|UNITED STATES
                                                  SECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549

                                                               FORM 10-K
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|ý | Annual Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
           For the Fiscal Year Ended December 31, 2007
|- | -------------------------------------------------------------------------------------------------------------------------------------------

|o | Transition Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
              For the transition period from ______ to ______
|- | ------------------------------------------------------------------------------------------------------------------------------------------------------

|Commission file number: 0-22340






PALOMAR MEDICAL TECHNOLOGIES, INC.
|------------------------------------------------------------------------

|A Delaware Corporation | I.R.S Employer Identification No. 04-3128178
|---------------------- | --------------------------------------------

|82 Cambridge Street, Burlington, Massachusetts 01803
Registrant's telephone number, including area code: (781) 993-2300
Securities registered pursuant to Section 12(b) of the Act:
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Title of each class
Common Stock, $0.01 par value | Name of each exchange on which registered
NASDAQ -Global Select Market
|------------------------------------------------- | ----------------------------------------------------------------------
|Preferred Stock Purchase Rights                  

|Securities registered pursuant to Section 12(g) of the Act:
|-----------------------------------------------------------
|None.                                                      

|Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities
Act.
  Yes oNo
ý
|-----------------------------------------------------------------------------------------------------------------------------------

|Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange
Act.
  Yes oNo
ý

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities
Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such
reports), and (2) has been subject to such filing requirements for the past 90 days.
  YesýNo
o


Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will
not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in
Part III of this Form 10-K or any amendment to this Form 10-K.ý

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

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

Indicate by check mark if the registrant is a shell company, in Rule 12b(2) of the Exchange Act.    Yes  o    No   ý

The aggregate market value of the voting stock (common stock) held by non-affiliates of the registrant
as of the close of business on June 30, 2007 was $500,079,257. The number of shares outstanding of the
registrants common stock as of the close of business on March 4, 2008 was 18,338,012.

DOCUMENTS INCORPORATED BY REFERENCE


Part III incorporates by reference certain information from
the registrants definitive proxy statement for its 2008 annual meeting of stockholders, which is expected to be filed on or before April 29, 2008.
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|
|

|Table of Contents
|-----------------

|           |                                                                                                            |    | Page No.
|---------- | ---------------------------------------------------------------------------------------------------------- | -- | --------
|PART I     |                                                                                                            |    |         
|           |                                                                                                            |    |         
|Item 1.    | Business                                                                                                   |    | 1       
|Item 1A.   | Risk Factors                                                                                               |    | 9       
|Item 1B.   | Unresolved Staff Comments                                                                                  |    | 20      
|Item 2.    | Properties                                                                                                 |    | 20      
|Item 3.    | Legal Proceedings                                                                                          |    | 20      
|Item 4.    | Submission of Matters to a Vote of Security Holders                                                        |    | 22      
|           |                                                                                                            |    |         
|PART II   
|           |                                                                                                            |    |         
|Item 5.    | Market for Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Services |    | 22      
|Item 6.    | Selected Financial Data                                                                                    |    | 24      
|Item 7.    | Managements Discussion and Analysis of Financial Condition and Results of Operations                      |    | 25      
|Item 7A.   | Quantitative and Qualitative Disclosures About Market Risk                                                 |    | 39      
|Item 8.    | Financial Statements and Supplementary Data                                                                |    | 41      
|Item 9.    | Changes in and Disagreements with Accountants on Accounting and
         Financial Disclosures             |    | 69      
|Item 9A.   | Controls and Procedures                                                                                    |    | 69      
|Item 9B.   | Other Information                                                                                          |    | 72      
|           |                                                                                                            |    |         
|PART III  
|           |                                                                                                            |    |         
|Item 10.   | Directors and Executive Officers of the Registrant                                                         |    | 72      
|Item 11.   | Executive Compensation                                                                                     |    | 72      
|Item 12.   | Security Ownership of Certain Beneficial Owners and Management and Related
         Stockholder Matters    |    | 72      
|Item 13.   | Certain Relationships and Related Transactions                                                             |    | 72      
|Item 14.   | Principle Accountant Fees and Services                                                                     |    | 72      
|           |                                                                                                            |    |         
|PART IV   
|           |                                                                                                            |    |         
|Item 15.   | Exhibits and Financial Statement Schedules                                                                 |    | 72      
|           |                                                                                                            |    |         
|SIGNATURES |                                                                                                            | 78

|PART I


Item
1. Business


Introduction


Palomar is
 a leading researcher and developer of innovative aesthetic light-based systems for
hair removal and other cosmetic procedures, including both lasers and high powered lamps.
For over a decade, we have been on the forefront of technology breakthroughs.





Highlights of the development of our business over the past five years include the following:
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | o |  | 2003 we signed a Development and License Agreement with The Gillette Company to complete
development and commercialize a patented home-use, light-based hair removal device for
women
| |  | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | o |  | 2004 we introduced the StarLux® Pulsed Light and Laser system which incorporates a
single power supply system capable of operating both lasers and lamps
| |  | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | o |  | 2004 we were awarded a research contract by the United States Department of the Army to
develop a light-based self-treatment device for Pseudofolliculitis Barbae
| |  | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | o |  | 2004
we signed a Development and License Agreement with Johnson & Johnson Consumer Companies,
Inc., a Johnson & Johnson               company (NYSE: JNJ), to develop, clinically test
and potentially commercialize home-use, light-based devices for (i)
              reducing or reshaping body fat including cellulite; (ii) reducing
appearance of skin aging; and (iii) reducing or               preventing acne
| |  | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | o |  | 2005 we were awarded additional funding and a one year extension for our research
contract with the United States Department of the Army to develop a light-based
self-treatment device for Pseudofolliculitis Barbae
| |  | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | o |  | 2005
we began shipping the Lux 1064 handpiece for use with the StarLux System for
removal of leg veins and other conditions
| |  | - |  | ----------------------------------------------------------------------------------------------------------------------------

| |  | o |  | 2005 we began shipping the Lux IR Fractional
Infrared handpiece for use with the StarLux System for deep heating for pain relief
and in 2006 we received FDA clearance for soft tissue coagulation
| |  | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | o |  | 2006 we were awarded additional funding and a five month extension for our research
contract with the United States Department of the Army to develop a light-based
self-treatment device for Pseudofolliculitis Barbae
| |  | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | o |  | 2006 we began shipping the Lux1540 Fractional Laser handpiece for use with the
StarLux System for soft tissue coagulation and non-ablative skin resurfacing
| |  | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | o |  | 2006 we received a 510(k) over-the-counter (OTC) clearance from the FDA for a new,
patented, home-use, light-based hair removal device
| |  | - |  | --------------------------------------------------------------------------------------------------------------------------------------

| |  | o |  | 2007 we introduced the StarLux® 500 Laser and Pulsed Light System featuring 70% more
power and increased functionality and speed of treatment
| |  | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------

| |  | o |  | 2007
we introduced new handpieces including:
| |  | - |  | --------------------------------------------

| |  |  | o |  | LuxDeepIR Fractional
handpiece, the second generation of the LuxIR Fractional handpiece, including
advanced cooling, contact sensors and longer pulse duration, and
| |  |  | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | o |  | LuxYs Pulsed
Light handpiece for permanent reduction of lighter, finer hair
| |  |  | - |  | ----------------------------------------------------------------------------

| |  | o |  | 2007
we were awarded a five month and an additional three month extension for our research
contract with the United States Department of the Army to develop a light-based
self-treatment device for Pseudofolliculitis Barbae
| |  | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | o |  | 2007 we expanded our Development and License Agreement with Gillette to allow for the
development of an additional home-use, light-based hair removal device for women. In
December 2007, we announced an extension of a Launch Decision under this Agreement to
allow the parties to negotiate terms for a potential new agreement.
| |  | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | o |  | 2007
and early 2008 we introduced new fractional handpieces including:
| |  | - |  | ----------------------------------------------------------------------

| |  |  | o |  | Lux2940 Fractional
Laser handpiece for ablative skin resurfacing and,
| |  |  | - |  | ----------------------------------------------------------------------

| |  |  | o |  | Lux1440 Fractional
Laser handpiece for faster non-ablative soft tissue coagulation and skin resurfacing.
| |  |  | - |  | ---------------------------------------------------------------------------------------------------------

|1
|-

| |  | o |  | 2008 we entered into a License Agreement with The Procter & Gamble Company
and its wholly owned subsidiary The Gillette Company under which we granted a non-exclusive license to certain patents and technology to commercialize  home-use light-based hair removal devices for women.
This License Agreement replaced the Development and License Agreement entered into with Gillette in 2003 which was amended and restated in February 2007.
| |  | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

We
are continuously researching, developing and testing new and exciting innovations for a
variety of cosmetic applications, such as:

| |  | o |  | skin
rejuvenation, including tone and texture
| |  | - |  | ---------------------------------------------

| |  | o |  | skin
tightening, including laxity and lifting
| |  | - |  | ---------------------------------------------

| |  | o |  | pigmented
lesion removal, such as sun and age spots, freckles and melasma
| |  | - |  | -------------------------------------------------------------------------

| |  | o |  | vascular
lesion removal, such as spider veins, cherry angiomas and rosacea
| |  | - |  | --------------------------------------------------------------------------

| |  | o |  | leg
vein removal
| |  | - |  | ----------------

| |  | o |  | acne
treatment
| |  | - |  | --------------

| |  | o |  | scars,
including acne scars, stretch marks and warts
| |  | - |  | ----------------------------------------------------

| |  | o |  | fat
reduction, including cellulite
| |  | - |  | ----------------------------------

|Palomar, a Delaware corporation, was
 organized in 1987 to design, manufacture, market and sell lasers and other light-based products and related disposable items and accessories for use in medical and
cosmetic procedures. We became a public company in December 1992.  We obtained FDA clearance to market our EpiLaser® ruby laser hair
removal system in March 1997 and were well positioned to focus on what we believed was the
most promising product in our core laser business. Under the direction of a new
board and management team, we undertook a program in 1997, which was completed in May of
1998, of exiting from all non-core businesses and investments and focusing only on those
businesses which we believed held the greatest promise for maximizing stockholder value.
Our exclusive focus became the use of lasers and other light-based products in
dermatology and cosmetic procedures.


We became the first company to receive FDA
clearance for a diode laser for hair removal and for leg vein treatment, the
LightSheer diode laser system. The LightSheer was the first generation of high-powered diode
lasers designed for hair removal, and like our EpiLaser and other prior hair removal
products, the LightSheer incorporated technology protected by patents licensed exclusively
to us from the General Hospital Corporation doing business as Massachusetts General
Hospital.




On
February 14, 2003, we entered into a Development and License Agreement with Gillette to
complete development and commercialize a home-use, light-based hair removal device for
women.  On June 28, 2004, we announced with Gillette that we completed the initial
phase of our agreement and that both parties would move into the next phase. In
conjunction with entering this next phase, the parties amended the agreement to provide
for additional development funding to further technical innovations. In September 2006, we
announced that Gillette had made the decision to move into the next phase of our
agreement. On December 8, 2006, we became the first company to receive a 510(k)
over-the-counter (OTC) clearance from the FDA for a new, patented, home-use, light-based
hair removal device. OTC clearance allows the product to be marketed and sold directly to
consumers without a prescription. Under our agreement, Gillette paid us $2.5 million
following our receipt of the OTC clearance as we were obligated to perform additional services and remain exclusive with Gillette during a
twelve month period. In February 2007, we announced an amendment to
our agreement with Gillette to include the development and commercialization of an
additional light-based hair removal device for home-use, and we also announced that we had
executed an Amended and Restated Joint Development Agreement to incorporate other prior
amendments and several new amendments to allow for more open collaboration through
commercialization. On December 21, 2007, we announced an amendment to our agreement with
Gillette to extend the Launch Decision from January 7, 2008 until February 29, 2008 to
enable the parties to enter into negotiations for a potential new agreement to replace the
existing agreement.  On March 3, 2008, we announced with The Procter & Gamble Company (P&G) that we had entered into a License Agreement with The Procter & Gamble Company
and its wholly owned subsidiary The Gillette Company under which we granted a non-exclusive license to certain patents and technology to commercialize home-use light-based hair removal devices for women.
This License Agreement replaced the Development and License Agreement entered into with Gillette in 2003 which was amended and restated in February 2007.





2


On
February 18, 2004, we announced that we were awarded a $2.5 million research contract by
the United States Department of the Army to develop a light-based self-treatment device
for Pseudofolliculitis Barbae, or PFB, commonly known as razor bumps. On
October 25, 2005, we announced that we were awarded additional funding of $888,000 for a
total of $3.4 million and a twelve month contract extension. On September 1, 2006, we were
awarded additional funding of $440,000 for a total of $3.8 million and an additional five
month extension until April 30, 2007.  Since April 30, 2007, the contract has been extended on multiple occasions and currently has been extended through March 31, 2008.


On
September 1, 2004, we entered into a Development and License Agreement with Johnson &
Johnson Consumer Companies, Inc. to develop, clinically test and potentially commercialize
home-use, light-based devices for (i) reducing or reshaping body fat including cellulite;
(ii) reducing appearance of skin aging; and (iii) reducing or preventing acne.  On
August 22, 2007, we signed an amendment to our agreement with Johnson & Johnson to
provide for additional development funding for certain development activities.



We
have two operating subsidiaries. Palomar Medical Products, Inc. is located at our
headquarters in Burlington, Massachusetts and  oversees the manufacture and sale of our
laser and lamp-based systems currently on the market. Palomar Medical Technologies BV
is located in Amsterdam, The Netherlands, and markets our products in Europe, Middle
East, and Africa as well as provides certain services of our products for those regions.


Market for Aesthetic
Procedures


The
market for light-based aesthetic procedures has seen significant growth over the past
decade, particularly in the last several years. Many factors are likely responsible for
this growth including the aging population of the United States and other industrialized
nations along with a desire to look and feel younger and a rising discretionary income
with which to pay for such procedures. Consumers often undergo aesthetic procedures to
improve their self-image and self-esteem, or to appear competitive in an ever-younger
workforce. Another important factor is the sophistication of the equipment for light-based
aesthetic procedures. Technological advancements made to the equipment have improved
safety, ease of use, efficacy, and cost which has in turn grown our customer base. Our
traditional customers have been plastic surgeons and dermatologists. However, increased
consumer demand and technological advancements as well as managed care and reimbursement
restrictions in the United States and similar constraints outside the United States, have
motivated non-traditional customers such as general practitioners, gynecologists,
surgeons, and others to offer aesthetic procedures. Such procedures have the advantage of
being provided on a fee-for-service basis. In addition, technological advances have
reduced both treatment and recovery times and made a broader variety of treatments for
different cosmetic issues possible, further increasing consumer demand.


Business Strategy


With
our strong focus on both the professional and consumer markets, we believe we are
positioned to capitalize on the ever expanding market for improving personal appearance.
Our strategy is three-fold: growth of our professional business, driving our technology
into the mass consumer markets, and executing our intellectual property enforcement
strategy.



Growth of Professional
Business.
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Innovative
Products. We grow our professional business by investing significant resources in
research and development to allow us to continually introduce innovative, patented
products. For example, in March 2007, we began shipping the new StarLux 500 Laser and
Pulsed Light System, and recently we introduced two new handpieces for that system, the
Lux2940 Fractional Handpiece for ablative skin resurfacing and the Lux1440 Fractional
Handpiece for faster non-ablative skin resurfacing. We have led the industry in offering
platforms that allow practitioners to grow their practice by adding handpieces for
additional applications and by moving to higher power, more sophisticated systems. This
strategy has been favorably received through the years by our customers allowing us to
leverage our installed base.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Expanding
Practitioner Base. We believe that our professional business has further growth
potential through non-traditional practitioners. In addition to our traditional base of
plastic surgeons and dermatologists, we intend to continue to market and sell to other
practitioners including general and family practitioners, gynecologists, surgeons,
physicians offering cosmetic treatments in medi-spa facilities and others.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|3
|-

| | Increasing
International Presence. We are expanding our international presence which we believe
will be a significant opportunity for us. In 2007, we opened an office in Amsterdam, The
Netherlands, to oversee our marketing efforts in Europe, Middle East, and Africa and
provide certain services for our products in these areas. On January 9, 2008, we announced
our international distribution agreement with the Swedish company Q-MED AB, the producer
of Restylane, one of the most popular and widely distributed dermal fillers in the world.
Q-MED sells Restylane globally through a network of fully owned sales companies, partners
and distributors.  The transition from our existing
distributors to Q-MED shall be on a country-by-country basis as the companies agree on the
terms of each transition. We plan to work with Q-MED and current distributors to determine
how each distributor might successfully work with Q-MED during and after each country is
transitioned.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Driving Our Technology into
Consumer Market. We direct significant resources toward driving our technology into
the mass consumer markets, including with both Johnson &
Johnson Consumer Companies, Inc. and The Procter & Gamble Company, and its wholly owned subsidiary The Gillette Company.


Intellectual Property
Enforcement. We are executing on our intellectual property enforcement strategy. We
have a portfolio of patents in a number of areas. In the light-based hair removal area, we
enforced a patent against Cutera, Inc. in a lawsuit which was successfully
concluded in June 2006.  In
October 2006, we announced that Cynosure agreed to take a license to our hair removal
patents. Several other competitors, Lumenis, Iridex, Ellipse A/S (formerly Danish Dermatologic Development A/S),
and New Star Lasers, Inc. (d/b/a CoolTouch, Inc.), also pay us royalties on sales of hair
removal products. In July 2006, we again tested the light-based hair removal
patents when we sued Alma Lasers, Inc. for patent infringement. This lawsuit was
successfully concluded in March 2007 with Alma admitting that their products infringe our
patents and that the patents are both valid and enforceable.  In August 2006, we filed suit against Candela
Corporation for infringement of these hair removal patents. We are reviewing various
strategies with additional parties, including granting additional licenses and further
litigation, if necessary, which would seek money damages as well as injunctions. (For more
information about our patent litigation, see Item 3 Legal Proceedings and Note 7 of Notes to our Consolidated Financial Statements.)


Financial Information
About Industry Segments






We
conduct business in one industry segment, medical and cosmetic products and services.



Principal Products


We research,
develop, manufacture, market, sell and service light-based products used to perform
procedures addressing medical and cosmetic concerns. We offer a comprehensive range of
products based on proprietary technologies that include, but are not limited to:
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | o |  | Hair
removal
| |  | - |  | ------------

| |  | o |  | Removal
of vascular lesions such as rosacea, spider veins, port wine stains and hemangiomas
| |  | - |  | -------------------------------------------------------------------------------------------

| |  | o |  | Removal
of leg veins
| |  | - |  | --------------------

| |  | o |  | Removal of benign pigmented lesions such as age and sun spots, freckles
and melasma
| |  | - |  | -----------------------------------------------------------------------------------

| |  | o |  | Tattoo
removal
| |  | - |  | --------------

| |  | o |  | Acne
treatment
| |  | - |  | --------------

| |  | o |  | Skin resurfacing
| |  | - |  | ----------------

| |  | o |  | Pseudofolliculitis
Barbae or PFB treatment
| |  | - |  | ------------------------------------------

| |  | o |  | Treatment
of red pigmentation in hypertrophic and keloid scars
| |  | - |  | --------------------------------------------------------------

| |  | o |  | Treatment
of verrucae, skin tags, seborrheic keratosis
| |  | - |  | ------------------------------------------------------

| |  | o |  | Skin
tightening through soft tissue coagulation
| |  | - |  | -----------------------------------------------

| |  | o |  | Scars,
including acne scars, stretch marks and warts
| |  | - |  | ----------------------------------------------------

| |  | o |  | Soft
tissue coagulation
| |  | - |  | -----------------------

| |  | o |  | Other
skin treatments
| |  | - |  | ---------------------

|4

Lux
Platform. With increasing market acceptance of light-based treatments for
new applications, we recognized the need for a cost effective platform that could expand
with the needs of our customers. In 2001, we announced the first product with the Lux
Platform: the EsteLux® Pulsed Light System. In March 2003, we introduced the higher
priced MediLux Pulsed Light System with the same six handpieces, but also with
higher power, faster repetition rate and a newsnap-on connector for faster changes
between handpieces. In February 2004, we enhanced the upgrade opportunities for our
customers with the introduction of the StarLux® Pulsed Light and Laser System with
increased power, a computer controlled touch screen, instant handpiece recognition, active
contact cooling, and a long pulse Nd:YAG laser handpiece, the Lux1064. In February
2005, we introduced a new infrared handpiece, the LuxIR. In June 2006, we introduced
and began shipping the Lux1540 Fractional Laser handpiece. In February 2007, we
introduced the StarLux® 500 Pulsed Light and Laser System with 70% more power and
increased functionality and speed of treatment as compared to the original StarLux System.
Capable of achieving higher peak and average power for greater efficacy with increased
contact cooling for added safety and comfort, the StarLux 500 offers customers faster
treatment times, more flexibility and improved results. The StarLux 500 supports the suite
of StarLux handpieces, as well as several handpieces introduced in 2007 and early 2008, the
LuxDeepIR handpiece, and the LuxYs handpiece, and two
new handpieces, the Lux2940 fractional handpiece for ablative treatment and the Lux1440 fractional handpiece for non-ablative treatment.




Customers
can invest in their first Lux system with one handpiece then purchase additional
handpieces as their practice grows and upgrade into a more powerful Lux system when ready.
The Lux platform enables us to custom tailor products to fit almost any professional
medical office or spa location and provide customers with the comfort that the system is
able to grow with their practice.


In
addition to being cost effective and upgradeable, the platform includes many technological
advances. For example, the platform includes our Smooth Pulse technology, a safe and
comfortable treatment that spreads power evenly over the entire pulse of light allowing us
to provide optimal wavelengths for faster results in fewer treatments. By contrast, many
competitive systems deliver a power spike at the beginning of each pulse which can cause
injury at the most effective wavelengths. The Smooth Pulse technology extends the life of
the light source. We sell replacement handpieces to existing customers providing a
reoccurring revenue stream.






The
Lux pulsed light handpieces combine the latest technology with simple, streamlined
engineering that is both effective and economical. Long pulse widths and
AccuSpectrum filtering provide increased safety and efficacy. Efficacy is further
improved through our Photon Recycling process which increases the effective fluence by
capturing light scattered out of the skin during treatments and redirecting it back into
the treatment target. Offering one of the largest spot sizes in the market and high
repetition rates allows for fast coverage which is especially important when removing hair
from large areas such as legs and backs. A back or a pair of legs can be treated in
approximately thirty minutes, and a smaller area, such as the underarms, in even less
time. The systems simple operation opens its applications to a wider band of
worldwide users.


     EsteLux.
          During 2001, we received FDA clearance to market and sell the Palomar
          EsteLux Pulsed Light System. In 2002 and 2003, we offered six handpieces
          for the EsteLux system: LuxY, LuxG, LuxR, LuxRs, LuxB and LuxV. These handpieces
          emit pulses of intense light to treat unwanted hair, solar lentigo (sunspots),
          rosacea, actinic bronzing, spider veins, birthmarks, telangiectasias, acne and
          more. The LuxY handpiece is used for hair removal for large body areas and for
          pigmented lesion treatments. The LuxG handpiece delivers the RejuveLux
          process  photofacial treatments that remove pigmented and vascular lesions
          to improve skin tone and texture. The LuxR handpiece can be used to remove hair
          on all skin types, from the fairest to the darkest, including deep tans.
          Likewise, the LuxRs handpiece can be used to remove hair on all skin types, but
          it has concentrated power in each pulse resulting in permanent hair reduction in
          fewer treatments. The LuxB handpiece provides effective treatment of lighter
          pigmented lesions on fair skin as well as leg and spider veins, and the LuxV
          handpiece treats pigmented lesions and mild to moderate acne. With these
          complimentary handpieces, the Lux Platform is one of the most affordable and
          multifaceted systems in the market.


     MediLux.
          In March 2003, we launched the Palomar MediLux Pulsed Light System with
          the six handpieces also available on the EsteLux. The MediLux provides increased
          power, a faster repetition rate and a snap-on connector making it easier to
          switch among handpieces and provide treatments tailored to each individual being
          treated.






     StarLux 300.
          In February 2004, we launched the StarLux® 300 Laser and Pulsed Light System,
          and in June 2004, we began shipping this system. The StarLux 300 has a single power
          supply capable of operating both lasers and lamps. The StarLux 300 includes
          increased power, active contact cooling and a full color touch screen for easy
          operation. The StarLux 300 operates five of the EsteLux / MediLux handpieces, namely
          the LuxY, LuxG, LuxR, LuxRs, and LuxV. In addition, the increased power of the
          StarLux 300 allows for the operation of a long pulse Nd:YAG laser handpiece, the
          Lux1064. In January 2005, the Lux1064 laser handpiece received FDA
          clearance for a variety of applications, including but not limited to removal of
          pigmented and vascular lesions, including visible leg veins. The Lux1064 is a high power laser handpiece featuring Smooth
          Pulse technology and Active Contact Cooling while also providing multiple spot
          sizes.


5


Our
patented Active Contact Cooling technology sends a chilled water supply through the
StarLux 300 handpieces, thus cooling the skin before, during, and after treatment. This
feature is designed to ensure safety and comfort during treatment. The StarLux 300s
high-powered treatments deliver long-lasting and even permanent results. The StarLux 300
full-color screen allows easy finger-touch operation and instant handpiece recognition
while providing constant feedback on operating parameters.


In
2005, we introduced and began shipping a new infrared handpiece, the LuxIR, for deep
tissue heating for relief of muscle and joint pain. In 2006, we received FDA clearance for
the LuxIR handpiece for soft tissue coagulation and began marketing the LuxIR for skin
tightening through soft tissue coagulation.


In
2006, we introduced and began shipping the Lux1540 Fractional Laser handpiece for
soft tissue coagulation. In 2007, we received FDA clearance for the Lux1540 for
non-ablative skin resurfacing. The Lux1540 delivers light in an array of high precision
microbeams which create narrow, deep columns of tissue coagulation that penetrate well
below the epidermis and into the dermis, while sparing the tissue surrounding the columns
from damage.


In
February 2007, we introduced the LuxYs Pulsed Light handpiece for permanent
reduction of lighter, finer hair.





StarLux
500. In February 2007, we launched the StarLux® 500 Laser and Pulsed
Light System, and began shipping in March 2007. The StarLux 500 provides 70% more power
and increased functionality and speed of treatment as compared to the StarLux 300.
The StarLux 500 operates all the handpieces available for the StarLux 300 System as
well as the LuxDeepIR handpiece. The LuxDeepIR Fractional handpiece is an upgrade of
the LuxIR Fractional handpiece and includes advanced cooling, contact sensors and
longer pulse duration for improved safety and efficacy. In addition, in December 2007, we
began shipping the Lux2940 Fractional handpiece for ablative skin resurfacing, and in
February 2008, we announced the Lux1440 Fractional handpiece for faster non-ablative skin
resurfacing.


Q-YAG
5. During 2001, we received FDA clearance to market and sell the Palomar
Q-YAG 5 system for tattoo and pigmented lesion removal. The Palomar Q-YAG 5 is a
Q-switched, frequency-doubled Neodymium laser. The combination of wavelengths allows users
to treat a full spectrum of colors and inks, and the systems design lowers costs and
allows broader use of the instrument. The single wavelength is ideal for treating darker
tattoo inks and dermal-pigmented lesions, such as Nevi of Ota common in Japan and other
Pacific Rim countries. The mixed wavelength is better suited for brighter colors and
epidermal-pigmented lesions, such as solar lentigines. In addition, the mixed wavelength
permits brighter, more superficial and deeper and darker target areas to be treated
simultaneously. The Palomar Q-YAG 5 incorporates the laser into the handpiece making it
smaller and lighter than competitive systems, which is especially desirable for mobile
and/or small physician offices. These attributes reduce the cost, increase the reliability
of the system and eliminate costly optics and service problems that are common with other
high power Q-Switched lasers.


Legacy
Products.We no longer sell the EpiLaser or E2000 hair removal
laser systems, the RD-1200 Q-switched ruby laser, SLP1000® Diode Laser System or
the NeoLux Pulsed Light System. However, we continue to service these systems. The service
of the RD-1200, Epilaser and E2000 have been contracted out to a third party service
provider, and we have the option of contracting out the service of the SLP1000 systems to
this same party.






Global Distribution


We
currently employ a global network of strategic distributors throughout Europe, Japan,
Australia, South and Central America, the Far East, and the Middle East. As of December
31, 2007, we utilized 40 distributors in 50 countries. To improve our international sales
and marketing efforts, in January 2008, we executed an international distribution
agreement with the Swedish company Q-MED AB, the producer of Restylane, one of the most
popular and widely distributed dermal fillers in the world. Q-MED sells Restylane globally
through a network of fully owned sales companies, partners and distributors.  The transition from our existing distributors to Q-MED shall be on a
country-by-country basis as the companies agree on the terms of each transition. We plan
to work with Q-MED and current distributors to determine how each distributor might
successfully work with Q-MED during and after each country is transitioned.


6


To
further improve our international sales and marketing efforts, we opened a new subsidiary
in The Netherlands. We use this location to coordinate various marketing and
distribution activities in Europe, Middle East and Africa as well as provide certain
services for our products sold in Europe.





The
following table shows product revenue relating to our international sales activities
during each of the last three fiscal years by geographic region:
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|At December 31,           | 2007 | 2006 | 2005
|------------------------- | ---- | ---- | ----
|North America             |      | 71   | %   
|Europe                    |      | 12   | %   
|South and Central America |      | 5    | %   
|Asia / Pacific            |      | 4    | %   
|Japan                     |      | 4    | %   
|Middle East               |      | 3    | %   
|Australia                 |      | 1    | %   
|                          |      |      |     
|Total                     |      | 100  | %   

|Products Under Development


We
are engaged in developing products for the dermatology and cosmetic market. Products under
development include lasers, lamps and other light-based products for the removal of
unwanted hair, tattoos, pigmented lesions, leg vein and other vascular lesions, acne, fat,
cellulite, and skin rejuvenation, including skin resurfacing, skin tone and texture as well as
other cosmetic applications. We perform our own research and we also fund research at
various institutions throughout the world. Product development is performed by scientists
and engineers at our headquarters. We direct resources at both new products for existing
markets such as the removal of unwanted hair, vascular and pigmented lesions and tattoos,
acne and skin resurfacing, and other products for new markets, such as fat reduction,
including the treatment of cellulite.


Production, Sources and
Availability of Materials


Our
manufacturing operations are located in Burlington, Massachusetts. We maintain control of
and manufacture most key subassemblies in-house. Manufacturing consists of the assembly
and testing of components purchased from outside suppliers and contract manufacturers.
Each fully assembled system is subjected to a rigorous set of tests prior to shipment to
the end user. We have obtained ISO 13485 2003, CDN MDR, and Council Directive 93/42/EEC
approvals. We are registered with the Federal Food and Drug Administration.





We
depend and will depend upon a number of outside suppliers for components used in our
manufacturing process. Most of our components and raw materials are available from a
number of qualified suppliers. If our suppliers are unable to meet our requirements on a
timely basis, production could be interrupted until an alternative source of supply is
obtained.


Patents and Licenses


Our
success and ability to compete are dependent on our ability to develop and maintain
proprietary technology and operate without infringing on the proprietary rights of others.
We rely on a combination of patents, trademarks, trade secret and copyright laws and
contractual restrictions to protect our proprietary technology. These legal protections
afford only limited protection for our technology. We are presently the exclusive licensee
of two United States patents and the non-exclusive licensee of three United States patents
as well as corresponding foreign patents and pending applications owned by Massachusetts
General Hospital, and we are the joint owner with Massachusetts General Hospital of seven
other United States patents as well as corresponding United States pending applications
and foreign patents and pending applications. In addition, we are the sole owner of
twenty-six United States patents as well as corresponding and non-corresponding United
States pending applications and foreign patents and pending applications, and have rights
to other patents under exclusive and non-exclusive licenses.


