Table ofContents

 

 

 

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

----

 

**FORM 10-Q**

 

----

 

**(Mark One)**

 

| **x**                                                 | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934**  |
|-------------------------------------------------------|----------------------------------------------------------------------------------------------------------|
|                                                  |                                                                                                     |
| **For the quarterly period ended June 30, 2009** |
|                                                  |                                                                                                     |
| **OR**                                                |
|                                                  |                                                                                                     |
| **o**                                                 | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |

 

**CommissionFile Number 001-33770**

 

----

 

**Power Medical Interventions, Inc.**

(Exact name of registrant as specified in its charter)

 

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

 

**2021 CabotBoulevard, Langhorne, Pennsylvania 19047**

(Address of principalexecutive offices)

 

**(267)775-8100**

(Registrant’s telephonenumber, including area code)

 

----

 

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

 

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

 

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

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

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

 

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

 

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

 

| **Class**                                | ** ** | **Outstanding  at August 7, 2009** |
|------------------------------------------|------------|-----------------------------------------|
| Common stock, par value $0.001 per share |       | 17,187,791                              |

 

 

 

----

Table ofContents

 

**POWER MEDICAL INTERVENTIONS, INC.**

 
| ** **    | ** **                                                                                                       | **PAGE** |
|---------------|------------------------------------------------------------------------------------------------------------------|----------|
| PART I:  | FINANCIAL INFORMATION                                                                                            | 3        |
|          |                                                                                                             |     |
| Item 1.  | Consolidated Financial  Statements (Unaudited)                                                                   | 3        |
|          |                                                                                                             |     |
|          | Condensed  Consolidated Balance Sheets as of June 30, 2009 and December 31,  2008                      | 3        |
|          |                                                                                                             |     |
|          | Condensed  Consolidated Statements of Operations for the Three and Six Months Ended  June 30, 2009 and 2008 | 4        |
|          |                                                                                                             |     |
|          | Condensed  Consolidated Statements of Cash Flows for the Six Months Ended June 30,  2009 and 2008           | 5        |
|          |                                                                                                             |     |
|          | Notes to Unaudited Condensed Consolidated Financial  Statements                                                  | 6        |
|          |                                                                                                             |     |
| Item 2.  | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                      | 15       |
|          |                                                                                                             |     |
| Item 3.  | Quantitative  and Qualitative Disclosures About Market Risk                                                      | 25       |
|          |                                                                                                             |     |
| Item 4.  | Controls and  Procedures                                                                                         | 26       |
|          |                                                                                                             |     |
| PART II: | OTHER INFORMATION                                                                                                | 27       |
|          |                                                                                                             |     |
| Item 1.  | Legal Proceedings                                                                                                | 27       |
|          |                                                                                                             |     |
| Item 1A. | Risk Factors                                                                                                     | 28       |
|          |                                                                                                             |     |
| Item 2.  | Unregistered  Sales of Equity Securities and Use of Proceeds                                                     | 46       |
|          |                                                                                                             |     |
| Item 3.  | Defaults Upon  Senior Securities                                                                                 | 46       |
|          |                                                                                                             |     |
| Item 4.  | Submission of  Matters to a Vote of Security Holders                                                             | 46       |
|          |                                                                                                             |     |
| Item 5.  | Other Information                                                                                                | 47       |
|          |                                                                                                             |     |
| Item 6.  | Exhibits                                                                                                         | 47       |
|          |                                                                                                             |     |
|          | Signatures                                                                                                       | 48       |

 

2

----

Table ofContents

 

PART I:                  FINANCIALINFORMATION

 

**Item 1.                    Consolidated Financial Statements (Unaudited)**

 

**Power Medical Interventions, Inc.**

**Condensed Consolidated Balance Sheets**

**(Amounts in thousands, except shareand per share data)**

 
| ** **                                                                                                                            | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                            | ** ** | **2009**          | ** ** | **2008**              | ** ** |
| **ASSETS**                                                                                                                            | ** ** | ** **        | ** ** | ** **            | ** ** |
| Current assets:                                                                                                                       | ** ** | ** **        | ** ** | ** **            | ** ** |
| Cash and cash  equivalents                                                                                                            |       | $                 | 4,277      |                  | $          | 8,384 |   |
| Restricted cash                                                                                                                       |       | —            |       | 875                   |       |
| Accounts receivable,  net of allowance for doubtful accounts                                                                          |       | 1,380             |       | 1,290                 |       |
| Inventory                                                                                                                             |       | 7,486             |       | 8,354                 |       |
| Prepaid expenses and  other current assets                                                                                            |       | 755               |       | 1,487                 |       |
| Total current assets                                                                                                                  |       | 13,898            |       | 20,390                |       |
|                                                                                                                                  |       |              |       |                  |       |
| Property and equipment,  net                                                                                                          |       | 3,918             |       | 4,380                 |       |
| Intangibles, net                                                                                                                      |       | 1,225             |       | 1,192                 |       |
| Deferred financing fees                                                                                                               |       | 425               |       | 709                   |       |
| Other assets                                                                                                                          |       | 199               |       | 223                   |       |
| Restricted cash                                                                                                                       |       | 1,160             |       | 1,303                 |       |
| Total assets                                                                                                                          |       | $                 | 20,825     |                  | $          | 28,197 |   |
|                                                                                                                                  |       |              |       |                  |       |
| **LIABILITIES  AND STOCKHOLDERS’ DEFICIT**                                                                                       |       |              |       |                  |       |
| Current liabilities:                                                                                                                  |       |              |       |                  |       |
| Accounts payable                                                                                                                      |       | $                 | 1,561      |                  | $          | 2,661 |   |
| Accrued expenses                                                                                                                      |       | 3,697             |       | 4,039                 |       |
| Long term debt, current  portion                                                                                                      |       | 24,885            |       | 71                    |       |
| Total current  liabilities                                                                                                            |       | 30,143            |       | 6,771                 |       |
|                                                                                                                                  |       |              |       |                  |       |
| Long-term debt, net of  current portion                                                                                               |       | 196               |       | 24,921                |       |
| Deferred revenue,  long-term                                                                                                          |       | 20,000            |       | 12,500                |       |
| Deferred rent, net of  current portion                                                                                                |       | 387               |       | 493                   |       |
| Total liabilities                                                                                                                     |       | 50,726            |       | 44,685                |       |
|                                                                                                                                  |       |              |       |                  |       |
| Commitments and  contingencies                                                                                                        |       |              |       |                  |       |
|                                                                                                                                  |       |              |       |                  |       |
| Stockholders’ deficit:                                                                                                           |       |              |       |                  |       |
| Common stock, $.001 par  value, 200,000,000 shares authorized, 17,187,791 and 17,152,465 shares issued  and outstanding, respectively |       | 17                |       | 17                    |       |
| Additional paid-in  capital                                                                                                           |       | 200,804           |       | 199,740               |       |
| Accumulated other  comprehensive loss                                                                                                 |       | (17               | )          | (20                   | )          |
| Accumulated deficit                                                                                                                   |       | (230,705          | )          | (216,225              | )          |
| Total stockholders’  deficit                                                                                                     |       | (29,901           | )          | (16,488               | )          |
| Total liabilities and  stockholders’ deficit                                                                                     |       | $                 | 20,825     |                  | $          | 28,197 |   |

 

*Seeaccompanying notes to these unaudited condensed consolidated financialstatements.*

 

3

----

Table ofContents

 

**Power Medical Interventions, Inc.**

**Condensed Consolidated Statements ofOperations**

**(Amounts in thousands, except shareand per share data)**

** **
| ** **                                                       | ** ** | **For the Three Months** | ** ** | **For the Six Months**  | ** ** |
|------------------------------------------------------------------|------------|--------------------------|------------|-------------------------|------------|
| ** **                                                       | ** ** | **Ended June 30,**  | ** ** | **Ended June 30,** | ** ** |
| ** **                                                       | ** ** | **2009**                 | ** ** | **2008**                | ** ** | **2009** | ** ** | **2008** | ** ** |
| ** **                                                       | ** ** | ** **               | ** ** | ** **              | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Sales**                                                        |       | $                        | 2,261      |                    | $          | 2,159 |   | $ | 5,004 |   | $ | 4,384 |   |
| **Cost  of Sales**                                               |       | 2,030                    |       | 3,018                   |       | 4,191 |   | 5,575 |   |
| ** **                                                       |       | 231                      |       | (859                    | )          | 813 |   | (1,191 | ) |
|                                                             |       |                     |       |                    |       |   |   |   |   |
| **Costs  and expenses**                                          |       |                     |       |                    |       |   |   |   |   |
| Research and  development                                        |       | 811                      |       | 1,508                   |       | 1,615 |   | 3,091 |   |
| Sales and marketing                                              |       | 3,507                    |       | 5,961                   |       | 7,001 |   | 12,758 |   |
| General and  administrative                                      |       | 2,708                    |       | 2,622                   |       | 5,333 |   | 5,635 |   |
|                                                             |       | 7,026                    |       | 10,091                  |       | 13,949 |   | 21,484 |   |
|                                                             |       |                     |       |                    |       |   |   |   |   |
| Operating loss                                                   |       | (6,795                   | )          | (10,950                 | )          | (13,136 | ) | (22,675 | ) |
|                                                             |       |                     |       |                    |       |   |   |   |   |
| **Other  income (expense)**                                      |       |                     |       |                    |       |   |   |   |   |
| Interest and other  income                                       |       | 9                        |       | 90                      |       | 53 |   | 284 |   |
| Interest and other  expense, net                                 |       | (747                     | )          | (651                    | )          | (1,397 | ) | (1,300 | ) |
| **Total  other income (expense)**                                |       | (738                     | )          | (561                    | )          | (1,344 | ) | (1,016 | ) |
|                                                             |       |                     |       |                    |       |   |   |   |   |
| **Net  loss**                                                    |       | $                        | (7,533     | )                       | $          | (11,511 | ) | $ | (14,480 | ) | $ | (23,691 | ) |
|                                                             |       |                     |       |                    |       |   |   |   |   |
| **Net  loss per common stock share:**                            |       |                     |       |                    |       |   |   |   |   |
| - Basic and diluted                                              |       | $                        | (0.44      | )                       | $          | (0.67 | ) | $ | (0.84 | ) | $ | (1.38 | ) |
|                                                             |       |                     |       |                    |       |   |   |   |   |
| **Weighted  average number of common stock shares outstanding:** |       |                     |       |                    |       |   |   |   |   |
| - Basic and diluted                                              |       | 17,180,898               |       | 17,108,716              |       | 17,177,261 |   | 17,108,282 |   |

 

*Seeaccompanying notes to these unaudited condensed consolidated financialstatements.*

 

4

----

Table ofContents

 

**Power Medical Interventions, Inc.**

**Condensed Consolidated Statements ofCash Flows**

**(Amounts in thousands)**

** **
| ** **                                                                  | ** ** | **For the Six Months**  | ** ** |
|-----------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                  | ** ** | **Ended June 30,** | ** ** |
| ** **                                                                  | ** ** | **2009**                | ** ** | **2008** | ** ** |
| ** **                                                                  | ** ** | ** **              | ** ** | ** ** | ** ** |
| **CASH  FLOWS FROM OPERATING ACTIVITIES:**                                  | ** ** | ** **              | ** ** | ** ** | ** ** |
| Net loss                                                                    |       | $                       | (14,480    | ) | $ | (23,691 | ) |
| Adjustments to  reconcile net loss to net cash used in operating activities |       |                    |       |   |   |
| Depreciation and  amortization                                              |       | 995                     |       | 876 |   |
| Amortization of debt  discount and deferred financing fees                  |       | 408                     |       | 408 |   |
| (Gain) loss on disposal  of property and equipment                          |       | (1                      | )          | 22 |   |
| Share-based  compensation                                                   |       | 1,064                   |       | 900 |   |
| Changes in operating  assets and liabilities:                               |       |                    |       |   |   |
| Accounts receivable                                                         |       | (72                     | )          | (43 | ) |
| Inventory                                                                   |       | 925                     |       | (1,798 | ) |
| Prepaid expenses and  other assets                                          |       | 577                     |       | (176 | ) |
| Accounts payable                                                            |       | (1,134                  | )          | (828 | ) |
| Accrued expenses                                                            |       | (113                    | )          | (564 | ) |
| Deferred rent                                                               |       | (106                    | )          | (93 | ) |
| Deferred revenue                                                            |       | 7,500                   |       | — |   |
| Net cash used in  operating activities                                      |       | (4,437                  | )          | (24,987 | ) |
|                                                                        |       |                    |       |   |   |
| **CASH  FLOWS FROM INVESTING ACTIVITIES:**                                  |       |                    |       |   |   |
| Purchases of property  and equipment                                        |       | (414                    | )          | (1,057 | ) |
| Proceeds from sale of  property and equipment                               |       | 4                       |       | — |   |
| Patent application  costs                                                   |       | (153                    | )          | (160 | ) |
| Change in restricted  cash                                                  |       | 1,016                   |       | 1,016 |   |
| Net cash provided by  (used in) investing activities                        |       | 453                     |       | (201 | ) |
| **CASH  FLOWS FROM FINANCING ACTIVITIES:**                                  |       |                    |       |   |   |
| Repayments of long-term  debt                                               |       | (35                     | )          | (34 | ) |
| Net proceeds from  issuance of common stock                                 |       | —                  |       | 72 |   |
| Net cash (used in)  provided by financing activities                        |       | (35                     | )          | 38 |   |
|                                                                        |       |                    |       |   |   |
| Effect of exchange rate  on cash and cash equivalents                       |       | (88                     | )          | 168 |   |
| Net decrease in cash  and equivalents                                       |       | (4,107                  | )          | (24,982 | ) |
| Cash and equivalents,  beginning of period                                  |       | 8,384                   |       | 36,592 |   |
| Cash and equivalents,  end of period                                        |       | $                       | 4,277      |   | $ | 11,610 |   |
|                                                                        |       |                    |       |   |   |
| **SUPPLEMENTAL  DISCLOSURE OF CASH FLOW INFORMATION**                       |       |                    |       |   |   |
| Cash paid for interest                                                      |       | $                       | 879        |   | $ | 889 |   |

 

*Seeaccompanying notes to these unaudited condensed consolidated financialstatements.*

 

5

----

Table of Contents

** **

**Power Medical Interventions, Inc.**

 

**Notes to Unaudited CondensedConsolidated Financial Statements**

 

**June 30, 2009**

 

**1. Business**

 

Power MedicalInterventions, Inc. (the Company), a Delaware corporation, is a medicaldevice company that designs, manufactures and markets a family ofcomputer-assisted, power-actuated endomechanical surgical instruments, referredto as Intelligent Surgical InstrumentsTM. Surgeons use 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.

 

The Company haswholly owned subsidiaries in Germany, Power Medical InterventionsDeutschland GmbH; in France, Power Medical Interventions France; and inJapan, Power Medical Interventions Japan, which conduct sales and marketingoperations.

 

On July 28, 2009, the Companyentered into an Agreement and Plan of Merger (the Merger Agreement) with United States Surgical Corporation, aDelaware corporation (Parent) andwholly owned, indirect subsidiary of Covidien plc, an Irish company, andCovidien Delaware Corp., a Delaware corporation and a wholly owned subsidiaryof Parent (Merger Sub).  Pursuant to the Merger Agreement, and upon theterms and subject to the conditions thereof, on August 10, 2009, Merger Subcommenced a tender offer (the Offer)to purchase all of the outstanding shares of Common Stock, par value $0.001 pershare, of the Company (the Shares),for $2.08 per Share in cash (the OfferPrice).  Unless subsequentlyextended, the Offer will be open for twenty business days and is expected to becompleted at 12:00 midnight at the end of September 4, 2009. The Companycurrently expects the transactions subject to the Merger Agreement (the Merger)to close by September 25, 2009, subject to the success of the Offer and otherclosing conditions.  See Note 9 to thecondensed consolidated financial statements of the Company for furtherdiscussion of the Merger Agreement.

