminal penalties, including largemonetary penalties, damages, fines, imprisonment and exclusion from Medicareand Medicaid program participation. If enforcement action were to occur, ourbusiness and financial condition would be harmed.

 

**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 to our products may require new regulatory approvals orclearances, including 510(k) clearances or premarket approvals, or requireus to recall or cease marketing the modified devices until these clearances orapprovals are obtained. The FDA requires device manufacturers to initially makeand document a determination of whether or not a modification requires a newapproval, supplement or clearance. A manufacturer may determine that amodification could not significantly affect safety or efficacy and does notrepresent a major change in its intended use, so that no new 510(k) clearanceis necessary. However, the FDA can review a manufacturer’s decision and may disagree.The FDA may also on its own initiative determine that a new clearance orapproval is required. We have made modifications to our products in the pastand may make additional modifications in the future that we believe do not orwill not require additional clearances or approvals. If the FDA disagrees andrequires new clearances or approvals for the modifications, we may be requiredto recall and to stop marketing our products as modified, which could requireus to redesign our products and harm our operating results. In thesecircumstances, we may be subject to significant enforcement actions.

 

If a manufacturer determines that a modification to an FDA-cleareddevice could significantly affect its safety or efficacy, or would constitute amajor change in its intended use, then the manufacturer must file for a new 510(k) clearanceor possibly a premarket approval application. Where we determine thatmodifications to our products require a new 510(k) clearance or premarketapproval application, we may not be able to obtain those additional clearancesor approvals for the modifications or additional indications in a timelymanner, or at all. For those products sold in the European Union, we mustnotify Orion Registrar, Inc., or Orion, our E.U. Notified Body, ifsignificant changes are made to the products or if there are substantialchanges to our quality assurance systems affecting those products. Obtainingclearances and approvals can be a time consuming process, and failure to obtainor delays in obtaining required future clearances or approvals would adverselyaffect our ability to introduce new or enhanced products in a timely manner,which in turn would harm our 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.**

 

Some of our new products, such as our proposed i60RB4 and i45V linearstaplers, will require FDA clearance of a 510(k), or may even require FDAapproval of a PMA. We are in the process of developing our regulatorystrategies for obtaining clearance or approval of these new products. The FDAmay not approve or clear these products for the indications that are necessaryor desirable for successful commercialization. Indeed, the FDA may refuse ourrequests for 510(k) clearance or premarket approval of new products, newintended uses or modifications to existing products. Failure to receiveclearance or approval for our new products would have an adverse effect on ourability 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 goods manufacturing processes, and those of some of ourcontract manufacturers, are required to comply with the FDA’s Quality System Regulations,or QSRs, which cover the procedures and documentation of the design, testing,production, control, quality assurance, labeling, packaging, sterilization,storage and shipping of our devices. The FDA enforces its QSRs through periodicinspections of manufacturing facilities. We and our contract manufacturers havebeen, and anticipate in the future being, subject to such inspections. If ourmanufacturing facilities or those of any of our contract manufacturers fail totake satisfactory corrective action in response to an adverse QSR inspection,the FDA could take enforcement action, including any of the followingsanctions, which could have a material impact on our operations:

 

·untitled letters, warning letters, fines, injunctions, consent decrees andcivil penalties;

 

·customer notifications or repair, replacement, refunds, recall, detention orseizure of our products;

 

·operating restrictions or partial suspension or total shutdown of production;

 

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

 

·withdrawing 510(k) clearances on PMA approvals that have already beengranted;

 

·refusal to grant export approval for our products; or

 

·criminal prosecution.

 

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

 

The FDA and similar foreign governmental authorities have the authorityto require the recall of commercialized products in the event of materialdeficiencies or defects in design or manufacture. In the case of the FDA, theauthority to require a recall must be based on an FDA finding that there is areasonable probability that the device would cause serious injury or death. Inaddition, foreign governmental bodies have the authority to require the recallof our products in the event of material deficiencies or defects in design ormanufacture. Manufacturers may, under their own initiative, 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 other deficienciesand issues. Recalls of any of our products would divert managerial andfinancial resources and have an adverse effect on our financial condition andresults of operations. The FDA requires that certain classifications of recallsbe reported to FDA within 10 working days after the recall is initiated.Companies are required to maintain certain records of recalls, even if they arenot reportable to the FDA. We have initiated certain voluntary recallsinvolving products that have been distributed to our customers and may takeadditional such actions in the future. We believe that certain of those recallsdo not require notification

 

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ofthe FDA. If the FDA disagrees with our determinations, they could require us toreport those actions as recalls. A future recall announcement could harm ourreputation with customers and negatively affect our sales. In addition, the FDAcould take enforcement action, including any of the following sanctions forfailing to report the recalls when they were conducted:

 

·untitled letters, warning letters, fines, injunctions, consent decrees andcivil penalties;

 

·customer notifications or repair, replacement, refunds, recall, detention ofseizure of our products;

 

·operating restrictions or partial suspension or total shutdown of production;

 

·refusing or delaying requests for 510(k) clearance or premarket approvalof new products or modified products;

 

·withdrawing 510(k) clearances or PMA approvals that have already beengranted;

 

·refusal to grant export approval for our products; or

 

·criminal prosecution.