7


We
seek to limit disclosure of our intellectual property by requiring employees, consultants
and any third party with access to our proprietary information to execute confidentiality
agreements with us and often agreements that include assignment of rights provisions to
us. Due to rapid changes in technology, we believe that factors such as the technological
and creative skills of our personnel, new product developments and enhancements to
existing products are as important as the various legal protections of our technology to
establishing and maintaining a leadership position.




Despite
our efforts to protect our proprietary rights, unauthorized parties may attempt to copy
aspects of the products or to obtain and use information that we regard as proprietary.
Policing unauthorized use of our products is difficult. Litigation may be necessary to
enforce intellectual property rights, to protect our trade secrets, to determine the
validity and scope of the proprietary rights of others or to defend against claims of
infringement or invalidity. Any such resulting litigation could result in substantial
costs and diversion of resources and could have a material adverse effect on our business,
operating results and financial condition. There can be no assurance that our means of
protecting proprietary rights will be adequate or that our competitors will not
independently develop similar technology. Any failure by us to meaningfully protect our
proprietary rights could have a material adverse effect on our business, operating results
and financial condition.


Management
believes that none of our current products infringe upon valid claims of patents owned by
third parties. However, there have been claims made against us and there can be no
assurance that third parties will not make further claims of infringement with respect to
our current or future products.Any such claims, with or without merit, could be
time-consuming to defend, result in costly litigation, divert our attention and resources,
cause product shipment delays or require us to enter into royalty or licensing agreements.
Such royalty or licensing agreements, if required, may not be available on terms
acceptable to us or at all. A successful claim of intellectual property infringement
against us and our failure or inability to license the infringed technology or develop or
license technology with comparable functionality could have a material adverse effect on
our business, financial condition and operating results. (For more information about our patent litigation, see Item 3 Legal Proceedings and Note 7 of Notes to our Consolidated Financial Statements.)


Backlog


Generally,
we do not maintain a high level of backlog. As a result, we do not believe that our
backlog at any particular time is indicative of future sales levels.


Competition


The
market in which we are engaged is subject to intense competition and rapid technological
change. Our competitors include but are not limited to: Candela, Inc., Cutera, Inc.,
Cynosure, Inc., Syneron, Inc., Lumenis, Inc., Alma, Inc., Iridex, Inc., Reliant
Technologies, Inc., and other smaller competitors. Some of our competitors have greater
financial, marketing, and technical resources than we have. Moreover, some competitors
have developed, and others may attempt to develop, products with applications similar to
that of ours. We expect that there may be further consolidation of companies within the
light-based industry via acquisitions, partnering arrangements or joint ventures. We
compete primarily on the basis of technology, product performance, price, quality,
reliability, distribution and customer service. To remain competitive, we will be required
to continue to develop new products and periodically enhance our existing products.





Food and Drug
Administration Regulations


All
of our current products are light-based devices, which are subject to FDA regulations for
clinical testing, manufacturing, labeling, sale, distribution and promotion. Before a new
product or a new use of or claim for an existing product can be marketed in the United
States, we must obtain clearance from the FDA. The types of medical devices that we seek
to market in the United States generally must receive either 510(k) clearance
or PMA approval in advance from the FDA pursuant to the Federal Food, Drug,
and Cosmetic Act. The FDAs 510(k) clearance process usually takes from three to
twelve months, but it can last longer. The process of obtaining PMA approval is much more
costly and uncertain and generally takes from one to three years or even longer. To date,
the FDA has deemed our products eligible for the 510(k) clearance process. We believe that
most of our products in development will receive similar treatment. However, we cannot be
sure that the FDA will not impose the more burdensome PMA approval process upon one or
more of our future products, nor can we be sure that 510(k) clearance or PMA approval will
ever be obtained for any product it proposes to market and failure to do so could
adversely affect our ability to sell products.


8


Number of Employees


As
of December 31, 2007, we employed 252 people. We are not subject to any collective
bargaining agreements, have not experienced a work stoppage and consider our relations
with our employees to be good.




Available Information


Our
internet site is www.palomarmedical.com. You can access our Investor
Relations webpage through our internet site by clicking on
the Investors link to the heading SEC Filings. We make
available free of charge, on or through our Investor Relations webpage, our proxy
statements, our Annual Reports on Form 10-K, our Quarterly Reports on Form 10-Q, Current
Reports on Form 8-K and any amendments to those reports filed or furnished pursuant to the
Securities Exchange Act of 1934, as amended (Exchange Act), as soon as
reasonably practicable after such material is electronically filed with, or furnished to,
the SEC. We also make available, through our Investor Relations webpage, via a link to the
SECs internet site, statements of beneficial ownership of our equity securities
filed by our directors, officers, 10% or greater shareholders and others under
Section 16 of the Exchange Act.  We have also made our Code of Conduct available through our internet site by clicking on the
Corporate Governance link under Investors.



Item 1A. Risk Factors


This
report contains forward-looking statements that involve risks and uncertainties, such as
statements of our objectives, expectations and intentions. The cautionary statements made
in this report should be read as applicable to all forward-looking statements wherever
they appear in this report. Our actual results could differ materially from those
discussed herein. Factors that could cause or contribute to such differences include those
discussed below, as well as those discussed elsewhere in this report.


If we do not continue to develop
and commercialize new products and identify new markets for our products and technology,
we may not remain competitive, and our revenues and operating results could suffer.


The
aesthetic light-based (both lasers and lamps) treatment system industry is subject to
continuous technological development and product innovation. If we do not continue to be
innovative in the development of new products and applications, our competitive position
will likely deteriorate as other companies successfully design and commercialize new
products and applications. We compete in the development, manufacture, marketing, sales
and servicing of light-based devices with numerous other companies, some of which have
substantially greater direct worldwide sales capabilities. Our products also face
competition from medical products, prescription drugs and cosmetic procedures, such as
electrolysis and waxing.





Our products are subject to
numerous medical device regulations. Compliance is expensive and time-consuming. Without
necessary clearances, we may be unable to sell products and compete effectively.


All
of our current products are light-based devices, which are subject to FDA regulations for
clinical testing, manufacturing, labeling, sale, distribution and promotion. Before a new
product or a new use of or claim for an existing product can be marketed in the United
States, we must obtain clearance from the FDA. In the event that we do not obtain FDA
clearances, our ability to market products in the United States and revenue derived there
from may be adversely affected.  The types of medical devices that we seek to market
in the U.S. generally must receive either 510(k) clearance or PMA
approval in advance from the FDA pursuant to the Federal Food, Drug, and Cosmetic
Act. The FDAs 510(k) clearance process can be expensive and usually takes from three
to twelve months, but it can last longer. The process of obtaining PMA approval is much
more costly and uncertain and generally takes from one to three years or even longer from
the time the pre-market approval application is submitted to the FDA until an approval is
obtained.

9


In
order to obtain pre-market approval and, in some cases, a 510(k) clearance, a product
sponsor must conduct well controlled clinical trials designed to test the safety and
effectiveness of the product. Conducting clinical trials generally entails a long,
expensive and uncertain process that is subject to delays and failure at any stage. The
data obtained from clinical trials may be inadequate to support approval or clearance of a
submission. In addition, the occurrence of unexpected findings in connection with clinical
trials may prevent or delay obtaining approval or clearance. If we conduct clinical
trials, they may be delayed or halted, or be inadequate to support approval or clearance,
for numerous reasons, including:
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|o |  | FDA,
other regulatory authorities or an institutional review board may place a clinical trial
on hold;
|- |  | ------------------------------------------------------------------------------------------------------

|o |  | patients
may not enroll in clinical trials, or patient follow-up may not occur, at the rate we
expect;
|- |  | ------------------------------------------------------------------------------------------------------

|o |  | patients
may not comply with trial protocols;
|- |  | ---------------------------------------------

|
|

|o |  | institutional
review boards and third party clinical investigators may delay or reject our trial
protocol;
|- |  | ----------------------------------------------------------------------------------------------------------

|o |  | third
party clinical investigators may decline to participate in a trial or may not perform a
trial on our anticipated schedule
or consistent with the clinical trial protocol, good clinical practices, or other FDA
requirements;
|- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|o |  | third
party organizations may not perform data collection and analysis in a timely or accurate
manner;
|- |  | ------------------------------------------------------------------------------------------------------

|o |  | regulatory inspections of our clinical trials or manufacturing facilities may,
among other things, require us to undertake corrective
action or suspend or terminate our clinical trials, or invalidate our clinical trials;
|- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|o |  | governmental regulations may change or administrative actions may occur that cause delays; and
|- |  | ----------------------------------------------------------------------------------------------

|o |  | the
interim or final results of the clinical trials may be inconclusive or unfavorable as to
safety or effectiveness.
|- |  | ---------------------------------------------------------------------------------------------------------------------

|Medical devices may be marketed
only for the indications for which they are approved or cleared. The FDA may not approve
or clear indications that are necessary or desirable for successful commercialization.
Indeed, the FDA may refuse our requests for 510(k) clearance or pre-market approval of new
products, new intended uses or modifications to existing products. Our clearances can be
revoked if safety or effectiveness problems develop.


To
date, the FDA has deemed our products eligible for the 510(k) clearance process. We
believe that our products in development will receive similar treatment. However, we
cannot be sure that the FDA will not impose the more burdensome PMA approval process upon
one or more of our future products, nor can we be sure that 510(k) clearance or PMA
approval will ever be obtained for any product we propose to market, and our failure to do
so could adversely affect our ability to sell our products.


We
often seek FDA clearance for additional indications for use. Clinical trials in support of
such clearances for additional indications may be costly and time-consuming. In the event
that we do not obtain additional FDA clearances, our ability to market products in the
United States and revenue derived therefrom may be adversely affected. Medical devices may
be marketed only for the indications for which they are approved or cleared, and if we are
found to be marketing our products for off-label, or non-approved, uses we might be
subject to FDA enforcement action or have other resulting liability.






Our
products are subject to similar regulations in many international markets. Complying with
these regulations is necessary for our strategy of expanding the markets for sales of our
products into these countries. Compliance with the regulatory clearance process in any
country is expensive and time consuming.  Regulatory clearances may necessitate
clinical testing, limitations on the number of sales and limitations on the type of end
user, among other things.  In certain instances, these constraints can delay planned
shipment schedules as design and engineering modifications are made in response to
regulatory concerns and requests.  We may not be able to obtain clearances in each
country in a timely fashion or at all, and our failure to do so could adversely affect our
ability to sell our products in those countries.


10


After clearance or approval of our
products, we are subject to continuing regulation by the FDA, and if we fail to comply
with FDA regulations, our business could suffer.


Even
after clearance or approval of a product, we are subject to continuing regulation by the
FDA, including the requirements that our facility be registered and our devices listed
with the agency. We are subject to Medical Device Reporting regulations, which require us
to report to the FDA if our products may have caused or contributed to a death or serious
injury or malfunction in a way that would likely cause or contribute to a death or serious
injury if the malfunction were to recur. We must report corrections and removals to the
FDA where the correction or removal was initiated to reduce a risk to health posed by the
device or to remedy a violation of the Federal Food, Drug, and Cosmetic Act caused by the
device that may present a risk to health, and we must maintain records of other
corrections or removals. The FDA closely regulates promotion and advertising and our
promotional and advertising activities could come under scrutiny. If the FDA objects to
our promotional and advertising activities or finds that we failed to submit reports under
the Medical Device Reporting regulations, for example, the FDA may allege our activities
resulted in violations.


The
FDA and state authorities have broad enforcement powers. Our failure to comply with
applicable regulatory requirements could result in enforcement action by the FDA or state
agencies, which may include any of the following sanctions:
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|o |  | letters,
warning letters, fines, injunctions, consent decrees and civil penalties;
|- |  | ----------------------------------------------------------------------------------

|o |  | repair,
replacement, refunds, recall or seizure of our products;
|- |  | ----------------------------------------------------------------

|o |  | operating
restrictions or partial suspension or total shutdown of production;
|- |  | -----------------------------------------------------------------------------

|o |  | refusing
or delaying our requests for 510(k) clearance or pre-market approval of new products or
new intended uses; and
|- |  | -----------------------------------------------------------------------------------------------------------------------

|o |  | criminal
prosecution.
|- |  | ---------------------

|If any of these events were to occur,
they could harm our business.


We have modified some of our
products and sold them under prior 510(k) clearances. The FDA could retroactively decide
the modifications required new 510(k) clearances and require us to cease marketing and/or
recall the modified products.


Any
modification to one of our 510(k) cleared devices that could significantly affect its
safety or effectiveness, or that would constitute a major change in its intended use,
requires a new 510(k) clearance. We may be required to submit pre-clinical and clinical
data depending on the nature of the changes. We may not be able to obtain additional
510(k) clearances or pre-market approvals for modifications to, or additional indications
for, our existing products in a timely fashion, or at all. Delays in obtaining future
clearances or approvals would adversely affect our ability to introduce new or enhanced
products into the market in a timely manner, which in turn would harm our revenue and
operating results. We have modified some of our marketed devices, but we believe that new
510(k) clearances are not required. We cannot be certain that the FDA would agree with any
of our decisions not to seek 510(k) clearance. If the FDA requires us to seek 510(k)
clearance for any modification, we also may be required to cease marketing and/or recall
the modified device until we obtain a new 510(k) clearance.








Federal regulatory reforms may
adversely affect our ability to sell our products profitably.


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


We may also be subject to state
regulations.   State regulations, and changes to state regulations, may prevent
sales to particular end users or may restrict use of the products to particular end users
or under particular supervision which may decrease revenues or prevent growth of revenues.

11


Our
products may also be subject to state regulations.   Federal regulation allows
our products to be sold to and used by licensed practitioners as determined on a
state-by-state basis which complicates monitoring compliance. As a result, in some states
non-physicians may purchase and operate our products. In most states, it is within a
physicians discretion to determine whom they can supervise in the operation of our
products and the level of supervision. However, some states have specific regulations as
to appropriate supervision and who may be supervised. A state could disagree with our
decision to sell to a particular type of end user or change regulations to prevent sales
to particular types of end users or change regulations as to supervision requirements. In
several states applicable regulations are in flux.  Thus, state regulations and
changes to state regulations may decrease revenues or prevent growth of revenues.


Outside of the United States, we
rely on third party distributors to market and sell a large portion of our products. Due
to our January 2008 international distribution agreement with Q-MED AB, we will be
terminating or changing our relationship with our current distributors as we transition to
Q-MED as our exclusive distributor outside of North America. During this transition
period, current distributors may not commit the necessary resources to effectively market
and sell our products and we may not be able to collect receivables due for past sales to
these distributors and our business and operating results may be harmed. Our relationship
with Q-MED may not be successful and our business and operating results may be harmed.



In
the United States, we sell our products through our internal sales organization. Outside
of this market, we sell our products through third party distributors. Our sales and
marketing success in these other markets depends on these distributors, in particular
their sales and service expertise and relationships with the customers in the marketplace.
On January 9, 2008, we announced our international distribution agreement with the Swedish
company Q-MED AB, the producer of Restylane, one of the most popular and widely
distributed dermal fillers in the world. Q-MED sells Restylane globally through a network
of fully owned sales companies, partners and distributors.  The
transition from our current distributors to Q-MED shall be on a country-by-country basis
as the companies agree on the terms of each transition. We plan to work with Q-MED and
current distributors to determine how each distributor might successfully work with Q-MED
during and after the time each country is transitioned. The relationship with most, if not all, of
our current distributors will be terminated or changed. During this transition period, our
relationship with current distributors may be damaged such that they may not commit the
necessary resources to effectively market and sell our products and may leave us with a
greater collection risk on our outstanding receivables from these distributors. In
addition, the transition to and our future relationship with Q-MED may not be successful.
If the current distributors do not perform adequately or if our agreement with Q-MED is unsuccessful, our revenue from international sales may be adversely affected and our
operating results could suffer.


Because we do not require training
for all users of our products, and sell our products to non-physicians, there exists an
increased potential for misuse of our products, which could harm our reputation and our
business.






Federal regulations allow us to sell our products to or on the order of practitioners
licensed by state law. The definition of licensed practitioners varies from
state to state. As a result, our products may be purchased or operated by physicians with
varying levels of training and, in many states, by non-physicians, including nurse
practitioners, chiropractors and technicians. Outside the United States, many
jurisdictions do not require specific qualifications or training for purchasers or
operators of our products. We do not supervise the procedures performed with our products,
nor do we require that direct medical supervision occur. Our products come with an
operators manual. We and our distributors offer product training sessions, but
neither we nor our distributors require purchasers or operators of our products to attend
training sessions. The lack of required training and the purchase and use of our products
by non-physicians may result in product misuse and adverse treatment outcomes, which could
harm our reputation and expose us to costly product liability litigation.


Achieving complete compliance with
FDA regulations is difficult, and if we fail to comply, we could be subject to FDA
enforcement action or our business could suffer.


We
are subject to inspection and market surveillance by the FDA to determine compliance with
regulatory requirements. The FDAs regulatory scheme is complex, especially the
Quality System Regulation, which requires manufacturers to follow elaborate design,
testing, control, documentation, and other quality assurance procedures. Because some of
our products involve the use of lasers, those products also are covered by a performance
standard for lasers set forth in FDA regulations. The laser performance standard imposes
specific record keeping, reporting, product testing and product labeling requirements.
These requirements include affixing warning labels to laser products as well as
incorporating certain safety features in the design of laser products. The FDA enforces
the Quality System Regulation and laser performance standards through periodic unannounced
inspections. We have been, and anticipate in the future being, subject to such
inspections. The complexity of the Quality System Regulation makes complete compliance
difficult to achieve. Also, the determination as to whether a Quality System Regulation
violation has occurred is often subjective. If the FDA finds that we have failed to comply
with the Quality System Regulation or other applicable requirements or failed to take satisfactory
corrective action in response to an adverse Quality System Regulation inspection or comply
with applicable laser performance standards, the agency can institute a wide variety of
enforcement actions, including a public warning letter or other stronger remedies, such as
fines, injunctions, criminal and civil penalties, recall or seizure of our products,
operating  restrictions, partial suspension, or total shutdown of our production,
refusing to permit the import or export of our products, delaying or refusing our requests
for 510(k) clearance or PMA approval of new products, withdrawing product approvals
already granted or criminal prosecution, any of which could cause our business and
operating results to suffer.



12



Our effective income tax
rate may vary significantly.


Unanticipated
changes in our tax rates could affect our future results of operations. Our future
effective tax rates could be unfavorably affected by changing interpretations of existing
tax laws or regulations, changes in estimates of prior years items, changes in the
valuation of our deferred tax assets, future levels of research and development spending,
deductions for employee stock option exercises being different than what we projected, and
changes in overall levels of income before taxes.


Failure to manage our
relationships with third party researchers effectively may limit our access to new
technology, increase the cost of licensing new technology, and divert management attention
from our core business.


We
are dependent upon third-party researchers over whom we do not have absolute control to
satisfactorily conduct and complete research on our behalf.  We are also dependent
upon third-party researchers to grant us licensing terms, which may or may not be
favorable, for products and technology they may develop. We provide research funding,
light technology and optics know-how in return for licensing rights with respect to
specific dermatologic and cosmetic applications and patents. In return for certain
exclusive license rights, we are subject to due diligence obligations in order to maintain
such exclusivity.  Our success will be dependent upon the results of research with
our partners and meeting due diligence obligations. We cannot be sure that third-party
researchers will agree with our interpretation of the terms of our agreements, that we
will meet our due diligence obligations, or that such research agreements will provide us
with marketable products in the future or that any of the products developed under these
agreements will be profitable for us.





If our new products do not gain
market acceptance, our revenues and operating results could suffer.


The
commercial success of the products and technology we develop will depend upon the
acceptance of these products by providers of aesthetic procedures and their patients and
clients. It is difficult for us to predict how successful recently introduced products, or
products we are currently developing, will be over the long term. If the products we
develop do not gain market acceptance, our revenues and operating results could suffer.


We
expect that many of the products we develop will be based upon new technologies or new
applications of existing technologies. It may be difficult for us to achieve market
acceptance of some of our products, particularly the first products that we introduce to
the market based on new technologies or new applications of existing technologies.


13


If demand for our aesthetic
treatment systems by non-traditional physician customers and spas does not develop as we
expect, our revenues will suffer and our business will be harmed.


Our
revenues from non-traditional physician customers and spa purchasers of our products
continue to increase. We believe, and our growth expectations assume, that we and other
companies selling light-based (lasers and lamps) aesthetic treatment systems have only
begun to penetrate these markets and that our revenues from selling to these markets will
continue to increase. If our expectations as to the size of these markets and our ability
to sell our products to participants in these markets are not correct, our revenues will
suffer and our business will be harmed.


If there is not sufficient
consumer demand for the procedures performed with our products, practitioner demand for
our products could decline, which would adversely affect our operating results.


Most
procedures performed using our aesthetic treatment systems are elective procedures that
are not reimbursable through government or private health insurance. The cost of these
elective procedures must be borne by the client. As a result, the decision to undergo a
procedure that utilizes our products may be influenced by a number of factors, including:
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|o |  | consumer
awareness of procedures and treatments;
|- |  | ------------------------------------------------

|o |  | the
cost, safety and effectiveness of the procedure and of alternative treatments;
|- |  | ----------------------------------------------------------------------------------

|o |  | the
success of our and our customers sales and marketing efforts to purchasers of these
procedures; and
|- |  | --------------------------------------------------------------------------------------------------------

|o |  | consumer
confidence, which may be affected by economic and other conditions.
|- |  | ----------------------------------------------------------------------------

|If
there is not sufficient demand for the procedures performed with our products,
practitioner demand for our products would be reduced, which would adversely affect our
operating results.


Our business and operations are
experiencing rapid growth. If we fail to effectively manage our growth, our business and
operating results could be harmed.


We
have experienced increased growth in the scope of our operations and the number of our
employees. This growth has placed significant demands on our management, as well as our
financial and operational resources. If we do not effectively manage our growth, the
efficiency of our operations and the quality of our products could suffer, which could
adversely affect our business and operating results. To effectively manage this growth, we
will need to continue to:
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|o |  | implement
appropriate operational, financial and management controls, systems and procedures;
|- |  | ---------------------------------------------------------------------------------------------

|o |  | expand
our manufacturing capacity and scale of production;
|- |  | ----------------------------------------------------------

|o |  | expand
our sales, marketing and distribution infrastructure and capabilities; and
|- |  | ---------------------------------------------------------------------------------

|o |  | provide
adequate training and supervision to maintain high quality standards.
|- |  | -----------------------------------------------------------------------------

|Failure to receive shipments of
critical components could reduce revenues and reduced reliability of critical components
could increase expenses.


We develop light-based systems that incorporate third-party components and we purchase
some of these components from small, specialized vendors that are not well capitalized. We
do not have long-term contracts with some of these third parties for the supply of parts.
A disruption in the delivery of these key components, or our inability to obtain
substitute components or subassemblies from alternate sources at acceptable prices in a
timely manner, or our inability to obtain assembly or testing services could prevent us
from manufacturing products and result in a decrease in revenue.  We depend on an
acceptable level of reliability for purchased components.  Reliability below
expectations for key components could have an adverse affect on inventory and inventory
reserves. Any extended interruption in our supplies of third party components could
materially harm our business.


14






We forecast sales to determine
requirements for components and materials used in our products and if our forecasts are
incorrect, we may experience either delays in shipments or increased inventory costs.


To
manage our manufacturing operations with our suppliers, we forecast anticipated product
orders and material requirements to predict our inventory needs and enter into purchase
orders on the basis of these requirements. Our limited historical experience may not
provide us with enough data to accurately predict future demand. If our business expands,
our demand for components and materials would increase and our suppliers may be unable to
meet our demand. If we overestimate our component and material requirements, we will have
excess inventories, which would increase our expenses. If we underestimate our component
and material requirements, we may have inadequate inventories, which could interrupt,
delay, or prevent delivery of our products to our customers.

Our proprietary technology has only limited protections which may not prevent competitors from copying
our new developments.  This may impair our ability to compete effectively. We may expend significant
resources enforcing our intellectual property rights to prevent such copying, and our intellectual
property could be determined to be not infringed, invalid or unenforceable.

Our business could be materially and adversely affected if we are not able to adequately
protect our intellectual property rights. We rely on a combination of patent, copyright, trademark and
trade secret laws, licenses and confidentiality agreements to protect our proprietary rights. We own and
license a variety of patents and patent applications in the United States and corresponding patents and
patent applications in many foreign jurisdictions. Our pending and future patent applications may not
issue as patents or, if issued, may not issue in a form that will be advantageous to us. Even if issued,
patents may be challenged, narrowed, invalidated or circumvented, which could limit our ability to stop
competitors from marketing similar products or limit the length of term of patent protection we may have
for our products. Changes in either patent laws or in interpretations of patent laws in the United
States and other countries may diminish the value of our intellectual property or narrow the scope of our
patent protection.

We have granted certain patent licenses to several competitors, and in return for those license
grants, we receive a significant ongoing royalty revenue stream. A few of these competitors entered
into license agreements only after we sued them for patent infringement. We are currently enforcing
these patents against Candela Corporation and intend to enforce against other competitors in the
future. We do not know how successful we will be in asserting our patents against Candela or other
suspected infringers. Whether or not we are successful in the pending lawsuit, litigation consumes
substantial amounts of our financial resources and diverts managements attention away from our core
business. Public announcements concerning this litigation that are unfavorable to us may in the future
result in significant declines in our stock price. An adverse ruling or judgment in this matter could
result in a loss of our significant ongoing royalty revenue stream and could also have a material
adverse effect on license agreements with other companies both of which could have a material adverse
effect on our business and results of operation and cause our stock price to decline significantly.
 (For more information about our patent litigation, see Item 3 Legal Proceedings and Note 7 of Notes to
our Consolidated Financial Statements.)

In addition to patented technology, we rely upon unpatented proprietary technology, processes
and know-how. We generally enter into agreements with our employees and third parties with whom we work,
including but not limited to consultants and vendors, to restrict access to, and distribution of, our
proprietary information and define our intellectual property ownership rights. Despite our efforts to
protect our proprietary rights, unauthorized parties may attempt to copy or otherwise obtain and use our
technology, proprietary information and know-how and we may not have adequate remedies for any such
breach. Monitoring unauthorized use of our technology is difficult and we cannot be certain that the
steps we have taken will prevent unauthorized use of our technology, particularly in foreign countries
where the laws may not protect our proprietary rights as fully as in the United States. If competitors
are able to use our technology, our ability to compete effectively could be harmed and the value of our
technology and products could be adversely affected.  Costly and time consuming lawsuits may be
necessary to enforce and defend patents issued or licensed exclusively to us, to protect our trade
secrets and/or know-how or to determine the enforceability, scope and validity of others intellectual
property rights. Such lawsuits may result in patents issued or licensed exclusively to us to be found
invalid and unenforceable. In addition, our trade secrets may otherwise become known or our competitors
also may independently develop technologies that are substantially equivalent or superior to our
technology and which do not infringe our patents.




15


Claims by others that our products
infringe their patents or other intellectual property rights could prevent us from
manufacturing and selling some of our products or require us to pay royalties or incur
substantial costs from litigation or development of non-infringing technology.


In recent years, there has been significant litigation in the United States involving
patents and other intellectual property rights.  The light-based cosmetic and
dermatology industry in particular is characterized by a large number of patents and
related litigation regarding patents and other intellectual property rights. Because our
resources are limited and patent applications are maintained in secrecy for a period of
time, we can conduct only limited searches to determine whether our technology infringes
any patents or patent applications. Any claims for patent infringement, regardless of
merit, could be time-consuming, result in costly litigation and diversion of technical and
management personnel, cause shipment delays, require us to develop non-infringing
technology or to enter into royalty or licensing agreements. Uncertainties resulting from
the initiation and continuation of patent litigation or other proceedings could have a
material adverse effect on our ability to compete in the marketplace. Although patent and
intellectual property disputes in the light-based industry have often been settled through
licensing or similar arrangements, costs associated with such arrangements may be
substantial and often require the payment of ongoing royalties, which could have a
negative impact on gross margins. There can be no assurance that necessary licenses would
be available to us on satisfactory terms, or that we could redesign our products or
processes to avoid infringement, if necessary. Accordingly, an adverse determination in a
judicial or administrative proceeding or failure to obtain necessary licenses could
prevent us from manufacturing and selling some of our products. This could have a material
adverse effect on our business, results of operations and financial condition.






Candela
Corporation has filed two patent infringement lawsuits against us. (For more information about our patent litigation, see Item 3 Legal
Proceedings and Note 7 of Notes to our Consolidated Financial Statements.) Litigation with Candela is expected to be expensive and protracted, and our
intellectual property position may be weakened as a result of an adverse ruling or
judgment. Whether or not we are successful in the pending lawsuits, litigation consumes
substantial amounts of our financial resources and diverts managements attention
away from our core business. Public announcements concerning this litigation that are
unfavorable to us may in the future result in significant declines in our stock price. An
adverse ruling or judgment in this matter could cause our stock price to decline
significantly.


We may not be able to
successfully collect licensing royalties.


Material portions of our revenues consist of royalties from sub-licensing patents licensed
to us on an exclusive basis by Massachusetts General Hospital. If we are unable to collect
our licensing royalties, our revenues will decline.


Quarterly revenue or operating
results could cause the price of our common stock to fall.


Our quarterly revenue and operating results are difficult to predict and may swing sharply
from quarter to quarter.  If our quarterly revenue or operating results fall
below the expectations of investors or public market analysts, the price of our common
stock could fall substantially. Our quarterly revenue is difficult to forecast for many
reasons, some of which are outside of our control.  For example, many factors are
related to market supply and demand, including potential increases in the level and
intensity of price competition between our competitors and us, potential decrease in
demand for our products and possible delays in market acceptance of our new
products.  Other factors are related to our customers and include changes in or
extensions of our customers budgeting and purchasing cycles and changes in the
timing of product sales in anticipation of new product introductions or enhancements by us
or our competitors.   Factors related to our operations may also cause quarterly
revenue or operating results to fall below expectations, including our effectiveness in
our manufacturing process, unsatisfactory performance of our distribution channels,
service providers, or customer support organizations, and timing of any acquisitions and
related costs.


16

Managing our relationships with
The Procter & Gamble Company (and its wholly owned subsidiary The Gillette Company), Johnson & Johnson Consumer Companies, Inc., and
future development partners may divert the attention of
key technical personnel and management from the core business.   If, pursuant to rights in their respective agreements with us, any of these
parties should end their relationship with us, our stock price could fall, and we may be unable to bring
home-use devices to the market.