 

Thecondensed consolidated financial statements of the Company have been preparedon a going-concern basis, which contemplates the realization of assets and thesatisfaction of liabilities in the normal course of business. Accordingly, thefinancial statements do not include any adjustments that might be necessaryshould the Company be unable to continue in existence. The Company incurred anet loss of approximately $14.5 million in the six months ended June 30,2009 and net losses of approximately $42.3 million and $36.8 millionfor the years ended December 31, 2008, and 2007, respectively, and has anaccumulated deficit of approximately $230.7 million at June 30, 2009.Losses are expected to continue at least through 2009. The Company believesthat its cash and cash equivalents, together with the Company’s future sales,will be sufficient to meet its cash requirements through September 25,2009, the latest date by which the Merger is expected to close. If the Mergerdoes not close, the Company’s ability to meet its obligations in the normalcourse of business will be dependent on its securing additional externalfinancing, increasing its customer and revenue base, and continuing to controlexpenses. There can be no assurance that if the Merger were not to close, suchadditional external financing will be available in amounts or on termsacceptable to the Company, if at all. These factors raise substantial doubtabout the Company’s ability to continue as a going concern.  On a stand-alone basis, the Company’s futurecash requirements will depend on many factors, including its ability toincrease its sales and improve its gross margins, and the success of its 2008restructuring initiative. The Company implemented this restructuring initiativein the fourth quarter of 2008 to reduce cash used in operations throughheadcount reductions and other spending programs. Examples of such costsinclude certain sales and marketing costs, product development costs, clinicalresearch costs, employee bonuses, and capital expenditures.

 

**2. Summary of Significant Accounting Policies**

 

*Unauditedinterim financial data*

 

Theaccompanying unaudited condensed consolidated financial statements have beenprepared in accordance with accounting principles generally accepted in theUnited States and the requirements of Form 10-Q and Regulation S-X.

 

Theaccompanying condensed consolidated balance sheet as of June 30, 2009, thecondensed consolidated statements of operations for the three and six monthsended June 30, 2009 and 2008, and the condensed consolidated statements ofcash flows for the six months ended June 30, 2009 and 2008 are unaudited.The unaudited interim financial statements have been prepared on the same basisas the annual financial statements and, in the opinion of management, reflectall adjustments, which include only normal recurring adjustments, necessary tostate fairly the Company’s financial position as of June 30, 2009 and theresults of its operations and cash flows for the three and six months ended June 30,2009 and 2008. The financial data and other information disclosed in these 

 

6

----

Table of Contents

 

notes to the financialstatements are unaudited. The results for the three and six months ended June 30,2009 are not necessarily indicative of the results to be expected for anyfuture period.

 

*Revenuerecognition*

 

Most of theCompany’s revenue historically has been derived from the sale ofsingle-patient, disposable loading units and from the sale of reload cartridgesfor reusable Intelligent Surgical Instruments. Revenue related to the sale ofsuch individual products is recognized when persuasive evidence of anarrangement exists, delivery has occurred, the sales price is fixed anddeterminable, and collectibility is reasonable assured, which is generally atthe time of shipment upon delivery to a common carrier.

 

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

 

The Company’sIntelligent Surgical Instrument surgical platform includes cutting and staplingdevices in a variety of sizes and linear, right angle and circularconfigurations designed for differing surgical needs. The Company’s IntelligentSurgical Instruments are available in a reusable multiple-patient format whichcan be autoclaved and used in multiple cases. The Company’s reusableIntelligent Surgical Instruments use disposable cutting and stapling cartridgesin various sizes, which the Company refers to as reload cartridges and digitalloading units.

 

In certain cases,the Company offers its Intelligent Surgical Instruments at no cost in exchangefor higher unit pricing on the sale of reload cartridges over a specifiedperiod of time. In these cases, the Company recognizes the revenue ratably overthe period of delivery of the reload cartridges, as long as such revenue is notcontingent on the delivery of the undelivered products. 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.

 

The Company hasalso made its i60, i45 and iDrive instruments available to customers at no chargeunder an “in service under evaluation” program. The evaluation period hastypically been six months and the Company has derived and continues to deriverecurring revenues from sales of the reload cartridges necessary for theevaluation instruments’ use. At the end of the evaluation period, customershave the option to (i) buy the equipment and continue to receive reloadcartridge pricing consistent with that of the evaluation period, (ii) keepthe equipment and agree to higher sales prices on the reload cartridge than wascharged during the evaluation period or (iii) return the equipment with nofurther obligation.

 

The Company’scustomers generally order product using standard purchase orders and paymentterms are 30 days. The Company provides discounted pricing to itscustomers based on volume and commitment levels. Allowance for product returnsare estimated based on historical experience and provisions are recorded at thetime of shipment. The Company also provides limited warranties to its customersagainst material defects in materials and workmanship. Such warranties aregenerally for a one year period from the date of shipment. Historically,warranty costs have not been material.

 

7

----

Table ofContents

 

The Company’srevenues were derived from customers located in the following geographicregions:

 
| ** **    | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|---------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **    | ** ** | **2009**                             | ** ** | **2008**                           | ** ** | **2009** | ** ** | **2008** | ** ** |
|          |       |                                 |       |                               |       |   |   |   |   |
| North America |       | 76                                   | %          | 82                                 | %          | 72 | % | 83 | % |
| Europe        |       | 9                                    | %          | 11                                 | %          | 12 | % | 12 | % |
| Asia          |       | 15                                   | %          | 7                                  | %          | 16 | % | 5 | % |

 

Amounts billed tocustomers for product shipping and handling are included in sales. Costsincurred related to product shipping and handling are included in cost ofsales.

 

*RevenueRecognition—Arrangement with Intuitive Surgical, Inc.*

 

In September 2008,the Company entered into two agreements with Intuitive Surgical, Inc. Thefirst agreement is a License and Development Agreement (the License and DevelopmentAgreement) under which Intuitive Surgical expects to develop a surgicalstapling device which will attach to Intuitive Surgical’s da VinciTM SurgicalSystems and will utilize the Company’s patented technology. Once developed,this attachment will enable Intuitive Surgical’s da VinciTM Surgical Systems tocut and staple tissue in a broad array of surgical applications. The secondagreement is an exclusive Reload Supply Agreement whereby the Company willmanufacture and will be the exclusive supplier to Intuitive Surgical of staplereloads for the newly developed device at agreed upon prices. The Companyrefers to the License and Development Agreement and the Reload Supply Agreementcollectively as the Intuitive Agreements.

 

Under the terms ofthe Intuitive Agreements, the Company received an upfront license payment of$12.5 million in September 2008. The Company is responsible for providing,at its expense, up to an aggregate of 3,900 man hours of engineering andtechnical support services to Intuitive to assist Intuitive in designing anddeveloping the new device.  In February 2009,the Company received a payment of $2.5 million related to the achievementof a development milestone. In May 2009, Intuitive Surgical elected toexercise its right under the License and Development Agreement to receive anirrevocable license to certain Company intellectual property in exchange for anaccelerated aggregate milestone payment of $5.0 million. The Company receivedthe $5.0 million payment in May 2009. The Company was originally eligible to receive the $5.0 million in theform of milestone payments over the term of the License and Development Agreementif certain agreed upon development milestones were achieved.  The Company’s receipt of this $5.0 millionpayment precludes it from receiving additional milestone payments related tothese development milestones. Since inception of the Intuitive Agreements, theCompany has received a total of $20.0 million in payments from IntuitiveSurgical.

 

The Company hasidentified four deliverables within this arrangement: (i) the license toutilize its patented technology, (ii) consultative services during Intuitive’sdevelopment of the new device, (iii) a six-year supply arrangement tosupply reload cartridges to Intuitive, including a minimum purchase obligationduring the first 18 months subsequent to the first commercial sale of thedevice by Intuitive to a third party and (iv) a significant andincremental discount on the future purchases of reload cartridges. The Companyhas concluded that these deliverables should be accounted for as a single unitof accounting, with recognition of revenue for the single unit of accountingcommencing upon the delivery of the final element in the arrangement(i.e., commencement of delivery of the staple reload cartridgescontemplated by the Reload Supply Agreement). Accordingly, the$20.0 million the Company has received since September 2008 has beendeferred and is reported in the consolidated financial statements as deferredrevenue, long-term as of June 30, 2009.

 

Should the projectreach the first commercial sale, the $20.0 million of up-front andmilestone payments, as well as the guaranteed minimum amount of reload sales,will begin to be recognized as revenues over the term of the Reload SupplyArrangement (i.e., the six-year period following the date of the firstcommercial sale of the device to a third party). Revenues from the sale ofadditional reloads beyond the minimum guaranteed quantity will be recognized assuch reloads are shipped.

 

*Share-basedcompensation*

 

The Company’sshare-based compensation is accounted for in accordance with the fair valuerecognition provisions of Statements of Financial Accounting Standards, orSFAS, No. 123 (revised 2004) *Share-Based Payments*,or SFAS 123(R). In addition, the Company accounts for its share-basedcompensation to non-employees in accordance with EITF 96-18, *Accounting for Equity Investments that are Issued to Other ThanEmployees for Acquiring, or in connection with, Selling Goods or Services,*orEITF 96-18. The Company uses the Black-Scholes option-pricing model to estimatethe fair value its share-based awards as of the date of grant. 

 

8

----

Table of Contents

 

The Black-Scholes model,by its design, is highly complex and dependent upon key data inputs estimatedby management. The primary data inputs with the greatest degree of judgment aregenerally the estimated lives of the share-based awards and the estimatedvolatility of the Company’s common stock price. The Black-Scholes model issensitive to changes to these two data inputs.

 

Beginning infiscal year 2006, the Company calculated the estimated life of stock optionsgranted using a “simplified” method, based upon guidance from the Securitiesand Exchange Commission, or SEC, as contained in Staff Accounting Bulletin, orSAB, No. 107 permitting the initial use of this method through 2007. In December 2007,the SEC issued SAB No. 110, which was effective January 1, 2008,expressing the expectation that companies should be employing information frominternal or external sources about employee stock option exercise behavior whendeveloping estimates of expected term as they relate to stock optionvaluations. SAB No. 110 states that the SEC will continue to accept theuse of the “simplified” method, under certain circumstances, beyond December 31,2007. The Company evaluated the exercise behavior of its employees anddetermined that the exercise history was an inadequate measure of the expectedterm of the Company’s stock options. Therefore, the Company has continued itsuse of the simplified method as prescribed in SAB No. 107. Expected stockprice volatility is typically based on the daily historical trading data froman appropriate point in time through the last day of the applicable period.Because the Company’s historical trading data only dates back to October 26,2007, the first trading date subsequent to our initial public offering, theexpected volatility of its common stock was calculated for each date of grantbased on an alternative method (defined as “calculated value”). The Companyidentified similar public entities for which share price information isavailable and have considered the historical volatility of these entities’share prices in estimating expected volatility.

 

*Netloss attributable to common shares*

 

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

 

Thefollowing summarizes the potential outstanding common stock of the Company asof the end of each period (in thousands):

 
| ** **                                | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                | ** ** | **2009**          | ** ** | **2008**              | ** ** |
| Convertible Notes                         |       | 2,643             |       | 2,643                 |       |
| Common stock warrants                     |       | 854               |       | 959                   |       |
| Common stock options  outstanding         |       | 2,760             |       | 2,456                 |       |
| Common stock options  available for grant |       | 510               |       | 844                   |       |
| Total                                     |       | 6,767             |       | 6,902                 |       |

 

If theoutstanding options, warrants, and convertible notes 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.

 

*Recent Accounting Pronouncements*

 

In May 2009, the FASB issued SFAS No. 165,*Subsequent Events*, or SFAS No. 165,which establishes general standards of accounting for and disclosure of eventsthat occur after the balance sheet date but before financial statements areissued or are available to be issued. This statement sets forth thecircumstances under which an entity should recognize events or transactionsoccurring after the balance sheet date in its financial statements. SFAS 165also requires the disclosure of the date through which an entity has evaluatedsubsequent events and the basis for that date—that is, whether that daterepresents the date the financial statements were issued or were available tobe issued. This statement is effective for interim or annual reportingperiods ending after June 15, 2009. During the second quarter of 2009, theCompany adopted SFAS 165. The adoption of SFAS 165 did not have a significantimpact on the Company’s consolidated financial statements or related footnotes.See Note 9 — Subsequent Events to our consolidated financial statements.

 

In April 2009,the FASB issued FSP FAS 107-1 and APB 28-1, *InterimDisclosures about Fair Value of Financial Instruments*(“FSP 107-1”),which the Company adopted for the second quarter of 2009. FSP 107-1 requires anentity to provide the 

 

9

----

Table of Contents

 

annual disclosuresrequired by FASB Statement No. 107, *Disclosuresabout Fair Value of Financial Instruments*, in its interim financialstatements.  The adoption of FSP 107-1had no material impact on the Company’s consolidated financial statements.

 

The Company adopted SFAS No. 157,*Fair Value Measurements,*or SFAS No. 157,effective January 1, 2008, for financial assets and liabilities.  In addition, effective January 1, 2009,the Company adopted SFAS No. 157 as it relates to nonfinancial assets andliabilities that are not recognized or disclosed at fair value in the financialstatements on at least an annual basis. SFAS No. 157 defines fair value asthe price that would be received to sell an asset or paid to transfer aliability, referred to as the exit price, in an orderly transaction betweenmarket participants at the measurement date. The standard outlines a valuationframework and creates a fair value hierarchy in order to increase theconsistency and comparability of fair value measurements and the related disclosures.In determining fair value of financial assets, the Company primarily usesprices and other relevant information generated by market transactionsinvolving identical or comparable assets, called the market approach. As of June 30,2009 and December 31, 2008, the fair value of all of the Company’sfinancial assets was based on level one observable inputs. The implementationof SFAS No. 157for nonfinancial assets and liabilities did not have an impact on theCompany’s consolidated financial statements as of June 30, 2009. Theprovisions of SFAS No. 157 will be applied at such time a fair valuemeasurement of a nonfinancial asset or liability is required, which may resultin a fair value that is materially different than would have been calculatedprior to the adoption of SFAS No. 157.

 

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

 

In May 2008,the Financial Accounting Standards Board, or FASB, issued Staff Position No. AccountingPrinciples Board 14-1, *or* FSP No. APB 14-1,*Accounting for Convertible Debt InstrumentsThat May Be Settled in Cash upon Conversion (Including Partial CashSettlement)*. FSP No. APB 14-1 requires that the liabilityand equity components of convertible debt instruments that may be settled incash upon conversion (including partial cash settlement) be separatelyaccounted for in a manner that reflects an issuer’s nonconvertible debtborrowing rate. The Company adopted FSP No. APB 14-1 effective January 1,2009. The adoption of APB 14-1 did not have an impact on the Company’sconsolidated financial statements as of and for the three and six months ended June 30,2009.

 

In June 2008,the FASB issued EITF 07-5, *DeterminingWhether an Instrument (or Embedded Feature) Is Indexed to an Entity’s Own Stock*,or EITF 07-5. EITF 07-5 provides guidance in assessing whether anequity-linked financial instrument (or embedded feature) is indexed to anentity’s own stock for purposes of determining whether the appropriateaccounting treatment falls under the scope of SFAS No. 133, *Accounting For Derivative Instruments and Hedging Activities*,or SFAS No. 133, and/or EITF 00-19, *AccountingFor Derivative Financial Instruments Indexed to, and Potentially Settled in, aCompany’s Own Stock*,**or EITF 00-19.EITF 07-5 is effective for financial statements issued for fiscal yearsbeginning after December 15, 2008. The Company adopted EITF 07-5 effectiveJanuary 1, 2009. The fair value of certain of the Company’s outstandingwarrants to which this guidance applies was not material as of June 30,2009. As such, the Company’s adoption of EITF 07-5 did not have a materialimpact on its consolidated financial statements as of and for the three and sixmonths ended June 30, 2009.

 

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

 

In September 2008,the Company entered into two agreements with Intuitive Surgical, Inc. Thefirst agreement is a License and Development Agreement under which IntuitiveSurgical expects to develop a surgical stapling device that will attach toIntuitive Surgical’s da VinciTM Surgical Systems and will utilize the Company’spatented technology. Once developed, this attachment will enable IntuitiveSurgical’s da VinciTM Surgical Systems to cut and staple tissue in a broad arrayof surgical applications. The second agreement is an exclusive Reload SupplyAgreement whereby the Company will manufacture and be the exclusive supplier toIntuitive Surgical of staple reloads for the newly developed device at agreedupon prices.

 

Under the terms ofthe Intuitive Agreements, the Company received an upfront license payment of$12.5 million in September 2008. The Company is responsible forproviding, at its expense, up to an aggregate of 3,900 man hours of engineeringand technical support services to Intuitive to assist Intuitive in designingand developing the new device.  In February 2009,the Company received a payment of $2.5 million related to the achievementof a development milestone. In May 2009, Intuitive Surgical elected toexercise its right under the License and Development Agreement to receive anirrevocable license to certain Company intellectual property in exchange for anaccelerated aggregate milestone payment of $5.0 million. The Company receivedthe $5.0 million payment in May 2009. The Company was originally eligible to receive the $5.0 million in theform of milestone payments over the term of the License and DevelopmentAgreement if certain agreed upon development milestones were achieved.  The Company’s 

 

10

----

Table of Contents

 

receipt of this $5.0million payment precludes it from receiving additional milestone paymentsrelated to these development milestones.