 

**If our products, or malfunction of our products, cause orcontribute to a death or a serious injury, we will be subject to medical devicereporting regulations, which can result in voluntary corrective actions oragency enforcement actions.**

 

Under the FDA medical device reporting regulations, medical devicemanufacturers are required to report to the FDA information that a device hasor may have caused or contributed to a death or serious injury or has malfunctionedin a way that would likely cause or contribute to a death or serious injury ifthe malfunction 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 adverse event involving our products could result in futurevoluntary corrective actions, such as recalls or customer notifications, oragency action, such as inspection or enforcement action. Adverse eventsinvolving our products have been reported to us in the past, and we cannotguarantee that they will not occur in the future. Any corrective action,whether voluntary or involuntary, as well as defending ourselves in a lawsuit,will require the dedication of our time and capital, distract management from operatingour business, and may harm our reputation and financial results. Failure toreport such adverse events to appropriate government authorities on a timelybasis, or at all, could result in an enforcement action against us.

 

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

 

We intend to market our products in a number of international markets.Although certain of our products have been approved for commercialization inJapan and in the European Union, in order to market our products in otherforeign jurisdictions we must obtain separate regulatory approvals. Theapproval procedure varies among jurisdictions and can involve substantialadditional testing. Approval or clearance by the FDA does not ensure approvalby regulatory authorities in other jurisdictions, and approval by one foreignregulatory authority does not ensure approval by regulatory authorities inother foreign jurisdictions or by the FDA. The foreign regulatory approvalprocess may include all of the risks associated with obtaining FDA approval inaddition to other risks. In addition, the time required to obtain foreignapproval may differ from that required to obtain FDA approval, and we may notobtain foreign regulatory approvals on a timely basis, if at all. We may not beable to file for regulatory

 

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approvalsand may not receive necessary approvals to commercialize our products in anyforeign market other than in the European Union and Japan.

 

**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 promotional materials and training methods for surgeons must complywith FDA and other applicable laws and regulations. Many of our products arecleared by the FDA for use in various surgical applications. We believe thatthe specific surgical procedures for which our products are marketed fall withinthe scope of the surgical applications that have been cleared by the FDA.However, the FDA could disagree and require us to stop promoting our productsfor those specific procedures until we obtain FDA clearance or approval forthem. In addition, if the FDA determines that our promotional materials ortraining constitutes promotion of an unapproved use, it could request that wemodify our training or promotional materials or subject us to regulatory orenforcement actions, including the issuance of an untitled letter, a warningletter, injunction, seizure, civil fine and criminal penalties. It is alsopossible that other federal, state or foreign enforcement authorities mighttake action if they consider our promotional or training materials to constitutepromotion of an unapproved use, which could result in significant fines orpenalties under other statutory authorities, such as laws prohibiting falseclaims for reimbursement. In that event, our reputation could be damaged andadoption of the products would be impaired.

 

**Federal regulatory reforms may adversely affect our abilityto sell our products profitably.**

 

From time to time, legislation is drafted and introduced in Congressthat could significantly change the statutory provisions governing the clearanceor approval, manufacture and marketing of a medical device. In addition, FDAregulations and guidance are often revised or reinterpreted by the agency inways that may significantly affect our business and our products. It isimpossible to predict whether legislative changes will be enacted or FDAregulations, guidance or interpretations changed, and what the impact of suchchanges, if any, may be.

 

Without limiting the generality of the foregoing, Congress has recentlyenacted, and the President has signed into law, the Food and DrugAdministration Amendments Act of 2007. The amendments require, among otherthings, that FDA propose, and ultimately implement, regulations that willrequire manufacturers to label medical devices with unique identifiers unless awaiver is received from FDA. Once implemented, compliance with thoseregulations may require us to take additional steps in the manufacture of ourproducts and labeling. These steps may require additional resources and couldbe costly. In addition, the law, as amended, will require us to, among otherthings, pay annual establishment registration fees to the FDA for each of ourFDA registered facilities.