We
believe that our relationships with The Procter & Gamble Company (and its wholly owned subsidiary The Gillette Company)
and Johnson & Johnson Consumer Companies, Inc. represent unique opportunities to bring
light-based devices to the mass market. Significant resources and the attention of key
technical personnel and management have been and may continue to be directed to the
development and commercialization of such devices even though such devices will not likely
be commercialized for several years, if ever.  In addition, we cannot be sure that
these parties will agree with our interpretation of the terms of the agreements, that the
agreements will provide us with marketable products in the future or that we will receive
payments for any of the products developed under the agreements.  During the terms of
the agreements, Procter & Gamble and Johnson & Johnson have the ability to choose not to
continue and may terminate the agreements.  If either Procter & Gamble or Johnson & Johnson should
terminate their agreements with us, we will not receive certain payments, and the price of our common stock could fall
significantly.  In that event, we may proceed to develop
and commercialize the devices on our own or with a third party.  However, there can
be no assurance that we will be able to successfully implement such a strategy.  In
addition, after commercialization of such devices, Procter & Gamble and Johnson & Johnson are
to pay us a percentage of net sales of such devices. Certain of these percentages of net
sales are only owed if the devices are covered by valid patents.  There can be no
assurance that valid patents will cover the devices in any or all countries, in which the
devices will be manufactured, used or sold.  This could have a material adverse
effect on our business, results of operations and financial condition.


The expense and potential
unavailability of liability insurance coverage for our customers could adversely affect
our ability to sell our products and our financial condition.


Some
of our customers and prospective customers have had difficulty in procuring or maintaining
liability insurance to cover their operation and use of our products. Medical malpractice
carriers are withdrawing coverage in some states or substantially increasing premiums. If
this trend continues or worsens, our customers may discontinue using our products, and
potential customers may elect not to purchase laser and other light-based products.


The reduced availability of consumer financing could have a material adverse effect on our
results of operations.



Prior to selling to a new customer, we require proof of financing.  Availability of
financing is dependent on the lending practices of financial institutions, financial markets,
governmental policies, and economic conditions, all of which are largely beyond our control.  The
reduced availability of financing from third party lenders for our customers could affect our sales
volume and have a material adverse effect on our results of operations.







We may be unable to attract and
retain key executives and research and development personnel that we need to succeed.




As a small company with approximately 250 employees, our success depends on the services
of key employees in executive and research and development positions. The loss of the
services of one or more of these employees could have a material adverse effect on our
business.  Our future success will depend in large part upon our ability to attract,
retain, and motivate highly skilled employees. We cannot be certain that we will be able
to do so.


Product liability suits could be
brought against us due to a defective design, material or workmanship or due to misuse of
our products. These lawsuits could be expensive and time consuming and result in
substantial damages to us and increases in our insurance rates.


17


If
our products are defectively designed, manufactured or labeled, contain defective
components or are misused, we may become subject to substantial and costly litigation by
our customers or their patients or clients. Furthermore, in the event that any of our
products prove to be defectively designed and manufactured, we may be required to recall
and redesign such products. Misusing our products or failing to adhere to operating
guidelines for our products can cause severe burns or other damage to the eyes, skin or
other tissue. We are routinely involved in claims related to the use of our products.
Product liability claims could divert managements attention from our core business,
be expensive to defend and result in sizable damage awards against us. Our current
insurance coverage may not be sufficient to cover these claims. Moreover, in the future,
we may not be able to obtain insurance in amount or scope sufficient to provide us with
adequate coverage against potential liabilities. Any product liability claims brought
against us, with or without merit, could increase our product liability insurance rates or
prevent us from securing continuing coverage, could harm our reputation in the industry
and reduce product sales. We would need to pay any product losses in excess of our
insurance coverage out of cash reserves, harming our financial condition and adversely
affecting our operating results.


We face risks associated with
product warranties.


We
could incur substantial costs as a result of product failures for which we are responsible
under warranty obligations.






Because we derive a significant
amount of our revenue from international sales, we are susceptible to currency
fluctuations, long payment cycles, credit risks and other risks associated with conducting
business overseas.


We sell a significant amount of our products and services outside the U.S. 
International product revenue, consisting of sales from our distributors in Japan, Europe,
Australia, Asia\Pacific Rim and South and Central America and sales shipped directly to
international locations from the United States, and we expect that international sales
will continue to be significant.  As a result, a major part of our revenues and
operating results could be adversely affected by risks associated with international
sales, including but not limited to political and economic instability and difficulties in
managing our foreign operations.  In particular, longer payment cycles common in
foreign markets, credit risk and delays in obtaining necessary import or foreign
certification or regulatory approvals for products may occur.  In addition,
significant fluctuations in the exchange rates between the U.S. dollar and foreign
currencies could cause us to lower our prices and thus reduce our profitability, or could
cause prospective customers to push out orders to later dates because of the increased
relative cost of our products in the aftermath of a currency devaluation or currency
fluctuation.




We may not be able to sustain or increase profitability and we may seek additional financing
to grow the business.





Although
we have generated a profit in recent years, we have a history of losses. We may not be
able to sustain or increase profitability on a quarterly or annual basis. If our
operating results fall below the expectations of investors or public market analysts, the
price of our common stock could decline.


We
may determine, depending upon the opportunities available, to seek additional debt or
equity financing to fund the costs of expansion.  Additionally, if we incur
indebtedness to fund increased levels of accounts receivable, finance the acquisition of
capital equipment, or if we issue debt securities in connection with any acquisition we
will be subject to risks associated with incurring substantial additional indebtedness.



The liquidity of our investments may decrease.



As of December 31, 2007, we held approximately $41.9 million of auction-rate
securities.  Recently, there have been disruptions in the market for auction-rate securities.  All of
our securities held as of December 31, 2007 succeeded in at least the first auction subsequent to
December 31, 2007.  During 2008, we have had some auctions fail.  In the event that we are unable to
sell the underlying securities at or above our carrying value, these securities may not provide us a
liquid source of cash in the future.






Our common stock could be further
diluted by the conversion of outstanding options and warrants.


In
the past, we have issued and still have outstanding convertible securities in the form of
options and warrants.  We may continue to issue options, warrants and other equity
rights as compensation for services and incentive compensation for our employees,
directors and consultants or others who provide services to us. We have a substantial
number of shares of common stock reserved for issuance upon the conversion and exercise of
these securities. Such a conversion would dilute our stockholders and could adversely
affect the market price of our common stock.



18

Our charter documents, Delaware
law and our shareholder rights plan may discourage potential takeover attempts.


Our Second Restated Certificate of Incorporation and our By-laws contain provisions that
could discourage takeover attempts or make more difficult the acquisition of a substantial
block of our common stock. Our By-laws require a stockholder to provide to our Secretary
advance notice of director nominations and business to be brought by such stockholder
before any annual or special meeting of stockholders, as well as certain information
regarding such nomination and/or business, the stockholder and others known to support
such proposal and any material interest they may have in the proposed business. They also
provide that a special meeting of stockholders may be called only by the affirmative vote
of a majority of the board of directors. These provisions could delay any stockholder
actions that are favored by the holders of a majority of our outstanding stock until the
next stockholders meeting. In addition, the board of directors is authorized to
issue shares of our common stock and preferred stock that, if issued, could dilute and
adversely affect various rights of the holders of common stock and, in addition, could be
used to discourage an unsolicited attempt to acquire control of us.


We
are also subject to the anti-takeover provisions of Section 203 of the Delaware General
Corporation Law, which prohibits us from engaging in a business combination
with an interested stockholder for a period of three years after the date of
the transaction in which the person becomes an interested stockholder, unless the business
combination is approved in a prescribed manner. The application of Section 203 may limit
the ability of stockholders to approve a transaction that they may deem to be in their
best interests. These provisions of our Second Restated Certificate of Incorporation,
By-laws and the Delaware General Corporation Law could deter certain takeovers or tender
offers or could delay or prevent certain changes in control or our management, including
transactions in which stockholders might otherwise receive a premium for their shares over
the then current market price.






In
April 1999, we adopted a shareholder rights plan or poison pill. This is
intended to protect shareholders from unfair or coercive takeover practices.


Any acquisitions that we make
could disrupt our business and harm our financial condition.


From
time to time, we evaluate potential strategic acquisitions of complementary businesses,
products or technologies, as well as consider joint ventures and other collaborative
projects. We may not be able to identify appropriate acquisition candidates or strategic
partners, or successfully negotiate, finance or integrate any businesses, products or
technologies that we acquire. Any acquisition we pursue could diminish our cash available
to us for other uses or be dilutive to our stockholders, and could divert
managements time and resources from our core operations.


Our stock price may be
volatile.


Our
common stock price may be volatile. The stock market in general has experienced extreme
volatility that has often been unrelated to the operating performance of particular
companies. The market price for our common stock may be influenced by many factors,
including:
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|o |  | the
success of competitive products or technologies;
|- |  | ----------------------------------------------------

|o |  | regulatory
developments in the United States and foreign countries;
|- |  | -------------------------------------------------------------------

|o |  | developments
or disputes concerning patents or other foreign countries;
|- |  | -----------------------------------------------------------------------

|o |  | the
recruitment or departure of key personnel;
|- |  | ----------------------------------------------

|o |  | variations
in our financial results or those of companies that are perceived to be similar to us;
|- |  | -------------------------------------------------------------------------------------------------

|o |  | market
conditions in our industry and issuance of new or changed securities analysts
reports or recommendations; and
|- |  | ---------------------------------------------------------------------------------------------------------------------

|o |  | general
economic, industry and market conditions.
|- |  | -------------------------------------------------

|19
|--

|Item 1B. Unresolved
Staff Comments

None.


Item 2. Properties


We
lease a facility totaling approximately 69,000 square feet of office, manufacturing and
research space in Burlington, Massachusetts. The lease expires in August 2009. We also
lease a facility totaling approximately 1,000 square feet of office and service space in
Amsterdam, The Netherlands. The lease expires in March 2009. We believe that both
facilities are in good condition and are suitable and adequate for our current operations.


Item 3. Legal Proceedings



Alma Lasers Litigation


On
July 7, 2006, we commenced an action for patent infringement against Alma Lasers, Inc. in
the United States District Court for the District of Massachusetts seeking both monetary
damages and injunctive relief. The complaint alleged Almas Harmony, Soprano and
Sonata Systems which use pulsed light and laser technology for hair removal willfully
infringe U.S. Patent Nos. 5,595,568 & 5,735,844, which are exclusively licensed to us
by the Massachusetts General Hospital. On July 27, 2006, we filed an amended complaint
including an additional claim against Alma for unfair competition due to infringement by
Almas Harmony System of the distinctive trade dress of our products, including the
unique, distinctive, and immediately recognizable design of our EsteLux, MediLux and
StarLux Systems.






On April 2, 2007, we announced the resolution of our lawsuit against Alma Laser, Inc. through the
execution of a Non-Exclusive Patent License Agreement, a Trade Dress Settlement Agreement, and a Settlement
Agreement.  Under the Patent License Agreement, we granted Alma a non-exclusive, royalty bearing license to U.S.
Patent Nos. 5,595,568 & 5,735,844 & corresponding foreign patents and applications in the professional field,
excluding the consumer field. Alma admitted that its
products infringe these patents and that these patents are valid and enforceable. In addition, Alma agreed not to
challenge the infringement, validity and enforceability of these patents in the future. Alma paid us an estimated
payment for royalties due on past sales of their laser and lamp-based hair removal systems beginning with their
initial sales in 2003 through the date of settlement, plus interest and reimbursement of our legal costs.  Alma
also paid us an estimated payment for trade dress fees on past sales of their Harmony and Aria Systems and
interest, and Alma agreed to change and has changed the trade dress of the Harmony and Aria systems. The final
amounts due to us are the subject of an audit by an independent accounting firm. We have begun to recognize
royalty revenue as the amounts become determinable.  Starting on March 30, 2007, Alma began paying us a royalty
on sales of its existing and any new light-based hair removal systems later developed.


For more information, please see the Settlement Agreement, the Non-Exclusive Patent License
Agreement, the Trade Dress Settlement Agreement, the Consent Judgments and Stipulations of Dismissal
filed as exhibits to our Current Report on Form 8-K filed April 2, 2007.

Candela Corporation, Massachusetts Litigation



On August 9, 2006, we commenced an action for patent infringement against Candela Corporation
in the United States District Court for the District of Massachusetts seeking both monetary damages and
injunctive relief. The complaint alleges Candelas GentleYAG and GentleLASE systems, which use laser
technology for hair removal willfully, infringe U.S. patent No. 5,735,844, which is exclusively licensed
to us by the Massachusetts General Hospital.  Candela answered the complaint denying that its products
infringe valid claims of the asserted patents and filing a counterclaim seeking a declaratory judgment
that the asserted patent and U.S. patent No. 5,595,568 are invalid and not infringed.  We filed a reply
denying the material allegations of the counterclaims. This lawsuit has been transferred to the judge
who presided over Palomar v Cutera, Inc.




20



We filed an amended complaint on February 16, 2007 to add the Massachusetts General Hospital as
a plaintiff.  In addition, we further alleged that Candelas GentleMAX system willfully infringes U.S.
Patent No. 5,735,844 and that Candelas Light Station system willfully infringes both U.S. Patent Nos.
5,735,844 and 5,595,568.  On February 16, 2007, Candela filed an amended answer to our complaint adding
allegations of inequitable conduct, double patenting and violation of Massachusetts General Laws Chapter
93A.  On February 28, 2007, we filed a response to Candelas amended complaint pointing out many
weaknesses in Candelas allegations.  A claim construction hearing, sometimes called a Markman
Hearing, was held August 2, 2007, and we received what we consider to be a favorable Markman ruling on
November 9, 2007.  No trial date has yet been set.




On August 10, 2006, Candela Corporation commenced an action for patent infringement against us in the
United States District Court for the District of Massachusetts seeking both monetary damages and
injunctive relief.  The complaint alleged that our StarLux System with the LuxV handpiece willfully
infringes U.S. Patent No. 6,743,222 which is directed to acne treatment, that our QYAG5 System willfully
infringes U.S. Patent No. 5,312,395 which is directed to treatment of pigmented lesions, and that our
StarLux System with the LuxG handpiece willfully infringes U.S. Patent No. 6,659,999 which is directed
to wrinkle treatment.  On October 25, 2006, Candela filed an amended complaint which did not include
U.S. Patent No. 6,659,999.  Consequently, Candela no longer alleges in this lawsuit that the StarLux
System with LuxG handpiece infringes its patents. With regard to the two remaining patents, Candela is
seeking to enjoin us from selling these products in the United States if we are found to infringe the
patents, and to obtain compensatory and treble damages, reasonable costs and attorneys fees, and other
relief as the court deems just and proper. On October 30, 2006 we answered the complaint denying that
our products infringe the asserted patents and filing counterclaims seeking declaratory judgments that
the asserted patents are invalid and not infringed.  In addition, with regard to U.S. Patent No.
5,312,395, we filed a counterclaim of inequitable conduct.  A claim construction hearing, or a Markman
Hearing, is scheduled for April 15, 2008.  No trial date has yet been set. We are defending the action vigorously and believe that we
have meritorious defenses of non-infringement, invalidity and inequitable conduct. However, litigation
is unpredictable and we may not prevail in successfully defending or asserting our position. If we do
not prevail, we may be ordered to pay substantial damages for past sales and an ongoing royalty for
future sales of products found to infringe in the United States. We could also be ordered to stop
selling any products in the United States that are found to infringe.




Candela Corporation, Texas Litigation




On December 19, 2006, Candela Corporation commenced an action for patent infringement against
us in the United States District Court for the Eastern District of Texas, seeking both monetary damages
and injunctive relief.  The complaint alleges that our StarLux System with the LuxY handpiece willfully
infringes U.S. Patent No. 6,659,999 and that our StarLux System with the Lux1540 handpiece willfully
infringes related U.S. Patent Nos. 5,810,801 and 6,120,497.  The three asserted patents are directed to
wrinkle treatment. Candela is seeking to enjoin us from selling these products in the United States if
found to infringe the patents, and to obtain compensatory and treble damages, reasonable costs and
attorneys fees, and other relief as the court deems just and proper. On January 10, 2007, we answered
the complaint denying that our products infringe the asserted patents and filing counterclaims seeking
declaratory judgments that the asserted patents are invalid and not infringed.  On April 6, 2007,
Candela filed their infringement contentions which modified their complaint to accuse the Lux1540,
Lux1540-Z, LuxIR, LuxDeepIR, LuxB, LuxG and LuxY handpieces for use with the StarLux, StarLux 500,
MediLux and EsteLux Systems of infringing the three asserted patents.  On July 13, 2007, we filed an
amended answer to Candelas first amended complaint including counterclaim of inequitable conduct.  We
are defending the action vigorously and believe that we have meritorious defenses of non-infringement
and invalidity. However, litigation is unpredictable and we may not prevail in successfully defending or
asserting our position. If we do not prevail, we may be ordered to pay substantial damages for past
sales and an ongoing royalty for future sales of products found to infringe in the United States. We
could also be ordered to stop selling any products that are found to infringe in the United States.  A
Markman Hearing was held on November 13, 2007 and we are waiting on a ruling from the Judge.  The trial
is scheduled to begin July 14, 2008.



21


Item 4.  Submission of Matters to a Vote of Security Holders


None.









PART II

Item 5.  Market for Registrant's Common Equity and Related Stockholder Matters and Issuer Purchases of Equity Securities


Our
common stock is currently traded on the NASDAQ Global Select Market under the symbol PMTI.
The following table sets forth the high and low information on NASDAQ for the common stock
for the periods indicated. Such quotations reflect inter-dealer prices, without retail
markup, markdown or commission and do not necessarily represent actual transactions.
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                 | Fiscal Year 2006 |            
|-------------------------------- | ---------------- | -----------
|
|Quarter ended March 31, 2006     | $     41.60      | $     30.20
|Quarter ended June 30, 2006      | 48.35            | 30.25      
|Quarter ended September 30, 2006 | 50.19            | 32.67      
|Quarter ended December 31, 2006  | 58.10            | 39.14      

|                                 | Fiscal Year 2007 |            
|-------------------------------- | ---------------- | -----------
|
|Quarter ended March 31, 2007     | $     55.02      | $     37.41
|Quarter ended June 30, 2007      | 43.73            | 33.89      
|Quarter ended September 30, 2007 | 39.57            | 27.51      
|Quarter ended December 31, 2007  | 30.97            | 15.25      

|As
of March 4, 2008, we had 3,115 holders of record of common stock. This does not include
holdings in street or nominee names.


We have not paid dividends to our common stockholders since our inception and do not plan to
pay dividends to our common stockholders in the foreseeable future.  We intend to retain substantially
all earnings to finance our operations.  On August 13, 2007, we announced the approval of a stock
repurchase program under which our management is authorized to repurchase up to one million shares of
our common stock.  As of December 31, 2007, we repurchased 105,000 shares of common stock at an average
price of $28.73.  We did not repurchase any of our common stock during the fourth quarter of 2007.  We
may buy back additional shares of our common stock on the open market from time to time.


22

Performance Graph


The
following graph compares our cumulative total stockholder return (Common Stock price
appreciation plus dividends, on a reinvested basis) over the last five fiscal years with
the NASDAQ Stock Market Total Return Index and the NASDAQ Medical Devices Stocks Index.


Comparison of Five Year Cumulative
Total Return *                                      Palomar Medical Technologies, Inc.,
NASDAQ Stock                                   Market Total Return, and NASDAQ Medical
Devices Stocks
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                   | For the years ended December 31, |         |         |         |         |        
|---------------------------------- | -------------------------------- | ------- | ------- | ------- | ------- | -------
|
|Palomar Medical Technologies, Inc. | $100                             | $1,002  | $2,483  | $3,337  | $4,826  | $1,459 
|NASDAQ Stock Market Total Return   | $100                             | $   150 | $   163 | $   166 | $   183 | $   198
|NASDAQ Medical Devices Stocks      | $100                             | $   148 | $   173 | $   190 | $   201 | $   255

|* Hypothetical $100 invested on
December 31, 2002 in Palomar Medical Technologies, Inc. Stock, NASDAQ Stock Market Total
Return Index, and NASDAQ Medical Devices Stock Index, assuming reinvestment of dividends,
if any.

23



Item 6. Selected
Financial Data


The
following table sets forth selected consolidated financial data for each of the last five
fiscal years. This data should be read in conjunction with the detailed information,
financial statements and related notes, as well as Managements Discussion and
Analysis of Financial Condition and Results of Operations included elsewhere herein. The
historical results are not necessarily indicative of the results of operations to be
expected in the future.
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                      | For the years ended December 31, |  |   |         | 
|----------------------------------------------------- | -------------------------------- |  | - | ------- | 
|
|
|Consolidated Statements of Operations Data:           |                                  |  |   |         | 
|                                                      |                                  |  |   |         | 
|Revenues:                                             |                                  | 
|Product revenues                                      |                                  |  | $ | 103,221 | 
|Royalty revenues                                      |                                  |  |   | 13,005  | 
|Funded product development revenues                   |                                  |  |   | 6,698   | 
|Other revenues                                        |                                  |  |   | 894     | 
|                                                      |                                  |  |   |         | 
|Total revenues                                        |                                  |  |   | 123,818 | 
|                                                      |                                  |  |   |         | 
|Costs and expenses:                                   |                                  | 
|Cost of product revenues                              |                                  |  |   | 33,391  | 
|Cost of royalty revenues                              |                                  |  |   | 5,202   | 
|Research and development                              |                                  |  |   | 16,673  | 
|Selling and marketing                                 |                                  |  |   | 24,886  | 
|General and administrative                            |                                  |  |   | 17,495  | 
|                                                      |                                  |  |   |         | 
|Total cost and expenses                               |                                  |  |   | 97,647  | 
|                                                      |                                  |  |   |         | 
|Income from operations                                |                                  |  |   | 26,171  | 
|                                                      |                                  |  |   |         | 
|Interest income                                       |                                  |  |   | 6,399   | 
|Other income, net                                     |                                  |  |   | 513     | 
|                                                      |                                  |  |   |         | 
|Income before income taxes                            |                                  |  |   | 33,083  | 
|                                                      |                                  |  |   |         | 
|Provision (benefit) for income taxes                  |                                  |  |   | 12,575  | 
|                                                      |                                  |  |   |         | 
|Net income                                            |                                  |  | $ | 20,508  | 
|                                                      |                                  |  |   |         | 
|Net income per common share:                          |                                  | 
|Basic                                                 |                                  |  | $ | 1.12    | 
|                                                      |                                  |  |   |         | 
|Diluted                                               |                                  |  | $ | 1.07    | 
|                                                      |                                  |  |   |         | 
|Weighted average number of common shares outstanding: |                                  | 
|Basic                                                 |                                  |  |   | 18,277  | 
|                                                      |                                  |  |   |         | 
|Diluted                                               |                                  |  |   | 19,254  | 
|                                                      |                                  |  |   |         | 

|                                                | For the years ended December 31, |           |         |          |         
|----------------------------------------------- | -------------------------------- | --------- | ------- | -------- | --------
|
|
|Consolidated Balance Sheet Data:                |                                  |           |         |          |         
|                                                |                                  |           |         |          |         
|Cash and cash equivalents                       | $  90,460                        | $  36,817 | $10,536 | $  7,509 | $  7,959
|Available-for-sale investments, at market value | 41,910                           | 67,352    | 38,758  | 17,650   | 2,600   
|Working capital                                 | 145,861                          | 118,117   | 50,845  | 28,163   | 13,670  
|Total assets                                    | 167,607                          | 143,196   | 66,336  | 39,599   | 21,660  
|Total stockholders' equity                      | 144,690                          | 117,132   | 51,866  | 29,174   | 14,364  

|24


Item 7.  Management's Discussion and Analysis of Financial Condition and Results of Operations

Forward-looking
statements


This
Annual Report on Form 10-K contains forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933, as amended, and Section 21E of the
Securities Exchange Act of 1934, as amended. All statements other than historical or
current facts, including, without limitation, statements about our business strategy,
plans and objectives of management and our future prospects, are forward-looking
statements. Although we believe that the expectations reflected in such forward-looking
statements are reasonable, such forward-looking statements are subject to risks and
uncertainties that could cause actual results to differ materially from these
expectations. Such risks and uncertainties include, without limitation, the following:
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 
 financing of future operations, manufacturing risks, variations in our quarterly results,
the occurrence of unanticipated events and circumstances and general economic
conditions, including stock market volatility, results of future operations,
technological difficulties in developing or introducing new products, the results of
future research, lack of product demand and market acceptance for current and
future products, challenges in managing joint ventures, government contracts and
research with third parties, the impact of competitive products and pricing, governmental regulations with respect to medical devices, including whether FDA clearance will
be obtained for future products, the results of litigation, difficulties in
collecting royalties, potential infringement of third-party intellectual property
rights;
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  we
expect to face increased competition that could result in price reductions and reduced
margins, as well as loss of market share; and
| | -----------------------------------------------------------------------------------------------------------------------------------------

| | 
 other risks contained in Item 1A under the caption Risk Factors.
| | ---------------------------------------------------------------------

|These
risks and uncertainties are beyond our control and, in many cases; we cannot predict the
risks and uncertainties that could cause our actual results to differ materially from
those indicated by the forward-looking statements. When used in this document, the words
assumptions, believes, plans, expects,
anticipates, intends, continue, may,
will, could, should, future,
potential, estimate, or the negative of such terms and similar
expressions as they relate to us or our management are intended to identify
forward-looking statements. We undertake no obligation to release publicly the
result of any revisions to these forward-looking statements that may be made to reflect
events or circumstances after the date hereof or to reflect the occurrence of
unanticipated events.


The
following discussion should be read in conjunction with, and is qualified in its entirety
by, the consolidated financial statements and notes thereto included in Item 8 of this
Annual Report. Historical results and percentage relationships among any amounts in the
financial statements are not necessarily indicative of trends in operating results for any
future periods.


Critical accounting
policies


Our
policies are more fully described in Note 1 of Notes to our Consolidated Financial Statements. As
disclosed in Note 1, the preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and assumptions about
future events that affect the amounts reported in the financial statements and
accompanying notes. Actual results could differ significantly from those estimates. We
believe that the following discussion addresses our most critical accounting policies,
which are those that are most important to the portrayal of our financial condition and
results of operations and require managements most difficult, subjective and complex
judgments.


Revenue
Recognition.  We recognize revenue in accordance with Securities
and Exchange Commission (SEC) Staff Accounting Bulletin No. 104, Revenue Recognition in
Financial Statements (SAB 104). SAB 104 requires that four basic criteria must be met
before revenue can be recognized: (1) persuasive evidence of an arrangement exists; (2)
delivery has occurred or services rendered; (3) the fee is fixed and determinable; and (4)
collectibility is reasonably assured. Determination of criteria (3) and (4) is based on
managements judgments regarding the fixed nature of the fee charged for services
rendered and products delivered and the collectibility of those fees. Should changes in
conditions cause management to determine that these criteria are not met for certain future
transactions, revenue recognized for any reporting period could be adversely affected. We
recognize product revenues upon shipment. If a product sale does not meet all of the above
criteria, the revenue from the sale is deferred until all criteria are met. Provisions are
made at the time of revenue recognition for any applicable warranty costs expected to be
incurred.




25


Periodically,
we sell products together with a product upgrade option that requires that the customer
pay an upgrade fee at the time of exercise, has no refund provisions and includes an
expiration date on the upgrade option. In accordance with Emerging Issues Task Force Issue
No. 00-21 (EITF 00-21), Accounting for Revenue Arrangements with Multiple
Deliverables,we defer the fair value ascribed to the upgrade option until the
expiration of the upgrade option or the exercise of the upgrade option and shipment of the
product upgrade.


Revenues
from the sale of service contracts is deferred and recognized on a straight-line basis
over the life of the service contract. Revenues from services administered by us that are
not covered by a service contract are recognized as the services are provided. In certain
instances, we sell products together with service contracts. We recognize revenue on such
multiple-element arrangements in accordance with SAB 104 and EITF 00-21, based on the
relative fair market value of each element.


We
generally recognize royalty revenue from licensees upon receipt of cash payments since the
royalty amounts are not determinable at the end of a quarter. Licensees are obligated to
make payments between 30 and 45 days after the end of each quarter. If at the end of a
quarter royalty revenue from licensees are determinable, we record royalty revenue during
the period earned. Periodically, as we sign on new licensees, we recognize back-owed
royalties in the period in which it is determinable and earned. We have the right under
our license agreements to engage independent auditors to review the royalty calculations.
The amounts owed as a result of these audits may be higher or lower than previously
recognized.






We
have funded product development revenue from the development agreements with Gillette,
Johnson & Johnson and the United States Department of the
Army. For both Gillette and Johnson & Johnson, we have received payments in accordance
with the work plans that were developed with both Gillette and Johnson & Johnson.
Revenue is recognized under the contracts as costs are incurred and services are rendered.
Any amounts received in advance of costs incurred and services rendered are recorded as
deferred revenue. Payments are not refundable if the development is not
successful.


We
provide services under a $3.8 million research contract with the United States Department
of the Army to develop a light-based self-treatment device for Pseudofolliculitis Barbae
or PFB. The contract is a cost plus fee arrangement whereby we are reimbursed for the
expenses incurred in connection with PFB research plus an 8% fee. Revenue is recognized
under the contract as the costs are incurred and the services are rendered. Our revenue
from the contract is subject to government audit.


Accounts
Receivable Reserves.Allowances for doubtful accounts are based on
estimates of losses related to customer receivable balances. In establishing the
appropriate provisions for customer receivable balances, we make assumptions with respect
to their future collectibility. Our assumptions are based on an individual assessment of a
customers credit quality as well as subjective factors and trends, including the
aging of receivable balances. Generally, these individual credit assessments occur prior
to the inception of the credit exposure and at regular reviews during the life of the
exposure and consider (a) a customers ability to meet and sustain their financial
commitments; (b) a customers current and projected financial condition; (c) the
positive or negative effects of the current and projected industry outlook; and (d) the
economy in general. Once we consider all of these factors, a determination is made as to
the probability of default. An appropriate provision is made, which takes into account the
severity of the likely loss on the outstanding receivable balance based on our experience
in collecting these amounts. Our level of reserves for our customer accounts receivable
fluctuates depending upon all of the factors mentioned above. We provide a general reserve
for doubtful accounts based on the aging of our accounts receivable balances, historical
experiences of write-offs and defaults.






We
also record a provision for estimated sales returns and allowances on product and service
related sales in the same period as the related revenues are recorded. These estimates are
based on the specific facts and circumstances of particular orders, analysis of credit
memo data, and other known factors. If the data we use to calculate these estimates do not
properly reflect reserve requirements, then a change in the allowances would be made in
the period in which such a determination is made and revenues in that period could be
adversely affected.

26


Inventory
Reserves.As a designer and manufacturer of high technology equipment, we
may be exposed to a number of economic and industry factors that could result in portions
of our inventory becoming either obsolete or in excess of anticipated usage. These factors
include, but are not limited to, technological changes in our markets, our ability to meet
changing customer requirements, competitive pressures in products and prices, reliability
and replacement of and the availability of key components from our suppliers. Our policy
is to establish inventory reserves when conditions exist that suggest that our inventory
may be in excess of anticipated demand or is obsolete based upon our assumptions about
future demand for our products and market conditions. Included in our inventory are
demonstration products that are used by our sales organization. We account for such
products as we do with any other finished goods item in our inventory in accordance with
the review of our entire inventory. We regularly evaluate our ability to realize the value
of our inventory based on a combination of factors including the following: historical
usage rates, forecasted sales or usage, product end of life dates, estimated current and
future market values and new product introductions. Assumptions used in determining our
estimates of future product demand may prove to be incorrect, in which case the provision
required for excess and obsolete inventory would have to be adjusted in the future. If
inventory is determined to be overvalued, we would be required to recognize such as cost
of goods sold at the time of such determination. Although we perform a detailed review of
our forecasts of future product demand, any significant unanticipated changes in demand
could have a significant impact on the value of our inventory and our reported operating
results. Additionally, purchasing requirements and alternative usage avenues are explored
within these processes to mitigate inventory exposure. When recorded, our reserves are
intended to reduce the carrying value of our inventory to its net realizable value.