 

See Note 2 to the condensedconsolidated financial statements for a description of the Company’s revenuerecognition treatment of consideration it has received under the IntuitiveAgreements.

 

**4.  Long-TermDebt**

 

During March 2007, the Company sold $25.0 millionof 7% Convertible Senior Secured Notes, or Convertible Notes, which generatednet proceeds to the Company of $23.3 million (net of financing fees). Of thisamount, $3.5 million was placed in escrow to fund the first four interestpayments on the Convertible Notes. The Convertible Notes accrue interestinitially at the rate of 7% per annum, payable semiannually in arrears, andwere subject to an increase to 8.5% per annum in the event that a qualifiedinitial public offering, or a Convertible Note Qualified IPO, did not occur by December 31,2007. The contingent adjustable interest feature in the Convertible Notes is aderivative requiring bifurcation under SFAS No. 133. The value of thederivative was not deemed material during 2007 and the Company completed itsinitial public offering in October 2007, which met the requirements of aConvertible Note Qualified IPO. Interest that accrued on or before March 31,2009 was payable in cash, while interest accruing after March 31, 2009 ispayable, at the Company’s option, in cash or paid-in-kind in the form ofadditional notes, or the PIK Notes. The principal amounts of any such PIK Noteswould have the same maturity as the Convertible Notes. Should the Company electto pay interest on the Convertible Notes in PIK Notes, the interest rate onsuch PIK Notes shall be equal to the then applicable interest rate plus 1.5%.As of June 30, 2009 the Company had not yet determined whether it willexercise its option to make its next interest payment to the holders of theConvertible Notes in cash or in the form of PIK Notes. However, during thethree months ended June 30, 2009, the Company accrued interest on theConvertible Notes at a rate of 8.5%, the interest rate that would be in effectif the Company elected to pay interest in the form of PIK Notes. Accruedinterest of approximately $531 thousand and $438 thousand is recorded in theCompany’s consolidated balance sheets as accrued expenses as of June 30,2009 and December 31, 2008, respectively.

 

TheConvertible Notes also require the payment of a terminal value that (i) willbe due upon redemption or conversion of the Convertible Notes, (ii) willbe considered 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 each case, the terminal value payment which, asamended, is defined to equal 7% per annum of the applicable principal from theclosing date of the Convertible Notes in March 2007 to October 31,2007, the date of the Company’s initial public offering). This amount totalsapproximately $1.0 million. 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. The accrued terminal value of approximately$1.0 million is included in accrued expenses in the accompanying balancesheets at June 30, 2009 and December 31, 2008.

 

TheConvertible Notes were not convertible until the occurrence of a conversionevent, which is defined as a Convertible Note Qualified IPO described above ora qualified sale of the Company. The Company’s initial public offeringconstituted a Convertible Note Qualified IPO. Upon the occurrence of theCompany’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 from thedate of the conversion event through the maturity date of the notes. Inaddition, upon the occurrence of the Convertible Note Qualified IPO, whichconstituted a conversion event, the Convertible Notes became unsecured byassets of the Company and subordinated to all existing and future indebtednessof the Company.

 

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

 

i)  Upon a stock dividend, stock distribution, stocksplit, reverse stock split or recapitalization, the conversion price shall beadjusted so that the holder of the Convertible Notes will be entitled toreceive the number of shares of common stock that they would have owned if theyhad converted the note immediately prior to such event.

 

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

 

11

----

Table of Contents

 

immediately prior to suchadjustment plus the number of additional shares of common stock offered (orinto which the securities so offered are convertible, exchangeable orexercisable).

 

iii)  Upon a distribution to all or substantially allholders of common stock any shares of capital stock of the Company (other thancommon stock), evidence of indebtedness or other non-cash assets, theconversion price shall be adjusted so that the conversion price would bereduced to a price equal to the conversion price currently in effect multipliedby a fraction, the numerator of which is equal to the current market price pershare of the common stock on the record date of the distribution, less the fairmarket value per share on such record date of the capital stock, evidence ofindebtedness or other non-cash assets distributed, and the denominator of whichshall be the current market price per share of common stock on such recorddate.

 

iv)  Upon a cash distribution to all or substantially allholders of common stock, the conversion price shall be decreased so that theconversion price would equal the conversion price in effect multiplied by afraction, the numerator of which is equal to the current market price per shareof the common stock on the date of the distribution less the per share amountof the distribution, and the denominator of which is the current market priceper share of common stock on the date of the distribution.

 

v)   Upon the purchase of any shares by theCompany or any of its subsidiaries by means of a tender offer, the conversionprice shall be decreased so that the conversion price would equal theconversion price in effect immediately prior to the close of the tender offer,multiplied a fraction, the numerator of which is the product of the number ofshares of common stock outstanding immediately prior to the closing of thetender offer multiplied by the current market price per share of the commonstock, and the denominator of which shall be the sum of the aggregateconsideration payable to the stockholders based on the acceptance of the tenderoffer and the product of the number of shares of common stock outstandingimmediately prior to the close of the tender offer and the current market priceper share of common stock.

 

Beginning on the date that is 180 days followingthe closing of a Convertible Note Qualified IPO, the Company may, at itsoption, redeem the Convertible Notes in whole at any time or in part from timeto time, upon 15 days prior written notice to the holder, at a redemptionprice payable in cash, equal to the principal amount plus any interest(including the terminal value) accrued and unpaid, subject to the satisfactionof 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 ofthe high and low sale price of the common stock, as reported on the principalsecurities exchange on which the common stock is listed, on each of any 20trading days during any period of 30 consecutive trading days ending within45 days prior to the Redemption Date (so long as, during the entire 30trading day period, the aforementioned registration statement has beeneffective and there has been no suspension of trading of the common stock),having been equal to or greater than 140% of the initial public offering pricein the Convertible Notes Qualified IPO (in each case, with prices adjusted forstock splits, reverse splits, stock dividends, share combination and otherantidilution events); and

 

(c) no more than$12,500,000 of outstanding Convertible Notes may be redeemed pursuant to thisprovision in any period of 30 consecutive trading days; and

 

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

 

In accounting for theConvertible Notes, the Company did not elect the fair value option for anyfinancial assets or liabilities as permissible under the provisions of SFAS No. 159.However, as of June 30, 2009 the fair value of the $25.0 million ofConvertible Notes, which are due in March 2010 and are no longer securedby the assets of the Company, is significantly lower than the carrying amountdue to the Company’s current liquidity issues. See Note 9 to the condensedconsolidated financial statements for disclosure regarding the Company’s recentannouncement of the Merger Agreement. If the Merger is completed in September 2009as currently anticipated, the fair value of the Convertible Notes would be positivelyimpacted.

 

**5.  Inventory**

 

Inventoryis stated at the lower of cost or market value, with cost being determined on afirst-in, first-out (FIFO) basis and market value based on the lower ofreplacement cost, or the estimated net realizable value, reduced by anallowance for normal profit margin.  Inventory consists of the following(in thousands):

 

12

----

Table of Contents

 
| ** **      | ** ** | **As of**              | ** ** | **As of**                  | ** ** |
|-----------------|------------|------------------------|------------|----------------------------|------------|
| ** **      | ** ** | **June 30, 2009** | ** ** | **December 31, 2008** | ** ** |
| Raw Materials   |       | $                      | 3,796      |                       | $          | 4,478 |   |
| Work in process |       | 799                    |       | 463                        |       |
| Finished goods  |       | 2,891                  |       | 3,413                      |       |
|            |       | $                      | 7,486      |                       | $          | 8,354 |   |

 

Duringthe three months ended June 30, 2009 and 2008, the Company recordedinventory obsolescence charges in the amount of approximately $195 thousand and$200 thousand, respectively.  During thesix months ended June 30, 2009 and 2008, the Company recorded inventoryobsolescence charges totaling $374 thousand and $501 thousand, respectively.

 

**6. Comprehensive Loss**

 

The Company’s comprehensive loss was as follows (inthousands):

 
| ** **                               | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                               | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                               | ** ** | **2009**                         | ** ** | **2008**                       | ** ** | **2009** | ** ** | **2008** | ** ** |
| ** **                               | ** ** | ** **                       | ** ** | ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net loss                                 |       | (7,533                           | )          | (11,511                        | )          | (14,480 | ) | (23,691 | ) |
| Foreign currency  translation adjustment |       | 51                               |       | 354                            |       | 3 |   | 400 |   |
| Comprehensive loss                       |       | (7,482                           | )          | (11,157                        | )          | (14,477 | ) | (23,291 | ) |

 

**7. Contingencies**

 

The Company has,on occasion, been named as a defendant in lawsuits alleging product failure,patent infringement, and breach of contract. These cases are routinely handledby external counsel. Based on the advice of counsel, management has providedreserves for the estimated potential losses, when such losses are deemedprobable and estimable. The Company currently has a patent infringement caseoutstanding. The Company received a favorable ruling from the German courts ontwo of the patent infringement claims and an unfavorable ruling on one of theclaims. However, the Company is in the process of appealing the ruling. TheCompany intends to defend this claim vigorously and has concluded it is tooearly to determine whether or not the Company will incur any loss under thisclaim. As such, no amounts are accrued in the accompanying consolidated balancesheets related to this claim.

 

The Company alsohas a product liability case outstanding which is currently suspended and theCompany has continued to contest the claim. The Company has accrued $100,000related to this matter which represents its best estimate of the potentialliability related to this claim.

 

In August 2008, the Company’s former Belgiandistributor, Duo-Med, S.A., initiated a breach of contract action againstthe Company in the Commercial Court of Brussels in Belgium. The complaintalleges that the Company breached its distribution agreement with Duo-Med byfailing to provide proper notice when the Company terminated that agreement in May 2007and that, as the result of problems with the Company’s products, Duo-Med wasunable to sell its existing inventory. The complaint asserts damages totalingapproximately €460,000. The Company believes that the allegations in thismatter are without merit and intends to vigorously defend against them. TheCompany has not accrued any amount in its financial statements as of June 30,2009 for this matter.

 

The Merger Agreementcontains customary termination provisions for the Company and Parent andprovides that, in connection with the termination of the Merger Agreement underspecified circumstances involving competing transactions or a change in therecommendation of the Company’s Board of Directors or certain breaches of theMerger Agreement, the Company may be required to pay Parent a termination feeof approximately $2.3 million.

 

**8. Share-based Compensation**

 

The fair value ofthe Company’s equity awards were estimated at the date of grant using theBlack-Scholes option-pricing model with the following range of assumptions:

 

13

----

Table of Contents

 
| ** **              | ** ** | **2009**  | ** ** | **2008**  | ** ** |
|-------------------------|------------|-----------|------------|-----------|------------|
| Dividend yield          |       | 0         | %          | 0         | %          |
| Expected volatility     |       | 61-62     | %          | 50        | %          |
| Risk-free interest rate |       | 1.64-3.24 | %          | 3.13-3.45 | %          |
| Expected life (years)   |       | 5.50      |       | 7.00      |       |

 

Compensationexpense under SFAS No. 123(R) and EITF 96-18 for the three andsix months ended June 30, 2009 and 2008 was recorded in the accompanyingcondensed consolidated financial statements as follows (in thousands):

 
| ** **                              | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|-----------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                              | ** ** | **2009**                             | ** ** | **2008**                           | ** ** | **2009** | ** ** | **2008** | ** ** |
| Cost of sales                           |       | $                                    | 14         |                               | $          | 12 |   | $ | 28 |   | $ | 22 |   |
| Research and  development               |       | 55                                   |       | 49                                 |       | 111 |   | 96 |   |
| Sales and marketing                     |       | 119                                  |       | 62                                 |       | 224 |   | 128 |   |
| General and  administrative             |       | 351                                  |       | 335                                |       | 701 |   | 654 |   |
| Total share-based  compensation expense |       | $                                    | 539        |                               | $          | 458 |   | $ | 1,064 |   | $ | 900 |   |

 

As of June 30,2009, there was approximately $4.8 million of unrecognized compensation costs,net of estimated forfeitures, related to stock option grants which are expectedto be recognized over a weighted average period of 1.8 years. There wereno cash proceeds from option exercises during the three and six months ended June 30,2009.

 

**9. Subsequent Events**

 

OnJuly 28, 2009, the Companyentered into the Merger Agreementwith Parent and MergerSub.  Pursuant to the Merger Agreement, and upon the terms and subject tothe conditions thereof, on August 10, 2009, Merger Sub commenced the Offer to purchase all of theoutstanding Shares for $2.08 per Share in cash (the Offer Price).  Unlesssubsequently extended, the Offer will be open for twenty business days and isexpected to be completed at 12:00 midnight at the end of September 4,2009.  The Company currently expects theMerger to close by September 25, 2009, subject to the success of the Offerand other closing conditions.

 

Pursuantto the Merger Agreement, after the consummation of the Offer, and subject tothe satisfaction or waiver of certain conditions set forth in the MergerAgreement, Merger Sub will merge with and into the Company (the Merger), with the Company survivingas a wholly-owned subsidiary of Parent.  Upon completion of the Merger,each Share outstanding immediately prior to the effective time of the Merger(excluding those Shares that are held by Parent, Merger Sub and the Company)will be cancelled and converted into the right to receive the Offer Price incash (without interest and subject to applicable withholding taxes). If MergerSub holds 90% or more of the outstanding Shares immediately prior to the Merger,it may effect a “short-form” merger under the Delaware General Corporation Law,without additional approval by the Company’s stockholders. Otherwise, theCompany may hold a special stockholders’ meeting to obtain stockholders’approval of the Merger.

 

Subjectto the terms and conditions of the Merger Agreement, the Company has grantedMerger Sub an irrevocable one-time option (the Top-Up Option) to purchase an aggregate number of newly issuedShares that, when added to the number of Shares owned by Parent and Merger Subat the time of such exercise, constitutes one Share more than 90% of the Sharesthen outstanding, subject to there being authorized Shares available forissuance. The Top-Up Option is exercisable only after Shares have been acceptedfor payment pursuant to the Offer. Merger Sub will pay the Offer Price for each Share acquired uponexercise of the Top-Up Option.

 

Completionof the Offer is subject to customary conditions, including (i) that there shallhave been validly tendered and not validly withdrawn prior to the expiration ofthe Offer, when added to the number of Shares directly or indirectly owned byParent or Merger Sub, a majority of the Shares then outstanding (determined ona “fully diluted basis” as defined in the Merger Agreement), (ii) subjectto certain exceptions, the accuracy of the representations and warranties inthe Merger Agreement and (iii) the absence of any material adverse effecton the Company.

 

The Merger Agreement contains representations, warranties and covenantsof the parties customary for transactions of this type.  Subject to certain limited exceptions in theMerger Agreement, the Company has also agreed not to solicit or initiatediscussions with third parties regarding other proposals to acquire the Companyand it has agreed to certain restrictions on its ability to respond to suchproposals, subject to the fulfillment of certain fiduciary requirements of theCompany’s Board of Directors. The Merger Agreement also contains customarytermination provisions for the Company and Parent and provides that, inconnection with the termination of the Merger Agreement under specifiedcircumstances involving competing transactions or a change in therecommendation of the Company’s Board of Directors or certain breaches of theMerger Agreement, the Company may be required to pay Parent a termination feeof approximately $2.3 million.

 

14

----

Table of Contents

 

The Merger Agreement provides that allunexercised options issued under each of the Company’s 1999 Stock Option Plan,2000 Stock Option Plan, 2004 Stock Incentive Plan and 2007 Equity IncentivePlan shall be cancelled immediately prior to the Merger and be of no furtherforce or effect.  Holders of options forwhich the Offer Price exceeds the exercise price of such options shall be paidan amount equal to the difference between the Offer Price and the exercise pricefor each such option. The Company has agreed to seek to terminate itsoutstanding warrants prior to the closing of the Merger. Each warrant that isnot terminated prior to the closing of the Merger shall become a warrant toacquire the merger consideration which the warrant holder would have beenentitled to receive had such holder exercised such warrant prior to suchclosing.  All outstanding convertiblenotes shall be amended to provide such notes shall be convertible into theportion of the merger consideration receivable by a holder of that number ofShares into which the holder would have received had such holder converted suchnotes prior to the closing of the Merger. Following the completion of the Offerand in accordance with the terms of the notes, Merger Sub shall make an offerto purchase such notes at a price equal to the outstanding principal amount (including anyapplicable “termination value” (as defined in the notes) plus accrued andunpaid interest (including any “additional payment amounts” (as defined in thenotes), if any).