 

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

 

**We expect that the price of our common stock will fluctuatesubstantially.**

 

Since our initial public offering in October 2007, the marketprice of our common stock has ranged from $3.71 to $14.79. The market price forour common stock is likely to continue to fluctuate as a result of a number offactors, including:

 

·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;

 

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

 

·announcements by us regarding transactions with potential strategic partners;

 

·changes in industry trends or conditions;

 

·trading volume of our common stock;

 

·changes in earnings estimates or recommendations by securities analysts,failure to obtain analyst coverage of our common stock or our failure toachieve 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 of many companies in the medical device industry haveexperienced wide fluctuations that have often been unrelated to the operatingperformance of these companies. In the past, securities class action litigationoften has been initiated against a company following a period of volatility inthe market price of the company’s securities. If securities class actionlitigation is initiated against us, we will incur substantial costs and ourmanagement’s attention will be diverted from our operations. All of thesefactors may materially and adversely affect the market price of our commonstock, and you may lose some or all of your investment.

 

**Securities analysts may not initiate or continue coverage forour common stock or may issue negative reports, and this may have a negativeimpact on the market price of our common stock.**

 

Securities analysts may elect not to provide research coverage of ourcommon stock, and if a sufficient number of securities analysts do not coverour common stock, the lack of research coverage may adversely affect the marketprice of our common stock. The trading market for our common stock may beaffected in part by the research and reports that industry or financialanalysts publish about us or our business. If one or more of the analysts whoelect to cover us downgrades our stock, our stock price could decline. If oneor more of these analysts ceases coverage of our company, we could losevisibility in the market, which in turn could cause our stock price to decline.In addition, rules mandated by the Sarbanes-Oxley Act and a globalsettlement reached in 2003 between the Securities and Exchange Commission, orSEC, 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.

 

**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 executive officers, directors and stockholders holding 5% or moreof our outstanding common stock beneficially own or control approximately 40.8%of the outstanding shares of our common stock, assuming no exercise ofoutstanding options and warrants or conversion of our convertible notes.Accordingly, these executive officers, directors and principal stockholders,acting as a group, will have substantial influence over the outcome ofcorporate actions requiring stockholder approval, including the election ofdirectors, any merger, consolidation or sale of all or substantially all of ourassets or any other significant corporate transaction. These stockholders mayalso delay or prevent a change of control or otherwise discourage a potentialacquirer from attempting to obtain control of our company, even if such achange of control would benefit our other stockholders. This significantconcentration of stock ownership may adversely affect the trading price of ourcommon stock due to investors’ perception that conflicts of interest may existor arise.

 

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

 

Provisions in our amended and restated certificate of incorporation andamended and restated bylaws, as well as provisions of Delaware law, maydiscourage, delay or prevent a merger, acquisition or change of control. Theseprovisions could also discourage proxy contests and make it more difficult forstockholders to elect directors and take other corporate actions. Theseprovisions 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

 

· aclassified board of directors.

 

In addition, we are subject to Section 203 of the Delaware GeneralCorporation Law, which imposes certain restrictions on mergers and otherbusiness combinations between us and any holder of 15% or more of our commonstock.

 

**Sales of a substantial number of shares of our common stockin the public market, or the perception that they may occur, may depress themarket price of our common stock.**

 

If our existing stockholders sell substantial amounts of our commonstock in the public market, or the public market perceives that existingstockholders might sell substantial shares of common stock, the market price ofour common stock could decline significantly. These sales might also make itmore difficult for us to sell equity securities at a time and price that wedeem appropriate.

 

Approximately 2.6 million shares of our common stock that are issuableupon conversion of the convertible notes that we issued in March 2007 arenow eligible for resale under Rule 144. Approximately 17.1 millionadditional shares of our common stock are outstanding, assuming no exercise ofoutstanding options or warrants or conversion of our convertible notes.  If the holders of these shares sell them orare perceived by the market as intending to sell them, the market price of ourcommon stock could drop significantly. Any substantial sale of common stockpursuant to any resale registration statements or Rule 144 may have anadverse effect on the market price of our common stock by creating an excessivesupply.

 

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**Item 2.****             UnregisteredSales of Equity Securities and Use of Proceeds.**

 

(a)        *Sales of UnregisteredSecurities:*

 

During the three months ending March 31, 2008,1,050 shares of common stock were issued to employees pursuant to grants ofrestricted stock awards.  Thesetransactions were exempt from registration under Section 4(2) of theSecurities Act.

 

(b)            *Use of Proceeds from Public Offering of Common Stock*

 

Our initial publicoffering of common stock was effected through a Registration Statement on Form S-1(File No. 333-142926) that was declared effective by the Securities andExchange Commission on October 25, 2007. The net offering proceeds to us,after deducting underwriting discounts and offering expenses, wereapproximately $42 million.  We investedthe $42 million in net proceeds from the offering in U.S. Treasury bills andcertificates of deposit pending their use. Through April 27, 2008, we have used approximately $22.9 million ofthe net proceeds from the offering for general working capital purposes.  We intend to continue to use the proceeds forgeneral corporate purposes, including working capital, continuation of ourresearch and development efforts, expansion of our manufacturing capabilitiesand purchases of capital equipment.