Warranty
Provision.We typically offer a one-year warranty for all of our base
products. We provide for the estimated cost of product warranties at the time product
revenue is recognized. Factors that affect our warranty reserves include the number of
units sold, historical and anticipated rates of warranty repairs and the cost per repair.
While we engage in extensive product quality programs and processes, including actively
monitoring and evaluating the quality of our component suppliers, our estimated warranty
obligation is affected by ongoing product failure rates, specific product class failures
outside of our baseline experience, material usage and service delivery costs incurred in
correcting a product failure. If actual product failure rates, material usage or service
delivery costs differ from our estimates, revisions to the estimated warranty liability
would be required. Assumptions and historical warranty experience are evaluatedto
determine the appropriateness of such assumptions. We assess the adequacy of the warranty
provision and we may adjust this provision if necessary.


Stock-Based
Compensation.In December 2004, the Financial Accounting Standards
Board (FASB) issued Statement of Financial Accounting Standard SFAS 123 (revised 2004),
Share-Based Payment(SFAS 123R). SFAS 123(R) supersedes APB Opinion No. 25,
Accounting for Stock Issued to Employees (APB 25), and amends SFAS No. 95,
Statement of Cash Flows. Generally, the approach in SFAS 123(R) is similar to the
approach described in SFAS 123. However, SFAS 123(R) requires share-based payments to
employees, including grants of employee stock options and stock-settled stock appreciation
rights (SAR), to be recognized in the income statement based on their fair
values at the date of grant. Pro forma disclosure is no longer an alternative.


On
January 1, 2006, we adopted SFAS 123(R) using the modified prospective method as
permitted under SFAS 123(R). Under this transition method, compensation cost recognized in
2006 includes compensation cost for all share-based payments granted prior to but not yet
vested as of December 31, 2005, based on the grant-date fair value estimated in accordance
with the provisions of SFAS 123. In accordance with the modified prospective method of
adoption, our results of operations and financial position for prior periods have not been
restated.





As
permitted under SFAS 123 and SFAS 123(R), we use the Black-Scholes option pricing
model to estimate the fair value of stock option and SAR grants. Key input assumptions
used to estimate the fair value of stock options and SARs include the exercise price of
the award, the expected option term, the expected volatility of our stock over the option
or SARs expected term, the risk-free interest rate over the option or SARs
expected term and our expected annual dividend yield. Expected volatilities are based on
historical volatilities of our common stock and other factors; the expected life
represents the weighted average period of time that options or SARs granted are expected
to be outstanding giving consideration to vesting schedules and our historical exercise
patterns; and the risk-free rate is based on the U.S. Treasury yield curve in effect at
the time of grant for periods corresponding with the expected life of the option or SAR.
Our assumed dividend yield of zero is based on the fact that we have never paid cash
dividends and have no present intention to pay cash dividends.



27


If
factors change and we employ different assumptions for estimating stock-based compensation
expense in future periods, or if we decide to use a different valuation model, the
stock-based compensation expense we recognize in future periods may differ significantly
from what we have recorded in the current period and could materially affect our income
from operations, net income, and earnings per share. It may also result in a lack of
comparability with other companies that use different models, methods, and assumptions.
The Black-Scholes option-pricing model was developed for use in estimating the fair value
of traded options that have no vesting restrictions and are fully transferable. These
characteristics are not present in our option and SAR grants. Existing valuation models,
including the Black-Scholes model, may not provide reliable measures of the fair values of
our stock-based compensation. Consequently, there is a risk that our estimates of the fair
values of our stock-based compensation awards on the grant dates may bear little
resemblance to the actual values realized upon the exercise, expiration, early termination
or forfeiture of those stock-based payments in the future. Certain stock-based payments,
such as employee stock options and SARs, may expire with little or no intrinsic value
compared to the fair values originally estimated on the grant date and reported in our
financial statements. Alternatively, the value realized from these instruments may be
significantly higher than the fair values originally estimated on the grant date and
reported in our financial statements. The guidance in SFAS 123(R) is relatively new and
the application of these principles may be subject to further interpretation and
refinement over time.






Prior
to December 31, 2005, we followed the provisions of SFAS  123, Accounting
for Stock-Based Compensation. The provisions of SFAS 123 allowed companies to
either expense the estimated fair value of stock options or to continue to follow the
intrinsic value method set forth in Accounting Principles Board Opinion No. 25,
Accounting for Stock Issued to Employees (APB 25), but disclose
the pro forma effects on net income had the fair value of the options been expensed. We
elected to apply APB 25 in accounting for our stock option incentive plans.


In
accordance with APB 25 and related interpretations, compensation expense for stock options
was recognized in income based on the excess, if any, of the quoted market price of the
stock at the grant date of the award or other measurement date over the amount an employee
must pay to acquire the stock. Generally, the exercise price for stock options granted to
employees was equal to the fair market value of our common stock at the date of grant,
thereby resulting in no recognition of compensation expense by us prior to December 31,
2005.


Income
taxes. We record deferred tax assets and liabilities based on the net tax
effects of tax credits, operating loss carryforwards and temporary differences between the
carrying amounts of assets and liabilities for financial reporting purposes and the
amounts used for income tax purposes.


We
regularly review deferred tax assets for recoverability taking into consideration such
factors as historical losses, projected future taxable income and the expected timing of
the reversals of existing temporary differences. SFAS No. 109, Accounting for
Income Taxes, requires us to maintain a valuation allowance when it is more likely
than not that some portion or all of the deferred tax assets will not be realized. For
2006, we removed the valuation allowance related to deferred tax assets based on the
conclusion that there was sufficient positive evidence to support that it was more likely
than not that the deferred tax asset would be realized. This resulted in a non-cash, $7.6
million tax benefit recorded through our 2006 provision for income taxes.





In
addition to the tax assets described above, we have deferred tax assets totaling $20.5
million, resulting from the exercise of employee stock options. In accordance with SFAS
 109 and SFAS 123(R), recognition of these assets would occur upon utilization
of these deferred tax assets to reduce taxes payable and would result in a credit to
additional paid-in capital within stockholders equity rather than the provision for
income taxes. For 2007, 2006 and 2005 the impact to paid-in capital resulting from the
exercise of employee stock options was $4.8 million, $1.2 million and $180,000,
respectively.


In
evaluating the potential exposure associated with the various tax filing positions, we
accrue charges for possible exposures. Based on the annual evaluations of tax positions,
we believe we have appropriately filed our tax returns and accrued for possible exposures.
To the extent we were to prevail in matters for which accruals have been established or be
required to pay amounts in excess of reserves, our effective tax rate in a given financial
period might be materially impacted.


28






Overview


We
are engaged in research, development, manufacturing and distribution of proprietary light-based systems for hair removal and other cosmetic treatments. Since our inception, we have
been able to develop a differentiated product mix of light-based systems for cosmetic
treatments through our research and development as well as with our partnerships
throughout the world. We are continually developing and testing new indications to further
the advancement in cosmetic light-based treatments.


During
2007, we continued to strengthen our presence in the international market. Part of our
strategy was to establish a subsidiary in The Netherlands which markets our products in
Europe, Middle East, and Africa as well as provides certain services of our products for
those regions. As a result of this new subsidiary and other initiatives, we were able to
increase our product sales outside of North America to 29% of product revenues as compared
to 19% in 2006.





Our
total revenues for the year ended December 31, 2007, decreased by 2% as compared to the
same period in 2006. This decrease was driven by a decline in royalty revenues as we
received one-time back-owed royalties of approximately $26.3 million in 2006 as compared
to $3.1 million in 2007. Offsetting the decrease in royalty revenues, product revenues
increased by 12% and funded product development revenues increased by 74% as compared to
the same period in 2006.


Although
we considered 2007 to be a very challenging year, we were able to strengthen our balance
sheet. Our cash and investment position increased by 27% and stockholders equity
grew by 24%. Our current ratio is now 8.2x, up from 6.0x at the end of 2006.


Sales
from our Lux family of products remained strong throughout 2007. The Lux line of products
consists of the StarLux Laser and Pulsed Light System, the MediLux and the
EsteLux® Pulsed Light Systems, including a base unit and multiple, optional
handpieces. The Lux family of products contains some of the most versatile systems in the
market today. The investments that we made in the past into new technologies have paid off
as the demand for our Lux family continued to increase in 2007.




29


Results of operations


Year 2007 Compared to
Year 2006


The
following table contains selected income statement information, which serves as the basis
of the discussion of our results of operations for the years ended December 31, 2007 and
2006, respectively (in thousands, except for percentages):
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                     | 2007 | 2006 | 2007 to 2006 |         |  | 
|------------------------------------ | ---- | ---- | ------------ | ------- |  | 
|
|Revenues:                            |      |      |              |         |  | 
|Product revenues                     |      |      | $            | 103,221 |  | 
|Royalty revenues                     |      |      |              | 13,005  |  | 
|Funded product development revenues  |      |      |              | 6,698   |  | 
|Other revenues                       |      |      |              | 894     |  | 
|                                     |      |      |              |         |  | 
|Total revenues                       |      |      |              | 123,818 |  | 
|                                     |      |      |              |         |  | 
|Cost and expenses:                   |      |     
|Cost of product revenues             |      |      |              | 33,391  |  | 
|Cost of royalty revenues             |      |      |              | 5,202   |  | 
|Research & development               |      |      |              | 16,673  |  | 
|Selling & marketing                  |      |      |              | 24,886  |  | 
|General & administrative             |      |      |              | 17,495  |  | 
|                                     |      |      |              |         |  | 
|Total costs and expenses             |      |      |              | 97,647  |  | 
|                                     |      |      |              |         |  | 
|Income from operations               |      |      |              | 26,171  |  | 
|                                     |      |      |              |         |  | 
|Interest income                      |      |      |              | 6,399   |  | 
|Other income                         |      |      |              | 513     |  | 
|                                     |      |      |              |         |  | 
|Income before income taxes           |      |      |              | 33,083  |  | 
|Provision (benefit) for income taxes |      |      |              | 12,575  |  | 
|                                     |      |      |              |         |  | 
|Net income                           |      |      | $            | 20,508  |  | 
|                                     |      |      |              |         |  | 

|Product
revenues. Sales of our StarLux Laser and Pulsed Light Systems, including a
base unit and multiple, optional handpieces were the leading contributor to our increase
in product revenues. Product revenues were favorably impacted by an increase of 15% in
sales related to the StarLux Laser and Pulsed Light System and an increase of 52% in
revenue related to customer service, offset by a decrease of 51% related to the other
Lux family of products, which includes the MediLux and EsteLux, and a decrease
of 8% from sales related to the Q-Yag 5 product line as compared to the same period in
2006. StarLux product sales increased as more customers opted for the higher powered,
faster and more versatile StarLux systems and related handpieces that are capable of
utilizing both laser and lamp-based applications to treat various cosmetic conditions. The
decline in revenues from other Lux products was directly attributable to the customer
acceptance of the StarLux product line and its additional laser and light-based
handpieces.


International
product revenue, consisting of revenue from our distributors in Japan, Europe, Australia, Asia\Pacific
Rim and South and Central America and our sales shipped directly to international
customers, was 29% of total product revenue for the year ended 2007 in comparison to 19%
for the same period in 2006.





Royalty
revenues. Royalty revenues decreased during 2007 in comparison to the same
period in 2006, mainly due to the $26.3 million in back-owed royalties received in 2006
versus the $3.1 million received in 2007. Excluding back-owed royalties in both periods,
royalty revenues increased by 139%. This increase is attributed to the execution of new
patent license agreements with Cutera and Cynosure in the second and fourth quarters of
2006, respectively, and Alma in the second quarter of 2007.




30


On April 2, 2007, we announced the resolution of our patent infringement and trade dress
lawsuit against Alma Lasers, Inc. through the execution of a Settlement Agreement, a Non-Exclusive
Patent License Agreement and a Trade Dress Settlement Agreement. Under the Patent License Agreement, we
granted Alma a non-exclusive, royalty bearing license to U.S. Patent Nos. 5,735,844 and 5,595,568 and
all corresponding foreign patents and patent applications in the professional field, excluding the
consumer field. Alma admitted that their products infringe these patents and that these patents are
valid and enforceable. In addition, Alma agreed not to challenge the infringement, validity and
enforceability of these patents in the future. Alma will pay for royalties and interest due on past
sales of their laser and lamp-based hair removal systems beginning with their initial sales in 2003 and
a trade dress fee plus interest on past sales of their Harmony and Aria systems. The amounts due to us
are being determined based on an audit by an independent accounting firm. We have begun to recognize
royalty revenue as the amounts become determinable. Under our license agreement with the Massachusetts
General Hospital, we pay to the Massachusetts General Hospital 40% of all patent royalty and interest
thereof from Alma. Starting on March 30, 2007, Alma began paying us royalties on sales of its existing
and any new light-based hair removal systems later developed.  For the year ended December 31, 2007, we
recognized $3.1 million for back-owed royalties from Alma.





On
June 5, 2006, we announced the resolution of our patent infringement lawsuits against
Cutera through the execution of a Settlement Agreement and a Non-Exclusive Patent License
Agreement. Under the License Agreement, we granted Cutera a non-exclusive, royalty bearing
license to the U.S. Patent Nos. 5,735,844 and 5,595,568 and all corresponding foreign
patents and patent applications in the professional field, excluding the consumer field.
 Cutera admitted that their products infringe
the U.S. Patent Nos. 5,735,844 and 5,595,568 and all corresponding foreign patents and
patent applications and that these patents are valid and enforceable. In addition, Cutera
agreed not to challenge the infringement, validity and enforceability of the U.S. Patent
Nos. 5,735,844 and 5,595,568 and all corresponding foreign patents and patent applications
in the future. Cutera paid us $22 million as an estimated payment for royalties due on
past sales of their laser and lamp-based hair removal systems beginning with their initial
sales in 2000 through March 31, 2006, interest and reimbursement of our legal costs.
Cutera subsequently informed us that they believed the actual liability for past
royalties, interest and legal costs was $19.6 million, versus the actual payment of $22
million. We recorded the difference of $2.4 million as deferred revenue at June 30, 2006
to be applied against future amounts owed, which was fully recognized as royalty revenue
as of December 31, 2006. The final amounts due were subject to audit by an independent
accounting firm which was completed during the fourth quarter of 2006, resulting in an
additional $648,000 of royalty and interest. Starting on April 1, 2006, Cutera began
paying us royalties on sales of its existing and any new light-based hair removal systems later developed.
For the year ended December 31, 2006, we recognized $14.2 million for back-owed royalties
from Cutera.




On October 18, 2006, we entered into a new Non-Exclusive Patent License Agreement with
Laserscope  and terminated our prior license agreement with them. Under the new license agreement,
Laserscope pays us a royalty on sales of its current light-based hair removal products, including the
Lyra and Gemini Laser Systems and the Solis IPL System, as well as on sales of new light-based hair
removal systems developed in the future. As a result of a royalty audit of Laserscopes product sales
from January 1, 2001 through June 30, 2006, there was an increase in the third quarter 2006 royalty
revenue of $2.2 million for back-owed royalties. For the year ended December 31, 2006, we recognized
$2.2 million for back-owed royalties from Laserscope.  American Medical Systems Holdings, Inc. acquired
Laserscope in July of 2006 and subsequently sold the assets of Laserscopes aesthetic division to Iridex
Corporation, effective in the first quarter of 2007.  As a result, the license agreement between Palomar
and Laserscope has been assigned to Iridex.  Iridex has assumed all of Laserscopes rights and
obligations under the license agreement.







On November 7, 2006, we announced the execution of a Non-Exclusive Patent License Agreement
with Cynosure, Inc. Under this Agreement, we granted to Cynosure a non-exclusive, royalty bearing
license to the U.S. Patent Nos. 5,735,844 and 5,595,568 and all corresponding foreign patents and patent
applications. In return, Cynosure granted us a non-royalty bearing (fully paid-up), non-exclusive
license to eight Cynosure patents and patent applications, including counterparts.  Cynosure also paid
us $10 million on November 7, 2006 as royalties on sales of their laser and lamp-based hair removal
systems made before October 1, 2006. Starting on October 1, 2006, Cynosure began paying us royalties on
sales of its existing and any new light-based hair removal systems later developed. For the year ended
December 31, 2006, we recognized $10 million of back-owed royalty revenue from Cynosure.

31






Funded
product development revenues.         Funded development revenue increased during 2007 as compared to the same period in 2006.
Funded product development revenue is generated from the development agreements with Gillette, Johnson &
Johnson, and the United States Department of the Army.


During 2007, we recognized approximately $3.8 million and $2.5 million of funded product
development revenue from Gillette and Johnson & Johnson, respectively.  During 2006, we recognized
approximately $1.1 million and $1.5 million of funded product development revenue from Gillette and
Johnson & Johnson, respectively. The increase in funded product development revenue from Gillette during
2007 was the result of the $2.5 million go decision payment following FDA OTC clearance in December 2006
which was recognized throughout 2007 as we were obligated to perform additional services and remain
exclusive with Gillette during that period in consideration for this payment.  The increase was also
attributable to the $1.2 million amendment in February 2007 which was recognized throughout the
remainder of 2007 as costs were incurred and services were provided.




During 2007
and 2006, we recognized approximately $390,000 and $1.3 million, respectively, of funded
product development revenues from the United States Department of the Army. We
provide services under a $3.8 million research contract with the United States Department
of the Army to develop a light-based self-treatment device for Pseudofolliculitis Barbae
or PFB. The contract is a cost plus fee arrangement whereby we are reimbursed for the
expenses incurred in connection with PFB research plus an 8% fee. Revenue is recognized
under the contract as the costs are incurred and the services are rendered.


Other
revenues.Other revenues of $894,000 during the year ended December 31,
2007 were related to the recognition of a portion of the trade dress infringement
associated with the settlement of our lawsuit with Alma.


Cost
of product revenues. The cost of product revenues increased both in
absolute dollars and as a percentage of product revenue to 32% in 2007 from 29% in 2006.
The increase was attributed to a shift in product sales to outside North America where we
sell our products at fixed transfer prices and by a shift in product mix to the higher
priced StarLux 500 Laser and Pulsed Light System and additional handpieces, offset by a
$1.7 million reduction related to royalties due to Massachusetts General Hospital after
finalizing licensing negotiations. Additionally, in 2006, cost of product revenues included a net
decrease as a result of a $762,000 non-recurring adjustment made to product royalties
offset by the write-off of certain customer service loaner inventory of $145,000.



Cost
of royalty revenues. As a percentage of royalty revenues, the cost
of royalty revenues was consistent at 40% in accordance with our license agreement with
Massachusetts General Hospital for the years ended December 31, 2007 and 2006. The
decrease in the cost of royalty revenues in absolute dollars during 2007 as compared to
2006 is attributed to the decrease in royalty revenue recognized from our licensees,
mainly due to the change in back-owed royalties received in 2006 as compared to 2007.






Research
and development expense. The increase in research and development expense
is a direct result of our spending related to the Johnson & Johnson and Gillette agreements and our continued commitment to introducing new
platforms and enhancing our current family of products, offset by reduced expenses related
to the research contract with the United States Department of the Army in 2007.


For
our research and development agreement with Gillette, costs related to payroll and payroll
related expenses increased by $404,000, material costs increased by $228,000 and other
clinical, consulting and overhead expenses increased by $165,000 as compared to the same
period in 2006.


For
our joint development agreement with Johnson & Johnson costs
related to payroll and payroll related expenses increased by $159,000, material costs
increased by $544,000, and other clinical, consulting and overhead expenses decreased by
$26,000 as compared to the same period in 2006.


For
our research agreement with the United States Department of the Army, costs related to
payroll and payroll related expenses decreased by $544,000, material costs decreased by
$176,000 and other clinical, consulting and overhead expenses decreased by $97,000 as
compared to the same period in 2006.

32



Expenses
relating to the introduction of new products, enhancements made to our current family of
products and research and development overhead increased by $2.0 million in comparison to
the same period in 2006. This increase is attributed to increases in payroll and payroll
related expenses, material costs, other clinical, consulting and overhead expenses.



Selling
and marketing expense. The increase in selling and marketing expense is primarily
comprised of $780,000 from payroll and payroll related expenses, $657,000 from tradeshows
and workshops, $324,000 from consultants, and approximately $600,000 relating to other
sales and marketing  costs in comparison to the same period in 2006.
Included in these increases are expenses of approximately $824,000 related to our new
subsidiary in Amsterdam, The Netherlands which markets our products in Europe, Middle
East, and Africa.







General
and administrative expense. The increase in general and administrative
expense is mainly attributed to increases in our corporate legal expenses of $5.1 million
which excludes a $3.8 million reimbursement (net of payments owed to the Massachusetts
General Hospital) from Cutera in 2006, offset by a $227,000 reimbursement (net of payments
owed to the Massachusetts General Hospital) from Alma in 2007. The remaining increase is
primarily comprised of $1.2 million from bad debt expense, $356,000 from payroll and
payroll related expenses and $1.0 million from other  costs offset by a
decrease to incentive compensation of $1.3 million related to our 2007 incentive
compensation plan as compared to the same period in 2006.


Interest
income. In comparison to the same period in 2006, interest income increased
due to the growth in our cash balances and $259,000 (net of payments owed to the
Massachusetts General Hospital) received related to back-owed royalties from a new patent
license agreement in 2007, offset by $1.2 million (net of payments owed to the
Massachusetts General Hospital) received related to back-owed royalties in 2006.


Other
income. Other income for the year ended December 31, 2007 includes $500,000
cash received related to the expiration of a standstill agreement and the foreign exchange
gain (loss) as a result of transactions in currencies other than the U.S. dollar.


Provision
(benefit) for income taxes. The income tax provision for the year ended
December 31, 2007 was 38% as compared to an income tax benefit of 10% for the year ended
December 31, 2006. In 2007, our effective tax rate was less than the combined federal and state statutory
rates because of the benefit of research and development credits generated. In the fourth quarter of 2006, based on current and preceding years results
of operations and anticipated profit levels in future periods, we believed that it was
more likely than not that our deferred tax assets would be realized in the future and,
accordingly, that it was appropriate to release the valuation allowance recorded against
those deferred tax assets. In reaching this conclusion, we weighed both negative and
positive evidence regarding the realizability of these deferred tax assets and considered
the extent to which the evidence could be objectively verified.






33







Year 2006 Compared to
Year 2005


The
following table contains selected income statement information, which serves as the basis
of the discussion of our results of operations for the years ended December 31, 2006 and
2005, respectively (in thousands, except for percentages):
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                     | 2006 | 2005 | 2006 to 2005 |         |   | 
|------------------------------------ | ---- | ---- | ------------ | ------- | - | 
|
|Revenues:                            |      |      |              |         |   | 
|Product revenues                     |      |      | $            | 92,223  |   | 
|Royalty revenues                     |      |      |              | 30,481  |   | 
|Funded product development revenues  |      |      |              | 3,840   |   | 
|                                     |      |      |              |         |   | 
|Total revenues                       |      |      |              | 126,544 |   | 
|                                     |      |      |              |         |   | 
|Cost and expenses:                   |      |     
|Cost of product revenues             |      |      |              | 26,897  |   | 
|Cost of royalty revenues             |      |      |              | 12,192  |   | 
|Research & development               |      |      |              | 14,056  |   | 
|Selling & marketing                  |      |      |              | 22,467  |   | 
|General & administrative             |      |      |              | 7,645   |   | 
|                                     |      |      |              |         |   | 
|Total costs and expenses             |      |      |              | 83,257  |   | 
|                                     |      |      |              |         |   | 
|Income from operations               |      |      |              | 43,287  |   | 
|                                     |      |      |              |         |   | 
|Interest income                      |      |      |              | 4,719   |   | 
|                                     |      |      |              |         |   | 
|Income before income taxes           |      |      |              | 48,006  |   | 
|Provision (benefit) for income taxes |      |      |              | (4,971  | ) | 
|                                     |      |      |              |         |   | 
|Net Income                           |      |      | $            | 52,977  |   | 
|                                     |      |      |              |         |   | 

|Product
revenues. Sales of our StarLux Laser and Pulsed Light Systems, including a
base unit and multiple, optional handpieces were the leading contributor to our increase
in product revenues. Product revenues were favorably impacted by an increase of 59% in
sales related to the StarLux Laser and Pulsed Light System and an increase of 49% in
revenue related to customer service, offset by a decrease of 44% related to the other
Lux family of products, which includes the MediLux and EsteLux, and a decrease
of 40% from sales related to the Q-Yag 5 product line as compared to the same period in
2005. StarLux product sales increased as more customers opted for the higher powered,
faster and more versatile StarLux systems that are capable of utilizing both laser and
lamp-based applications to treat various cosmetic conditions. Customer service revenue
increased as an increased number of customers purchased replacement handpieces. The decline
in revenues from other Lux products was directly attributable to the customer acceptance
of the StarLux product line and its additional laser and light-based handpieces.





International
product revenue, consisting of revenue from our distributors in Japan, Europe, Australia, Asia\Pacific Rim and South and Central America
and our sales shipped directly to international customers was 19% of total product revenue
for the year ended 2006 in comparison to 23% for the same period in 2005. While
international product sales increased in absolute dollars in 2006 compared to 2005, they
declined as a percentage of revenues due to the much larger increase in domestic product
sales.


Royalty
revenues. Royalty revenues increased during 2006 in comparison to the same
period in 2005. This increase is attributed to the execution of a new patent license
agreement with Cynosure, a royalty audit of Laserscope providing back-owed royalties from
Laserscopes product sales from January 1, 2001 through June 30, 2006 and the
settlement of our patent infringement lawsuits against Cutera, offset by Lumenis making
its final installment for back-owed royalties during the fourth quarter in 2005.


34



For
the year ended December 31, 2005, we recognized $2.2 million for back-owed royalties from
Lumenis, respectively.




On June 5, 2006, we announced the resolution of our patent infringement lawsuits against Cutera
through the execution of a Settlement Agreement and a Non-Exclusive Patent License Agreement.  Under the
License Agreement, we granted Cutera a non-exclusive, royalty bearing license to the U.S. Patent Nos.
5,735,844 and 5,595,568 and all corresponding foreign patents and patent applications in the
professional field, excluding the consumer field. Cutera admitted that their products infringe the U.S. Patent Nos. 5,735,844 and 5,595,568 and
all corresponding foreign patents and patent applications and that these patents are valid and
enforceable. In addition, Cutera agreed not to challenge the infringement, validity and enforceability
of the U.S. Patent Nos. 5,735,844 and 5,595,568 and all corresponding foreign patents and patent
applications in the future. Cutera paid us $22 million as an estimated payment for royalties due on past
sales of their laser and lamp-based hair removal systems beginning with their initial sales in 2000
through March 31, 2006, interest and reimbursement of our legal costs. Cutera subsequently informed us
that they believed the actual liability for past royalties, interest and legal costs was $19.6 million,
versus the actual payment of $22 million. We recorded the difference of $2.4 million as deferred revenue
at June 30, 2006 to be applied against future amounts owed, which was fully recognized as royalty
revenue as of December 31, 2006.  The final amounts due were subject to audit by an independent
accounting firm which was completed during the fourth quarter of 2006, resulting in an additional
$648,000 of royalty and interest.  Starting on April 1, 2006, Cutera began paying us royalties on sales
of its existing light-based hair removal systems, and Cutera will pay us royalties on sales of its later
developed light-based hair removal systems.  For the year ended December 31, 2006, we recognized $14.2
million for back-owed royalties from Cutera.






On
October 18, 2006, we entered into a new Non-Exclusive Patent License Agreement with
Laserscope and terminated our prior license agreement with them. Under the new license
agreement, Laserscope pays us a royalty on sales of its current light-based hair removal
products, including the Lyra and Gemini Laser Systems and the Solis IPL System, as well as
on sales of new light-based hair removal systems developed in the future. As a result of a
royalty audit of Laserscopes product sales from January 1, 2001 through June 30,
2006, there was an increase in the third quarter 2006 royalty revenue of $2.2 million for
back-owed royalties. For the years ended December 31, 2006, we recognized $2.2 million for
back-owed royalties from Laserscope. American Medical Systems Holdings, Inc. acquired
Laserscope in July of 2006 and subsequently sold the assets of Laserscopes aesthetic
division to Iridex Corporation, effective in the first quarter of 2007. As a result, the
license agreement between Palomar and Laserscope has been assigned to Iridex. Iridex has
assumed all of Laserscopes rights and obligations under the license agreement.




On
November 7, 2006, we announced the execution of a Non-Exclusive Patent License Agreement
with Cynosure, Inc. Under this Agreement, we granted to Cynosure a non-exclusive, royalty
bearing license to the U.S. Patent Nos. 5,735,844 and 5,595,568 and all corresponding
foreign patents and patent applications and foreign counterparts. In return, Cynosure
granted us a non-royalty bearing (fully paid-up), non-exclusive license to eight Cynosure
patents and patent applications, including counterparts. Cynosure also paid us $10 million
on November 7, 2006 as royalties on sales of their laser and lamp-based hair removal
systems made before October 1, 2006. Starting on October 1, 2006, Cynosure began paying us
royalties on sales of its light-based hair removal systems as well as future developed
hair removal systems. For the year ended December 31, 2006, we recognized $10 million of
back-owed royalty revenue from Cynosure.


Funded
product development revenues.Funded development revenue decreased during
2006 as compared to the same period in 2005. Funded product development revenue is
generated from the development agreements with Gillette, Johnson & Johnson and the United States Department of the Army.


During
2006, we recognized approximately $1.1 million and $1.5 million of funded product
development revenue from Gillette and Johnson & Johnson,
respectively. During 2005, we recognized approximately $2.8 million and $1.6 million of
funded product development revenue from Gillette and Johnson & Johnson, respectively. The decrease in funded product development from Gillette
during 2006 was the result of the completion of the development phase under the agreement
that culminated with FDA clearance in December 2006. Upon FDA clearance, Gillette made a
$2.5 million payment in December 2006, which will be recorded as revenue over a 12 month
period, as we are obligated to perform additional services and remain exclusive to
Gillette during that period in consideration for this payment.



35


During 2006
and 2005, we recognized approximately $1.3 million and $1.0 million, respectively, of
funded product development revenues from the United States Department of the Army. We
provide services under a $3.8 million research contract with the United States Department
of the Army to develop a light-based self-treatment device for Pseudofolliculitis Barbae
or PFB. The contract is a cost plus fee arrangement whereby we are reimbursed for the
expenses incurred in connection with PFB research plus an 8% fee. Revenue is recognized
under the contract as the costs are incurred and the services are rendered.





Cost
of product revenues. The cost of product revenues increased in absolute
dollars, but decreased as a percentage of product revenue to 29% in 2006 from 32% in 2005.
The increase in absolute dollars was attributed to a shift in product mix to the higher
priced StarLux Laser and Pulsed Light System, additional handpieces and a shift in product
sales to North America and by a net decrease in cost of product revenues as a result of a
non-recurring adjustment made to product royalties of $762,000 offset by the write-off of
certain customer service loaner inventory of $145,000.



Cost
of royalty revenues. As a percentage of royalty revenues, the cost
of royalty revenues was consistent at 40% in accordance with our license agreement with
Massachusetts General Hospital for each period in comparison to the same periods in 2005.
The increase in the cost of royalty revenues in absolute dollars during 2006 as compared
to 2005 are attributed to the increase in royalty revenue recognized from our licensees.


Research
and development expense. The increase in research and development expense
is a direct result of our spending related to the Johnson & Johnson agreement and the research contract with the United States Department of
the Army and our continued commitment to introducing new platforms and enhancing our
current family of products, offset by a decrease in spending under the Gillette agreement
in 2006.