 

In connection with the Offer, Parent, Merger Sub andeach of the Company’s directors and executive officers entered into Tender andVoting Agreements (each, a Tender and Voting Agreement). The outstanding Sharessubject to the Tender and Voting Agreements represent approximately 13% of thetotal outstanding Shares. Pursuant to each Tender and Voting Agreement, theapplicable director or executive officer has agreed, among other things,subject to the termination of such Tender and Voting Agreement (i) to tenderin the Offer (and not to withdraw) all Shares beneficially owned orsubsequently acquired by them, (ii) to vote such Shares in support of theMerger in the event stockholder approval is required to consummate the Merger, (iii) toappoint Parent as his, her or its proxy to vote such shares in connection withthe Merger Agreement and (iv) not to otherwise transfer any of his, her orits Shares. Each Tender and Voting Agreement will terminate upon thetermination of the Merger Agreement.

 

TheCompany evaluated subsequent events through August 11, 2009, the date onwhich the financial statements were issued.

 

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

 

*You should read the following discussion in conjunction withour consolidated financial statements and notes thereto appearing elsewhere inthis report. In addition to historical consolidated financial information, thefollowing discussion and analysis contains forward-looking statements thatinvolve risks, uncertainties and assumptions. Our actual results could differmaterially from those anticipated by these forward-looking statements as aresult of many factors, including those discussed under “Risk Factors” andelsewhere in this report.*

 

**Overview**

 

We design,manufacture and market a family of computer-assisted, power-actuatedendomechanical surgical instruments, which we refer to as Intelligent SurgicalInstrumentsTM. Surgeons use our Intelligent Surgical Instruments for cutting,stapling and tissue manipulation in a variety of procedures in open surgery,minimally invasive surgery, or MIS, and in the emerging field of naturalorifice translumenal endoscopic surgery, or NOTES. We believe that, compared toconventional endomechanical devices, our Intelligent Surgical Instruments offergreater precision and consistency, superior compressive force, improved accessto anatomical sites and enhanced ease of use. To our knowledge, we are the onlycompany to apply digital technology to the field of endomechanical surgicalinstruments. Endomechanical devices are used in millions of surgical procedureseach year to cut tissue, close wounds and reconnect tubular anatomicalstructures. We believe that conventional, manually operated endomechanicaldevices have inherent shortcomings that can limit their efficacy and adverselyaffect clinical outcomes. We founded our company to address these shortcomingsand to improve surgical outcomes by introducing the next generation ofendomechanical instruments, designed specifically for the rapidly evolvingfield of minimally invasive surgery.

 

**OurMerger Agreement with Covidien**

 

OnJuly 28, 2009, we entered into the MergerAgreement with Parentand Merger Sub.  Pursuant to the Merger Agreement, and upon the terms andsubject to the conditions thereof, on August 10, 2009, Merger Sub commenced theOffer to purchase all of theoutstanding Shares for $2.08 per Share in cash (the Offer Price).  Unlesssubsequently extended, the Offer will be open for twenty business days and isexpected to be completed at 12:00 midnight at the end of September 4, 2009.  We filed with the SEC asolicitation/recommendation statement on Schedule 14D-9 on August 10,2009.  We currently expect the Merger toclose by September 25, 2009, subject to the success of the Offer and otherclosing conditions.

 

Pursuantto the Merger Agreement, after the consummation of the Offer, and subject tothe satisfaction or waiver of certain conditions set forth in the MergerAgreement, Merger Sub will merge with and into us, and we will survive as awholly-owned subsidiary of Parent.  Upon completion of the Merger, eachShare outstanding immediately prior to the effective time of the Merger(excluding those Shares that are held by Parent, Merger Sub and us) will becancelled and converted into the right to receive the Offer Price in cash(without interest and subject to applicable withholding taxes). If Merger Sub 

 

15

----

Table of Contents

 

holds90% or more of the outstanding Shares immediately prior to the Merger, it mayeffect a “short-form” merger under the Delaware General Corporation Law,without additional approval by our stockholders. Otherwise, we may hold aspecial stockholders’ meeting to obtain stockholders’ approval of the Merger.

 

Subjectto the terms and conditions of the Merger Agreement, we have granted Merger Suban irrevocable one-time option (the Top-UpOption) to purchase an aggregate number of newly issued Shares that,when added to the number of Shares owned by Parent and Merger Sub at the timeof such exercise, constitutes one Share more than 90% of the Shares thenoutstanding, subject to there being authorized Shares available for issuance. TheTop-Up Option is exercisable only after Shares have been accepted for paymentpursuant to the Offer.  Merger Sub willpay the Offer Price for each Share acquired upon exercise of the Top-Up Option.

 

Completionof the Offer is subject to customary conditions, including (i) that there shallhave been validly tendered and not validly withdrawn prior to the expiration ofthe Offer, when added to the number of Shares directly or indirectly owned byParent or Merger Sub, a majority of the Shares then outstanding (determined ona “fully diluted basis” as defined in the Merger Agreement), (ii) subjectto certain exceptions, the accuracy of the representations and warranties inthe Merger Agreement and (iii) the absence of any material adverse effecton us.

 

The Merger Agreement contains representations, warranties and covenantsof the parties customary for transactions of this type.  Subject to certain limited exceptions in theMerger Agreement, we have also agreed not to solicit or initiate discussionswith third parties regarding other proposals to acquire us and we have agreedto certain restrictions on our ability to respond to such proposals, subject tothe fulfillment of certain fiduciary requirements of our Board of Directors.The Merger Agreement also contains customary termination provisions for us andParent and provides that, in connection with the termination of the MergerAgreement under specified circumstances involving competing transactions or achange in the recommendation of our Board of Directors or certain breaches ofthe Merger Agreement, we may be required to pay Parent a termination fee ofapproximately $2.3 million.

 

The Merger Agreement provides that allunexercised options issued under each of our 1999 Stock Option Plan, 2000 StockOption Plan, 2004 Stock Incentive Plan and 2007 Equity Incentive Plan shall becancelled immediately prior to the Merger and be of no further force oreffect.  Holders of options for which theOffer Price exceeds the exercise price of such options shall be paid an amountequal to the difference between the Offer Price and the exercise price for eachsuch option. We have agreed to seek to terminate our outstanding warrants priorto the closing of the Merger. Each warrant that is not terminated prior to theclosing of the Merger shall become a warrant to acquire the mergerconsideration which the warrant holder would have been entitled to receive hadsuch holder exercised such warrant prior to such closing.  All outstanding convertible notes shall beamended to provide such notes shall be convertible into the portion of themerger consideration receivable by a holder of that number of Shares into whichthe holder would have received had such holder converted such notes prior tothe closing of the Merger. Following the completion of the Offer and inaccordance with the terms of the notes, Merger Sub shall make an offer topurchase such notes at a price equal to the outstanding principal amount (including anyapplicable “termination value” (as defined in the notes) plus accrued andunpaid interest (including any “additional payment amounts” (as defined in thenotes), if any).

 

We have made customary representations, warranties and covenants in theMerger Agreement.  Consummation of theMerger is subject to customary conditions, including success of the Offer andthe absence of any law or order prohibiting the consummation of the Merger.

 

**Our Future as a Stand-Alone Company**

 

As of June 30,2009, we had cash and cash equivalents of approximately $4.3 million.  In addition, as of June 30, 2009, we hadtotal liabilities of $50.7 million, including $25.0 million ofConvertible Notes due to be paid in March 2010. Our operations to datehave required significant cash expenditures. We have incurred net losses ineach year since our inception and have an accumulated deficit at June 30,2009 of approximately $230.7 million.  Webelieve that our current cash and cash equivalents, together with our expectednear-term future sales, will be sufficient to meet our anticipated cashrequirements through September 25, 2009, the latest date by which theMerger is expected to close.

 

If we do notconsummate the Merger and we remain an independent company, in order tocontinue our operations we will need to raise additional capital from one or acombination of approaches. We may raise additional funds through license anddevelopment agreements with corporate partners or public and private offeringsof securities, including debt or equity financings. Given the recent andcontinued turmoil in the capital markets, there are a number of risks anduncertainties related to our attempts to complete a financing or strategicpartnering arrangement that are outside our control. There can be no assurancethat such financing will be available in amounts or on terms acceptable to us,if at all. In addition, we may enter into arrangements to extend the maturity 

 

16

----

Table of Contents

 

of, purchase, redeem,replace or otherwise modify the terms of the Convertible Notes, and any sucharrangements may require us to expend additional cash. These conditions raisesubstantial doubt about our ability to continue as a going concern. Ourindependent registered public accounting firm has modified its audit report onour consolidated financial statements to include an explanatory paragraphregarding this contingency.

 

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

 

If we do notconsummate the Merger and we remain an independent company and are unable toraise additional funds when needed, we will need to:

 

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

 

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

 

·                  attempt to sell our company;

 

·                  cease operations; or

 

·                  declare bankruptcy.

 

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

 

**OurBusiness**

 

Ourfirst Intelligent Surgical Instruments were introduced during the fourthquarter of 2007. We introduced the i60 linear cutter and our iDriveC hand-heldpower and control unit. The i60 offers precise control and powerful, consistentcutting and stapling action. The iDriveC and iDriveS power and control oursuite of linear cutter, right-angle linear cutter, and circular staplerinstruments. We also launched the i45 articulating 45mm linear stapler, and thei45V—an articulating linear stapler for vascular applications, in the thirdquarter of 2008. During the first quarter of 2009, we announced that wereceived FDA 510(k) marketing clearance for our patented i60R IntelligentSurgical Instrument. The i60R Intelligent Surgical Instrument is the world’sfirst reverse pivot linear cutter, designed to improve medical outcomes byproviding surgeons with greater access to important anatomical sites that arecurrently difficult to reach. This unique instrument will be used to addresssurgical procedures performed throughout the digestive tract. During the secondquarter of 2009, we received FDA 510(k) marketing clearance for our iDriveIntelligent Power UnitTM, detachable Intelligent Surgical Instruments andiConsoleTM. A first-of-its-kind breakthrough inoperating room instrumentation, the iDrive is designed to support a variety ofminimally invasive procedures by offering surgeons a broad range of cutting andstapling configurations combined with increased flexibility, access andprecision. The iDrive is a novel hand-held, computer-controlled power unit towhich any of the company’s Intelligent Surgical Instruments can be attached.This innovation allows all of PMI’s Intelligent Surgical Instruments to bedriven by a single power unit. As a result, hospitals may be able to acquirePMI’s advanced technology platform at less than half of the current cost, whichmay lead to significant savings for hospitals. The potential now exists for acomprehensive surgical solution that may be significantly less expensive thanmanual surgical stapling devices. In addition, the iDrive is reusable, easy touse, cost effective, and less wasteful, potentially leading to savings forhospitals and health networks.

 

We currently focusour marketing and sales efforts on selected surgical procedures in minimallyinvasive colorectal, bariatric and thoracic surgery. We target those proceduresin which we believe the limitations of existing cutting and stapling technologyare most acute, where the number of procedures performed is growing rapidly andwhere clinicians have readily recognized the benefits of our IntelligentSurgical Instruments. We intend to promote the use of our Intelligent SurgicalInstruments in other surgical specialties. In the future, as surgicaltechniques continue to evolve beyond current MIS procedures to even lessinvasive techniques such as natural orifice translumenal endoscopic surgery, orNOTES, we believe our instruments may become a key enabling technology.

 

17

----

Table of Contents

 

In May 2009,we announced that we received notification from the NASDAQ ListingQualifications Panel, or the Panel, stating that the Panel has determined todelist the Shares from The NASDAQ Capital Market, effective with the open ofbusiness on May 22, 2009. The determination followed our announcement in March 2009that the Panel had granted our request for conditional listing, through May 20,2009, to satisfy the $2.5 million stockholders’ equity requirement forcontinued listing on The NASDAQ Capital Market.  The delisting was theresult of our non-compliance with the minimum stockholders’ equity requirementas of May 20, 2009. Effective with the open of business on May 22,2009, the Shares began trading on the Over-the-Counter Bulletin Board, or theOTCBB, an electronic quotation service maintained by the Financial IndustryRegulatory Authority, or the FINRA.  Our trading symbol will remain PMII,however for certain quote publication websites, investors may be required tokey PMII.OB to obtain quotes. The liquidity, trading market and price of ourcommon stock may be adversely affected by our listing on the OTCBB.

 

**FinancialOperations Overview**

 

The following is a description of the principalcomponents of our sales and expenses and of significant trends and challengesthat we believe are important to an understanding of our business and resultsof operations.

 

*Sales.* Our first generation SurgASSIST surgical platform includes cutting andstapling devices in a variety of sizes and linear, right angle and circularconfigurations designed for differing surgical needs. In the originalconfiguration of our system, our Intelligent Surgical Instruments wereconnected through a flexible shaft, or FlexShaft, to a power console. Our nextgeneration products, beginning with the i60 linear stapler that we introducedin the fourth quarter of 2007, are self-contained hand-held instruments that donot require a FlexShaft or separate power console. In December 2007, wealso introduced our self-contained, wireless handheld iDrive system, which canbe used to power and control our linear, right angle and circular staplers,without the need for a separate FlexShaft or power console. Further, in thethird quarter of 2008, we introduced our i45 reusable, autoclavable linearstapler and reload cartridge.

 

Our IntelligentSurgical Instruments are available as disposable, single-patient devices aswell as in a reusable multiple-patient format, using disposable cutting andstapling cartridges in various sizes, which we refer to as reload cartridgesand digital loading units.

 

Our revenue isderived from the sale of our single-patient, disposable Intelligent SurgicalInstruments and from the sale of reload cartridges for our reusable IntelligentSurgical Instruments. We expect that as our installed base of reusable,multiple-patient Intelligent Surgical Instruments grows, sales of reloadcartridges will become the largest component of our total sales.

 

We have made ouri60, i45 and iDrive instruments available to customers at no charge under an “inservice under evaluation” program. The evaluation period is typically sixmonths and we have derived recurring revenues from sales of the reloadcartridges necessary for their use. At the end of the evaluation period,customers have the option to (i) buy the equipment and continue to receivereload cartridge pricing consistent with that of the evaluation period, (ii) keepthe equipment and agree to higher sales prices on the reload cartridge than wascharged during the evaluation period or (iii) return the equipment with nofurther obligation.

 

Our future successwill depend on our ability to achieve and sustain significant growth in oursales. In the immediate term, our ability to grow our revenues will depend onmany factors, including:

 

·                  increased usage of our installed base of multiple-use IntelligentSurgical Instruments, resulting in recurring purchases of our reloadcartridges;

 

·                  continued growth in market acceptance of our Intelligent SurgicalInstruments;

 

·                  continued improvements in our supply chain and manufacturing operationsto assure the quality and adequate supply of our products; and

 

·                  successful commercialization by Intuitive of the device being developedunder the License and Development Agreement, enabling us to realize thebenefits of the Supply Agreement whereby we will manufacture and be theexclusive supplier to Intuitive of staple reloads for the device.

 

*Costof sales.*  Cost of sales includes the cost of rawmaterials and components that we purchase from third parties and use in theassembly and manufacturing of our products. Cost of sales also includespersonnel costs and overhead related to our assembly and test operations,related occupancy, equipment depreciation, shipping costs and charges for inventoryobsolescence.

 

Our future successwill depend on our ability to make significant improvements in our cost ofsales as a percentage of sales, or gross margins. In prior years, weexperienced high cost of sales, which were attributable to a number of factors,including product 

 

18

----

Table of Contents

 

defects that haverequired rework by us and by our suppliers, a labor-intensive manual assemblyprocess that has resulted in high labor costs, and excess manufacturingcapacity in relation to our sales, which has resulted in inefficient absorptionof manufacturing overhead. In 2008, we began to integrate our manufacturingoperations by acquiring the automated equipment necessary to enable us toassemble the reload cartridges used in our multiple-use linear staplers. Thissystem has had, and is expected to continue to have, a positive effect on ourability to better control the quality, cost and supply of our products and tomore rapidly develop, prototype and commercialize new products.