 

(c)             *Purchases of Equity Securitiesby the Issuer and Affiliated Purchasers:*

 

None.

 

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**Item 3.****                    DefaultUpon Senior Securities.**

 

None.

 

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

 

None.

 

**Item 5.****                    OtherInformation.**

 

None.

 

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

 
| **Exhibit** | ** ** | ** **                                                                                               | ** ** | **Filed with  this Form** | ** ** | **Incorporated by Reference** |
|-------------|------------|----------------------------------------------------------------------------------------------------------|------------|---------------------------|------------|-------------------------------|
| **No.**     | ** ** | **Description**                                                                                          | ** ** | **10-Q**                  | ** ** | **Form**                      | ** ** | **Filing Date** | ** ** | **Exhibit No.** |
| 3.1         |       | Fourth Amended and Restated Certificate of  Incorporation of the Company                                 |       |                      |       | S-1/A                         |   | October 9, 2007 |   | 3.2 |
|        |       |                                                                                                     |       |                      |       |                          |   |   |   |   |
| 3.2         |       | Amended and Restated By-Laws of the Company                                                              |       |                      |       | S-1/A                         |   | October 9, 2007 |   | 3.4 |
|        |       |                                                                                                     |       |                      |       |                          |   |   |   |   |
| 4.1         |       | Specimen certificate for common stock of Power  Medical Interventions, Inc.                         |       |                      |       | S-1/A                         |   | October 9, 2007 |   | 4.1 |
|        |       |                                                                                                     |       |                      |       |                          |   |   |   |   |
| 31.1        |       | Certification of Chief Executive Officer Pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002 | ** ** | **X**                     | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** |
|        |       |                                                                                                     | ** ** | ** **                | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** |
| 31.2        |       | Certification of Chief Financial Officer Pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002 | ** ** | **X**                     | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** |
|        |       |                                                                                                     | ** ** | ** **                | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** |
| 32.1        |       | Certification of Chief Executive Officer Pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002 | ** ** | **X**                     | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** |
|        |       |                                                                                                     | ** ** | ** **                | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** |
| 32.2        |       | Certification of Chief Financial Officer Pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002 | ** ** | **X**                     | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** |

 

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**SIGNATURES**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 
|              |            |                                   |
|-------------------|-----------------|----------------------------------------|
|              |            | POWER MEDICAL  INTERVENTIONS, INC.     |
|              |            | (Registrant)                           |
|              |            |                                   |
| May 15, 2008 |   By: | /s/ Michael P. Whitman                 |
|              |            | Michael P. Whitman                     |
|              |            | President and Chief  Executive Officer |
|              |            |                                   |
|              |            | POWER MEDICAL  INTERVENTIONS, INC.     |
|              |            | (Registrant)                           |
|              |            |                                   |
| May 15, 2008 |   By: | /s/ John P. Gandolfo                   |
|              |            | John P. Gandolfo                       |
|              |            | Chief Financial Officer                |

 

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**Exhibit Index**

** **
| **Exhibit** | ** ** | ** **                                                                                                   | ** ** | **Filed with  this Form** | ** ** | **Incorporated by Reference** |
|-------------|------------|--------------------------------------------------------------------------------------------------------------|------------|---------------------------|------------|-------------------------------|
| **No.**     | ** ** | **Description**                                                                                              | ** ** | **10-Q**                  | ** ** | **Form**                      | ** ** | **Filing Date** | ** ** | **Exhibit No.** |
| 3.1         |       | Fourth Amended and Restated Certificate of Incorporation  of the Company                                     |       |                      |       | S-1/A                         |   | October 9, 2007 |   | 3.2 |
|        |       |                                                                                                         |       |                      |       |                          |   |   |   |   |
| 3.2         |       | Amended and Restated By-Laws of the Company                                                                  |       |                      |       | S-1/A                         |   | October 9, 2007 |   | 3.4 |
|        |       |                                                                                                         |       |                      |       |                          |   |   |   |   |
| 4.1         |       | Specimen certificate for common stock of Power  Medical Interventions, Inc.                             |       |                      |       | S-1/A                         |   | October 9, 2007 |   | 4.1 |
|        |       |                                                                                                         |       |                      |       |                          |   |   |   |   |
| 31.1        |       | Certification of Principal Executive Officer  Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | ** ** | **X**                     | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** |
|        |       |                                                                                                         | ** ** | ** **                | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** |
| 31.2        |       | Certification of Principal Financial Officer  Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | ** ** | **X**                     | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** |
|        |       |                                                                                                         | ** ** | ** **                | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** |
| 32.1        |       | Certification of Principal Executive Officer  Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 | ** ** | **X**                     | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** |
|        |       |                                                                                                         | ** ** | ** **                | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** |
| 32.2        |       | Certification of Principal Financial Officer  Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 | ** ** | **X**                     | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** |

 

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