For
our research and development agreement with Gillette, costs related to payroll and payroll
related expenses decreased by $698,000, material costs decreased by $484,000 and other
clinical, consulting and overhead expenses decreased by $857,000 as compared to the same
period in 2005.


For
our research agreement with the United States Department of the Army, costs related to
payroll and payroll related expenses increased by $69,000, material costs increased by
$72,000 and other clinical, consulting and overhead expenses increased by $81,000 as
compared to the same period in 2005.


For
our joint development agreement with Johnson & Johnson, costs
related to payroll and payroll related expenses increased by $40,000 and material costs,
other clinical, consulting and overhead expenses increased by $314,000 as compared to the
same period in 2005.


Expenses
relating to the introduction of new products, enhancements made to our current family of
products and research and development overhead increased by $4.2 million in comparison to
the same period in 2005. This increase is attributed to increases in payroll and payroll
related expenses, material costs, other clinical, consulting and overhead expenses.


Selling
and marketing expense. The increase in selling and marketing expense is primarily
comprised of $1.8 million from payroll and payroll related expenses, approximately $1.5
million relating to tradeshows, consultants and other sales and marketing
costs, $160,000 related to the write-off of certain demo inventory and by an increase of
approximately $1.6 million relating to commission expense in comparison to the same period
in 2005. Domestic commission increased by approximately $2.0 million correlating with our
increased domestic product revenue offset by a decrease of $452,000 in commissions related
to European and Far East commissions.








General
and administrative expense. The decrease in general and administrative
expense is mainly attributed to decreases in our corporate legal expenses of $3.0 million
and other costs of approximately $1.2 million offset by increases to
incentive compensation of $2.3 million related to our incentive compensation plan of 2006,
an increase in payroll and payroll related expenses of $711,000, and an increase in bad
debt expense of $872,000 as compared to the same period in 2005. This decrease in legal
costs is mainly attributed to the settlement of our patent infringement lawsuits against
Cutera where Cutera reimbursed us approximately $3.8 million (net of payments owed to the
Massachusetts General Hospital) for legal expenses incurred in connection with the patent
infringement lawsuits.


36



Interest
income. Interest income increased due to the increase in cash balances and
the settlement of our patent infringement lawsuits against Cutera where Cutera paid us
approximately $1.2 million (net of what was paid to the Massachusetts General Hospital) in
interest in comparison to the same period in 2005.


Provision
(benefit) for income taxes. The income tax benefit for fiscal year 2006 was
approximately $5.0 million, which consisted of a $7.6 million non-cash federal and state
valuation allowance release offset by federal and state income taxes of approximately $2.6
million. Based on current and preceding years results of operations and anticipated
profit levels in future periods, we believe that it is more likely than not that our
deferred tax assets will be realized in the future and, accordingly, that it was
appropriate to release the valuation allowance recorded against those deferred tax assets.
In reaching this conclusion, we weighed both negative and positive evidence regarding the
realizability of these deferred tax assets and considered the extent to which the evidence
could be objectively verified.




During
2005, we provided approximately a 3% effective tax rate for anticipated federal
alternative minimum taxes and minimum state income taxes due for 2005.








Liquidity and capital
resources


The
following table sets forth, for the periods indicated, a year-over-year comparison of key
components of our liquidity and capital resources (in thousands):
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                          |  |  | 2007 to 2006 |       
|------------------------- |  |  | ------------ | ------
|
|Operating cash flows      |  |  | $            | 23,014
|Investing cash flows      |  |  |              | 24,736
|Financing cash flows      |  |  |              | 5,893 
|Capital expenditures, net |  |  |              | 706   

|Additionally,
our cash and investment position, accounts receivable, inventories and working capital are
shown below for the periods indicated (in thousands).
|--------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                |  |  | 2007 to 2006 |        
|----------------------------------------------- |  |  | ------------ | -------
|
|Cash and cash equivalents                       |  |  | $            | 90,460 
|Available-for-sale investments, at market value |  |  |              | 41,910 
|Accounts receivable, net                        |  |  |              | 16,037 
|Inventories, net                                |  |  |              | 12,896 
|Working capital                                 |  |  |              | 145,861

|As
of December 31, 2007, we had $132 million in cash and cash equivalents and
available-for-sale investments.  We believe that our current cash balances and expected
future cash flows will be sufficient to meet our anticipated cash needs for working
capital, capital expenditures, and other activities for at least the next twelve months.
As of December 31, 2007, we had no borrowings or debt.


Cash
provided by operating activities decreased for the twelve months ended December 31, 2007
compared to the same period in 2006. This decrease primarily reflects the effects of a
decrease in net profit, offset by a decrease in working capital requirements.  Cash from
(used in) investing activities increased during 2007 compared to the same period in 2006.
These amounts primarily reflect cash used for purchases of property and equipment,
purchases of available-for-sale investments offset by proceeds from the sale of
available-for-sale investments.  Cash provided by financing activities decreased for the
twelve month period ended December 31, 2007 compared to the same period in 2006. This
decrease was primarily due to a decrease in exercises of stock options and a buyback of
treasury stock, offset by an increase in tax benefits from the exercise of stock options.




37



We
anticipate that capital expenditures for 2008 will total approximately $1 million
consisting primarily of leasehold improvements, machinery, equipment, computers, and
peripherals.  We expect to finance these expenditures with cash on hand.


Effective
as of February 14, 2003, we entered into a Development and License Agreement with
Gillette to complete the development and commercialize a home-use, light-based hair
removal device for women. (See Note 11 for more information.)


In
the first quarter of 2004, we began providing services under a research contract with the
United States Department of the Army to develop a light-based self-treatment device for
PFB.  (See Note 13 for more information.)


On
June 17, 2004, we reached a settlement agreement with Lumenis resolving on-going
litigation concerning both patent infringement and contractual matters.  (See Note 14 for
more information.)


Effective
as of September 1, 2004, we entered into a Joint Development and License Agreement with
Johnson & Johnson to develop and commercialize home-use, light
based devices in the fields of (i) reducing or reshaping body fat including cellulite;
(ii) reducing appearance of skin aging; and (iii) reducing or preventing acne. (See Note
12 for more information.)










On
June 5, 2006, we announced the resolution of our patent infringement lawsuits against
Cutera, Inc. through the execution of a Settlement Agreement and a Non-Exclusive Patent
License Agreement.  (See Note 15 for more information.)


On
October 18, 2006, we entered into a new Non-Exclusive Patent License Agreement with
Laserscope and terminated our prior license agreement with them. (See Note 16 for more
information.)


On
November 7, 2006, we announced the execution of a Non-Exclusive Patent License Agreement
with Cynosure, Inc. (See Note 17 for more information.)


On
April 2, 2007, we announced the resolution of our patent infringement and trade dress
lawsuit against Alma Lasers, Inc. through the execution of a Settlement Agreement, a
Non-Exclusive Patent License Agreement and a Trade Dress Settlement Agreement. (See Note
18 for more information.)


On
August 13, 2007, our Board of Directors approved a stock repurchase program under which
our management is authorized to repurchase up to one million shares of our common stock.
The timing and actual number of shares purchased will depend on a variety of factors such
as price, corporate and regulatory requirements, alternative investment opportunities and
other market conditions. Stock repurchases under this program, if any, will be made using
our cash resources, and may be commenced or suspended at any time or from time to time at
management's discretion without prior notice.  During the year ended December 31, 2007,
we used $3.0 million to purchase 105,000 shares of our common stock at an average price
of $28.73.



Off-balance sheet arrangements


We
do not participate in transactions that generate relationships with unconsolidated
entities or financial partnerships, such as entities often referred to as variable
interest or special purpose entities, which would have been established for the purpose
of facilitating off-balance sheet arrangements or other contractually narrow or limited
purposes. As of December 31, 2007, we were not involved in any unconsolidated
transactions.


38




Contractual obligations


We
are a party to license agreements, as amended, with Massachusetts General Hospital
whereby we are obligated to pay royalties to Massachusetts General Hospital for sales of
certain products as well as 40% of royalties received from third parties. Royalty expense
in 2007 totaled approximately $5.9 million.


We
are obligated to make future payments under various contracts, including non-cancelable
inventory purchase commitments and our operating lease relating to our Burlington,
Massachusetts manufacturing, research and development and administrative offices.


On
January 18, 2006, we signed an amendment to our lease to add an additional 12,000 square
feet.  Rent expense, including this new lease, will total approximately $1.165 million
per year, expiring in August 2009.


On
July 30, 2007, we signed an amendment to our lease to add an additional 13,600 square
feet. Rent expense, including this new lease, will total approximately $1.3 million per
year, expiring in August 2009.


The
following table summarizes our estimated contractual cash obligations as of December 31,
2007, excluding royalty and employment obligations because they are variable and/or
subject to uncertain timing (in thousands):
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                              |        | Payments due by period |      |     |    
|----------------------------- | ------ | ---------------------- | ---- | --- | ---
|
|Operating lease               | $2,163 | $1,301                 | $862 | $-- | $--
|Purchase commitments          | 5,700  | 5,700                  | --   | --  | -- 
|                              |        |                        |      |     |    
|Total contractual obligations | $7,863 | $7,001                 | $862 | $-- | $--
|                              |        |                        |      |     |    

|Recently issued accounting
standards

In June 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation
No. 48, Accounting for Uncertainty in Income Taxes  an interpretation of FASB Statement No. 109 (FIN
48). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprises
financial statements in accordance with SFAS No. 109, Accounting for Income Taxes. FIN 48 prescribes a
recognition threshold and measurement attribute for the financial statement recognition and measurement
of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on
derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and
transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. We adopted FIN 48
effective January 1, 2007.




In
September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (SFAS 157).
 This Statement defines fair value, establishes a framework for measuring fair value
and expands disclosure of fair value measurements.  SFAS 157 applies under other
accounting pronouncements that require or permit fair value measurements and accordingly,
does not require any new fair value measurements.  SFAS 157 is effective for
financial statements issued for fiscal years beginning after November 15, 2007.  We
are currently assessing the impact that SFAS 157 may have on our consolidated financial
position, results of operations, and cash flows.


Item 7A. Quantitative
and Qualitative Disclosures About Market Risk


Our
primary market risk exposures are in the areas of interest rate risk and foreign currency
exchange risk.


Our investment portfolio of cash equivalents and debt securities is subject to interest rate
fluctuations, but we believe this risk is immaterial because of the short-term nature of these
investments.   At December 31, 2007, we held $41.9 million in auction-rate securities (ARS).  These ARS
are classified as available-for-sale securities on our consolidated balance sheets and are high quality
securities.   Subsequent to December 31, 2007, several of our securities failed at auction.  However, all
 of the securities which were held on December 31, 2007
succeeded in at least the first auction subsequent to December 31, 2007.  As of February 29, 2008, we
held $23.5 million in ARS which failed in their last auction.
39


Our
international subsidiary in The Netherlands conducts business in both local and foreign
currencies and therefore, we are exposed to foreign currency exchange risk resulting from
fluctuations in foreign currencies. This risk could adversely impact our results and
financial condition. We believe our current exposure to fluctuations in foreign currency
exchange rates is immaterial. We have not entered into any foreign currency exchange and
option contracts to reduce our exposure to foreign currency exchange risk and the
corresponding variability in operating results as a result of fluctuations in foreign
currency exchange rates.
40






Item 8. Financial
Statements and Supplementary Data




Palomar Medical
Technologies, Inc. and Subsidiaries Index to Consolidated Financial Statements
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |                                                                                                     |  | Page
| | --------------------------------------------------------------------------------------------------- |  | ----
| | Report of Independent Registered Public Accounting Firm                                             |  | 42  
| | Consolidated Balance Sheets - December 31, 2007 and 2006                                            |  | 43  
| | Consolidated Statements of Income - Years ended December 31, 2007, 2006
     and 2005               |  | 44  
| | Consolidated Statements of Stockholders' Equity - Years ended December 31, 2007,
     2006 and 2005 |  | 45  
| | Consolidated Statements of Cash Flows - Years ended December 31, 2007, 2006
     and 2005           |  | 46  
| | Notes to Consolidated Financial Statements                                                          |  | 47  

|41


Report of Independent Registered
Public Accounting Firm


The Board of Directors
and Stockholders of
Palomar Medical
Technologies, Inc.:


We have audited the accompanying
 consolidated  balance sheets of Palomar Medical  Technologies,  Inc. and subsidiaries
 as of  December  31,  2007 and 2006,  and the  related  consolidated  statements  of
income, stockholders  equity and cash flows for each of the three fiscal  years in the
period ended  December 31, 2007. These financial  statements are the responsibility of
the Companys  management.  Our responsibility is to express an opinion on these
financial statements based on our audits.


We conducted  our audits in
 accordance  with the  standards of the Public  Company  Accounting  Oversight Board
(United  States).  Those standards  require that we plan and perform the audit to obtain
 reasonable assurance  about whether the financial  statements  are free of material
 misstatement.  An audit includes examining,  on a test basis,  evidence supporting the
amounts and disclosures in the financial statements. An audit also  includes  assessing
 the  accounting  principles  used and  significant  estimates  made by management,  as
well as  evaluating  the overall  financial  statement  presentation.  We believe that
our audits provide a reasonable basis for our opinion.


In our opinion, the financial
 statements referred to above present fairly, in all material respects,  the consolidated
 financial  position of Palomar Medical  Technologies,  Inc. and subsidiaries at December
31, 2007 and 2006,  and the  consolidated  results  of their  operations  and their cash
flows for each of the three fiscal years in the period ended  December 31, 2007,  in
 conformity  with U.S.  generally  accepted accounting principles.


As  discussed in Note 1 to the
 consolidated  financial  statements,  effective  January 1, 2007,  Palomar Medical
  Technologies,   Inc.  adopted  Financial  Accounting  Standards  Board  Interpretation
 No.  48, Accounting for  Uncertainty in Income Taxes.  Also, as discussed in Note 1 to
the  consolidated  financial statements,  effective January 1, 2006, Palomar Medical
Technologies,  Inc. adopted Statement of Financial Accounting Standards No. 123(R), Share
Based Payment.


We also have audited,  in accordance
with the standards of the Public Company  Accounting  Oversight Board (United  States),
 the  effectiveness  of Palomar  Medical  Technologies,  Inc.s  internal  control  over
financial  reporting  as of December  31,  2007,  based on  criteria  established  in
 Internal  Control  Integrated  Framework issued by the Committee of Sponsoring
 Organizations of the Treadway  Commission and our report dated March 4, 2008 expressed
an unqualified opinion thereon.
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                      |                      
|--------------------- | ---------------------
|                      | /s/ Ernst & Young LLP
|Boston, Massachusetts |                      
|March 4, 2008         |                      

|42



Palomar Medical
Technologies, Inc. and Subsidiaries  Consolidated Balance
Sheets
|--------------------------------------------------------------------------------------

|                                                                               | December 31,
2007 | December 31,
2006
|------------------------------------------------------------------------------ | ----------------- | -----------------
|Assets                                                                         |                   |                  
|Assets:                                                                        |                  
|Cash and cash equivalents                                                      |                   | $   90,460,350   
|Available-for-sale investments, at market value                                |                   | 41,910,000       
|Accounts receivable, net of allowance of $1,470,360 and $950,000, respectively |                   | 16,037,475       
|Inventories                                                                    |                   | 12,896,154       
|Deferred tax assets                                                            |                   | 3,811,873        
|Other current assets                                                           |                   | 1,129,300        
|                                                                               |                   |                  
|Total current assets                                                           |                   | 166,245,152      
|                                                                               |                   |                  
|Property and equipment, net                                                    |                   | 1,250,437        
|Other assets                                                                   |                   | 111,074          
|                                                                               |                   |                  
|Total assets                                                                   |                   | $ 167,606,663    
|                                                                               |                   |                  
|Liabilities and Stockholders' Equity                                           |                  
|Liabilities:                                                                   |                  
|Accounts payable                                                               |                   | $     1,987,579  
|Accrued liabilities                                                            |                   | 12,606,422       
|Deferred revenue                                                               |                   | 5,789,936        
|                                                                               |                   |                  
|Total current liabilities                                                      |                   | 20,383,937       
|                                                                               |                   |                  
|Deferred taxes                                                                 |                   | 2,533,220        
|                                                                               |                   |                  
|                                                                               |                   |                  
|Total liabilities                                                              |                   | $   22,917,157   
|                                                                               |                   |                  
|Commitments and contingencies (Note 7)                                         |                  
|                                                                               |                   |                  
|Stockholders' equity:                                                          |                  
|Preferred stock, $.01 par value-                                               |                   |                  
|Authorized - 1,500,000 shares                                                  |                   |                  
|Issued -  none                                                                 |                   | --               
|Common stock, $.01 par value-                                                  |                  
|Authorized - 45,000,000 shares                                                 |                  
|Issued - 18,442,846 and 18,063,103 shares, respectively                        |                   | 184,429          
|Additional paid-in capital                                                     |                   | 199,988,081      
|Accumulated other comprehensive income                                         |                   | 12,590           
|Accumulated deficit                                                            |                   | (52,479,008      
|Treasury stock, at cost - 105,000 shares                                       |                   | (3,016,586       
|                                                                               |                   |                  
|Total stockholders' equity                                                     |                   | 144,689,506      
|                                                                               |                   |                  
|Total liabilities and stockholders equity                                     |                   | $ 167,606,663    
|                                                                               |                   |                  

|See
accompanying notes to consolidated financial statements.

43


Palomar Medical
Technologies, Inc. and Subsidiaries  Consolidated
Statements of Income
|---------------------------------------------------------------------------------------------------------------------------------------------------------

|                                               | Years Ended December 31, |  |  
|---------------------------------------------- | ------------------------ |  | -
|
|Revenues:                                      |                          |  |  
|Product revenues                               |                          |  | $
|Royalty revenues                               |                          |  |  
|Funded product development revenues            |                          |  |  
|Other revenues                                 |                          |  |  
|                                               |                          |  |  
|Total revenues                                 |                          |  |  
|                                               |                          |  |  
|Costs and expenses:                            |                          | 
|Cost of product revenues                       |                          |  |  
|Cost of royalty revenues                       |                          |  |  
|Research and development                       |                          |  |  
|Selling and marketing                          |                          |  |  
|General and administrative                     |                          |  |  
|                                               |                          |  |  
|Total costs and expenses                       |                          |  |  
|                                               |                          |  |  
|Income from operations                         |                          |  |  
|Interest income                                |                          |  |  
|Other income                                   |                          |  |  
|                                               |                          |  |  
|Income before income taxes                     |                          |  |  
|Provision (benefit) for income taxes           |                          |  |  
|                                               |                          |  |  
|Net income                                     |                          |  | $
|                                               |                          |  |  
|Net income per share:                          |                          | 
|Basic                                          |                          |  | $
|                                               |                          |  |  
|Diluted                                        |                          |  | $
|                                               |                          |  |  
|Weighted average number of shares outstanding: |                          | 
|Basic                                          |                          |  |  
|                                               |                          |  |  
|Diluted                                        |                          |  |  
|                                               |                          |  |  
|Comprehensive income:                          |                          | 
|Net income                                     |                          |  | $
|Currency translation adjustment                |                          |  |  
|                                               |                          |  |  
|Comprehensive income                           |                          |  | $
|                                               |                          |  |  
|                                               |                          |  |  

|See
accompanying notes to consolidated financial statements.

44


Palomar Medical
Technologies, Inc. and Subsidiaries Consolidated
Statements of Stockholders Equity
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                               | Common Stock |  | Treasury Stock |            |  |   |        
|-------------------------------------------------------------- | ------------ |  | -------------- | ---------- |  | - | -------
|
|Balance, December 31, 2004                                     |              |  |                | 16,231,502 |  | $ | 162,315
|Net income                                                     |              |  |                | --         |  |   | --     
|Issuance of stock for employer 401(k)    matching contribution |              |  |                | 11,124     |  |   | 111    
|Costs incurred related to the issuance of    common stock      |              |  |                | --         |  |   | --     
|Tax benefit from the exercise of stock    options              |              |  |                | --         |  |   | --     
|Exercise of warrants                                           |              |  |                | 50,000     |  |   | 500    
|Exercise of stock options                                      |              |  |                | 833,841    |  |   | 8,339  
|                                                               |              |  |                |            |  |   |        
|Balance, December 31, 2005                                     |              |  |                | 17,126,467 |  |   | 171,265
|                                                               |              |  |                |            |  |   |        
|                                                               |              |  |                |            |  |   |        
|Net income                                                     |              |  |                | --         |  |   | --     
|Issuance of stock for employer 401(k)    matching contribution |              |  |                | 9,355      |  |   | 94     
|Costs incurred related to the issuance    of common stock      |              |  |                | --         |  |   | --     
|Tax benefit from the exercise of stock    options              |              |  |                | --         |  |   | --     
|Exercise of warrants                                           |              |  |                | 55,000     |  |   | 550    
|Exercise of stock options                                      |              |  |                | 872,281    |  |   | 8,723  
|Stock-based compensation expense                               |              |  |                | --         |  |   | --     
|                                                               |              |  |                |            |  |   |        
|Balance, December 31, 2006                                     |              |  |                | 18,063,103 |  |   | 180,631
|                                                               |              |  |                |            |  |   |        
|Net income                                                     |              |  |                | --         |  |   | --     
|Issuance of stock for employer 401(k)    matching contribution |              |  |                | 41,865     |  |   | 419    
|Costs incurred related to the issuance    of common stock      |              |  |                | --         |  |   | --     
|Tax benefit from the exercise of stock    options              |              |  |                | --         |  |   | --     
|Exercise of stock options                                      |              |  |                | 337,878    |  |   | 3,379  
|Stock-based compensation expense                               |              |  |                | --         |  |   | --     
|Currency translation adjustment                                |              |  |                | --         |  |   | --     
|Treasury stock buyback                                         |              |  |                | --         |  |   | --     
|                                                               |              |  |                |            |  |   |        
|Balance, December 31, 2007                                     |              |  |                | 18,442,846 |  | $ | 184,429
|                                                               |              |  |                |            |  |   |        
|                                                               |              |  |                |            |  |   |        

|See
accompanying notes to consolidated financial statements.

45


Palomar Medical
Technologies, Inc. and Subsidiaries Consolidated
Statements of Cash Flows
|------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                                                   | Years Ended December 31, |  |  
|---------------------------------------------------------------------------------- | ------------------------ |  | -
|
|Cash flows from operating activities:                                              |                          |  |  
|Net income                                                                         |                          |  | $
|Adjustments to reconcile net income  to net cash provided by operating activities: |                          | 
|Depreciation and amortization                                                      |                          |  |  
|Stock-based compensation expense                                                   |                          |  |  
|Provision for bad debt                                                             |                          |  |  
|Inventory write-off                                                                |                          |  |  
|Tax benefit from the exercise of stock options                                     |                          |  |  
|Other non-cash items                                                               |                          |  |  
|Changes in assets and liabilities:                                                 |                          | 
|Accounts receivable                                                                |                          |  |  
|Inventories                                                                        |                          |  |  
|Deferred tax assets                                                                |                          |  |  
|Other current assets                                                               |                          |  |  
|Accounts payable                                                                   |                          |  |  
|Accrued liabilities                                                                |                          |  |  
|Deferred income taxes                                                              |                          |  |  
|Deferred revenue                                                                   |                          |  |  
|                                                                                   |                          |  |  
|Net cash from operating activities                                                 |                          |  |  
|                                                                                   |                          |  |  
|Cash flows used in investing activities:                                           |                          | 
|Purchases of property and equipment                                                |                          |  |  
|Purchases of available-for-sale investments                                        |                          |  |  
|Proceeds from sale of available-for-sale investments                               |                          |  |  
|                                                                                   |                          |  |  
|Net cash from (used in) investing activities                                       |                          |  |  
|                                                                                   |                          |  |  
|Cash flows from financing activities:                                              |                          | 
|Proceeds from the exercise of stock options and warrants                           |                          |  |  
|Tax benefit from the exercise of stock options                                     |                          |  |  
|Costs incurred related to issuance of common stock                                 |                          |  |  
|Costs incurred related to treasury stock buyback                                   |                          |  |  
|                                                                                   |                          |  |  
|Net cash from financing activities                                                 |                          |  |  
|                                                                                   |                          |  |  
|Net increase in cash and cash equivalents                                          |                          |  |  
|Cash and cash equivalents, beginning of the period                                 |                          |  |  
|                                                                                   |                          |  |  
|Cash and cash equivalents, end of the period                                       |                          |  | $
|                                                                                   |                          |  |  
|                                                                                   |                          |  |  
|Supplemental disclosure of cash flow information:                                  |                          | 
|Cash paid for income taxes                                                         |                          |  | $
|                                                                                   |                          |  |  
|Supplemental disclosure of noncash financing and investing activities:             |                          | 
|Issuance of stock for employer 401(k) matching contribution                        |                          |  | $
|                                                                                   |                          |  |  

|See
accompanying notes to consolidated financial statements.




46


Palomar Medical
Technologies, Inc. and Subsidiaries  Notes to Consolidated
Financial Statements


Note 1  Summary of
Significant Accounting Policies


Business


We
are engaged in research, development, manufacturing and distribution of proprietary laser
and lamp (light-based) systems for cosmetic treatments.


Basis of Presentation


The
accompanying consolidated financial statements reflect the consolidated financial
position, results of operations and cash flows of Palomar and all of its wholly owned
subsidiaries. All intercompany transactions have been eliminated in consolidation.




Reclassifications

Beginning in 2006, certain expenses previously reported as research and development expenses and selling
and marketing expenses are reported as general and administrative expenses and certain balance sheet
reclassifications have been made. Accordingly, such amounts from previous years have been reclassified
in the accompanying financial statements to conform to the current year presentation.







Use of Estimates


The
preparation of financial statements in conformity with accounting principles generally
accepted in the United States requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of contingent assets
and liabilities at the date of the consolidated financial statements and the reported
amounts of revenues and expenses during the reporting period. Actual results could differ
from those estimates.






In
the ordinary course of accounting for the items discussed above, we makes changes in
estimates as appropriate, and as we become aware of circumstances surrounding those
estimates. Such changes and refinements in estimation methodologies are reflected in
reported results of operations in the period in which the changes are made and, if
material, their effects are disclosed in the Notes to the Consolidated Financial
Statements.


Cash and Cash Equivalents


Cash
equivalents consist of short-term, highly liquid investments which are readily convertible
into cash with original maturities of three months or less when purchased. Cash
equivalents consist primarily of institutional money market funds.


Investments Securities
Available-For-Sale


Investment
securities, which primarily consist of state and municipal auction-rate securities and
variable rate demand obligations, are classified as available-for-sale under
provisions of Statement of Financial Accounting Standards No. 115, Accounting for
Certain Investments in Debt and Equity Securities and are recorded at fair value. We
invest in short-term investments that are generally highly liquid. Any unrealized gains
and losses, net of income tax effects, would be computed on the basis of specific
identification and reported as a component of Accumulated Other Comprehensive Income
(Loss) in our Consolidated Statements of Stockholders Equity. Substantially all of
our short-term investments have contractual maturities of twelve months or less. Because
of the short term to maturity, amortized costs approximate fair values for all of these
securities. Unrealized gains and losses for 2007, 2006 and 2005 were not material.




Our available-for-sale investments are comprised of auction-rate securities (ARS).  In 2007,
the ARS we typically invested in were high quality securities with interest rates often ranging from 5%
to 7% and have approximate maturities of at least 8 years.  However, because of the short-term nature of
our investment in these securities, they have been classified as available-for-sale and included in
short-term investments on our consolidated balance sheets.  Our holdings of auction-rate securities for
the years ended December 31, 2007 and 2006, were $41.9 million and $67.4 million, respectively.

47


Subsequent to December 31, 2007, several of our securities failed at auction.
However, all of the securities which were held on December 31, 2007 succeeded in at least the first auction subsequent to December 31, 2007.   As of February 29, 2008, we
held $23.5 million in ARS which failed in their last auction.  As a result of these failed auctions, we
have the potential to benefit from a penalty feature in our interest rates which allows us to earn
higher rates of interest on these securities until the next auction is set to occur.  All of our
investments are high quality securities, backed by creditworthy financial institutions, and have the
ability to potentially be sold in a secondary market.  Based on the underlying market conditions and
liquidity of the capital markets, we will determine the appropriate valuation treatment of these
securities in the first quarter of 2008.





Accounts Receivable
Reserve


We
maintain an allowance for losses resulting from the inability of our customers to make
required payments. We regularly evaluate the collectibility of our trade receivables based
on a combination of factors, which may include dialogue with the customer to determine the
cause in delay of payments, the use of collection agencies, and/or the use of litigation.
In the event that it is determined that the customer may not be able to meet its full
obligation to us, we record a specific allowance to reduce the related receivable to the
amount that we expect to recover given all information present. We also record a provision
for estimated sales returns and allowances on product and service related sales in the
same period as the related revenues are recorded. These estimates are based on the
specific facts and circumstances of a particular order, analysis of credit memo data and
other known factors. If the data we use to calculate these estimates do not properly
reflect reserve requirements, then a change in the allowances would be made in the period
in which such a determination is made and revenues in that period could be affected.
Accounts receivable allowance activity consisted of the following for the years ended
December 31, 2007, 2006 and 2005, respectively.
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|At December 31,              | 2007 | 2006 | 2005
|---------------------------- | ---- | ---- | ----
|Balance at beginning of year |      |      | $   
|Additions                    |      |      |     
|Deductions                   |      |      |     
|                             |      |      |     
|Balance at end of year       |      |      | $   
|                             |      |      |     

|Inventories


Inventories
are valued at the lower of cost (first in, first-out method) or market, and include
material, labor and manufacturing overhead. At December 31, 2007 and 2006, inventories
consisted of the following:
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|At December 31, | 2007         | 2006        
|--------------- | ------------ | ------------
|Raw materials   | $  5,541,725 | $  4,669,750
|Work in process | 1,383,689    | 1,998,420   
|Finished goods  | 5,970,740    | 4,343,540   
|                |              |             
|                | $12,896,154  | $11,011,710 
|                |              |             
|               

|Our
policy is to establish inventory reserves when conditions exist that suggest that
inventory may be in excess of anticipated demand or is obsolete based upon assumptions
about future demand for products and market conditions. Included in our finished goods
inventory are $1,601,565 in 2007 and $1,180,634 in 2006 of demonstration products that are
used by our sales organization. We account for such products as we do with any other
finished goods item in our inventory in accordance with the review of our entire
inventory. We regularly evaluate the ability to realize the value of inventory based on a
combination of factors including the following: historical usage rates, forecasted sales
or usage, product end of life dates, estimated current and future market values and new
product introductions. Assumptions used in determining our estimates of future product
demand may prove to be incorrect; in which case the provision required for excess and
obsolete inventory would have to be adjusted in the future. If inventory is determined to
be overvalued, we would be required to recognize such costs as cost of goods sold at the
time of such determination. Although we perform a detailed review of our forecasts of
future product demand, any significant unanticipated changes in this demand could have a
significant impact on the value of our inventory and our reported operating results.