 

Charges associatedwith write-offs of excess and obsolete inventory have also contributed to ourhigh cost of sales. During the three months ended June 30, 2009 and 2008,we recorded inventory obsolescence charges of approximately $195 thousand and$200 thousand, respectively. During the six months ended June 30, 2009 and2008, we recorded inventory obsolescence charges of approximately $374 thousandand $501 thousand, respectively.  Ourproduct development plans sometimes include introductions of new products thatoverlap functionally with existing products, while offering new or improvedcapabilities. We anticipate that in some cases, this may lead to a reduction indemand for, or discontinuation of, an existing product. In these circumstanceswe must carefully manage our finished goods inventory so that we havequantities of the existing product that are sufficient to meet customer demandpending introduction of the new product, but that do not leave us holdingexcess or obsolete inventory when a new product supplants the existing one.

 

In order tofacilitate market acceptance of our first generation Intelligent SurgicalInstruments, in certain circumstances, we made the power consoles and certainrelated accessories necessary for the use of our instruments available toinstitutions at no charge. We included deprecation expense in cost of sales forpower consoles and related accessories loaned to customers for their use at nocharge. In addition, we have made our i60, i45 and iDrive products available toour customers at no cost under our “in service under evaluation” program. Thecost for these instruments is amortized to cost of sales over the evaluationperiod, which is generally six months.

 

In order toachieve and sustain profitability, we will need to continue to improve ourprocurement and manufacturing processes, upgrade our management informationsystems, and implement new quality assurance, inventory and cost controls inorder to further reduce the cost of the components we purchase from third partyvendors and improve the efficiency of our manufacturing operations.

 

*Researchand development expenses.*  Research and developmentexpenses consist primarily of salaries and related expenses and overhead forour research, development and engineering personnel, prototype materials andresearch studies.  In October 2008,as part of a cost-reducing restructuring initiative, we reduced our headcountin this area and our research and development efforts have been redeployed witha focus on fulfilling our obligations under our agreements with Intuitive. Weexpense our research and development costs as incurred.

 

*Salesand marketing expenses.*  Sales and marketing expensesconsist primarily of salaries and related expenses, sales commissions andoverhead for personnel performing sales and marketing functions. Othersignificant sales and marketing expenses include travel and entertainmentexpense, costs of attending medical conferences and trade shows, cliniciantraining and other promotional costs and costs of demonstration systems andsamples.

 

Our sales andmarketing expenses have substantially exceeded our sales in each year since2004, as we have invested in building the sales and marketing organization andadministrative infrastructure necessary to support our planned sales growth.During 2008, we took steps, including the implementation of a restructuringplan in October 2008, to reduce our future sales and marketing expensesthrough a reduction in the number of our direct sales personnel, and as aresult we do not expect these expenses to grow in 2009 at the same rate theyhave in recent years.

 

*Generaland administrative expenses.*  General andadministrative expenses consist primarily of salaries and related expenses andoverhead for personnel performing executive, finance, information technologyand human resource functions. Other significant general and administrativeexpenses include consulting fees and professional fees for legal services(including services related to obtaining and maintaining protection of ourintellectual property) and accounting services.

 

*Interestincome.*  Interest income consists of interest earnedon our cash and cash equivalents.

 

*Interestexpense.*  Interest expense consists primarily ofinterest costs incurred on our Convertible Notes that we issued in March 2007.

 

19

----

Table of Contents

 

**Liquidityand Capital Resources**

 

Since ourinception, we have financed our operations primarily through private placementsof equity securities, unsecured borrowings from our stockholders, a creditfacility and, more recently, the issuance in March 2007 of our ConvertibleNotes in the aggregate principal amount of $25.0 million, and our initialpublic offering in October 2007, which generated proceeds of approximately$42.0 million. In addition, we have received $20.0 million under our agreementswith Intuitive Surgical.  Our principalsource of liquidity as of June 30, 2009 consisted of our cash and cashequivalents of $4.3 million and our accounts receivable balance ofapproximately $1.4 million.

 

**Netcash used in operating activities**

 

Net cash used inoperating activities for the six months ended June 30, 2009 were primarilyrelated to cash used to fund our efforts to expand our customer base and ourproducts’ acceptance within that customer base, to develop and introduce ournext generation of Intelligent Surgical Instruments, and to further integrateour manufacturing processes, offset by $7.5 million in payments we receivedunder our agreements with Intuitive in 2009. Had we not received thesepayments, our net cash used in operating activities would have beenapproximately $11.9 million.

 

**Netcash provided by investing activities**

 

Net cash providedby investing activities for the six months ended June 30, 2009 wasprimarily attributable to reductions in restricted cash balances as of June 30,2009 offset by cash used for capital expenditures related to the integration ofour manufacturing process and patent application costs.

 

**Netcash used in financing activities**

 

Net cash used infinancing activities was primarily attributable to debt repayments on equipmentloans during the six months ended June 30, 2009.

 

**Liquidityand Capital Resources Outlook**

 

As of June 30,2009, we had cash and cash equivalents of approximately $4.3 million. Inaddition, as of June 30, 2009, we had total liabilities of$50.7 million, including $25.0 million of Convertible Notes due to bepaid in March 2010.

 

Our operations todate have required significant cash expenditures. Although we significantlyreduced our operating expenses through the restructuring plan we implemented inthe fourth quarter of 2008, our operations continue to require significant cashexpenditures, and we must raise additional capital to be able to fund them. Webelieve that our current cash and cash equivalents, together with our future saleswill be sufficient to meet our anticipated cash requirements through September 25,2009, the latest date by which the Merger is expected to close.

 

If we do notconsummate the Merger and we remain an independent company, in order tocontinue our operations and to satisfy our obligations under the ConvertibleNotes, we will need to raise additional capital from one or a combination ofapproaches. We may raise funds through license and development agreements withcorporate partners or public and private offerings of securities, includingdebt or equity financings. We may enter into arrangements to extend thematurity of, purchase, redeem, replace or otherwise modify the terms of theConvertible Notes, and any such arrangements may require us to expend additionalcash. Given the recent and continued turmoil in the capital markets, there area number of risks and uncertainties related to our attempts to complete afinancing or strategic partnering arrangement that are outside our control.There can be no assurance that such financing will be available in amounts oron terms 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 for the year ended December 31, 2008 to include anexplanatory paragraph regarding this contingency.

 

Historically, wehave financed our operations and internal growth primarily through private placementsof equity securities and debt, through our initial public offering and morerecently, through licensing arrangements with corporate partners. If we do notconsummate the Merger and we remain an independent company, we cannot becertain that additional public or private financing will be available inamounts acceptable to us, or at all. If we raise additional funds by issuingequity securities or debt, significant dilution may occur. Debt financing, ifavailable, may involve restrictive covenants. Any debt financing or additionalequity that we raise may contain terms that are not favorable to us or ourstockholders. Our ability to obtain additional debt financing will be limitedby certain covenants we have made to holders of our Convertible Notes. Inaddition, if we default in the payment of our obligations under our ConvertibleNotes, our noteholders will be entitled to exercise their rights as creditors.

 

If we do notconsummate the Merger and we remain an independent company and are unable toraise additional funds when needed, we will need to:

 

20

----

Table ofContents

 

·                  delay, scale-back oreliminate some or all of our research and product development programs;

 

·                  license third parties to develop and commercialize products or technologiesthat we would otherwise seek to develop and commercialize ourselves;

 

·                  attempt to sell our company;

 

·                  cease operations; or

 

·                  declare bankruptcy.

 

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

 

Additionally, ifwe default in the payment of our Convertible Notes, our noteholders will beentitled to exercise their rights under the Convertible Notes and immediatelyaccelerate repayment of the Convertible Notes, which could materially impairour ability to continue to operate our business.

 

We have incurred and expect to further incursignificant costs related to the Merger, including investment banking fees,legal fees, and other costs necessary to complete the Merger. Many of thesecosts have been or will be incurred irrespective of whether or not the Mergeris consummated. In addition, the Merger Agreement contains customarytermination provisions for us and Parent and provides that, in connection withthe termination of the Merger Agreement under specified circumstances involvingcompeting transactions or a change in the recommendation of our Board ofDirectors or certain breaches of the Merger Agreement, we may be required topay Parent a termination fee of approximately $2.3 million.

 

In May 2009,we announced that we received notification from the NASDAQ ListingQualifications Panel, or the Panel, stating that the Panel has determined todelist the Shares from the NASDAQ Capital Market, effective with the open ofbusiness on May 22, 2009. The determination follows our announcement in March 2009that the Panel had granted our request for conditional listing, through May 20,2009, to satisfy the $2.5 million stockholders’ equity requirement forcontinued listing on the NASDAQ Capital Market.  The delisting is theresult of our non-compliance with the minimum stockholders’ equity requirementas of May 20, 2009. Effective with the open of business on May 22,2009, the Shares began trading on the OTCBB, an electronic quotation servicemaintained by the FINRA.  Our trading symbol will remain PMII, however forcertain quote publication websites, investors may be required to key PMII.OB toobtain quotes.  The liquidity, tradingmarket and price of our common stock may be adversely affected by our listingon the OTCBB.

 

If we do notconsummate the Merger and are unable to raise additional funds when needed, wemay have to delay or reduce the scope of or eliminate some or all of ourdevelopment programs or we may be forced to seek protection under applicablebankruptcy laws. Any restructuring or bankruptcy could materially impair yourinvestment.

 

**Results of Operations**

 

**Three month periods ended June 30, 2009 and 2008**

 

*Sales.*   Our sales in the three monthsended June 30, 2009 increased by 5% to $2.3 million compared with $2.2million during the corresponding period in 2008. This increase relatedprimarily to sales growth in Japan, which accounted for 15% of sales in thethree months ended June 30, 2009 compared with 7% of sales in the correspondingperiod in 2008. Sales of reload cartridges totaled approximately $1.2 millionduring the three months ended June 30, 2009 compared to approximately $0.4million during the three months ended June 30, 2008.

 

*Cost of sales and gross profit.*   Our cost of sales in the threemonths ended June 30, 2009 decreased by 33%, to $2.0 million compared with$3.0 million during the corresponding period in 2008. Our cost of salesincluded inventory obsolescence charges of approximately $0.2 million duringeach of the three month periods ended June 30, 2009 and 2008,respectively.  Our gross margin was $0.2million, or 10% of sales, in the three months ended June 30, 2009 comparedto a gross margin of ($0.9 million) or (40%) of sales, during the correspondingperiod in 2008.  Our gross margins in 2009 improved versus 2008 due toimprovements in our manufacturing process, including our Reload AutomationMachine, or RAM. However, gross margins are likely to fluctuate fromperiod to period until we are able to realize further economies of scale in ourpurchasing and manufacturing process through increased manufacturing capacityutilization and automation.

 

21

----

Table of Contents

 

*Research and development expenses.*   Our research and developmentexpenses in the three months ended June 30, 2009 decreased by 46% to $0.8million, compared with $1.5 million during the corresponding period in 2008 dueto our restructuring initiative that was implemented in the fourth quarter of2008.  The restructuring initiativeincluded headcount reductions and a redeployment of much of our availableresources to our engineering and technical support obligations under theIntuitive Agreements.  Research anddevelopment costs decreased as a percentage of sales to 36% in the three monthsended June 30, 2009, compared with 70% of sales during the correspondingperiod in 2008.

 

*Sales and marketing expenses.*   Our domestic and internationalsales and marketing expenses in the three months ended June 30, 2009decreased by 41%, to $3.5 million, compared with $6.0 million during thecorresponding period in 2008, and decreased as a percentage of sales to 155% ofsales in the three months ended June 30, 2009, compared with 276% of salesduring the corresponding period in 2008.  The decrease in dollar amount in2009 was primarily due to a reduction in our sales force and improvedefficiencies in our sales and marketing department.

 

*General and administrative expenses.*   Our general and administrativeexpenses in the three months ended June 30, 2009 increased by 3%, to $2.7million, compared with $2.6 million during the corresponding period in 2008,but decreased as a percentage of sales to 120% in the three months ended June 30,2009, compared to 121% during the corresponding period in 2008. Theincrease in general and administrative expenses related primarily to increasedconsulting costs and share-based compensation costs offset by cost reductionsrelated to the restructuring initiative that was implemented in the fourthquarter of 2008.

 

*Interest and other income.*  Our interest and other income inthe three months ended June 30, 2009 decreased by 90% to $9 thousandcompared with $90 thousand during the corresponding period in 2008, due tosignificantly lower average cash balances and lower interest rates.

 

*Interest expense.*  Our interest expense in the threemonths ended June 30, 2009 and 2008 totaled approximately $0.7 million foreach period and relates primarily to our Convertible Notes issued in March 2007.

 

**Results of Operations**

 

**Six month periods ended June 30, 2009 and 2008**

 

*Sales.*   Our sales in the six months endedJune 30, 2009 increased by 14% to $5.0 million compared with $4.4 millionduring the corresponding period in 2008. This increase related primarily tosales growth in Japan, which accounted for 16% of sales in the six months endedJune 30, 2009 compared with 5% of sales in the corresponding period in2008. Sales of reload cartridges totaled approximately $2.5 million during thesix months ended June 30, 2009 compared to approximately $0.9 millionduring the six months ended June 30, 2008.

 

*Cost of sales and gross profit.*   Our cost of sales in the sixmonths ended June 30, 2009 decreased by 25%, to $4.2 million compared with$5.6 million during the corresponding period in 2008.  Our cost of salesincluded inventory obsolescence charges of approximately $0.4 million and $0.5million during the six months ended June 30, 2009 and 2008,respectively.  Our gross margin was $0.8million, or 16% of sales, in the six months ended June 30, 2009 comparedto a gross margin of ($1.2 million) or (27%) of sales, during the correspondingperiod in 2008.  Our gross margins in 2009 improved versus 2008 due toimprovements in our manufacturing process, including our Reload AutomationMachine, or RAM.  However, gross margins are likely to fluctuate fromperiod to period until we are able to realize furthereconomies of scale in our purchasing andmanufacturing process through increased manufacturing capacity utilization andautomation.

 

*Research and development expenses.*   Our research and developmentexpenses in the six months ended June 30, 2009 decreased by 48% to $1.6million, compared with $3.1 million during the corresponding period in 2008 dueto our restructuring initiative that was implemented in the fourth quarter of2008.  The restructuring initiativeincluded headcount reductions and a redeployment of much of our availableresources to our engineering and technical support obligations under theIntuitive Agreements.  Research anddevelopment costs decreased as a percentage of sales to 32% in the six monthsended June 30, 2009, compared with 71% of sales during the correspondingperiod in 2008.

 

*Sales and marketing expenses.*   Our domestic and internationalsales and marketing expenses in the six months ended June 30, 2009decreased by 45%, to $7.0 million, compared with $12.8 million during thecorresponding period in 2008, and decreased as a percentage of sales to 140% ofsales in the six months ended June 30, 2009, compared with 291% of salesduring the corresponding period in 2008.  The decrease in dollar amount in2009 was primarily due to a reduction in our sales force and improvedefficiencies in our sales and marketing department.

 

22

----

Table of Contents

 

*General and administrative expenses.*   Our general and administrativeexpenses in the six months ended June 30, 2009 decreased by 5%, to $5.3million, compared with $5.6 million during the corresponding period in 2008,and decreased as a percentage of sales to 107% in the six months ended June 30,2009, compared to 129% during the corresponding period in 2008. Thedecrease in general and administrative expenses related primarily to therestructuring initiative that was implemented in the fourth quarter of 2008,offset by an increase consulting costs and costs related to share-basedcompensation.

 

*Interest and other income.*  Our interest and other income inthe six months ended June 30, 2009 decreased by 81% to $53 thousandcompared with $284 thousand during the corresponding period in 2008, due tosignificantly lower average cash balances and lower interest rates.

 

*Interest expense.*  Our interest expense in the sixmonths ended June 30, 2009 and 2008 totaled approximately $1.4 million and$1.3 million, respectively, and relates primarily to our Convertible Notesissued in March 2007.

 

**CriticalAccounting Policies and Estimates**

 

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States requires management to make estimates andassumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenue and expenses during thereporting period. These estimates and judgments are inherently subject touncertainty. On an ongoing basis, we re-evaluate our judgments and estimates,including those related to uncollectible accounts receivable, inventories,recoverability of long-lived assets, stock-based compensation, accrued expensesand other contingencies. We base our estimates and judgments on our historicalexperience and on other assumptions that we believe are reasonable under thecircumstances, the results of which form the basis for making the judgmentsabout the carrying values of assets and liabilities that are not readilyapparent from other sources. Actual results could differ from those estimates,and material effects on our operating results and financial position couldresult. The accounting policies described below are those which, in ouropinion, involve the most significant application of judgment or involvecomplex estimation, and which could, if different judgments or estimates weremade, materially affect our reported results of operations.