48



Property and Equipment


Property
and equipment are recorded at cost. Repairs and maintenance costs are expensed as
incurred. Depreciation and amortization are provided using the straight-line method over
the estimated useful lives of property and equipment. At December 31, 2007 and 2006,
property and equipment consist of the following:
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|At December 31,               | 2007       | 2006       | Useful Life                                      
|----------------------------- | ---------- | ---------- | -------------------------------------------------
|Machinery and equipment       | $1,902,425 | $1,759,984 | 3 - 8 years                                      
|Furniture and fixtures        | 2,956,610  | 2,516,408  | 5 years                                          
|Leasehold improvements        | 517,673    | 394,330    | Shorter of estimated useful life or term of lease
|                              |            |            |                                                  
|                              | 5,376,708  | 4,670,722 
|Less accumulated depreciation | 4,126,271  | 3,540,737 
|                              |            |            |                                                  
|Total                         | $1,250,437 | $1,129,985
|                              |            |            |                                                  

|Revenue Recognition


We
recognize revenue in accordance with Securities and Exchange Commission (SEC) Staff
Accounting Bulletin No. 104, Revenue Recognition in Financial Statements (SAB 104).
SAB 104 requires that four basic criteria must be met before revenue can be recognized:
(1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services
rendered; (3) the fee is fixed and determinable; and (4) collectibility is reasonably
assured. Determination of criteria (3) and (4) is based on our judgments regarding the
fixed nature of the fee charged for services rendered and products delivered and the
collectibility of those fees. Should changes in conditions cause us to determine that these
criteria are not met for certain future transactions, revenue recognized for any reporting
period could be adversely affected. We recognize product revenues upon shipment. If a
product sale does not meet all of the above criteria, the revenue from the sale is
deferred until all criteria are met. Provisions are made at the time of revenue
recognition for any applicable warranty costs expected to be incurred.


Periodically,
we sell products together with a product upgrade option that requires that the customer
pay an upgrade fee at the time of exercise, has no refund provisions and includes an
expiration date on the upgrade option. In accordance with EITF 00-21, we defer the fair
value ascribed to the upgrade option until the expiration of the upgrade option or the
exercise of the upgrade option and shipment of the product upgrade.


Revenues
from the sale of service contracts are deferred and recognized on a straight-line basis
over the life of each service contract. Revenues from services administered by us that are
not covered by a service contract are recognized as the services are provided. In certain
instances, we sell products together with service contracts. We recognize revenue on such
multiple-element arrangements in accordance with SAB 104 and EITF 00-21, based on the
relative fair value of each element.





We
generally recognize royalty revenue from licensees upon receipt of cash payments since the
royalty amounts are not determinable at the end of a quarter. Licensees are obligated to
make payments between 30 and 45 days after the end of each quarter. If at the end of a
quarter, royalty revenue from licensees are determinable we record royalty revenue during
the period earned. Periodically, as we sign on new licensees, in the period determinable
and earned we recognize back-owed royalties. We have the right under our license
agreements to engage independent auditors to review the royalty calculations. The amounts
owed as a result of these audits may be higher or lower than previously recognized.


We account for funded development revenue from Gillette and Johnson & Johnson in accordance with the
work plan that was developed with both Gillette and Johnson & Johnson. Revenue is recognized under the
contracts as costs are incurred and services are rendered.  Any amounts received in advance of costs
incurred and services rendered from Gillette or Johnson & Johnson Consumer Companies, Inc are recorded
as deferred revenue. As of December 31, 2007, we have deferred $48,000 and $477,000 relating to Gillette and Johnson &
Johnson, respectively.  Payments are not refundable if the development is not successful.  During 2007,
we recognized approximately $3.8 million and $2.5 million of funded product development revenue from
Gillette and Johnson & Johnson, respectively. During 2006, we recognized approximately $1.1 million and
$1.5 million of funded product development revenue from Gillette and Johnson & Johnson, respectively.
During 2005, we recognized approximately $2.8 million and $1.6 million of funded product development
revenue from Gillette and Johnson & Johnson, respectively.

49



We
provide services under a $3.8 million research contract with the United States Department
of the Army to develop a light-based self-treatment device for Pseudofolliculitis Barbae
or PFB. The contract is a cost plus fee arrangement whereby we are reimbursed for the
expenses incurred in connection with PFB research plus an 8% fee. Revenue is recognized
under the contract as the costs are incurred and the services are rendered. Our revenue
from the contract is subject to government audit. During the years ended December 31,
2007, 2006 and 2005, we recognized approximately $388,000, $1.3 million and $1.0 million,
respectively, of funded product development revenues from the United States Department of
the Army.







In
accordance with EITF 00-10, reimbursed shipping and handling costs are included in revenue
with the offsetting expense included in selling and marketing and cost of product revenues. Included in revenues are
$291,000, $304,000 and $249,000 of reimbursed shipping and handling costs during the years
ended December 31, 2007, 2006 and 2005, respectively.


Product Warranty Costs


We
typically offer a one-year warranty for all of our base products. We provide for the
estimated cost of product warranties at the time product revenue is recognized. Factors
that affect our warranty reserves include the number of units sold, historical and
anticipated rates of warranty repairs, and the cost per repair. We assess the adequacy of
the warranty provision and we may adjust this provision if necessary.


The
following table provides the detail of the change in our product warranty accrual, which
is a component of accrued liabilities on the Consolidated Balance Sheets for the years
ended December 31, 2007 and 2006.
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|At December 31,                                     | 2007 | 2006
|--------------------------------------------------- | ---- | ----
|Warranty accrual, beginning of year                 |      |     
|Charged to costs and expenses relating to new sales |      |     
|Costs of product warranty claims                    |      |     
|                                                    |      |     
|Warranty accrual, end of year                       |      |     
|                                                    |      |     

|Research and Development
Expenses


We
charge research and development expenses to operations as incurred.





Advertising costs


Advertising
costs are included as part of selling and marketing expense and are expensed as incurred.
Advertising expense for the years ended December 31, 2007, 2006 and 2005, were $473,000,
$485,000 and $347,000, respectively.

50






Net Income per Common
Share


Basic
net income per share was determined by dividing net income by the weighted average common
shares outstanding during the period. Diluted net income per share was determined by
dividing net income by the diluted weighted average shares outstanding. Diluted weighted
average shares reflect the dilutive effect, if any, of common stock options, stock
appreciation rights, and warrants based on the treasury stock method. The reconciliation
of basic and diluted weighted average shares outstanding is as follows:
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|At December 31,                                                      | 2007       | 2006       | 2005      
|-------------------------------------------------------------------- | ---------- | ---------- | ----------
|Basic weighted average common shares outstanding                     | 18,277,324 | 17,519,242 | 16,831,185
|Potential common shares pursuant to stock options, SARs and warrants | 976,699    | 2,689,445  | 2,327,153 
|                                                                     |            |            |           
|Diluted weighted average common shares outstanding                   | 19,254,023 | 20,208,687 | 19,158,338
|                                                                     |            |            |           

|For the years ended December 31, 2007, 2006 and 2005, all potential shares related to
outstanding common stock options, stock appreciation rights, and warrants were included in diluted
weighted average shares outstanding.


Stock based
compensation


In
December 2004, the Financial Accounting Standards Board (FASB) issued Statement of
Financial Accounting Standard SFAS 123 (revised 2004), Share-Based Payment(SFAS
123R). SFAS 123(R) supersedes APB Opinion No. 25, Accounting for Stock Issued to
Employees(APB 25), and amends SFAS No. 95, Statement of Cash Flows.
Generally, the approach in SFAS 123(R) is similar to the approach described in SFAS 123.
However, SFAS 123(R) requires share-based payments to employees, including grants of
employee stock options and stock-settled stock appreciation rights (SAR), to
be recognized in the income statement based on their fair values at the date of grant. Pro
forma disclosure is no longer an alternative.





On
January 1, 2006, we adopted SFAS 123(R) using the modified prospective method as
permitted under SFAS 123(R). Under this transition method, compensation cost recognized in
2006 includes compensation cost for all share-based payments granted prior to but not yet
vested as of December 31, 2005, based on the grant-date fair value estimated in accordance
with the provisions of SFAS No. 123, Accounting for Stock-Based
Compensation. In accordance with the modified prospective method of adoption,
our results of operations and financial position for prior periods have not been restated.


Our
income before taxes and net income was $489,546 and $462,067 lower for the twelve month
periods ended December 31, 2007 and 2006, respectively, due to the recognition of
stock-based compensation expense as a result of the adoption of SFAS 123(R). For the year
ended December 31, 2007, the compensation expense reduced both basic and diluted earnings
per share by $0.03. For the year ended December 31, 2006, the compensation expense reduced
basic and diluted earnings per share by $0.03 and $0.02, respectively. As of December 31,
2007, there was $6.6 million of unrecognized compensation expense related to non-vested
market-based share awards. The expense is expected to be recognized over a weighted-average period of 3.6 years.


Prior
to December 31, 2005, we followed the provisions of SFAS 123. The provisions of SFAS 123
allowed companies to either expense the estimated fair value of stock options or to
continue to follow the intrinsic value method set forth in APB 25, but disclose the pro
forma effects on net income had the fair value of the options been expensed. We elected to
apply APB 25 in accounting for our stock option incentive plans.


In
accordance with APB 25 and related interpretations, compensation expense for stock options
was recognized based on the excess, if any, of the quoted market price of the stock at the
grant date of the award or other measurement date over the amount an employee must pay to
acquire the stock. Generally, the exercise price for stock options granted to employees
was equal to the fair market value of our common stock at the date of grant, thereby
resulting in no recognition of compensation expense by us prior to December 31, 2005.


51






Had
compensation cost for our stock option plans been determined based on the fair value
method set forth in SFAS 123 during the prior years, our net income and basic and
diluted net income per common share would have been changed to the pro forma amounts
indicated below:
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|At December 31,                                | 2005
|---------------------------------------------- | ----
|Net income, as reported                        |     
|Add: Stock-based compensation included in      |     
|reported net income                            |     
|Less:  Total stock-based employee compensation |     
|expense determined under fair value based      |     
|method for all awards                          |     
|                                               |     
|Pro forma net income                           |     
|                                               |     
|Diluted net income per share:                  |     
|As reported                                    |     
|Pro forma                                      |     

|During
the twelve months ended December 31, 2007, 482,500 stock-settled stock appreciation rights
(SARs) were granted to employees and directors. The SARs become exercisable
over a four year period with one-third vesting on the second, third, and fourth
anniversaries of the date of grant. The related compensation expense will be recognized over the four year period.


There
were no options granted during the twelve months ended December 31, 2006.






On
May 11, 2005, we granted 645,000 options that were also fully vested in 2005 to employees
and directors with exercise prices equal to fair market value on the date of grant of
$24.63, and expire ten years from the date of grant. Of the $8,284,820 pro forma expense
in 2005, $7,568,817 relates to these options. In accordance with SFAS 123(R), had we
granted these options with longer time-based vesting, we would have incurred significant
stock-based payment expenses in future years upon adoption of SFAS 123(R).


We granted 1,440,000 performance based stock options in 2004 to employees and directors with
exercise prices equal to the fair market value on the date of grant of $16.53, and which expire ten
years from the date of grant. 815,000 of these options would vest upon Gillette making a Launch
Decision, and the remaining 625,000 of these options would vest twelve months after the Launch
Decision.  On December 21, 2007, we announced an agreement with Gillette to extend the Launch Decision
until no later than February 29, 2008.  During this extension, we negotiated with Gillette and its
parent company, The Procter and Gamble Company (P&G), for a new agreement to replace the existing
one.  On March 3, 2008, we announced with P&G that we had entered into a License Agreement including
with P&Gs wholly owned subsidiary Gillette under which we granted a non-exclusive license to certain
patents and technology to commercialize home-use light-based hair removal devices for women.  As a
Launch Decision did not occur under the original Development and License Agreement, on February 29,
2008, the 1,365,000 performance based stock options which remained outstanding were cancelled
and the related stock-based payment expense was never incurred.  Also on February 29, 2008, we
granted 1,315,000 stock options to employees and directors with exercise prices equal to the fair market
value on the date of grant of $13.31, and which expire ten years from the date of grant.  700,000 of
these options vested immediately on the date of grant while the remaining 615,000 vest annually over a
three-year period.  We expect our stock-based payment expense to be approximately $3.0 million in Q1
2008 and $180,000 in subsequent quarters through February 27, 2011.  The total compensation expense for
the options granted on February 29, 2008 is expected to be approximately $5.5 million.






We
use the Black-Scholes option pricing model to calculate the grant-date fair value of an
award. Key input assumptions used to estimate the fair value of stock options or SARS
include the exercise price of the award, the expected option or SAR term, the expected
volatility of our stock over the option or SARs expected term, the risk-free
interest rate over the option or SARs expected term, and our expected annual
dividend yield. Expected volatilities are based on historical volatilities of our common
stock and other factors; the expected life represents the weighted average period of time
that options or SARs granted are expected to be outstanding giving consideration to
vesting schedules and our historical exercise patterns; and the risk-free rate is based on
the U.S. Treasury yield curve in effect at the time of grant for periods corresponding
with the expected life of the option or SAR. The fair value of each option or SAR was
estimated on the grant date using the Black-Scholes option-pricing model with the
following assumptions:
52
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|At December 31,                                                | 2007        | 2006 | 2005          
|-------------------------------------------------------------- | ----------- | ---- | --------------
|Risk-free interest rate                                        | 4.21%       | N/A  | 2.55%         
|Expected dividend yield                                        | --          | N/A  | --            
|Expected lives                                                 | 4 years     | N/A  | 2 years       
|Expected volatility                                            | 55%         | N/A  | 100%          
|Grant date fair value of options or SARs granted during period | $     18.91 | N/A  | $         8.99

|Based
on our historical turnover rates, we assumed an annual estimated forfeiture rate of 8%
when we calculated the estimated compensation cost for the year ended December 31, 2007. A
recovery of prior expense will be recorded if the actual forfeitures are higher than
estimated and vice versa. Prior to the adoption of SFAS 123(R), forfeitures were not estimated at the
time of award.


Prior
to the adoption of SFAS 123(R), we presented all tax benefits of deductions from the
exercise of stock options as operating cash flows in the Consolidated Statement of Cash
Flows. SFAS 123(R) requires the cash flows from the tax benefits resulting from tax
deductions in excess of compensation cost recognized for those options to be classified as
financing cash flows.
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Concentration of Credit
Risk






SFAS
No. 105, Disclosure of Information about Financial Instruments with Off-Balance-Sheet
Risk and Financial Instruments with Concentrations of Credit Risk, requires disclosure
of any significant off-balance-sheet and credit risk concentrations. Financial instruments
that subject us to credit risk consist primarily of cash and cash equivalents,
available-for-sale securities, and accounts receivable. We place cash and cash equivalents
and available-for-sale securities in established financial institutions. We have no
significant off-balance-sheet risk or concentration of credit risk, such as foreign
exchange contracts, options contracts, or other foreign hedging arrangements. Our trade
accounts receivable are primarily from sales to end users and distributors servicing the
medical and beauty industry, and reflect a broad domestic and international base. We
maintain an allowance for potential credit losses. Our accounts receivable credit risk is
not concentrated within any one geographic area. We have not experienced significant
losses related to receivables from any individual customers or groups of customers in any
specific industry or by geographic area. Due to these factors, no additional credit risk
beyond amounts provided for collection losses is believed by management to be inherent in
our accounts receivable.


On
January 9, 2008, we announced the execution of an international distribution agreement
with the Swedish company Q-MED AB. Q-MED will eventually be responsible for the marketing,
advertising, promotion, sale and distribution of our professional products for aesthetic
treatments outside North America.  We have outstanding receivables due from our
current distributors. As a result of the Q-MED distribution agreement and subsequent
transition, we may not be able to collect receivables due for past sales to our current
distributors.


Disclosures About Fair
Value of Financial Instruments


SFAS
No. 107,Disclosure About Fair Value of Financial Instruments (SFAS 107),
requires disclosure of an estimate of the fair value of certain financial instruments. At
December 31, 2007 and 2006, financial instruments consisted principally of cash, cash
equivalents, available-for-sale securities and accounts receivable. The fair value of
financial instruments pursuant to SFAS 107 approximated their carrying values at December
31, 2007 and 2006. Fair values have been determined through information obtained from
market sources and management estimates.



53



Foreign Currencies


In
accordance with SFAS No. 52, Foreign Currency Translation, the financial statements
of subsidiaries outside the United States are measured using the foreign subsidiarys
local currency as the functional currency. We translate the assets and liabilities of our
foreign subsidiary at the exchange rate in effect at the end of the reporting period.
Revenues and expenses are translated using the average exchange rate in effect during the
reporting period. Transaction gains and losses and remeasurement of foreign currency
denominated assets and liabilities are included in other income (expense). Gains and
losses from foreign currency translation are recorded in accumulated other comprehensive
income (loss) included in stockholders equity. Foreign currency transaction gains or
losses included in other income (expense) were not material for the twelve months ended
December 31, 2007.


Income Taxes


We
account for income taxes using an asset and liability approach that requires the
recognition of deferred tax assets and liabilities for the expected future tax
consequences of events that have been recognized in the financial statements or tax
returns. In estimating future tax consequences, all expected future events are considered
other than enactments of changes in tax laws or rates. Valuation allowances are
established as necessary to reduce deferred tax assets in the event that realization of
the assets is considered unlikely.




Recently issued
accounting standards






In
June 2006, the Financial Accounting Standards Board (FASB) issued FASB
Interpretation No. 48, Accounting for Uncertainty in Income Taxes an
interpretation of FASB Statement No. 109 (FIN 48). FIN 48 clarifies the accounting
for uncertainty in income taxes recognized in an enterprises financial statements in
accordance with SFAS No. 109, Accounting for Income Taxes. FIN 48 prescribes a
recognition threshold and measurement attribute for the financial statement recognition
and measurement of a tax position taken or expected to be taken in a tax return. FIN 48
also provides guidance on derecognition, classification, interest and penalties,
accounting in interim periods, disclosure, and transition. FIN 48 is effective for fiscal
years beginning after December 15, 2006. We adopted FIN 48 effective January 1, 2007.




In
September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (SFAS 157).
 This Statement defines fair value, establishes a framework for measuring fair value
and expands disclosure of fair value measurements.  SFAS 157 applies under other
accounting pronouncements that require or permit fair value measurements and accordingly,
doe s not require any new fair value measurements.  SFAS 157 is effective for
financial statements issued for fiscal years beginning after November 15, 2007.  We
are currently assessing the impact that SFAS 157 may have on our consolidated financial
position, results of operations, and cash flows.


Note 2  Segment
and Geographic Information


In
accordance with SFAS No. 131, Disclosures about Segments of an Enterprise and Related
Information (SFAS 131), operating segments are identified as components of an
enterprise about which separate discrete financial information is available for evaluation
by the chief operating decision maker, or decision-making group, in making decisions how
to allocate resources and assess performance. Our chief decision maker, as defined under
SFAS 131, is a combination of the Chief Executive Officer and the Chief Financial Officer.
To date, we have viewed our operations and manage our business as principally one segment,
medical and cosmetic products and services, and our long-lived assets are located in one
facility in the United States. As a result, the financial information disclosed herein
represents all of the material financial information related to our principal operating
segment.




54



The
following table represents percentages of product revenue by geographic destination for
2007, 2006 and 2005:
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|At December 31,           | 2007 | 2006 | 2005
|------------------------- | ---- | ---- | ----
|North America             |      | 71   | %   
|Europe                    |      | 12   | %   
|South and Central America |      | 5    | %   
|Asia / Pacific            |      | 4    | %   
|Japan                     |      | 4    | %   
|Middle East               |      | 3    | %   
|Australia                 |      | 1    | %   
|                          |      |      |     
|Total                     |      | 100  | %   

|Note 3  Research
and Development Arrangement


On
August 1, 2004, we entered into a new agreement, replacing an existing agreement with the
Massachusetts General Hospital (the Research Agreement) whereby Massachusetts
General Hospital agreed to conduct clinical and non-clinical research in the field of
photo thermal removal or reduction of hair, using light. The Research Agreement had a term
of three years and expired in August 2007. We provided Massachusetts General Hospital at
least $230,000 on an annual basis to cover the direct and indirect costs of the research.
We have the right to exclusively license, on royalty terms to be negotiated,
Palomar-funded inventions that are discovered as a result of this research.



Note 4  Income
Taxes


We
provide for income taxes under the liability method in accordance with SFAS
No. 109,Accounting for Income Taxes (SFAS 109). The provision
(benefit) for income taxes in the accompanying Consolidated Statements of Income consists
of the following:
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|At December 31, | 2007 | 2006 | 2005
|--------------- | ---- | ---- | ----
|Federal:        |      |      |     
|Current         |      |      | $   
|Deferred        |      |      |     
|                |      |      |     
|                |      |      |     
|State:          |      |     
|Current         |      |      |     
|Deferred        |      |      |     
|                |      |      |     
|                |      |      |     
|                |      |      |     
|Total           |      |      | $   
|                |      |      |     

|A
reconciliation of the federal statutory rate to our effective tax rate is as follows:
|---------------------------------------------------------------------------------------

|At December 31,                                               | 2007 | 2006 | 2005
|------------------------------------------------------------- | ---- | ---- | ----
|Income tax provision at federal statutory rate                |      |      |     
|Increase (decrease) in tax resulting from:                    |      |     
|State income taxes, net of federal benefit                    |      |      |     
|Change in valuation allowance, net operating loss utilization |      |      |     
|Other                                                         |      |      |     
|                                                              |      |      |     
|Provision (benefit) for income taxes                          |      |      |     
|                                                              |      |      |     

|55






The
components of the net deferred tax asset recognized in the accompanying consolidated
balance sheets are as follows:
|--------------------------------------------------------------------------------------------------------------------------------

|At December 31,                   | 2007            | 2006      
|--------------------------------- | --------------- | ----------
|Net operating loss carry forwards | $            -- | $3,149,706
|Nondeductible accruals            | 2,437,202       | 2,144,000 
|Nondeductible reserves            | 1,177,470       | 1,166,000 
|Stock based compensation          | 197,201         | --        
|Tax credits                       | --              | 3,168,999 
|                                  |                 |           
|Total                             | $3,811,873      | $9,628,705
|                                  |                 |           

|Under SFAS 109, we can only recognize a deferred tax asset for future benefit of our tax loss,
temporary differences and tax credit carry forwards to the extent that it is more likely than not that
these assets will be realized.  During the fourth quarter of 2006, we determined, based on current and
preceding years results of operations, anticipated profit levels in future periods, and the industry
in which we operate, that it is more likely than not that our domestic deferred tax assets will be
realized in the future and, accordingly, that it was appropriate to release the valuation allowance
recorded against those deferred tax assets. In reaching this conclusion, we weighed both negative and
positive evidence regarding the realizability of these deferred tax assets and considered the extent to
which the evidence could be objectively verified. The primary factors we considered were that:
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|o |  | Although
we operate in an industry which is competitive and experiences rapid technological
change, we have operated successfully in this environment. During the
last several                   years, we have expanded our product mix and our newest
products have been driving our                   revenue growth. We have maintained
profitability and achieved year-over-year revenue                   growth during the
past years.
|- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|o |  | We
have cumulative profits before income taxes of $75.7 million for the three-year period
ended                   with the fourth quarter of 2006.
|- |  | --------------------------------------------------------------------------------------------------------------------------------------------------

|o |  | Based
upon our recent results of operations, as well as our internal projections, we expect to
                  utilize our NOL carry forwards and tax credit carry forwards prior to
their expiration.
|- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|o |  | We
have never had any expired federal operating loss carry forwards in our history, and
after                   utilization of net operating losses against the fiscal year 2006
federal taxable                   income, the first federal NOL carry forward scheduled
to expire is in the year 2012.
|- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Although
we have determined that a valuation allowance is not required with respect to our
domestic net operating loss carry forwards, deferred expenses and tax credit carry
forwards, recovery is dependent on achieving the forecast of future operating income over
a protracted period of time. Failure to achieve future operating income targets or
negative changes to expected trends may change the assessment regarding the
recoverability of the net deferred tax assets and such change could result in a valuation
allowance being recorded against some or all of the deferred tax assets. Any increase in
a valuation allowance would result in additional income tax expense and could have a
significant impact on our earnings in future periods.











In
addition to the tax assets described above, we have deferred tax assets totaling $20.5
million, resulting from the exercise of employee stock options. In accordance with SFAS
109 and SFAS 123R, recognition of these assets would occur upon utilization of these
deferred tax assets to reduce taxes payable and would result in a credit to additional
paid-in capital within stockholders equity rather than the provision for income
taxes. For 2007, 2006, and 2005, the impact to paid-in capital resulting from the exercise
of employee stock options was $4.8 million, $1.2 million, and $180,000, respectively. As
part of the adoption of Statement 123(R), we have chosen to derecognize our deferred tax
asset and the related valuation allowance resulting from the excess tax benefit of stock
options.


At
December 31, 2007, we had available, subject to review and possible adjustment by the
Internal Revenue Service, federal net operating loss carry forwards and tax credit carry
forwards of approximately $51 million and $2.7 million, respectively, to be used to offset
future taxable income. These net operating loss carry forwards will expire through 2024.


We
adopted the provisions of Financial Standards Accounting Board Interpretation No. 48
Accounting for Uncertainty in Income Taxes  an interpretation of FASB
Statement No. 109 (FIN 48) on January 1, 2007. As a result of the
implementation of FIN 48, we recognized no material adjustment in the liability for
unrecognized income tax benefits. At the adoption date of January 1, 2007, we had $2.2
million of unrecognized tax benefits, all of which would affect our effective tax rate if
recognized. At December 31, 2007, we have $2.5 million of unrecognized tax benefits.


56






A reconciliation of our total gross unrecognized tax benefits for the year ended December 31, 2007 is below.
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                       |           
|-------------------------------------- | ----------
|Balance at December 31, 2006           | $2,501,126
|Tax positions related to current year:
|Additions                              | 433,051   
|                                       |           
|Reductions                             | --        
|                                       |           
|Balance at December 31, 2007           | $2,934,177
|                                       |           

|We establish reserves based on managements assessment of exposure associated with permanent tax
differences and tax credits. The tax reserves are analyzed periodically and adjustments are made, as events occur to
warrant adjustment to the reserve.

         
We recognize interest and penalties related to uncertain tax positions in income tax expense. As of
December 31, 2007, we had no accrued interest related to uncertain tax positions.


         
The tax years 2003-2007 remain open to examination by the major taxing jurisdictions to which we are
subject. We file income tax returns in the U.S. federal jurisdiction, and various state and foreign jurisdictions.














Note 5  401(k) Plan


We
have a 401(k) Plan, which covers substantially all employees who have attained the age of
18 and are employed for at least a three-month period. Employees may contribute up to the
maximum amount allowed by the Internal Revenue Service, subject to restrictions defined by
the Internal Revenue Service. At our discretion, we may make a matching contribution in
cash or our common stock up to 50% of all employee contributions in each plan year. Our
contributions to our employees vest over a three-year period from date of hire.


During
2007, 2006 and 2005, we matched in Palomar common stock 50% of all employee contributions
by issuing 41,865, 9,355 and 11,124 shares of common stock, respectively, to the 401(k)
Plan in satisfaction of our employer match for employee contributions. The number of
shares of common stock reserved for issuance under the 401(k) Plan was initially 1,000,000
shares. As of December 31, 2007, 238,585 shares of common stock remained available for
issuance there under.


Note 6  Accrued
Liabilities



At December 31, 2007 and 2006, accrued liabilities consisted of the following:
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|At December 31,               | 2007         | 2006        
|----------------------------- | ------------ | ------------
|Payroll and employee benefits | $  5,269,567 | $  7,207,167
|Commissions                   | 2,318,674    | 1,599,915   
|Royalties                     | 3,006,818    | 3,929,007   
|Warranties                    | 1,051,432    | 1,120,420   
|Other                         | 959,931      | 1,749,266   
|                              |              |             
|Total                         | $12,606,422  | $15,605,775 
|                              |              |             

|57







Note 7 
Commitments and Contingencies


Operating lease and
purchase commitments


We
are obligated to make future payments under various contracts, including non-cancelable
inventory purchase commitments and our operating lease relating to our Burlington,
Massachusetts manufacturing, research and development and administrative offices.





On
January 18, 2006, we signed an amendment to this lease to add an additional 12,000 square
feet.


On
July 30, 2007, we signed an amendment to our lease to add an additional 13,600 square
feet. Rent expense, including this new lease, will total approximately $1.3 million per
year, expiring in August 2009.


The
following table summarizes our estimated contractual cash obligations as of December 31,
2007, excluding royalty and employment obligations because they are variable and/or
subject to uncertain timing:
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|At December 31,      | 2008 | 2009      | 2010 | 2011      | 2012 | Thereafter 
|-------------------- | ---- | --------- | ---- | --------- | ---- | -----------
|Purchase commitments | $    | 5,700,000 |      | $      -- |      | $        --
|Operating lease      |      | 1,301,000 |      | 862,000   |      | --         
|                     |      |           |      |           |      |            
|Total                | $    | 7,001,000 | $    | 862,000   |      | $        --
|                     |      |           |      |           |      |            

|We
incurred rent expense of $1,358,000, $1,147,000 and $1,074,000 for the years ended
December 31, 2007, 2006 and 2005, respectively.





Royalties


We
are a party to license agreements, as amended, with Massachusetts General Hospital
whereby we are obligated to pay royalties to Massachusetts General Hospital for sales of
certain products as well as 40% of royalties received from third parties related to
certain patents. For the years ended December 31, 2007, 2006 and 2005, approximately
$5,918,000, $13,465,000 and $3,690,000 of royalty expense, respectively, was incurred
under this agreement.


Litigation


On
July 7, 2006, we commenced an action for patent infringement against Alma Lasers, Inc. in
the United States District Court for the District of Massachusetts seeking both monetary
damages and injunctive relief. The complaint alleged Almas Harmony, Soprano and
Sonata Systems which use pulsed light and laser technology for hair removal willfully
infringe U.S. Patent Nos. 5,595,568 & 5,735,844, which are exclusively licensed to us
by the Massachusetts General Hospital. On July 27, 2006, we filed an amended complaint
including an additional claim against Alma for unfair competition due to infringement by
Almas Harmony System of the distinctive trade dress of our products, including the
unique, distinctive, and immediately recognizable design of our EsteLux, MediLux and
StarLux Systems.


On April 2, 2007, we announced the resolution of our lawsuit against Alma Laser, Inc. through
the execution of a Non-Exclusive Patent License Agreement, a Trade Dress Settlement Agreement, and a
Settlement Agreement.  Under the Patent License Agreement, we granted Alma a non-exclusive, royalty
bearing license to U.S. Patent Nos. 5,595,568 & 5,735,844 & corresponding foreign patents and
applications in the professional field, excluding the consumer field. Alma admitted that its products infringe these patents and that these patents are
valid and enforceable. In addition, Alma agreed not to challenge the infringement, validity and
enforceability of these patents in the future. Alma paid us an estimated payment for royalties due on
past sales of their laser and lamp-based hair removal systems beginning with their initial sales in 2003
through the date of settlement, plus interest and reimbursement of our legal costs.  Alma also paid us
an estimated payment for trade dress fees on past sales of their Harmony and Aria Systems and interest,
and Alma agreed to change and has changed the trade dress of the Harmony and Aria systems. The final
amounts due to us are the subject of an audit by an independent accounting firm. We have begun to
recognize royalty revenue as the amounts become determinable. Starting on March 30, 2007, Alma began
paying us a royalty on sales of its existing light-based hair removal systems, and Alma will pay us a
royalty on sales of its later developed light-based hair removal systems.



58







For more information, please see the Settlement Agreement, the Non-Exclusive Patent License
Agreement, the Trade Dress Settlement Agreement, the Consent Judgments and Stipulations of Dismissal
filed as Exhibits to a Current Report on our Form 8-K filed April 2, 2007.



On August 9, 2006, we commenced an action for patent infringement against Candela Corporation
in the United States District Court for the District of Massachusetts seeking both monetary damages and
injunctive relief. The complaint alleges Candelas GentleYAG and GentleLASE systems which use laser
technology for hair removal willfully infringe U.S. patent No. 5,735,844, which is exclusively licensed
to us by the Massachusetts General Hospital.  Candela answered the complaint denying that its products
infringe valid claims of the asserted patents and filing a counterclaim seeking a declaratory judgment
that the asserted patent and U.S. patent No. 5,595,568 are invalid and not infringed.  We filed a reply
denying the material allegations of the counterclaims. This lawsuit has been transferred to the judge
who presided over Palomar v Cutera, Inc.  We filed an amended complaint on February 16, 2007 to add the
Massachusetts General Hospital as a plaintiff.  In addition, we further alleged that Candelas GentleMAX
system willfully infringes U.S. Patent No. 5,735,844 and that Candelas Light Station system willfully
infringes both U.S. Patent Nos. 5,735,844 and 5,595,568.  On February 16, 2007, Candela filed an amended
answer to our complaint adding allegations of inequitable conduct, double patenting and violation of
Massachusetts General Laws Chapter 93A.  On February 28, 2007, we filed a response to Candelas amended
complaint pointing out many weaknesses in Candelas allegations.  A claim construction hearing,
sometimes called a Markman Hearing, was held August 2, 2007, and we received what we consider to be a
favorable Markman ruling on received November 9, 2007.  No trial date has yet been set.







On August 10, 2006, Candela Corporation commenced an action for patent infringement against us
in the United States District Court for the District of Massachusetts seeking both monetary damages and
injunctive relief.  The complaint alleged that our StarLux System with the LuxV handpiece willfully
infringes U.S. Patent No. 6,743,222 which is directed to acne treatment, that our QYAG5 System willfully
infringes U.S. Patent No. 5,312,395 which is directed to treatment of pigmented lesions, and that our
StarLux System with the LuxG handpiece willfully infringes U.S. Patent No. 6,659,999 which is directed
to wrinkle treatment.  On October 25, 2006, Candela filed an amended complaint which did not include
U.S. Patent No. 6,659,999.  Consequently, Candela no longer alleges in this lawsuit that the StarLux
System with LuxG handpiece infringes its patents. With regard to the two remaining patents, Candela is
seeking to enjoin us from selling these products in the United States if we are found to infringe the
patents, and to obtain compensatory and treble damages, reasonable costs and attorneys fees, and other
relief as the court deems just and proper. On October 30, 2006 we answered the complaint denying that
our products infringe the asserted patents and filing counterclaims seeking declaratory judgments that
the asserted patents are invalid and not infringed.  In addition, with regard to U.S. Patent No.
5,312,395, we filed a counter claim of inequitable conduct.  A claim construction hearing, or a Markman
Hearing, is scheduled for April 15, 2008.  No trial date has yet been set. We are defending the action
vigorously and believe that we have meritorious defenses of non-infringement, invalidity and inequitable
conduct. However, litigation is unpredictable and we may not prevail in successfully defending or
asserting our position. If we do not prevail, we may be ordered to pay substantial damages for past
sales and an ongoing royalty for future sales of products found to infringe in the United States. We
could also be ordered to stop selling any products in the United States that are found to infringe.








On December 19, 2006, Candela Corporation commenced an action for patent infringement against
us in the United States District Court for the Eastern District of Texas, seeking both monetary damages
and injunctive relief.  The complaint alleges that our StarLux System with the LuxY handpiece willfully
infringes U.S. Patent No. 6,659,999 and that our StarLux System with the Lux1540 handpiece willfully
infringes related U.S. Patent Nos. 5,810,801 and 6,120,497.  The three asserted patents are directed to
wrinkle treatment. Candela is seeking to enjoin us from selling these products in the United States if
found to infringe the patents, and to obtain compensatory and treble damages, reasonable costs and
attorneys fees, and other relief as the court deems just and proper. On January 10, 2007, we answered
the complaint denying that our products infringe the asserted patents and filing counterclaims seeking
declaratory judgments that the asserted patents are invalid and not infringed.  On April 6, 2007,
Candela filed their infringement contentions which modified their complaint to accuse the Lux1540,
Lux1540-Z, LuxIR, LuxDeepIR, LuxB, LuxG and LuxY handpieces for use with the StarLux, StarLux 500,
MediLux and EsteLux Systems of infringing the three asserted patents.  On July 13, 2007, we filed an
amended answer to Candelas first amended complaint including counter claim of inequitable conduct.  We
are defending the action vigorously and believe that we have meritorious defenses of non-infringement
and invalidity. However, litigation is unpredictable and we may not prevail in successfully defending or
asserting our position. If we do not prevail, we may be ordered to pay substantial damages for past
sales and an ongoing royalty for future sales of products found to infringe in the United States. We
could also be ordered to stop selling any products that are found to infringe in the United States.  A
Markman Hearing was held on November 13, 2007 and we are waiting on a ruling from the Judge.  The trial
is scheduled to begin July 14, 2008.



59



Employment Agreements


We
have two-year employment agreements with certain officers. These employment agreements
automatically renew for successive two-year periods absent notice of non-renewal by either
party. In the event of termination by us without cause, non-renewal by us or termination
by us for good reason without a change in control, these employment agreements provide for
two years salary as then in effect, in addition to any earned incentive
compensation, and continued benefits and insurance payments for two years. The agreements
further provide that in the event of termination by reason of death, beneficiaries receive
the officers base salary for one year following death (plus any pro rata bonus to
which the officer would have been entitled). In the event of termination due to a change
in control of Palomar, the agreements provide three times the annual salary as then in
effect (plus any bonus to which the officer would have been entitled) and the continuation
of benefits and insurance payments for two years.





Note 8 
Stockholders Equity


Common Stock


During 1998, we sold 1,457,142 shares of common stock to a group of investors for $10,200,000.
Under the terms of this private placement, we are obligated to pay the investors a fee of 5% per annum
(payable quarterly) of the dollar value invested in Palomar as long as the investors continue to hold
their common stock in their name.  During 2007, 2006 and 2005, we paid $62,100, $83,077 and $59,049,
respectively, related to this fee.  These amounts have been charged to additional paid-in capital.


Preferred Stock


Our
Amended and Restated Certificate of Incorporation provides for, and the Board of Directors
and stockholders authorized, 1,500,000 shares of $0.01 par value preferred stock. We have
designated 100,000 shares as Series A Participating Cumulative Preferred Stock
(Series A) in connection with the Rights Agreement discussed below. No shares
of Series A have been issued. However, upon issuance the Series A will be entitled to
vote, receive dividends, and have liquidation rights. The remaining authorized preferred
stock is undesignated and the Board of Directors has the authority to issue such shares in
one or more series and to fix the relative rights and preferences without vote or action
by the stockholders.


Rights Agreement







In
April 1999, we adopted a shareholder rights plan (Rights Plan). The Rights
Plan is intended to protect shareholders from unfair or coercive takeover practices. In
accordance with the Rights Plan, the Board of Directors declared a dividend distribution
of one right for each share of common stock outstanding until the rights become
exercisable. Each right entitles the registered holder to purchase from us seven
one-thousandths (7/1000th) of a share of Series A Participating Cumulative
Preferred Stock (Series A shares) for $56, adjusted for certain events. The
rights will be exercisable if a person or group acquires beneficial ownership of 15% or
more of our common stock or announces a tender or exchange offer for 15% or more of our
common stock. At such time, each holder of a right (other than the 15% holder) will
thereafter have a right to purchase, upon payment of the purchase price of the right, that
number of Series A shares equivalent to the number of shares of our common stock, which
have a market value of twice the purchase price of the right. In the event that we are
acquired in a merger or other business combination transaction or more than 50% of our
assets or earning power is sold, each holder shall thereafter have the right to receive,
upon exercise of each right, that number of shares of common stock of the acquiring
company that, at the time of such transaction, would have a market value of two times the
$56 purchase price. The rights will not be exercisable until certain events occur. The
Board of Directors may elect to terminate the rights under certain circumstances.


60




Note 9  Stock
Option Plans and Warrants


Stock Options


We
have several Stock Option Plans and Incentive Stock Plans (the Plans)
providing for the issuance of a maximum of 9,778,571 shares of common stock, which may be
issued as incentive stock options (ISOs), nonqualified stock options, or
stock-settled stock appreciation rights (SARs). Under the terms of the Plans,
ISOs may not be granted at less than the fair market value on the date of grant (and in no
event less than par value); in addition, ISO grants to holders of 10% of the combined
voting power of all classes of Palomar stock must be granted at an exercise price of not
less than 110% of the fair market value at the date of grant. Pursuant to the Plans,
options are exercisable at varying dates, as determined by the board of directors, and
have terms not to exceed 10 years (five years for 10% or greater stockholders). The board
of directors, in its discretion, may convert the optionees ISOs into nonqualified
stock options at any time prior to the expiration of such ISOs.






The
following table summarizes all stock option activity of Palomar for the years ended
December 31, 2007, 2006 and 2005:
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                     | Number of
Shares | Exercise Price | Weighted
Average
Exercise
Price | Weighted
Average
Remaining
Contractual
Term
(in Years) | Aggregate
Intrinsic Value
|------------------------------------ | ---------------- | -------------- | ------------------------------- | ------------------------------------------------------ | -------------------------
|Outstanding, December 31, 2004       | 4,967,402        | $0.90 -$26.00  | $     12.33                     | 8.51                                                   | $67,919,865              
|Granted                              | 645,000          | 24.63 -  24.63 | 24.63                          
|Exercised                            | (833,841)        | 0.90 - 19.00   | 5.42                            |                                                        |                          
|Canceled                             | (28,596)         | 2.19 - 16.53   | 13.83                          
|                                     |                  |                |                                 |                                                        |                          
|Outstanding, December 31, 2005       | 4,749,965        | 0.90 - 26.00   | 15.20                           | 8.02                                                   | 94,378,778               
|Granted                              | --               | --             | --                              |                                                       
|Exercised                            | (872,267)        | 0.90 - 26.00   | 11.39                           |                                                        |                          
|Canceled                             | (55,331)         | 4.50 - 16.53   | 15.09                          
|                                     |                  |                |                                 |                                                        |                          
|Outstanding, December 31, 2006       | 3,822,367        | 0.90 - 26.00   | 16.07                           | 7.19                                                   | 131,978,861              
|Granted                              | --               | --             | --                              |                                                       
|Exercised                            | (337,878)        | 0.97 - 26.00   | 12.42                           |                                                        |                          
|Canceled                             | (4,000)          | 4.50 - 16.53   | 7.85                           
|                                     |                  |                |                                 |                                                        |                          
|Outstanding, December 31, 2007       | 3,480,489        | 0.90 - 26.00   | 16.44                           | 6.05                                                   | 5,148,147                
|                                     |                  |                |                                 |                                                        |                          
|Exercisable, December 31, 2005       | 3,167,018        | 0.90 - 26.00   | 15.09                           | 7.90                                                   | 63,292,431               
|                                     |                  |                |                                 |                                                        |                          
|Exercisable, December 31, 2006       | 2,448,537        | 0.90 - 26.00   | 15.82                           | 7.09                                                   | 85,150,767               
|                                     |                  |                |                                 |                                                        |                          
|Exercisable, December 31, 2007       | 2,115,489        | 0.90 - 26.00   | 16.38                           | 5.99                                                   | 5,148,147                
|                                     |                  |                |                                 |                                                        |                          
|Vested and expected to vest at       |                  |                |                                 |                                                        |                          
|December 31, 2007                    | 1,547,455        |                |                                 | 6.03                                                   | 5,148,147                
|                                     |                  |                |                                 |                                                        |                          
|Available for future issuances under
|the plans as of December 31, 2007    | 598,535         
|                                     |                  |                |                                 |                                                        |                          

|The
total intrinsic value for options exercised during the year ended December 31, 2007, 2006
and 2005 was $10,390,187, $30,116,146 and $18,020,301, respectively.



61




The
following table summarizes information about stock options outstanding as of December 31,
2007:
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Options Outstanding | Options Exercisable |            |              |           |             
|------------------- | ------------------- | ---------- | ------------ | --------- | ------------
|
|$0.90  -  $1.00     | 224,361             | 3.13 years | $       0.97 | 224,361   | $       0.97
|1.97  -    2.19     | 39,500              | 1.79 years | 1.98         | 39,500    | 1.98        
|3.18  -    4.50     | 49,655              | 2.51 years | 3.52         | 49,655    | 3.52        
|5.05  -    7.28     | 75,382              | 4.44 years | 5.07         | 75,382    | 5.07        
|8.11  -  10.72      | 4,433               | 5.93 years | 10.09        | 4,433     | 10.09       
|13.66  -  16.00     | 16,333              | 6.42 years | 14.22        | 16,333    | 14.22       
|16.53  -  16.53     | 1,050,325           | 6.16 years | 16.53        | 1,050,325 | 16.53       
|23.61  -  26.00     | 655,500             | 7.35 years | 24.64        | 655,500   | 24.64       
|                    |                     |            |              |           |             
|$0.90  -$26.00      | 2,115,489           | 6.05 years | $     16.44  | 2,115,489 | $16.38      
|                    |                     |            |              |           |             

|On
February 29, 2008, we granted 1,315,000 stock options to employees and directors with
exercise prices equal to the fair market value on the date of grant of $13.31, and which
expire ten years from the date of grant.  700,000 of these options vested immediately on
the date of grant while the remaining 615,000 vest annually over a three-year period.  We
expect our stock-based payment expense to be approximately $3.0 million in Q1 2008 and
$180,000 in subsequent quarters through February 27, 2011.  The total compensation
expense for the options granted on February 29, 2008 is expected to be approximately $5.5
million.








Stock-Settled Stock
Appreciation Rights


The
stock-settled stock appreciation rights (SARs) granted since December 31, 2006
are awards that allow the recipient to receive an amount of our common stock equal to the
appreciation (if any) in the fair market value of our common stock on the date of exercise
over the initial SAR valuation set on the date of grant per share of common stock for the
number of shares vested. For the stock-settled SARs granted since December 31, 2006, the
initial SAR valuation per share of the common stock was set at less than the fair market
value of our common stock on the date of grant, and the holders right to receive
shares of common stock under these grants occurs automatically on the vesting date.


The
following table summarizes the stock-settled stock appreciation rights activity of Palomar since
December 31, 2006:
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                               | Number of
Shares | Weighted Average Conversion Price | Weighted Average Remaining Contractual Term (in Years) | Aggregate Intrinsic Value
|------------------------------ | ---------------- | --------------------------------- | ------------------------------------------------------ | -------------------------
|Outstanding, December 31, 2006 | --               | --                                | --                                                     | --                       
|                               |                  |                                   |                                                        |                          
|                               |                  |                                   |                                                        |                          
|Granted                        | 482,500          | $     14.40                       | 3.59                                                  
|Converted                      | --               | --                                |                                                        |                          
|Canceled                       | (5,000)          | 14.40                            
|                               |                  |                                   |                                                        |                          
|Outstanding, December 31, 2007 | 477,500          | $     14.40                       | 3.59                                                   | $439,300                 
|                               |                  |                                   |                                                        |                          
|Vested, December 31, 2007      | --               | --                                | --                                                     | --                       
|                               |                  |                                   |                                                        |                          

|62



Warrants


The
following table summarizes all warrant activity of Palomar for the years ended December
31, 2007, 2006 and 2005:
|-------------------------------------------------------------------------------------------------------------------------------------

|                               | Number of
Shares | Exercise Price  | Weighted
Average
Exercise
Price | Weighted
Average
Remaining
Contractual
Term | Aggregate
Intrinsic Value
|------------------------------ | ---------------- | --------------- | ------------------------------- | ------------------------------------------- | -------------------------
|Outstanding, December 31, 2004 | 180,000          | $1.97  - $3.19  | $2.77                           | 4.73                                        | $4,180,781               
|Exercised                      | (50,000)         | 1.97   -   3.19 | 2.82                            |                                             |                          
|                               |                  |                 |                                 |                                             |                          
|Outstanding, December 31, 2005 | 130,000          | 1.97   -   3.19 | 2.75                            | 3.77                                        | 4,200,975                
|Exercised                      | (55,000)         | 1.97   -   3.19 | 2.74                            |                                             |                          
|                               |                  |                 |                                 |                                             |                          
|Outstanding, December 31, 2006 | 75,000           | 1.97   -   3.19 | 2.76                            | 2.86                                        | 3,587,812                
|Exercised                      | --               | --              | --                              |                                             |                          
|                               |                  |                 |                                 |                                             |                          
|Outstanding, December 31, 2007 | 75,000           | 1.97   -   3.19 | 2.76                            | 1.86                                        | 941,812                  
|                               |                  |                 |                                 |                                             |                          
|Exercisable, December 31, 2005 | 130,000          | 1.97   -   3.19 | 2.75                            | 3.77                                        | 4,200,975                
|                               |                  |                 |                                 |                                             |                          
|Exercisable, December 31, 2006 | 75,000           | 1.97   -   3.19 | 2.76                            | 2.86                                        | 3,587,812                
|                               |                  |                 |                                 |                                             |                          
|Exercisable, December 31, 2007 | 75,000           | 1.97   -   3.19 | 2.76                            | 1.86                                        | 941,812                  
|                               |                  |                 |                                 |                                             |                          

|The
total intrinsic value for warrants exercised during the year ended December 31, 2007, 2006
and 2005 was $0, $2,288,312 and $1,301,406, respectively.


The
ranges of exercise prices for warrants outstanding and exercisable at December 31, 2007
are as follows:
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Warrants Outstanding | Warrants Exercisable |            |            |        |      
|-------------------- | -------------------- | ---------- | ---------- | ------ | -----
|
|$1.97 - $1.97        | 20,000               | 2.08 years | $     1.97 | 20,000 | $1.97
|2.81 - 2.81          | 20,000               | 2.43 years | 2.81       | 25,000 | 2.81 
|3.19 - 3.19          | 35,000               | 1.41 years | 3.19       | 35,000 | 3.19 
|                     |                      |            |            |        |      
|$1.97 - $3.19        | 75,000               | 1.86 years | $     2.76 | 75,000 | $2.76
|                     |                      |            |            |        |      

|Reserved Shares


At
December 31, 2007, we have reserved shares of our common stock for the following:
|------------------------------------------------------------------------------------------------------

|At December 31,                           |          
|----------------------------------------- | ---------
|Stock option and stock appreciation plans | 4,556,524
|Warrants                                  | 75,000   
|Employee 401(k) plan                      | 238,585  
|                                          |          
|                                          | 4,870,109
|                                          |          

|63



Note 10  Quarterly
Results of Operations (Unaudited)


The
following tables present a condensed summary of quarterly results of operations for the
years ended December 31, 2006 and 2007 (in thousands, except per share data).
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                      | 2006      |           |           |          
|--------------------- | --------- | --------- | --------- | ---------
|
|Revenues              | $22,455   | $36,657   | $28,022   | $39,412  
|Cost and expenses     | 16,577    | 20,384    | 20,215    | 26,081   
|Net income            | 6,244     | 17,367    | 8,368     | 20,998   
|Net income per share:
|Basic                 | $    0.36 | $    1.00 | $    0.47 | $    1.18
|Diluted               | $    0.31 | $    0.86 | $    0.41 | $    1.03

|                      | 2007      |           |           |          
|--------------------- | --------- | --------- | --------- | ---------
|
|Revenues              | $31,518   | $32,768   | $31,379   | $28,153  
|Cost and expenses     | 23,416    | 25,400    | 24,720    | 24,112   
|Net income            | 5,871     | 5,829     | 5,323     | 3,484    
|Net income per share:
|Basic                 | $    0.32 | $    0.32 | $    0.29 | $    0.19
|Diluted               | $    0.30 | $    0.30 | $    0.28 | $    0.18

|This
financial information includes several transactions which affect the comparability of the
quarterly results for the years ended December 31, 2006 and 2007. For the year ended
December 31, 2006, the following transactions are included:
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | o |  | First
quarter: After finalizing negotiations with The Massachusetts General Hospital
regarding royalty due to Massachusetts  General Hospital for sales of certain
products, we recognized a reduction to cost of product revenues of $762,000. In addition,
we wrote-off $145,000 of certain customer service loaner inventory. | 
| |  | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | 

| |  | o |  | Second quarter: As a result of the resolution of our patent infringement lawsuits
against Cutera, we recognized $13.6 million in royalty revenues for back-owed royalties,
$5.4 million in cost of royalties related to the back-owed royalties, a legal
reimbursement of $3.8 million in general and administrative expense, and $1.2 million
reduction to interest expense related to the back-owed royalties.
| |  | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | o |  | Third quarter: As a result of a royalty audit of Laserscopes product sales
from January 1, 2001 through June 30, 2006, we recognized $2.2 million of royalty revenue
for back-owed royalties and $864,000 in cost of royalty revenue related to the back-owed
royalties.
| |  | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | o |  | Fourth quarter: As a result of a new patent license agreement with Cynosure, we
recognized $10 million in royalty revenues for back-owed royalties and $4 million in cost
of royalty revenue related to the back-owed royalties. In addition, due to the completion
of an audit by an independent accounting firm of back-owed royalties owed by Cutera, we
recognized an additional $560,000 in royalty revenues.
| |  | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|For
the year ended December 31, 2007, the following transactions are included:
|------------------------------------------------------------------------------

| |  | o |  | Third quarter: As a result of our successful resolution of our patent infringement
and trade dress lawsuits against Alma, we recognized $3.1 million in royalty revenues for
back-owed royalties, $894,000 in other revenues related to trade dress, $1.2 million in
cost of royalties related to the back-owed royalties, a legal reimbursement of $227,000 in
general and administrative expense, and $259,000 reduction to interest expense related to
the back-owed royalties.
| |  | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|64
|--

| |  | o |  | Fourth quarter: After finalizing negotiations with The Massachusetts General
Hospital regarding royalty due to Massachusetts General Hospital for sales of certain
products, we recognized a reduction to cost of product revenues of $1.7 million.
| |  | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Note 11 
Development and License Agreement with The Gillette Company and New License Agreement with The Procter &
Gamble Company (and its wholly owned subsidiary The Gillette Company)


Effective
as of February 14, 2003, we entered into a Development and License Agreement (the
Agreement) with Gillette to complete the development and commercialize a
home-use, light-based hair removal device for women. In October 2005, Procter & Gamble
Company (NYSE: PG) completed its acquisition of Gillette. Under the Agreement, Procter
& Gamble, as the acquiring party, assumed all of Gillettes rights and
obligations. The agreement provided for up to $7 million in support of research and
development to be paid by Gillette over approximately 30 months. Effective as of June 28,
2004, we completed the initial phase of the agreement and both parties decided to move
onto the next phase. Accompanying this decision, we amended the original agreement,
whereby, Gillette provided $2.1 million in additional development funding to further
technical innovations over a 9-month extension of the development phase, which was
completed on August 31, 2006 (the Development Phase).


On
September 29, 2006, in response to a first decision point in the Agreement, Gillette
decided to continue with the project. On December 8, 2006, over-the-counter clearance was
obtained from the United States Food and Drug Administration for the device and, per the
Agreement, Gillette was obligated to make a development completion payment to us of $2.5
million, which was paid on December 26, 2006. The $2.5 million payment will be recorded as
revenue over a 12 month period, as we were obligated to perform additional services to
Gillette during that period in consideration for this payment.


Gillette was to conduct approximately 12 months of commercial assessment tests with respect to the
device. Based on the commercial assessment tests, Gillette was to decide by January 7, 2008 whether or
not to continue with the project (the Launch Decision). On February 21, 2007, we announced an
amendment to our agreement with Gillette to include the development and commercialization of an
additional light-based hair removal device for home-use for women, and we also announced that we had
executed an amended and restated joint development agreement to incorporate other amendments and several new amendments to allow for
more open collaboration through commercialization.  With regard to the additional light-based hair
removal device for home-use for women, we completed certain development activities in consultation with
Gillette during an eleven month program.  Gillette provided us with $1.2 million and an additional
$300,000 upon the completion of certain deliverables to be recognized over an eleven month period as
costs are incurred and services are provided.



         On December 21, 2007, we announced an agreement with Gillette to extend the Launch Decision
until no later than February 29, 2008.  During this extension period, we negotiated with Gillette and
its parent company The Procter & Gamble Company (P&G) for a new agreement to replace the existing
one.  On March 3, 2008, we announced with P&G that we had entered into a License Agreement including
with P&Gs wholly owned subsidiary Gillette under which we granted a non-exclusive license to certain
patents and technology to commercialize home-use light-based hair removal devices for women.  This
License Agreement replaced the prior Development and License Agreement.

         For the years ended December 31, 2007, 2006 and 2005, we recognized $3.8 million, $1.1 million
and $2.8 million of funded product development revenues from Gillette, respectively.  As of December 31,
2007, 2006 and 2005, $48,000, $2.9 million, and $0, respectively, of advance payments received from
Gillette for which services were not yet provided were included in deferred revenue.

         For more information, please see the License Agreement filed as Exhibit 10.1 to our Current
Report on Form 8-K filed March 3, 2008, the Development and License Agreement and subsequent amendments
filed as Exhibit 10.1 to our Current Report on Form 8-K filed on February 19, 2003, Exhibits 99.1, 99.2,
and 99.3 to our Current Report on Form 8-K filed on June 28, 2004, Exhibit 10.30 to our Annual Report on
Form 10-K filed on March 6, 2006, and Exhibits 10.1 and 10.2 to our Current Report on Form 8-K filed on
February 21, 2007.





65



Note 12  Joint
Development and License agreement with Johnson & Johnson Consumer Companies, Inc.


Effective
as of September 1, 2004, we entered into a Joint Development and License Agreement with
Johnson & Johnson Consumer Companies, Inc. to develop and commercialize home-use,
light-based devices in the fields of (i) reducing or reshaping body fat including
cellulite; (ii) reducing appearance of skin aging; and (iii) reducing or preventing acne.
Under the agreement, Johnson & Johnson funds our research and clinical studies during
an initial proof-of-principle phase. At the end of the proof-of-principle phase, Johnson
& Johnson will decide whether or not to continue with one or more of the devices in
one or more of the fields into a development phase. If Johnson & Johnson decides to
continue, Johnson & Johnson will be obligated to fund the development of the selected
devices.  If Johnson & Johnson decides not to continue,
we may proceed in fields not selected by Johnson & Johnson to develop and
commercialize these and other devices on our own or with a different party.






At
the end of the development phase, Johnson & Johnson will decide whether or not to
commercialize one or more of the devices in one or more fields. If Johnson & Johnson
decides to commercialize one or more of the devices, Johnson & Johnson will make
payments to us for each selected field. Upon commercial launch of the first device in each
selected field, Johnson & Johnson will make a payment to us, and for all devices sold
for use in each selected field, Johnson & Johnson shall pay us a percentage of sales
of such devices and certain topical compounds. If Johnson & Johnson decides not to
commercialize or fails to launch a device, we may proceed in fields not selected by
Johnson & Johnson to develop and commercialize these and other devices on our own or
with a different party.


On
August 22, 2007, we signed an amendment to our agreement with Johnson & Johnson to
provide for additional development funding for certain development activities. Johnson
& Johnson will provide us with quarterly payments of $448,000 for these development
activities. We will recognize this revenue as costs are incurred and services are
provided.


For
the years ended December 31, 2007, 2006 and 2005, we recognized approximately $2.5
million, $1.4 million and $1.6 million, respectively, of funded product development
revenues from Johnson & Johnson. As of December 31, 2007, 2006 and 2005, $477,000,
$63,000 and $375,000, respectively, of advance payments received from Johnson &
Johnson for which services were not yet provided were included in deferred revenue.


For more information, please see the Joint Development and License Agreement and amendments
filed as Exhibit 99.1 to our Current Report on Form 8-K filed on September 7, 2004, Exhibit 10.45 to our
Quarterly Report on Form 10-Q filed on May 8, 2007, and Exhibits 10.47 and 10.48 to our Quarterly Report
on Form 10-Q filed on November 2, 2007.


Note 13  Research
contract with the United States Department of the Army


In the first quarter of 2004, we began providing services under a $2.5 million research
contract with the United States Department of the Army to develop a light-based self-treatment device
for Pseudofolliculitis Barbae or PFB.  On October 25, 2005, we announced that we had been awarded
additional funding of $888,000 for a total of $3.4 million and a twelve month extension. On September 1,
2006, we were awarded additional funding of $440,000 for a total of $3.8 million and an additional five
month extension until April 30, 2007. Since April 30, 2007, the contract has been extended on multiple occasions
and currently has been extended through March 31, 2008.  The contract is a cost plus fee arrangement
whereby we are reimbursed for the expenses incurred in connection with PFB research plus an 8% fee.  Our
revenue from the contract is subject to government audit.



For
the years ended December 31, 2007, 2006 and 2005, we recognized $388,000, $1.3 million and
$1.0 million of funded product development revenues under this agreement, respectively.




Note 14 
Settlement of Lumenis Litigation


On
June 22, 2004, we announced that we had reached a settlement with Lumenis Ltd. resolving
our on-going litigation concerning both patent infringement and contractual matters.
Pursuant to the settlement, the parties dismissed with prejudice both the federal action
in the Northern District of California as well as the state court action in Massachusetts.
Palomar and Lumenis executed a Settlement Agreement and a Patent License Agreement. Under
the Patent License Agreement, we granted Lumenis a non-exclusive, royalty bearing license
to the U.S. Patent Nos. 5,735,844 and 5,595,568 and all corresponding foreign patents and
patent applications in the professional field, excluding the consumer field.
66



Under
the terms of the Settlement Agreement and Patent License Agreement, Lumenis paid $868,000
in the second quarter of 2004 for back-owed royalties from sales of the LightSheer made
prior to July 1, 2002 and agreed to pay $3.225 million over the next six quarters, or
$537,500 per quarter, for back-owed royalties due on sales of the LightSheer made between
July 1, 2002 and December 31, 2003. Beginning on January 1, 2004, Lumenis agreed to pay us
a royalty on sales of the LightSheer and other professional laser hair removal devices and
modules.







In
addition, Lumenis granted us a paid up license to a variety of Lumenis patents for
our light-based devices. We granted Lumenis a paid up license to the U.S. Patent Nos.
5,735,844 and 5,595,568 and all corresponding foreign patents and patent applications for
Lumenis lamp-based devices. Both parties have agreed to the validity and
enforceability of each others patents and not to challenge such validity and
enforceability in the future.


For
the year ended December 31, 2005, Lumenis made payments of approximately $2.2 million for
back-owed royalties.


For
more information, please see the Settlement Agreement and the Patent License Agreement
filed as Exhibits 99.1 and 99.2 to our Current Report on Form 8-K filed June 22, 2004.