 

*Revenuerecognition.*  Most of our revenue historically has beenderived from the sale of single-patient, disposable loading units and from thesale of reload cartridges for reusable Intelligent Surgical Instruments.Revenue related to the sale of such individual products is recognized whenpersuasive evidence of an arrangement exists, delivery has occurred, the salesprice is fixed and determinable, and collectibility is reasonably assured,which is generally at the time of shipment upon delivery to a common carrier.

 

We also considerthe provisions of EITF, 00-21, *RevenueArrangements with Multiple Deliverables*, when recognizing revenue.Under multiple-element arrangements involving the sale of multiple products,services and/or rights to use assets, the multiple elements are divided intoseparate units of accounting when certain criteria are met, including whetherthe delivered items have stand alone value to the customer and whether there isobjective and reliable evidence of the fair value of the undelivered items.When separate units of accounting exist, consideration is allocated among theseparate elements based on their respective fair values. If such evidence offair value for each undelivered element of the arrangement does not exist, allrevenue from the arrangement is deferred until such time that evidence of fairvalue for each undelivered element does exist or until all elements of thearrangement are delivered.

 

Our IntelligentSurgical Instrument surgical platform includes cutting and stapling devices ina variety of sizes and linear, right angle and circular configurations designedfor differing surgical needs. Our Intelligent Surgical Instruments areavailable in a reusable multiple-patient format which can be autoclaved andused in multiple cases. Our reusable Intelligent Surgical Instruments usedisposable cutting and stapling cartridges in various sizes, which we refer toas reload cartridges and digital loading units.

 

In certain cases,we offer such Intelligent Surgical Instruments at no cost in exchange forhigher unit pricing on the sale of reload cartridges over a specified period oftime. In these cases, we recognize revenue ratably over the period of deliveryof the reload cartridges, as long as such revenue is not contingent on thedelivery of the undelivered products. We have in certain cases agreed totransfer title to such systems to the customer upon the customer’s purchase ofa specified number of disposable Intelligent Surgical Instruments although thecustomer is under no obligation to purchase the Intelligent SurgicalInstruments. In these instances, we recognize revenue attributable to thecomplete system as the Intelligent Surgical Instruments are delivered.

 

We have also madeour i60, i45 and iDrive instruments available to customers at no charge underan “in service under evaluation” program. The evaluation period has typicallybeen six months and we have derived recurring revenues from sales of the reloadcartridges necessary for the evaluation instruments’ use. At the end of theevaluation period, customers have the option to (i) buy the equipment andcontinue to receive reload cartridge pricing consistent with that of theevaluation period, (ii) keep the equipment and agree to higher salesprices on the reload cartridge than was charged during the evaluation period or(iii) return the equipment with no further obligation.

 

23

----

Table of Contents

 

*RevenueRecognition—Arrangement with Intuitive Surgical, Inc.*

 

In September 2008,we entered into two agreements with Intuitive Surgical. The first agreement isa License and Development Agreement under which Intuitive Surgical expects todevelop a surgical stapling device which will attach to its da VinciTM SurgicalSystems and will utilize our patented technology. Once developed, thisattachment will enable the da VinciTM Surgical System to cut and staple tissuein a broad array of surgical applications. The second agreement is an exclusiveReload Supply Agreement whereby we will manufacture and be the exclusivesupplier to Intuitive Surgical of staple reloads for the newly developed deviceat agreed upon prices.

 

Under the terms ofthe Intuitive Agreements, we received an upfront license payment of$12.5 million in September 2008. We are responsible for providing, atour expense, up to an aggregate of 3,900 man hours of engineering and technicalsupport services to Intuitive to assist Intuitive in designing and developingthe new device.  In February 2009,we received a payment of $2.5 million related to the achievement of adevelopment milestone. In May 2009, Intuitive Surgical elected to exerciseits right under the License and Development Agreement to receive an irrevocablelicense to certain of our intellectual property in exchange for an acceleratedaggregate milestone payment of $5.0 million. We received the $5.0 millionpayment in May 2009.  We wereoriginally eligible to receive the $5.0 million in the form of milestonepayments over the term of the License and Development Agreement if certainagreed upon development milestones were achieved.  Our receipt of this $5.0 million paymentprecludes us from receiving additional milestone payments related to thesedevelopment milestones. Since inception of the Intuitive Agreements, we havereceived a total of $20.0 million in payments from Intuitive Surgical.

 

We have identifiedfour deliverables within this arrangement: (i) the license to utilize ourpatented technology, (ii) consultative services during Intuitive Surgical’sdevelopment of the new device, (iii) a six-year supply arrangement tosupply reload cartridges to Intuitive Surgical, including a minimum purchaseobligation during the first 18 months subsequent to the first commercialsale of the device by Intuitive Surgical to a third party and (iv) asignificant and incremental discount on the future purchases of reloadcartridges. We have concluded that these deliverables should be accounted foras a single unit of accounting, with recognition of revenue for the single unitof accounting commencing upon the delivery of the final element in thearrangement (i.e., commencement of delivery of the staple reloadcartridges contemplated by the Reload Supply Agreement). Accordingly, the $20.0 millionwe have received since September 2008 has been deferred and is reported inthe consolidated financial statements as deferred revenue as of June 30,2009.

 

Should the projectreach the first commercial sale, the $20.0 million of up-front andmilestone payments, as well as the guaranteed minimum amount of reload sales,will begin to be recognized as revenues over the term of the Reload SupplyArrangement (i.e., the six-year period following the date of the firstcommercial sale of the device to a third party). Revenues from the sale ofadditional reloads beyond the minimum guaranteed quantity will be recognized assuch reloads are shipped.

 

*Share-basedcompensation*

 

Our share-basedcompensation is accounted for in accordance with the fair value recognitionprovisions of SFAS No. 123 (revised 2004) *Share-BasedPayments*, or SFAS 123(R). In addition, we account for ourshare-based compensation to non-employees in accordance with EITF 96-18.We use the Black-Scholes option-pricing model to estimate the fair value ourshare-based awards as of the date of grant. The Black-Scholes model, by itsdesign, is highly complex and dependent upon key data inputs estimated bymanagement. The primary data inputs with the greatest degree of judgment aregenerally the estimated lives of the share-based awards and the estimatedvolatility of our common stock price. The Black-Scholes model is sensitive tochanges to these two data inputs.

 

Beginning infiscal year 2006, we calculated the estimated life of stock options grantedusing a “simplified” method, based upon guidance from the SEC as contained inSAB No. 107 permitting the initial use of this method through 2007. In December 2007,the SEC issued SAB No. 110, which was effective January 1, 2008,expressing the expectation that companies should be employing information frominternal or external sources about employee stock option exercise behavior whendeveloping estimates of expected term as they relate to stock optionvaluations. SAB No. 110 states that the SEC will continue to accept theuse of the “simplified” method, under certain circumstances, beyond December 31,2007. We evaluated the exercise behavior of our employees and determined thatthe exercise history was an inadequate measure of the expected term of ourstock options. Therefore, we have continued our use of the simplified method asprescribed in SAB No. 107. Expected stock price volatility is typicallybased on the daily historical trading data from an appropriate point in timethrough the last day of the applicable period. Because our historical tradingdata only dates back to October 26, 2007, the first trading datesubsequent to our initial public offering, the expected volatility of ourcommon stock was calculated for each date of grant based on an alternative method(defined as “calculated value”). We identified similar public entities forwhich share price information is available and have considered the historicalvolatility of these entities’ share prices in estimating expected volatility.

 

24

----

Table of Contents

 

**Recent Accounting Pronouncements**

 

In May 2009, the FASB issued SFAS No. 165,which establishes general standards of accounting for and disclosure of eventsthat occur after the balance sheet date but before financial statements areissued or are available to be issued. This statement sets forth thecircumstances under which an entity should recognize events or transactionsoccurring after the balance sheet date in its financial statements. SFAS 165also requires the disclosure of the date through which an entity has evaluatedsubsequent events and the basis for that date—that is, whether that daterepresents the date the financial statements were issued or were available tobe issued. This statement is effective for interim or annual reportingperiods ending after June 15, 2009. During the second quarter of 2009, weadopted SFAS 165. The adoption of SFAS 165 did not have a significant impact onour consolidated financial statements or related footnotes. See Note 9 —Subsequent Events to our consolidated financial statements.

 

In April 2009,the FASB issued FSP FAS 107-1 and APB 28-1, *InterimDisclosures about Fair Value of Financial Instruments*(“FSP 107-1”),which we adopted for the second quarter of 2009. FSP 107-1 requires an entityto provide the annual disclosures required by FASB Statement No. 107, *Disclosures about Fair Value of Financial Instruments*,in its interim financial statements.  The adoption of FSP 107-1 had no material impact on our consolidatedfinancial statements.

 

We adopted SFAS No. 157,effective January 1, 2008, for financial assets and liabilities.  In addition, effective January 1, 2009,we adopted SFAS No. 157 as it relates to nonfinancial assets andliabilities that are not recognized or disclosed at fair value in the financialstatements on at least an annual basis. SFAS No. 157 defines fair value asthe price that would be received to sell an asset or paid to transfer aliability, referred to as the exit price, in an orderly transaction betweenmarket participants at the measurement date. The standard outlines a valuationframework and creates a fair value hierarchy in order to increase theconsistency and comparability of fair value measurements and the relateddisclosures. In determining fair value of financial assets, we primarily useprices and other relevant information generated by market transactionsinvolving identical or comparable assets, called the market approach. As of June 30,2009 and December 31, 2008, the fair value of all of our financial assets wasbased on level one observable inputs. The implementation of SFAS No. 157for nonfinancial assets and liabilitiesdid not have an impact on the Company’s consolidated financial statements as ofJune 30, 2009. The provisions of SFAS No. 157 will be applied at suchtime a fair value measurement of a nonfinancial asset or liability is required,which may result in a fair value that is materially different than would havebeen calculated prior to the adoption of SFAS No. 157.

 

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

 

In May 2008,the FASB issued Staff Position No. Accounting Principles Board 14-1, *or* FSP No. APB 14-1, *Accounting for Convertible Debt Instruments That May BeSettled in Cash upon Conversion (Including Partial Cash Settlement)*.FSP No. APB 14-1 requires that the liability and equity components ofconvertible debt instruments that may be settled in cash upon conversion(including partial cash settlement) be separately accounted for in a mannerthat reflects an issuer’s nonconvertible debt borrowing rate. We adopted FSP No. APB 14-1effective January 1, 2009. The adoption of APB 14-1 did not have animpact on our consolidated financial statements as of and for the three and sixmonths ended June 30, 2009.

 

In June 2008,the FASB issued EITF 07-5, *DeterminingWhether an Instrument (or Embedded Feature) Is Indexed to an Entity’s Own Stock*,or EITF 07-5. EITF 07-5 provides guidance in assessing whether anequity-linked financial instrument (or embedded feature) is indexed to anentity’s own stock for purposes of determining whether the appropriateaccounting treatment falls under the scope of SFAS No. 133 and/orEITF 00-19. EITF 07-5 is effective for financial statements issuedfor fiscal years beginning after December 15, 2008. We adopted EITF 07-5effective January 1, 2009. The fair value of certain of our outstandingwarrants to which this guidance applies was not material as of June 30,2009. As such, our adoption of EITF 07-5 did not have a material impact on ourconsolidated financial statements as of and for the three and six months ended June 30,2009.

 

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

 

We are exposed tomarket risk in the ordinary course of business, which consists primarily ofinterest rate risk associated with our cash and cash equivalents and debt andforeign exchange rate risk.

 

*Interestrate risk.*  The primary objective of our investmentactivity is to preserve principal, provide liquidity and maximize incomewithout increasing risk. Our investments have limited exposure to market risk.To minimize this risk, we maintain our 

 

25

----

Table of Contents

 

portfolio of cash andcash equivalents in a variety of investments, consisting primarily of bankdeposits, money market funds and short-term government funds. The interestrates are variable and fluctuate with current market conditions. The riskassociated with fluctuating interest rates is limited to this investmentportfolio, and we do not believe that a 10% change in interest rates would havea material impact on our financial position or results of operations.

 

The interest rateson our Convertible Notes are not subject to market fluctuations and thereforeour market risk is limited.

 

*Foreigncurrency risk.*  To date, our international customeragreements have been denominated primarily in the local currency of theinternational customer. The functional currency of our foreign operations inEurope and Japan is the local currency and, as a result, any fluctuation in theexchange rates of these net assets, denominated in local currency, would bereflected in the translation gains or losses, which are accounted for in othercomprehensive income in our statements of changes in equity. We do not believethat a change of 10% in the foreign currency exchange rates would have amaterial impact on our financial position or results of operations.

 

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

 

**Evaluationof Disclosure Controls and Procedures**

 

Our management,with the participation of our chief executive officer and chief financialofficer, evaluated the effectiveness of our disclosure controls and procedures(as defined in Rules 13a-15(e) and 15d-15(e) under the ExchangeAct) as of June 30,2009.  Based onthat evaluation, our chief executive officer and chief financial officerconcluded that, as of June 30, 2009, our disclosure controls andprocedures were ineffective due to the material weaknesses described in ourAnnual Report on Form 10-K, as amended, for the year ended December 31,2008, filed with the SEC on April 9, 2009, which identified the materialweakness listed below that had not been fully remediated at June 30, 2009.

 

Our managementdetermined that we have a material weakness in our internal control overfinancial reporting related to not having a sufficient number of personnel withthe appropriate 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 financialstatement close process in 2008 that have been recorded in the consolidatedfinancial statements. Until this design deficiency in our internal control overfinancial reporting is remediated, there is a reasonable possibility that amaterial misstatement to our annual or interim consolidated financialstatements could occur and not be prevented or detected by our internalcontrols in a timely manner.

 

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

 

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

 

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

 

In addition, ourmanagement determined that we have a material weakness in our entity-levelcontrols as we did not have a control to prevent loans to executive officers.In connection with the review of our internal controls, management noted thatin October 2008 we made an advance of salary of approximately $24,000 toour president and chief executive officer, Michael Whitman. Such advance wasmade by us on Mr. Whitman’s behalf to Mr. Whitman’s brokerage accountto enable Mr. Whitman to satisfy a margin call requirement in cash ratherthan in shares of our common stock, which would have resulted in sales of ourstock during a restricted trading period. This advance was approved by our thenchief financial officer and was repaid by Mr. Whitman in full in December 2008.

 

Following aninvestigation by the Audit Committee of the Board of Directors, our Board ofDirectors, with our chief executive officer and president having removedhimself from its deliberations, determined that the advance was an inadvertentviolation of Section 402 of the Sarbanes-Oxley Act of 2002 which ourinternal controls and procedures did not prevent. Our then chief financialofficer, did not consider that short term salary advances are deemed to beloans under the provisions of Section 402 of the Sarbanes-Oxley Act andtherefore was unaware of the Section’s prohibitions on such advances toexecutive officers. Our Board of Directors determined that this matter was anisolated incident and required the payment of imputed interest calculated basedon an annual interest rate of 2.19% on the amounts of salary advanced, which Mr. Whitmanhas paid. In addition, the Board of Directors has 

 

26

----

Table of Contents

 

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

 

**Changesin Internal Control Over Financial Reporting**

 

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

 

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

 

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

 

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

 

*Patentlitigation against Ethicon Endo-Surgery in Germany.*    In March 2005,Ethicon Endo-Surgery initiated three patent infringement lawsuits against usand our German subsidiary in district court in Düsseldorf, Germany. The lawsuitsallege that certain of our products infringe the German parts of three Europeanpatents owned by Ethicon Endo-Surgery, which we refer to as the Hooven, Clarkand Rothfuss patents. We hired German counsel to defend the patent infringementcases and to seek revocation of Ethicon Endo-Surgery’s patents in nullityproceedings before a separate court in Munich, Germany.

 

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

 

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

 

In the Rothfuss infringementaction, Ethicon Endo Surgery asserts that it is entitled to collect damages ofapproximately €526,000 and has instituted damages proceedings for part of itsclaim, asking the Düsseldorf court for a partial damages award of at least€142,000, or alternatively, €263,000.

 

We introduced aredesigned stapling product that would not infringe the Rothfuss patent even ifthe patent and the infringement decision were upheld. Subsequently, the appealcourt stayed the provisional enforcement of the district court ruling inEthicon Endo-Surgery’s favor in the Rothfuss patent infringement litigation andwe re-introduced the product accused of infringement in that case.

 

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

 

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

 

27

----

Table of Contents

 

We have not accrued anyamount in our consolidated financial statements as of June 30, 2009 forthese matters.

 

*Duo-Medlitigation in Belgium.*    In August 2008, our former Belgiandistributor, Duo-Med, S.A., initiated a breach of contract action againstus in the Commercial Court of Brussels in Belgium. The complaint alleges thatwe breached our distribution agreement with Duo-Med by failing to provideproper notice when we terminated that agreement in May 2007 and that, asthe result of problems with our products, Duo-Med was unable to sell itsexisting inventory. The complaint asserts damages totaling approximately€460,000. We believe that the allegations in this matter are without merit andintend to vigorously defend against them. We have not accrued any amount in ourconsolidated financial statements as of June 30, 2009 for this matter.

 

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

 

**RisksRelated to Our Business as a Stand-Alone Company**

 

***If we are unable to consummate the Merger with Covidien, wewill be required to raise additional capital. If we cannot raise such capital,we will be forced to curtail operations,******consummate transactionswith respect to our assets that we might not otherwise enter into, attempt tosell our company, cease operations or declare bankruptcy******.***

 

As June 30,2009, we had cash and cash equivalents of approximately $4.3 million. Inaddition, as of June 30, 2009, we had total liabilities of approximately$50.7 million, including approximately $25.0 million of ConvertibleNotes due to be paid in March 2010.

 

Our operations to datehave required significant cash expenditures. We have incurred net losses ineach year since our inception and have an accumulated deficit at June 30,2009 of $230.7 million. We believe that our current cash and cash equivalents,together with our expected near-term future sales, will be sufficient to meetour anticipated cash requirements through September 25, 2009, the latestdate by which the Merger is expected to close.

 

If we do notconsummate the Merger and we remain an independent company, in order tocontinue our operations and to satisfy our obligations under the ConvertibleNotes, we will need to raise additional capital from one or a combination ofapproaches. We may raise funds through license and development agreements withcorporate partners or public and private offerings of securities, includingdebt or equity financings. We may enter into arrangements to extend thematurity of, purchase, redeem, replace or otherwise modify the terms of theConvertible Notes, and any such arrangements may require us to expendadditional cash. Given the recent and continued turmoil in the capital markets,there are a number of risks and uncertainties related to our attempts tocomplete a financing or strategic partnering arrangement that are outside ourcontrol. There can be no assurance that such financing will be available inamounts or on terms acceptable to us, if at all. These conditions raisesubstantial doubt about our ability to continue as a going concern. Ourindependent registered public accounting firm has modified its audit report onour consolidated financial statements for the year ended December 31, 2008to include an explanatory paragraph regarding this contingency.

 

If we do notconsummate the Merger, our actual capital requirements will depend on manyfactors, many of which are outside our control, including:

 

·                  future revenue generation;

 

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

 

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

 

·                  the cost and timing of regulatory approvals;

 

·                  expenses of future clinical studies, if any;

 

·                  the effect of competing technological and market developments; and

 

·                  licensing technologies for future development.

 

Historically, wehave financed our operations and internal growth primarily through privateplacements of equity securities and debt, through our initial public offeringand more recently, through licensing arrangements with corporate partners. Ifwe do not 

 

28

----

Table of Contents

 

consummate the Merger andwe remain an independent company, we cannot be certain that additional publicor private financing will be available in amounts acceptable to us, or at all.If we raise additional funds by issuing equity securities or debt, significantdilution may occur. Debt financing, if available, may involve restrictivecovenants. Any debt financing or additional equity that we raise may containterms that are not favorable to us or our stockholders. Our ability to obtainadditional debt financing will be limited by certain covenants we have made toholders of our Convertible Notes. In addition, if we default in the payment ofour obligations under our Convertible Notes, our noteholders will be entitledto exercise their rights as creditors.

 

If we do notconsummate the Merger and we remain an independent company and are unable toraise additional funds when needed, we will need to:

 

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

 

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

 

·                  attempt to sell our company;

 

·                  cease operations; or

 

·                  declare bankruptcy.

 

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

 

As of June 30,2009, there were approximately 2.8 million stock options and approximately0.9 million warrants outstanding. These equity instruments representapproximately 21% of our shares outstanding at June 30, 2009. Thesignificant dilution represented by our outstanding warrants and equitycompensation awards may make it more difficult for us to raise additionalcapital.

 

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

 

We are a company with alimited operating history and have sustained net losses since our inception,including a net loss of $14.5 million in the six months ended June 30,2009 and net losses of $42.3 million and $36.8 million for the yearsended December 31, 2008 and 2007, respectively. We had an accumulateddeficit of $230.7 million at June 30, 2009. We expect to continue toincur significant operating losses at least through 2009. Our losses have hadand will continue to have an adverse effect on our stockholders’ equity andworking capital and could cause us to take actions that could materially impairor eliminate the value of your investment in us.

 

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

 

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

 

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

 

29

----

Table ofContents

 

***Our Convertible Notes contain certain covenants that, if we violate,could result in an event of default. If we are in default, our noteholders willbe entitled to exercise their rights under the Convertible Notes andimmediately accelerate payment, which could materially impair our ability tocontinue to operate our business.***

 

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

 

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

 

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

 

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

 

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

 

·                  maintaining product yields;

 

·                  maintaining quality control and assurance;

 

·                  providing component and service availability;

 

·                  maintaining adequate control policies and procedures; and

 

·                  hiring and retaining qualified personnel.

 

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

 

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

 

The historicalunit costs for our products, based on limited manufacturing volumes, have beenvery high in relation to our sales, resulting in low or negative gross margins.It will be necessary for us to achieve substantial reductions in our cost ofsales as a 

 

30

----

Table of Contents

 

percentage of sales inorder to become profitable. The transition to in-house production or to newproduction processes initially had a negative effect on our manufacturingyields or costs, which adversely affected our gross margins in the first halfof 2008. While we have seen improvements to our gross margins since June 2008,due to these new production processes, we may not be able to maintain suchmargins as new products are introduced to the market. Certain of ourmanufacturing processes are labor intensive, and achieving significant costreductions will depend in part upon reducing the time required to perform theseprocesses. We cannot assure you that we will be able to achieve the significantcost reductions in the manufacture of our products necessary for our businessto achieve profitability.

 

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

 

Our successdepends upon acceptance of our technology by the medical community as safe,clinically effective and cost effective and a preferred device as compared toproducts of our competitors. We have not collected, and are not aware thatothers have collected, long-term data regarding efficacy, safety and clinicaloutcomes associated with the use of our products. Any data that is generated inthe future may not be positive or consistent with our current, largelyanecdotal data, which would negatively affect market acceptance and the rate atwhich our Intelligent Surgical Instruments are adopted. Equally important willbe physicians’ perceptions of the safety of our products. Our technology isrelatively new in surgery, and the results of short-term clinical experiencewith our Intelligent Surgical Instruments do not necessarily predict long-termclinical benefits as compared to the products of our competitors. If, over thelong term, our Intelligent Surgical Instruments do not meet surgeons’expectations as to safety, efficacy and ease of use, our Intelligent SurgicalInstruments may not become widely adopted.Even if the data collected from future clinicalstudies or clinical experience indicates positive results, each surgeon’sactual experience with our device outside the clinical study setting may vary.Consequently, both short- and long-term results reported in any future clinicalstudies may be significantly more favorable than typical results of otherpracticing surgeons, which could negatively affect rates of adoption andnegatively affect our results.

 

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

 

Our IntelligentSurgical Instruments rely on new technology and must compete with the moreestablished manual devices of our competitors. Conventional manual devices arewidely accepted in the medical community, have a long history of use and do notrequire the purchase of additional, expensive capital equipment. We cannot becertain that surgeons will use our products to replace or supplementestablished treatments or that our products will be competitive with current orfuture products and technologies.

 

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

 

·                  significantly greater name recognition;

 

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

 

·                  longer operating histories;

 

·                  established relationships with healthcare professionals, customers 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; and

 

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

 

In addition, ourfirst generation SurgASSIST system in its original configuration had certainperceived disadvantages compared to conventional manual endomechanical devices.Prior to the introduction of our new i60 and i45 linear staplers and our iDrivewireless handheld power and control system, our Intelligent SurgicalInstruments had to be tethered by a flexible shaft to a power console which islocated outside the sterile field. Some surgeons and operating room personnelfound this to be cumbersome and not well suited for all procedures. This factormay initially have limited market acceptance of our SurgASSIST platform. Ournext 

 

31

----

Table of Contents

 

generation untetheredself-contained Intelligent Surgical Instruments are designed to eliminate thisdisadvantage of our SurgASSIST system, but we may need to overcome an initialnegative perception by clinicians of our first-generation tethered technology.

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

32

----

Table of Contents

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

In October 2008,we implemented a restructuring plan aimed at reducing costs, primarily throughheadcount reductions. As of June 30, 2009, we had approximately 122employees globally, compared with 178 in June 2008. It is possible thatour management, finance, technical and regulatory personnel, systems andfacilities currently in place may not be adequate to support our expectedfuture growth. Our need to effectively manage our operations, growth andprograms requires that we continue to improve our systems and procedures ineach of these areas and to attract and retain sufficient numbers of talentedemployees. We may be unable to successfully implement these tasks on a largerscale and, accordingly, may not achieve our research, development and growthgoals.

 

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

 

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

 

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

 

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

 

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

 

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

 

33

----

Table of Contents

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

·                  decreased demand for our products;

 

·                  injury to our reputation;

 

·                  diversion of management’s attention;

 

34

----

Table of Contents

 

·                  significant costs of related litigation;

 

·                  substantial monetary awards to patients;

 

·                  product recalls or market withdrawals;

 

·                  loss of sales; and

 

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

 

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

 

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

 

·                  loss of sales;

 

·                  delay in market acceptance of our products;

 

·                  damage to our reputation;

 

·                  additional regulatory filings;

 

·                  product recalls;

 

·                  increased service or warranty costs; or

 

·                  product liability claims.

 

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

 

During the threemonths ended June 30, 2009 and 2008, sales in international markets totaled24% and 18%, respectively, of our total sales. During the six months ended June 30,2009 and 2008, sales in international markets totaled 28% and 17%,respectively, of our total sales. By doing business in international markets,we are exposed to risks separate and distinct from those we face in ourdomestic operations. Our international business may be adversely affected bychanging economic conditions in foreign countries. Because most of ourinternational sales are denominated in the functional currency of the countrywhere the product is being shipped, increases or decreases in the value of theU.S. dollar relative to foreign currencies could affect our results ofoperations. Engaging in international business inherently involves a number ofother difficulties and risks, including:

 

·                  export restrictions and controls relating to technology and governmentregulation;

 

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

 

·                  pricing pressure that we may experience internationally;

 

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

 

·                  laws and business practices favoring local companies;

 

·                  longer payment cycles;

 

35

----

Table of Contents

 

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

 

·                  political and economic instability;

 

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

 

·                  international terrorism and anti-American sentiment;

 

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

 

·                  difficulties in enforcing intellectual property rights.

 

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

 

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

 

Our futurebusiness and operating results depend significantly on the continuedcontributions of our key technical personnel and senior management,particularly those of Mr. Whitman. These individuals and the services theyprovide would be difficult to replace. While we are subject to certainseverance obligations to Mr. Whitman, either he or we may terminate hisemployment at any time and for any lawful reason or for no reason. Our businessand future operating results also depend significantly on our ability toattract and retain qualified management, manufacturing, technical, regulatory,marketing, sales and support personnel for our operations. Competition for suchpersonnel is intense, and there can be no assurance that we will be successfulin attracting or retaining such personnel.

 

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

 

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

 

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

 

In the UnitedStates, our products are purchased primarily by medical institutions, whichthen bill various third-party payors, such as the Centers for Medicare and MedicaidServices, or CMS, which administers the Medicare and Medicaid programs, andother government programs and private insurance plans, for the healthcareservices provided to their patients. The process involved in applying forcoverage and incremental reimbursement from CMS is lengthy and expensive.

 

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

 

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

 

36

----

Table of Contents

 

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

 

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

 

***RisksRelated to the Merger***

 

***The Merger is subject to closing conditions that couldresult in the completion of the Merger being delayed or not consummated, whichcould negatively impact our stock price and future business and operations.***

 

Completion of the Mergeris conditioned upon Parent and us satisfying closing conditions, includingsuccess of the Offer, all as set forth in the Merger Agreement.  Therequired conditions to closing may not be satisfied in a timely manner, if atall, or, if permissible, waived, and the Merger may not be consummated. Failureto consummate the Merger could negatively impact our stock price, futurebusiness and operations, and financial condition. Any delay in the consummationof the Merger or any uncertainty about the consummation of the Merger mayadversely affect our future business, growth, revenue and results ofoperations.

 

***Failure to complete the Merger could negatively impact themarket price of our common stock and our future business and financial results.***

 

If the Merger is notcompleted for any reason, our ongoing business may be adversely affected andwill be subject to a number of risks, including:

 

· we will be required to raise additional capital. Ifwe cannot raise such capital, we will be forced to curtail operations, consummatetransactions with respect to our assets that we might not otherwise enter into,attempt to sell our company, cease operations or declare bankruptcy

 

· we may be required, under somecircumstances, to pay Parent a termination fee of approximately $2.3 million;

 

· the diversion of management’s attention,the reduction in capital spending and acquisitions, the suspension of plannedhiring and other affirmative and negative covenants in the Merger Agreementrestricting our business;

 

· failure to pursue other beneficialopportunities as a result of the focus of management on the Merger, withoutrealizing any of the anticipated benefits of the Merger;

 

· the market price our common stock maydecline to the extent that the current market price reflects a marketassumption that the Merger will be completed;

 

· we may experience negative reactions tothe termination of the Merger from licensors, suppliers, or other strategicpartners; and

 

· our costs incurred related to theMerger, such as legal and accounting fees, must be paid even if the Merger isnot completed.

 

If the MergerAgreement is terminated and our board of directors seeks another merger orbusiness combination, our stockholders cannot be certain that we will be ableto find a party willing to pay a price equivalent to or more attractive thanthe price Parent has agreed to pay in the Merger.

 

***During the pendency of the Merger, we may not be able toenter into certain business combinations with other parties because ofrestrictions in the Merger Agreement.***

 

37

----

Table of Contents

 

Covenants in the MergerAgreement impede our ability to make certain acquisitions or complete othertransactions that are not, among other things, in the ordinary course ofbusiness pending completion of the Merger. As a result, if the Merger is notcompleted, we may be at a disadvantage to our competitors.

 

***The Merger Agreement limits our ability topursue alternatives to the Merger.***

 

The Merger Agreementcontains ‘‘no shop’’ provisions that, subject to limited exceptions, precludeus, whether directly or indirectly through our subsidiaries, officers,directors, agents or other representatives, from soliciting, initiating,knowingly facilitating, encouraging or inducing, any inquiry with respect to,or the making, submission or announcement of, any acquisition proposal,participating in any discussions or negotiations, or furnishing any nonpublicinformation with respect to any acquisition proposal, or taking any otheraction to facilitate any inquiries or proposal that would be reasonablyexpected to result in an acquisition proposal, approving, endorsing orrecommending any acquisition proposal, or entering into any agreement contemplatingor otherwise relating to any acquisition proposal. Under certain circumstances,the Merger Agreement also provides that we will be required to pay atermination fee of approximately $2.3 million to Parent upon termination of theMerger Agreement. These provisions might discourage a potential competingacquirer that might have an interest in acquiring all or a significant part ofus from considering or proposing an acquisition even if it were prepared to payconsideration with a higher per share market price than that proposed in theMerger, or might result in a potential competing acquirer proposing to pay alower per share price to acquire us than it might otherwise have proposed topay.