Note 15 
Settlement of Cutera Litigation


On June 5, 2006, we announced the resolution of our patent infringement lawsuits against
Cutera, Inc. through the execution of a Settlement Agreement and a Non-Exclusive Patent License
Agreement. Under the License Agreement, we granted Cutera a non-exclusive, royalty bearing license to
U.S. Patent Nos. 5,735,844 and 5,595,568 and all corresponding foreign patents and patent applications
in the professional field, excluding the consumer field. Cutera admitted that their products infringe these patents and that these patents are valid and
enforceable. In addition, Cutera agreed not to challenge the infringement, validity and enforceability
of these patents in the future. Cutera paid us $22 million as an estimated payment for royalties on past
sales of their laser and lamp-based hair removal systems beginning with their initial sales in 2000
through March 31, 2006, interest and reimbursement of our legal costs. Cutera subsequently informed us
that they believed the actual liability for past royalties, interest and legal costs was $19.6 million,
versus the actual payment of $22 million. We recorded the difference of $2.4 million as deferred revenue
at June 30, 2006 to be applied against future amounts owed. The final amounts due were subject to an
audit by an independent accounting firm which was completed during the fourth quarter of 2006, resulting
in an additional $648,000 of royalty and interest. Under our license agreement with the Massachusetts
General Hospital, we pay to the Massachusetts General Hospital 40% of all royalty and interest payments
from Cutera. In connection with the settlement, during the three and nine months ended September 30,
2006, we recorded $13.6 million of royalty revenue and $5.4 million in cost of royalties. We also
recorded, net of amounts owed to the Massachusetts General Hospital, $3.8 million as a reduction in
general and administrative expense and $1.2 million in interest income. Starting on April 1, 2006,
Cutera began paying us a royalty on sales of its existing and any new light-based hair removal systems later developed.





For
the year ended December 31, 2006 we recognized $14.2 million of back-owed royalty revenues
related to the settlement of the Cutera litigation.


For
more information, please see the Settlement Agreement, the Non-Exclusive Patent License
Agreement, the Consent Judgments and Stipulations of Dismissal filed as Exhibits 99.1,
99.2, 99.3 and 99.4 to our Current Report on Form 8-K filed June 5, 2006.



67



Note 16 
Laserscope Agreement


On October 18, 2006, we entered into a new Non-Exclusive Patent License Agreement with
Laserscope and terminated the prior license agreement. Under the Patent License Agreement, we granted
Laserscope a non-exclusive, royalty bearing license to U.S. Patent Nos. 5,735,844 and 5,595,568 and all
corresponding foreign patents and patent applications in the professional field, excluding the consumer
field.  Under the new license agreement,
Laserscope will pay us a royalty on sales of its current light-based hair removal products, including
the Lyra and Gemini Laser Systems and the Solis IPL System, as well as on sales of new light-based hair
removal systems developed in the future.


As a result of a royalty audit of Laserscopes product sales from January 1, 2001 through June
30, 2006, there was an increase in the third quarter of 2006 royalty revenue of $2.2 million for
back-owed royalties, cost of royalty revenue of $864,000 and net income of $1.3 million.





American
Medical Systems Holdings, Inc. acquired Laserscope in July of 2006 and subsequently sold
the assets of Laserscopes aesthetic division to Iridex Corporation, effective in the
first quarter of 2007. As a result, the license agreement between Palomar and Laserscope
has been assigned to Iridex. Iridex has assumed all of Laserscopes rights and
obligations under the license agreement.


For
the year ended December 31, 2006, we recognized $2.2 million of back-owed royalty revenues
as a result of the Laserscope agreement.


For
more information, please see the Non-Exclusive Patent License Agreement filed as Exhibit
99.2 to our Current Report on Form 8-K filed October 26, 2006.


Note 17  Cynosure
Agreement


On November 7, 2006, we announced the execution of a Non-Exclusive Patent License Agreement
with Cynosure, Inc.  Under this Agreement, we granted to Cynosure a non-exclusive, royalty bearing
license to U.S. Patent Nos. 5,735,844 and 5,595,568 and all corresponding foreign patents and patent
applications in the professional field, excluding the consumer field. In return, Cynosure granted us a non-royalty bearing (fully paid up), non-exclusive
license to eight Cynosure patents and patent applications, including counterparts.  Cynosure also paid
us $10 million on November 7, 2006 as a royalty on sales of their laser and lamp-based hair removal
systems made before October 1, 2006. Starting on  October 1, 2006, Cynosure began paying us a royalty on sales
of existing and any new light-based hair removal systems later developed.


For
the year ended December 31, 2006, we recognized $10.0 million of back-owed royalty
revenues as a result of the Cynosure license.


For
more information, please see the Non-Exclusive Patent License Agreement filed as Exhibit
99.2 to our Current Report on Form 8-K filed November 7, 2006.

Note 18  Alma
Agreement


On April 2, 2007, we announced the resolution of our patent infringement and trade dress
lawsuit against Alma Lasers, Inc. through the execution of a Settlement Agreement, a Non-Exclusive
Patent License Agreement and a Trade Dress Settlement Agreement. Under the Patent License Agreement, we
granted Alma a non-exclusive, royalty bearing license to U.S. Patent Nos. 5,735,844 and 5,595,568 and
all corresponding foreign patents and patent applications in the professional field, excluding the
consumer field. Alma admitted that their products
infringe these patents and that these patents are valid and enforceable. In addition, Alma agreed not to
challenge the infringement, validity and enforceability of these patents in the future. Alma will pay
for royalties and interest due on past sales of their laser and lamp-based hair removal systems
beginning with their initial sales in 2003 and a trade dress fee plus interest on past sales of their
Harmony and Aria systems. The amounts due to us are being determined based on an audit by an independent
accounting firm. We have begun to recognize royalty revenue as the amounts become determinable. Under
our license agreement with the Massachusetts General Hospital, we pay to the Massachusetts General
Hospital 40% of all patent royalty and interest thereof from Alma. Starting on March 30, 2007, Alma began
paying us a royalty on sales of its existing and any new light-based hair removal systems later
developed.

68


For
the year ended December 31, 2007, we recognized $3.1 million of back-owed royalty revenues
and $894,000 of other revenues for trade dress infringement. At December 31, 2007, we had
deferred revenue of $1.6 million related to payments received from Alma.


For
more information, please see the Settlement Agreement, the Non-Exclusive Patent License
Agreement, the Trade Dress Settlement Agreement, the Consent Judgments and Stipulations of
Dismissal filed as Exhibits 10.1, 10.2, 10.3, 10.4 and 10.5 to our Current Report on Form
8-K filed on April 2, 2007.







Note 19 
Subsequent Events


On January 9, 2008, we announced the execution of an international distribution agreement with
the Swedish company Q-MED AB.  Q-MED will eventually be responsible for the marketing, advertising,
promotion, sale and distribution of our professional products for aesthetic treatments outside North
America.


On March 3, 2008, we announced with The Procter & Gamble Company (P&G) that we had entered
into a License Agreement including with P&Gs wholly owned subsidiary The Gillette Company under which
we granted a non-exclusive license to certain patents and technology to commercialize home-use
light-based hair removal devices for women.  This License Agreement replaced the Development and License
Agreement entered into with Gillette in 2003 which was amended and restated in February 2007.


         Item 9.  Changes in and Disagreements with Accountants on Accounting and Financial Disclosures

None.


Item 9A. Controls and
Procedures


Evaluation of disclosure
controls and procedures


The Company carried out an evaluation, as required by Rule 13a-15(b) under the Securities Exchange Act
of 1934, as amended (Exchange Act), under the supervision and with the participation of the Companys
management, including the Companys Chief Executive Officer and Chief Financial Officer, of the
effectiveness of the design and operation of the Companys disclosure controls and procedures, as
defined in Rule 13a-15(e) of the Exchange Act, as of the end of the period covered by this report (the
Evaluation Date).  Based on such evaluation, such officers have concluded that, as of the Evaluation
Date, the Companys disclosure controls and procedures were effective to provide reasonable assurance
that information required to be disclosed by the Company in reports that it files or submits under the
Exchange Act is recorded, processed, summarized and reported within the time periods specified in the
Securities and Exchange Commissions rules and forms and to provide reasonable assurance that such
information is accumulated and communicated to the Companys management, including the Companys Chief
Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding
required disclosure.


The
effectiveness of a system of disclosure controls and procedures is subject to various
inherent limitations, including cost limitations, judgments used in decision making,
assumptions about the likelihood of future events, the soundness of internal controls, and
the risk of fraud. Because of these limitations, there can be no assurance that any system
of disclosure controls and procedures will be successful in preventing all errors or fraud
or in making all material information known in a timely manner to the appropriate levels
of management.


69


Changes in internal
controls


There
have been no changes in our internal control over financial reporting that occurred during
the quarter ended December 31, 2007 that have materially affected or are reasonably
likely to materially affect our internal control over financial reporting.


Managements report
on internal controls over financial reporting


Our management is responsible for establishing and maintaining adequate internal control over
financial reporting as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934, as amended.
Our internal control system was designed to provide reasonable assurance regarding the reliability of
financial reporting and the preparation of financial statements for external purposes in accordance with
generally accepted accounting principles.


Internal
control over financial reporting cannot provide absolute assurance of achieving financial
reporting objectives because of its inherent limitations. Internal control over financial
reporting is a process that involves human diligence and compliance and is subject to
lapses in judgment and breakdowns resulting from human failures. Internal control over
financial reporting also can be circumvented by collusion or improper management override.
Because of such limitations, there is a risk that material misstatements may not be
prevented or detected on a timely basis by internal control over financial reporting.
However, these inherent limitations are known features of the financial reporting process.
Therefore, it is possible to design into the process safeguards to reduce, though not
eliminate, this risk.


In conducting their evaluation of the effectiveness of our companys internal control over
financial reporting, management used the framework set forth in the report entitled Internal
ControlIntegrated Framework published by the Committee of Sponsoring Organizations (COSO) of the
Treadway Commission. Management has concluded that the Companys internal control over financial
reporting was effective as of December 31, 2007.

70


Report of Independent Registered
Public Accounting Firm


The Board of Directors and
Stockholders of Palomar Medical Technologies, Inc.:


We have audited  Palomar Medical
 Technologies,  Inc.s  internal  control over financial  reporting as of December 31,
2007, based on criteria  established in Internal  ControlIntegrated  Framework issued by
the Committee of Sponsoring  Organizations  of the Treadway  Commission (the COSO
 criteria).  Palomar Medical Technologies,  Inc.s management is responsible for
maintaining  effective internal control over financial reporting,  and for its
 assessment of the  effectiveness  of internal  control over  financial  reporting
included in the  accompanying  managements  report on internal  control  over  financial
 reporting.  Our responsibility is to express an opinion on the Companys  internal
control over financial  reporting based on our audit.


We conducted our audit in accordance
with the standards of the Public Company  Accounting  Oversight Board (United  States).
 Those  standards  require  that we plan and  perform  the  audit to  obtain  reasonable
assurance  about  whether  effective  internal  control over  financial  reporting  was
 maintained in all material  respects.  Our audit  included  obtaining an  understanding
 of internal  control over financial reporting,  assessing the risk that a material
 weakness  exists,  testing and  evaluating  the design and operating  effectiveness  of
internal  control  based on the  assessed  risk,  and  performing  such other procedures
 as we  considered  necessary  in the  circumstances.  We  believe  that our audit
 provides  a reasonable basis for our opinion.


A companys  internal  control  over
 financial  reporting  is a process  designed  to provide  reasonable assurance
 regarding the reliability of financial  reporting and the  preparation of financial
 statements for external purposes in accordance with generally accepted  accounting
 principles.  A companys internal control  over  financial  reporting  includes  those
 policies  and  procedures  that (1)  pertain  to the maintenance of records that, in
reasonable  detail,  accurately and fairly  reflect the  transactions  and dispositions
 of the assets of the  company;  (2)  provide  reasonable  assurance  that  transactions
 are recorded as  necessary  to permit  preparation  of  financial  statements  in
 accordance  with  generally accepted accounting  principles,  and that receipts and
expenditures of the company are being made only in accordance  with  authorizations  of
management and directors of the company;  and (3) provide  reasonable assurance
 regarding  prevention or timely detection of unauthorized  acquisition,  use, or
disposition of the companys assets that could have a material effect on the financial
statements.


Because of its inherent limitations,
internal control over financial reporting may not prevent or detect misstatements.  Also,
projections of any evaluation of effectiveness to future periods are subject to the risk
that controls may become inadequate because of changes in conditions, or that the degree
of compliance with the policies or procedures may deteriorate.


In our opinion, Palomar Medical
Technologies, Inc. maintained, in all material respects, effective internal control over
financial reporting as of December 31, 2007, based on the COSO criteria.


We also have audited, in accordance
with the standards of the Public Company Accounting Oversight Board (United States), the
consolidated balance sheets of Palomar Medical Technologies, Inc. and subsidiaries as of
December 31, 2007 and 2006, and the related consolidated statements of income,
stockholdersequity and cash flows for each of the three fiscal years in the period ended
December 31, 2007 of Palomar Medical Technologies, Inc. and our report dated March 4,
2008 expressed an unqualified opinion thereon.
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|                      |                      
|--------------------- | ---------------------
|                      | /s/ Ernst & Young LLP
|Boston, Massachusetts |                      
|March 4, 2008         |                      

|71




Item 9B. Other
Information


None.







PART III


Item 10. Directors and
Executive Officers of the Registrant


We
incorporate information required by this item by reference to the sections responsive
hereto of our 2008 annual proxy statement to be filed prior to April 29, 2008.


Item 11. Executive
Compensation


We
incorporate the information required by this item by reference to the sections responsive
hereto of our 2008 annual proxy statement to be filed prior to April 29, 2008.


Item 12. Security
Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters


We
incorporate the information required by this item by reference to the sections responsive
hereto of our 2008 annual proxy statement to be filed prior to April 29, 2008.


Item 13. Certain
Relationships and Related Transactions


We
incorporate the information required by this item by reference to the sections responsive
hereto of our 2008 annual proxy statement to be filed prior to April 29, 2008.


Item 14. Principal
Accountant Fees and Services


We
incorporate the information required by this item by reference to the sections responsive
hereto of our 2008 annual proxy statement to be filed prior to April 29, 2008.






PART IV


Item 15.    Exhibits,
Financial Statement Schedules


(a)                 The
following documents are filed as part of this report:
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (1)             Financial
Statements
| | ------------------------------------

| | Report
of Independent Registered Public Accounting Firm on Consolidated Financial Statements
| | --------------------------------------------------------------------------------------------

| | Consolidated
Balance Sheets as of December 31, 2007 and December 31, 2006
| | -------------------------------------------------------------------------

| | Consolidated
Statements of Income for the years ended December 31, 2007, December 31, 2006 and
December 31, 2005
| | ----------------------------------------------------------------------------------------------------------------

| | Consolidated
Statements of Stockholders Equity for the years ended December 31, 2007, December
31, 2006 and December 31, 2005
| | ------------------------------------------------------------------------------------------------------------------------------

| | Consolidated
Statements of Cash Flows for the years ended December 31, 2007, December 31, 2006
and December 31, 2005
| | --------------------------------------------------------------------------------------------------------------------

| | Notes
to Consolidated Financial Statements
| | ------------------------------------------

| | (2)   
          Financial Statement Schedules
| | ----------------------------------------------

|72
|--

| | All
schedules have been omitted because they are not required or because the required
information is given in the Consolidated Financial Statements or Notes thereto.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(b)
Listing of Exhibits
|-----------------------

|        |                                                                                                              |  | Incorporated by Reference |                
|------- | ------------------------------------------------------------------------------------------------------------ |  | ------------------------- | ---------------
|
|3.1     | Certificate of Designation, Preferences and Rights of the  Series A Participating Cumulative Preferred Stock |  | 10-Q                      | May 17, 1999   
|        |                                                                                                              |  |                          
|3.2     | Second Restated Certificate of Incorporation                                                                 |  | S-3                       | January 1, 1999
|        |                                                                                                              |  |                          
|3.3     | Certificate of Amendment to Certificate of Incorporation                                                     |  | 10-K                      | March 17, 2004 
|        |                                                                                                              |  |                          
|3.4     | Amended and Restated By-Laws                                                                                 |  | 10-Q                      | August 9, 2000 
|        |                                                                                                              |  |                          
|4.1     | Specimen certificate of common stock                                                                         |  | 10-Q                      | May 17, 1999   
|        |                                                                                                              |  |                          
|4.2     | Form of rights certificate                                                                                   |  | 8-K                       | April 21, 1999 
|        |                                                                                                              |  |                          
|4.3     | Rights Agreement with American Stock Transfer & Trust Company  dated April 20, 1999                          |  | 8-K                       | April 21, 1999 
|        |                                                                                                              |  |                          
|10.1*   | Second Amended 1991 Stock Option Plan                                                                        |  | 10-Q                      | August 16, 1999
|        |                                                                                                              |  |                          
|10.2*   | Second Amended 1993 Stock Option Plan                                                                        |  | 10-Q                      | August 16, 1999
|        |                                                                                                              |  |                          
|10.3*   | Second Amended 1995 Stock Option Plan                                                                        |  | 10-Q                      | August 16, 1999
|        |                                                                                                              |  |                          
|10.4*   | Second Amended 1996 Stock Option Plan                                                                        |  | 10-Q                      | August 16, 1999
|        |                                                                                                              |  |                          
|10.5*   | 1998 Incentive and Non-Qualified Stock Option Plan                                                           |  | DEF 14A                   | April 22, 1998 
|        |                                                                                                              |  |                          
|10.6*   | 2004 Stock Incentive Plan                                                                                    |  | DEF 14A                   | March 17, 2004 
|        |                                                                                                              |  |                          
|10.7*   | 2007 Stock Incentive Plan                                                                                    |  | DEF 14A                   | March 21, 2007 
|        |                                                                                                              |  |                          
|10.8*   | 401(k) Plan                                                                                                  |  | S-8                       | October 4, 1995
|        |                                                                                                              |  |                          
|10.9*+  | 2006 Incentive Compensation Program with Louis P. Valente                                                    |  | 10-K                      | March 6, 2006  
|        |                                                                                                              |  |                          
|10.10*+ | 2006 Incentive Compensation Program with Joseph P. Caruso                                                    |  | 10-K                      | March 6, 2006  
|        |                                                                                                              |  |                          
|10.11*+ | 2006 Incentive Compensation Program with Paul S. Weiner                                                      |  | 10-K                      | March 6, 2006  
|        |                                                                                                              |  |                          

|73
|--

|       |                                                                                                        |  | Incorporated by Reference |                  
|------ | ------------------------------------------------------------------------------------------------------ |  | ------------------------- | -----------------
|
|10.12* | Employment Agreement with Louis P. Valente dated July 1, 2001                                          |  | 10-K                      | March 17, 2004   
|       |                                                                                                        |  |                          
|10.13* | Employment Agreement with Joseph P. Caruso dated July 1, 2001                                          |  | 10-K                      | March 17, 2004   
|       |                                                                                                        |  |                          
|10.14* | Employment Agreement with Paul S. Weiner dated July 1, 2001                                            |  | 10-K                      | March 17, 2004   
|       |                                                                                                        |  |                          
|10.15  | Form of common stock purchase warrant                                                                  |  | S-8                       | June 22, 1998    
|       |                                                                                                        |  |                          
|10.16  | Form of common stock purchase warrant                                                                  |  | S-8                       | May 21, 2004     
|       |                                                                                                        |  |                          
|10.17  | Form of common stock purchase warrant                                                                  |  | S-8                       | May 21, 2004     
|       |                                                                                                        |  |                          
|10.18  | Lease for 82 Cambridge Street, Burlington, MA dated June 17,   1999                                    |  | 10-Q                      | August 16, 1999  
|       |                                                                                                        |  |                          
|10.19  | First Amendment to Lease for 82 Cambridge Street, Burlington,   MA dated March 20, 2000                |  | 10-K                      | March 6, 2006    
|       |                                                                                                        |  |                          
|10.20  | Second Amendment to Lease for 82 Cambridge Street,   Burlington, MA dated January 18, 2006             |  | 10-K                      | March 6, 2006    
|       |                                                                                                        |  |                          
|10.21  | License Agreement with The General Hospital Corporation dated         August 18, 1995                  |  | 10-K                      | February 12, 1999
|       |                                                                                                        |  |                          
|10.22  | First Amendment to License Agreement with The General Hospital Corporation                             |  | 10-K                      | February 12, 1999
|       |                                                                                                        |  |                          
|10.23  | Second Amendment to License Agreement with The General Hospital Corporation                            |  | 10-K                      | February 12, 1999
|       |                                                                                                        |  |                          
|10.24+ | Third and Fourth Amendments to License Agreement with The  General Hospital Corporation                |  | 10-K                      | March 27, 2003   
|       |                                                                                                        |  |                          
|10.25+ | Research Agreement with The General Hospital Corporation  dated August 1, 2004                         |  | 8-K                       | November 18, 2004
|       |                                                                                                        |  |                          
|10.26+ | The Development and License Agreement with The Gillette Company dated February 14, 2003                |  | 8-K                       | February 19, 2003
|       |                                                                                                        |  |                          
|10.27  | Amendment to the Development and License Agreement with The   Gillette Company dated February 14, 2003 |  | 8-K                       | June 28, 2004    
|       |                                                                                                        |  |                          
|10.28  | Amendment to the Development and License Agreement with The    Gillette Company dated October 2, 2003  |  | 8-K                       | June 28, 2004    
|       |                                                                                                        |  |                          
|10.29  | Second Amendment to the Development and License Agreement      with The Gillette Company               |  | 8-K                       | June 28, 2004    
|       |                                                                                                        |  |                          

|74
|--

|       |                                                                                                                                                                                                  |  | Incorporated by Reference |                  
|------ | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ |  | ------------------------- | -----------------
|
|10.30+ | Third Amendment to the Development and License Agreement with     The Gillette Company                                                                                                           |  | 10-K                      | March 6, 2006    
|       |                                                                                                                                                                                                  |  |                          
|10.31+ | Joint Development and License Agreement with Johnson &     Johnson Consumer Companies, Inc. dated September 1, 2004                                                                              |  | 8-K                       | September 7, 2004
|       |                                                                                                                                                                                                  |  |                          
|10.32  | Settlement Agreement with The General Hospital Corporation,  Lumenis, Inc. and Lumenis, Ltd. dated June 17, 2004                                                                                 |  | 8-K                       | June 22, 2004    
|       |                                                                                                                                                                                                  |  |                          
|10.33+ | Patent License Agreement with Lumenis, Inc. dated June 17,        2004                                                                                                                           |  | 8-K                       | June 22, 2004    
|       |                                                                                                                                                                                                  |  |                          
|10.34+ | Fifth Amendment to License Agreement with The General   Hospital dated March 20, 2006                                                                                                            |  | 10-Q                      | May 9, 2006      
|       |                                                                                                                                                                                                  |  |                          
|10.35+ | First Amendment to Joint Development and License Agreement    with Johnson & Johnson Consumer Companies, Inc. dated May 1,  2006.                                                                |  | 10-Q                      | August 8, 2006   
|       |                                                                                                                                                                                                  |  |                          
|10.36  | Settlement Agreement dated June 2, 2006 between Palomar      Medical Technologies, Inc., The General Hospital Corporation  and Cutera, Inc.                                                      |  | 8-K                       | June 5, 2006     
|       |                                                                                                                                                                                                  |  |                          
|10.37  | Patent License Agreement dated June 2, 2006 between Palomar    Medical Technologies, Inc. and Cutera, Inc.                                                                                       |  | 8-K                       | June 5, 2006     
|10.38  | Consent Judgments, Palomar v Cutera                                                                                                                                                              |  | 8-K                       | June 5, 2006     
|       |                                                                                                                                                                                                  |  |                          
|10.39  | Stipulations of Dismissal, Palomar v Cutera                                                                                                                                                      |  | 8-K                       | June 5, 2006     
|       |                                                                                                                                                                                                  |  |                          
|10.40  | Non Exclusive Patent License Agreement dated November 6, 2006 between Palomar Medical Technologies, Inc. and Cynosure, Inc.                                                                      |  | 8-K                       | November 7, 2006 
|       |                                                                                                                                                                                                  |  |                          
|10.41  | FDA notification letter of 510K OTC clearance for a new, patented home-use, light-based hair removal device                                                                                      |  | 8-K                       | December 11, 2006
|       |                                                                                                                                                                                                  |  |                          
|10.42* | 2007 Incentive Compensation Program - Executive Level                                                                                                                                            |  | 8-K                       | February 9, 2007 
|       |                                                                                                                                                                                                  |  |                          
|10.43+ | Amended and Restated Development and License Agreement
effective as of February 14, 2003 restated as of February 14, 2007, between Palomar Medical Technologies, Inc. and The   Gillette Company |  | 8-K                       | February 21, 2007
|       |                                                                                                                                                                                                  |  |                          
|10.44+ | Amendment to the Amended and Restated Development and License
 Agreement, dated February 14, 2007, between Palomar Medical Technologies, Inc. and The Gillette Company                           |  | 8-K                       | February 21, 2007
|       |                                                                                                                                                                                                  |  |                          
|       |                                                                                                                                                                                                  |  |                          

|75
|--

|        |                                                                                                                                                                                                                      |   | Incorporated by Reference |                  
|------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | - | ------------------------- | -----------------
|
|10.45   | Settlement Agreement dated March 29, 2007 between Palomar
 Medical Technologies, Inc., The General Hospital Corporation   and Alma Lasers, Inc                                                                       |   | 8-K                       | April 2, 2007    
|        |                                                                                                                                                                                                                      |   |                          
|10.46   | Non-Exclusive Patent License Agreement dated March 29, 2007
between Palomar Medical Technologies, Inc. and Alma Lasers,    Inc. and Alma Lasers, Ltd.                                                                |   | 8-K                       | April 2, 2007    
|        |                                                                                                                                                                                                                      |   |                          
|10.47   | Trade Dress Settlement dated March 29, 2007 between Palomar
  Medical Technologies, Inc. and Alma Lasers, Inc. and Alma Lasers, Ltd.                                                                                 |   | 8-K                       | April 2, 2007    
|        |                                                                                                                                                                                                                      |   |                          
|10.48   | Consent Judgment, Palomar v Alma                                                                                                                                                                                     |   | 8-K                       | April 2, 2007    
|        |                                                                                                                                                                                                                      |   |                          
|10.49   | Stipulation of Dismissal with Prejudice, Palomar v Alma                                                                                                                                                              |   | 8-K                       | April 2, 2007    
|        |                                                                                                                                                                                                                      |   |                          
|10.50+  | Second Amendment to Joint Development and License Agreement
   with Johnson & Johnson Consumer Companies, Inc. dated May 7,   2007                                                                                   |   | 10-Q                      | May 8, 2007      
|        |                                                                                                                                                                                                                      |   |                          
|10.51   | Amended and Restated Bylaws                                                                                                                                                                                          |   | 8-K                       | October 24, 2007 
|        |                                                                                                                                                                                                                      |   |                          
|10.52   | Third Amendment to Lease for 80/82 Cambridge Street,    Burlington, MA dated July 30, 2007                                                                                                                           |   | 10-Q                      | November 2, 2007 
|        |                                                                                                                                                                                                                      |   |                          
|10.53+  | Third Amendment to Joint Development and License Agreement
 with Johnson & Johnson Consumer Companies, Inc. dated August  15, 2007                                                                                   |   | 10-Q                      | November 2, 2007 
|        |                                                                                                                                                                                                                      |   |                          
|10.54+  | Fourth Amendment to Joint Development and License Agreement
  with Johnson & Johnson Consumer Companies, Inc. dated August  22, 2007                                                                                 |   | 10-Q                      | November 2, 2007 
|        |                                                                                                                                                                                                                      |   |                          
|10.55   | Amendment to the Amended and Restated Development and License
  Agreement, effective as of February 14, 2003 restated as of   February 14, 2007, between Palomar Medical Technologies, Inc. and The Gillette Company |   | 8-K                       | December 21, 2007
|        |                                                                                                                                                                                                                      |   |                          
|10.56+  | International Distributor Agreement, effective as of January
   8, 2008 between Palomar Medical Technologies, Inc. and Q-MED     AB (Publ).                                                                          |   | 8-K                       | January 9, 2008  
|        |                                                                                                                                                                                                                      |   |                          
|10.57*+ | 2008 Incentive Compensation Program - Executive Level                                                                                                                                                                |   | 8-K                       | February 11, 2008
|        |                                                                                                                                                                                                                      |   |                          
|        |                                                                                                                                                                                                                      |   |                          
|10.58*+ | 2008 Incentive Compensation Program with Louis P. Valente                                                                                                                                                            | X | 10-K                      | March 6, 2008    
|        |                                                                                                                                                                                                                      |   |                          
|10.59*+ | 2008 Incentive Compensation Program with Joseph P. Caruso                                                                                                                                                            | X | 10-K                      | March 6, 2008    
|        |                                                                                                                                                                                                                      |   |                          
|10.60*+ | 2008 Incentive Compensation Program with Paul S. Weiner                                                                                                                                                              | X | 10-K                      | March 6, 2008    
|        |                                                                                                                                                                                                                      |   |                          

|76
|--

|       |                                                                                                                                     |   | Incorporated by Reference |              
|------ | ----------------------------------------------------------------------------------------------------------------------------------- | - | ------------------------- | -------------
|
|10.61+ | License Agreement, executed February 29, 2008, effective as of February 14, 2003                                                    |   | 8-K                       | March 3, 2008
|       |                                                                                                                                     |   |                          
|21     | List of subsidiaries                                                                                                                | X |                           |              
|       |                                                                                                                                     |   |                          
|23.1   | Consent of Ernst & Young LLP                                                                                                        | X |                           |              
|       |                                                                                                                                     |   |                          
|31.1   | Certification of Chief Executive Officer pursuant to Section  302 of the Sarbanes-Oxley Act of 2002                                 | X |                           |              
|       |                                                                                                                                     |   |                          
|31.2   | Certification of Chief Financial Officer pursuant to Section  302 of the Sarbanes-Oxley Act of 2002                                 | X |                           |              
|       |                                                                                                                                     |   |                          
|32.1   | Certification of Chief Executive Officer and Chief Financial    Officer pursuant to Section 906 of the Sarbanes-Oxley Act of
  2002 | X |                           |              
|       |                                                                                                                                     |   |                          
|+      | Portions of this exhibit have been omitted pursuant to a request for confidential treatment and filed
separately with the SEC       |   |                           |              
|       |                                                                                                                                     |   |                          
|*      | Management contract or compensatory plan or arrangement                                                                             |   |                           |              
|       |                                                                                                                                     |   |                          

|77
|--

|SIGNATURES



Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused
this report to be signed on its behalf by the undersigned, thereunto duly authorized.
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Palomar Medical
Technologies, Inc.
| |  | ----------------------------------

| |                                                                         
| | ------------------------------------------------------------------------
| | By:/s/ Paul S. Weiner
      Paul S. Weiner
      Chief Financial Officer
| |                                                                         

|Pursuant
to the requirements of the Securities Exchange Act of 1934, this report has been signed by
the following persons on behalf of the registrant in the capacities and on the dates
indicated.
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Name                     | Capacity                                        | Date          
|------------------------ | ----------------------------------------------- | --------------
|                         |                                                 |               
|/s/Louis P. Valente      | Chairman of the Board of Directors              | March 6, 2008 
|Louis P. Valente         |                                                 |               
|                         |                                                 |               
|/s/Joseph P. Caruso      | President, Chief Executive Officer and Director | March  6, 2008
|Joseph P. Caruso         |                                                 |               
|                         |                                                 |               
|/s/Paul S. Weiner        | Chief Financial Officer                         | March  6, 2008
|Paul S. Weiner           |                                                 |               
|                         |                                                 |               
|/s/ Nicholas P. Economou | Director                                        | March  6, 2008
|Nicholas P. Economou     |                                                 |               
|                         |                                                 |               
|/s/ A. Neil Pappalardo   | Director                                        | March  6, 2008
|A. Neil Pappalardo       |                                                 |               
|                         |                                                 |               
|/s/ James G. Martin      | Director                                        | March  6, 2008
|James G. Martin          |                                                 |               
|                         |                                                 |               
|/s/ Jeanne Cohane        | Director                                        | March  6, 2008
|Jeanne Cohane            |                                                 |               
|                         |                                                 |               

|78
|--