 

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

 

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

 

Until our initialpublic offering in October 2007, there was no public market for shares ofour common stock. Since our initial public offering, the closing market priceof our common stock has ranged from $0.22 at its low point in December 2008to $14.40 at its high point in February 2008. The closing market price ofour common stock during the six months ended June 30, 2009 ranged from$0.24 at its low point in January 2009 to $1.00 at its high point in May 2009.The market price for our common stock is likely to continue to fluctuate as aresult of a number of factors, including:

 

·                  whether the Merger is consummated;

 

·                  if the Merger is not consummated, developments relating to our effortsto obtain additional financing to fund our operations or our issuance ofadditional debt or equity securities;

 

·                  if the Merger is not consummated, and we are unable to obtain such additionalfinancing or issue such debt or equity securities, our consequent need to:

 

-                    delay, scale-back or eliminate some orall of our research and product development programs;

 

-                    license third parties to develop andcommercialize products or technologies that we would otherwise seek to developand commercialize ourselves;

 

-                    attempt to sell our company;

 

-                    cease operations; or

 

-                    declare bankruptcy;

 

·                  actual or anticipated announcements of technological innovations;

 

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

 

·                  actual or anticipated changes in laws and governmental regulations;

 

·                  disputes relating to patents or proprietary rights;

 

38

----

Table of Contents

 

·                  changes in business practices;

 

·                  announcements by us regarding transactions with potential strategicpartners;

 

·                  changes in industry trends or conditions;

 

·                  trading volume of our common stock;

 

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

 

·                  developments in our industry; and

 

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

 

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

 

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

 

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

 

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

 

Our executiveofficers, directors and stockholders holding 5% or more of our outstandingcommon stock beneficially own or control approximately 33% of the outstandingshares of our common stock, assuming no exercise of outstanding options andwarrants or conversion of our Convertible Notes. Accordingly, these executiveofficers, directors and principal stockholders, acting as a group, will havesubstantial influence over the outcome of corporate actions requiringstockholder approval, including consummation of the Merger, the election ofdirectors, any other merger or consolidation or sale of all or substantiallyall of our assets or any other significant corporate transaction. Thesestockholders may also delay or prevent a change of control or otherwise discouragea potential acquirer from attempting to obtain control of our company, even ifsuch a change 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.

 

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

 

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

 

·                  advance notice requirements for stockholder proposals and nominations;

 

·                  limitations on convening stockholder meetings;

 

39

----

Table ofContents

 

·                  the elimination ofstockholder action by written consent;

 

·                  the elimination of cumulative voting; and

 

·                  a classified board of directors.

 

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

 

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

 

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

 

Much of thetechnology used in the markets in which we compete is covered by patents. Ourcommercial success will depend in large part on our ability to obtain andmaintain patent and trade secret protection for our products and methods. Wecurrently hold 24 issued United States patents, five granted European patents,more than 100 pending United States and foreign patent applications and twolicensed patents that cover key aspects of our technology. Our issued patentsexpire at various dates beginning in 2019. The loss of our patents could reducethe value of the related products. In addition, the cost to litigateinfringements of our patents or the cost to defend ourselves against patentinfringement actions by others could be substantial.

 

Our ability toobtain additional patents is uncertain and the legal protection afforded bythese patents is limited and may not adequately protect our rights or permit usto gain or keep any competitive advantage. In addition, the specific contentrequired of patents and patent applications that is necessary to support andinterpret patent claims is highly uncertain due to the complex nature of therelevant legal, scientific and factual issues. Changes in either patent laws orin interpretations of patent laws in the United States or elsewhere maydiminish the value of our intellectual property or narrow the scope of ourpatent protection. Even if patents are issued regarding our products andmethods, our competitors may challenge the validity of those patents. Patentsalso will not protect our products and methods if competitors devise ways ofmaking competitive products without infringing our patents.

 

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

 

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

 

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

 

There has beensubstantial litigation and other proceedings regarding patent and otherintellectual property rights in the medical device industry. Defendingourselves against third-party claims, including litigation in particular, wouldbe costly and time consuming and would divert management’s attention from ourbusiness, which could lead to delays in our development or commercializationefforts. Currently, we are involved in two appeal proceedings in Germany inconnection with two of three patent-infringement lawsuits against us. Thelawsuits alleged that certain of our products infringe three European patentsheld by Ethicon Endo-Surgery. We prevailed in two of the three infringementactions and the products in question were found not to infringe the EthiconEndo-Surgery patents, and Ethicon Endo-Surgery is appealing one of thosedecisions. 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:

 

40

----

Table of Contents

 

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

 

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

 

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

 

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

 

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

 

***Risks Related to Regulatory Compliance***

 

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

 

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

 

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

 

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

 

·                  unanticipated expenditures to address or defend such actions;

 

·                  customer notifications for repair, replacement, refunds;

 

41

----

Table of Contents

 

·                  recall, detention or seizure of our products;

 

·                  operating restrictions or partial suspension or total shutdown ofproduction;

 

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

 

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

 

·                  refusal to grant export approval for our products; and

 

·                  criminal prosecution.

 

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

 

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

 

To address the FDA’sinspectional observations made during on-site inspections of the Langhorne,Pennsylvania facility, we have improved our complaint handling and medicaldevice reporting procedures to ensure our compliance with the FDA’s qualitysystem regulations and our related controls and internal audit functions. In2008 we engaged an independent consultant to audit our compliance with certainaspects of the FDA’s quality system regulations. While certain improvementswere noted, further improvements are necessary in our corrective action andpreventative action processes. We also have engaged a third-party to superviseour MDR decision making process, which will continue until the FDA clears theWarning letter it issued to us in October 2008.

 

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

 

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

 

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

 

If a manufacturerdetermines that a modification to an FDA-cleared device could significantlyaffect its safety or efficacy, or would constitute a major change in itsintended use, then the manufacturer must file for a new 510(k) clearanceor possibly a premarket approval application. Where we determine 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.

 

42

----

Table of Contents

 

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

 

Certain of our newproducts will require FDA 510(k) clearance to market or may even requireFDA approval of a PMA. We will need to develop our regulatory strategies forobtaining clearance or approval of new products, as necessary. The FDA may notapprove or clear such products for the indications that are necessary ordesirable for successful commercialization. In addition, the FDA may refuse ourrequests for 510(k) clearance to market or premarket approval of new products,new intended 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 goodsmanufacturing processes, and those of some of our contract manufacturers, arerequired to comply with the FDA’s Quality System Regulations, or QSRs, whichcover the procedures and documentation of the design, testing, production,control, quality assurance, labeling, packaging, sterilization, storage andshipping of our devices. The FDA enforces its QSRs through periodic inspectionsof manufacturing facilities. We and our contract manufacturers have been, andanticipate continuing to be, subject to such inspections. If our manufacturingfacilities or those of any of our contract manufacturers fail to takesatisfactory corrective action in response to an adverse QSR inspection, theFDA could take enforcement action, including any of the following sanctions,which could have a material impact on our operations:

 

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

 

·                  unanticipated expenditures to address or defend such actions;

 

·                  customer notifications for repairs, replacements or refunds;

 

·                  recall, detention or seizure of our products;

 

·                  operating restrictions or partial suspension or total shutdown ofproduction;

 

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

 

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

 

·                  refusal to grant export approval for our products; and

 

·                  criminal prosecution.

 

Between February 2007and May 2008, the FDA conducted two inspections of our facilities. Each ofthose inspections resulted in the issuance of a Notice of InspectionalObservations, or Form 483. Certain observations regarding our processesfor handling customer complaints and submitting medical device reports wereidentified by the FDA as areas of possible non-compliance with FDA regulations.For each of the Form 483s issued by the FDA, we submitted a timelyresponse, which identified our proposed corrective action plans to addressthese inspectional observations. The FDA has not issued an EstablishmentInspection Report, or EIR, which officially closes an inspection, for either the2007 or 2008 inspections. Regarding the most recent inspection, which occurredfrom April 7, 2008 through May 21, 2008, we submitted to the FDA awritten response to the Form 483 on May 30, 2008. That responsedescribed the corrective actions that we were taking to address theinspectional observations identified in the Form 483. We also submittedvarious follow up letters to the FDA regarding the status of our ongoingcorrective actions. On October 21, 2008, the FDA issued a warning letterto us. The warning letter listed the same inspectional observations identifiedin the Form 483. The warning letter also acknowledged the FDA’s receipt ofour Form 483 response and indicated that the agency would verify that wehave taken such corrective actions during a future inspection. On November 5,2008, we submitted a written response to the warning letter which updated theagency on the status of our ongoing corrective actions. The FDA acknowledgedreceipt of our warning letter response in a January 23, 2009. In thatletter, the FDA stated that the adequacy of our corrective actions will bedetermined during the FDA’s next inspection. We also have provided the FDA withregular updates regarding the status of our corrective actions. We expect to bere-inspected by the FDA in 2009. If the FDA finds additional inspectionalobservations, or if the FDA is not satisfied with our corrective actions to the2008 inspection and warning letter, we could be subject to various enforcementactions as identified above.

 

43

----

Table of Contents

 

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

 

The FDA andsimilar foreign governmental authorities have the authority to require therecall of commercialized products in the event of material deficiencies ordefects in design or manufacture. In the case of the FDA, the authority torequire a recall must be based on an FDA finding that there is a reasonableprobability that the device would cause serious injury or death. In addition,foreign governmental bodies have the authority to require the recall of ourproducts in the event of material deficiencies or defects in design ormanufacture. Manufacturers may, under their own initiative, voluntarily recalla product if any material deficiency in a device is found. Agovernment-mandated or voluntary recall by us or one of our distributors couldoccur as a result of component failures, manufacturing errors, design orlabeling defects or other deficiencies and issues. Recalls of any of ourproducts would divert managerial and financial resources and have an adverseeffect on our financial condition and results of operations. The FDA requiresthat certain classifications of recalls be reported to FDA within 10 workingdays after the recall is initiated. Companies are required to maintain certainrecords of recalls, even if they are not reportable to the FDA. We haveinitiated certain voluntary recalls involving products that have beendistributed to our customers and may take additional such actions in thefuture. We believe that certain of those recalls do not require notification 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 decreesand civil penalties;

 

·                  unanticipated expenditures to address or defend such actions

 

·                  customer notifications for repairs, replacements or refunds;

 

·                  recall, detention or seizure of our products;

 

·                  operating restrictions or partial suspension or total shutdown ofproduction;

 

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

 

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

 

·                  refusal to grant export approval for our products; and

 

·                  criminal prosecution.

 

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

 

Under the FDAmedical device reporting regulations, or MDR, medical device manufacturers arerequired to report to the FDA information that a device has or may have causedor contributed to a death or serious injury or has malfunctioned in a way thatwould likely cause or contribute to a death or serious injury if the malfunctionof the device or one of our similar devices were to recur. All manufacturersplacing medical devices in the market in the European Union are legally boundto report any serious or potentially serious incidents involving devices theyproduce or sell to the Competent Authority in whose jurisdiction the incidentoccurred. Were this to happen to us, the relevant Competent Authority wouldfile an initial report, and there would then be a further inspection orassessment if there are particular issues. This would be carried out either bythe Competent Authority or it could require that Orion, as the Notified Body,carry out the inspection or assessment.

 

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

 

44

----

Table of Contents

 

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

 

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

 

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

 

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

 

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

 

*Healthcare*

 

Changes in thehealth care industry in the United States and elsewhere could adversely affectthe demand for our products as well as the way in which we conduct ourbusiness. Significantly, the new administration and Congressional and state leadershave expressed a strong desire to reform the U.S. health care system. Includedin this reform could be laws that narrow Medicare coverage or reducereimbursement levels for healthcare services or items provided by physiciansand hospitals. Furthermore, many private payors look to Medicare’s coverage andreimbursement policies in setting their coverage policies and reimbursementamounts such that federal reforms could influence the private sector as well.Finally, many states also may attempt to reform their Medicaid programs suchthat either coverage for certain items or services may be narrowed orreimbursement for them could be reduced. These healthcare reforms may adverselyaffect our business.

 

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

 

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

 

45

----

Table of Contents

 

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

 

*MedicalDevices*

 

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

 

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

 

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

 

The federalanti-kickback law and several similar state laws prohibit payments that areintended to induce physicians or others either to refer patients for, orrecommend the acquisition of, healthcare products or services. These lawsaffect our sales, marketing and other promotional activities by limiting thekinds of financial arrangements and sales programs we may have with hospitals,physicians or other potential purchasers or users of medical devices. Inparticular, these laws influence how we structure our sales, customer support,education and training programs and physician consulting and other servicearrangements. Although we seek to structure such arrangements in compliancewith applicable requirements, these laws are broadly written and it isdifficult to determine precisely how these laws will be applied in specificcircumstances. We could be subject to a claim under these anti-kickback lawsfor our consulting arrangements with surgeons, grants for training and othereducation, grants for research and other interactions with doctors which havecome under scrutiny by federal and state regulators and law enforcemententities. Anti-kickback laws prescribe civil, criminal and administrativepenalties for noncompliance, which can be substantial. Due to the breadth ofthe statutory provisions and the lack of guidance in the form of regulations orcourt decisions addressing some industry activities, it is possible that oursales, marketing and promotional activities and practices might be challengedunder anti-kickback or related laws. Even an unsuccessful challenge to orinvestigation into our practices could cause adverse publicity and thus couldharm our business and results of operations.

 

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

 

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

 

None.

 

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

 

None.

 

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

 

The stockholders of theCompany adopted the following proposals at the Company’s Annual Meeting ofStockholders held on June 10, 2009 in Lambertville, NJ:

 

46

----

Table of Contents

 
| ** **                                                                                                                                                                       | ** ** | **For**    | ** ** | **Withhold** | ** ** | ** **  | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|--------------|------------|-------------|------------|
| 1.To elect two member to the Board of  Directors to serve for three-year terms as Class II directors:                                                                       |       |       |       |         |       |        |       |   |
| James R. Locher  III                                                                                                                                                             |       | 11,240,236 |       | 139,757      |       |        |       |   |
| Lon E. Otremba                                                                                                                                                                   |       | 11,313,007 |       | 66,986       |       |        |       |   |
|                                                                                                                                                                             |       |       |       |         |       |        |       |
|                                                                                                                                                                             | ** ** | **For**    | ** ** | **Against**  | ** ** | **Abstain** |       |
| 2.To ratify the selection of Ernst &  Young LLP as the Company’s independent registered public accounting firm for  the fiscal year ending December 31, 2009: |       | 11,028,356 |       | 342,512      |       | 9,125       |       |

 

The Board of Directors ofthe Company withdrew the proposals in the proxy statement dated May 11,2009 that related to (i) approval of an amendment to each of the Company’s2000 Stock Option Plan, 2004 Stock Incentive Plan and 2007 Equity IncentivePlan, as amended, to allow for a one-time option exchange program for eligibleemployees and (ii) approval of a one-time option exchange program foreligible employees.

 

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

 

None.

 

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

 
| 31.1   |   | Certification of the  Principal Executive Officer of Power Medical Interventions, Inc.  pursuant to Rule 13a-l4(a) of the Securities Exchange Act of 1934,  as amended, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act  of 2002(1)                              |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                              |
| 31.2   |   | Certification of the  Principal Financial Officer and Chief Accounting Officer of Power Medical  Interventions, Inc. pursuant to Rule 13a-14(a) of the  Securities Exchange Act of 1934, as amended, as adopted pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002(1) |
|   |   |                                                                                                                                                                                                                                                                                              |
| 32.1   |   | Certification of the  Principal Executive Officer of Power Medical Interventions, Inc.  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002(1)                                                                               |
|   |   |                                                                                                                                                                                                                                                                                              |
| 32.2   |   | Certification of the  Principal Financial Officer and Chief Accounting Officer of Power Medical  Interventions, Inc. to 18 U.S.C. Section 1350, as adopted pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002(1)                                                           |

 

----

(1) Filed herewith

 

47

----

Table of Contents

 

**SIGNATURES**

 

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

 
|                  |   | POWER MEDICAL  INTERVENTIONS, INC.     |
|-----------------------|--------|----------------------------------------|
|                  |   |                                   |
|                  |   |                                   |
| August 11,  2009 | By:    | /s/ Michael P.  Whitman                |
|                  |   | Michael P.  Whitman                    |
|                  |   | President and  Chief Executive Officer |
|                  |   |                                   |
|                  |   |                                   |
| August 11,  2009 | By:    | /s/ Brian M.  Posner                   |
|                  |   | Brian M. Posner                        |
|                  |   | Chief Financial  Officer               |

 

48

----

Table of Contents

 

**Exhibit Index**

 
| 31.1   |   | Certification of the  Principal Executive Officer of Power Medical Interventions, Inc.  pursuant to Rule 13a-l4(a) of the Securities Exchange Act of 1934,  as amended, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act  of 2002(1)                              |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                              |
| 31.2   |   | Certification of the  Principal Financial Officer and Chief Accounting Officer of Power Medical  Interventions, Inc. pursuant to Rule 13a-14(a) of the  Securities Exchange Act of 1934, as amended, as adopted pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002(1) |
|   |   |                                                                                                                                                                                                                                                                                              |
| 32.1   |   | Certification of the  Principal Executive Officer of Power Medical Interventions, Inc.  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002(1)                                                                               |
|   |   |                                                                                                                                                                                                                                                                                              |
| 32.2   |   | Certification of the  Principal Financial Officer and Chief Accounting Officer of Power Medical  Interventions, Inc. to 18 U.S.C. Section 1350, as adopted pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002(1)                                                           |

 

----

(1) Filedherewith

 

49

----