|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, 2008
|- | -------------------------------------------------------------------------------------------------------------------------------------------

|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, 2008 was $158,563,767.  The number of shares outstanding of the registrant's common stock as of the close of business on
March 2, 2009 was 18,479,345.


DOCUMENTS INCORPORATED BY REFERENCE



Part III incorporates by reference certain information from the registrant's definitive proxy statement for its 2009 annual
meeting of stockholders, which is expected to be filed on or before April 30, 2009.
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|
|

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

|           |                                                                                                            |    | Page No.
|---------- | ---------------------------------------------------------------------------------------------------------- | -- | --------
|PART I     |                                                                                                            |    |         
|           |                                                                                                            |    |         
|Item 1.    | Business                                                                                                   |    | 3       
|Item 1A.   | Risk Factors                                                                                               |    | 12      
|Item 1B.   | Unresolved Staff Comments                                                                                  |    | 25      
|Item 2.    | Properties                                                                                                 |    | 25      
|Item 3.    | Legal Proceedings                                                                                          |    | 25      
|Item 4.    | Submission of Matters to a Vote of Security Holders                                                        |    | 27      
|           |                                                                                                            |    |         
|PART II   
|           |                                                                                                            |    |         
|Item 5.    | Market for Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Services |    | 27      
|Item 6.    | Selected Financial Data                                                                                    |    | 29      
|Item 7.    | Managements Discussion and Analysis of Financial Condition and Results of Operations                      |    | 30      
|Item 7A.   | Quantitative and Qualitative Disclosures About Market Risk                                                 |    | 45      
|Item 8.    | Financial Statements and Supplementary Data                                                                |    | 47      
|Item 9.    | Changes in and Disagreements with Accountants on Accounting and
         Financial Disclosures             |    | 79      
|Item 9A.   | Controls and Procedures                                                                                    |    | 79      
|Item 9B.   | Other Information                                                                                          |    | 82      
|           |                                                                                                            |    |         
|PART III  
|           |                                                                                                            |    |         
|Item 10.   | Directors and Executive Officers of the Registrant                                                         |    | 82      
|Item 11.   | Executive Compensation                                                                                     |    | 82      
|Item 12.   | Security Ownership of Certain Beneficial Owners and Management and Related
         Stockholder Matters    |    | 82      
|Item 13.   | Certain Relationships and Related Transactions                                                             |    | 82      
|Item 14.   | Principle Accountant Fees and Services                                                                     |    | 82      
|           |                                                                                                            |    |         
|PART IV   
|           |                                                                                                            |    |         
|Item 15.   | Exhibits and Financial Statement Schedules                                                                 |    | 82      
|           |                                                                                                            |    |         
|SIGNATURES |                                                                                                            | 89

|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  the development of our business over the past six 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 began shipping the Lux1064 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 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(TM)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 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
| |  |  |  | - |  | --------------------------------------------------------------------------------------------------------

| |  |  | 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.
| |  |  | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | o |  | 2008
we introduced and began shipping the Aspire body sculpting system and
SlimLipo handpiece for laser-assisted lipolysis
| |  |  | - |  | ----------------------------------------------------------------------------------------------------------------------------

|3
|-

| |  |  | o |  | 2008,
together with Massachusetts General Hospital and Reliant Technologies, Inc. (now Solta
Medical, Inc.), we announced               the formation of a Fractional Technology Open
Patent Program (F-TOPP) to offer licenses in the professional field to
              six key patent families in the fractional space.
| |  |  | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|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 |  | wrinkle
reduction
| |  |  | - |  | -----------------

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

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

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

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

| |  |  | o |  | body
sculpting.
| |  |  | - |  | ---------------

|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 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.




4






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. Subsequent to April 30, 2007, the contract was extended
on multiple occasions, the last of which was 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 three operating subsidiaries. Palomar Medical Products, Inc. is located at our
headquarters in Burlington, Massachusetts and oversees the development, 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. Palomar Medical Technologies (Australia) Pty Limited is located near
Sydney, Australia and oversees the sale and marketing of our products in Australia and New
Zealand as well as provides certain services of our products for those countries.



Market for Aesthetic
Procedures


The
downturn in the global economy in 2008 considerably affected the aesthetic laser industry.
A swift and severe decrease in revenue was seen across the sector in 2008 driven by the
inability of many prospective customers to obtain financing and prompting others to delay
their capital equipment purchases until economic conditions improve. In the ten years
prior to 2008, the market for light-based aesthetic procedures saw significant growth,
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


We
are responding to the current challenging economic times by taking actions to reduce our
cost structure to be more in line with current sales levels in all areas of the company,
including reductions in headcount and operating cost. We have built a diversified business
model that does not rely solely on high-priced capital equipment sales. These are volatile
economic times, but we feel confident that we have the resources needed to navigate
through them and continue as an industry leader.


With
our strong focus on both the professional and consumer markets, when the economy recovers,
we believe we will emerge as a stronger company positioned to continue capitalizing on the
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 the third quarter of
2008, we began shipping the new Aspire body sculpting system and SlimLipo handpiece. The
SlimLipo handpiece is our first minimally invasive product and provides laser-assisted
lipolysis during liposuction procedures. We have led the industry in offering platforms
that allow practitioners to grow their practice by adding new platforms and 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.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|5
|-

| | 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.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 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 regions. In 2008, we opened an office
located near Sydney, Australia which oversees the sale and marketing of our products in
Australia and New Zealand as well as provides certain services of our products for those
countries. On January 9, 2008, we announced our international distribution agreement with
the Swedish company Q-MED AB, the producer of Restylane. However, due to the downturn in
the world-wide economic environment, Q-MEDs efforts concentrated on their own
product line of dermal fillers. Both Palomar and Q-MED agreed that we would be better
served by separately continuing to expand our existing distribution channel. Palomar and
Q-MED mutually terminated the international distribution agreement on January 8, 2009 without any
financial penalty. We are currently in the process of working with current distributors
and seeking new distributors to improve our international sales and marketing efforts.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Driving Our Technology into the
Consumer Market. We direct significant resources toward driving our technology into
the mass consumer markets, including independently in our own research facility, with
Johnson & Johnson Consumer Companies, Inc. and, in the past, with 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
have licensed many companies to certain hair removal patents, several taking licenses
following our enforcement of the patents against them. We will continue to enforce these
hair removal patents. In the fractional technology area, we have begun our enforcement
efforts against Alma Lasers, Inc. In addition, in November 2008, together with
Massachusetts General Hospital and Reliant Technologies, Inc. (now Solta Medical, Inc.),
we announced the formation of a Fractional Technology Open Patent Program
(F-TOPP) to offer licenses in the professional field to six key patent
families in the fractional space. We have begun efforts to license the F-TOPP patent
families.


We
continue to review 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 |  | Body
sculpting, including laser-assisted liposuction
| |  |  | - |  | ----------------------------------------------------

|6
|-

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

| |  |  | o |  | Wrinkle
reduction
| |  |  | - |  | -----------------

| |  |  | 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, and
| |  |  | - |  | ----------------------------

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

|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® 300 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.


7






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 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.


Our
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.


Aspire.         In
April 2008, we launched the Aspire body sculpting system and           SlimLipo handpiece.
Shipments began in the third quarter of           2008. The SlimLipo handpiece is our
first minimally invasive product and           provides laser-assisted lipolysis during
liposuction procedures. The           SlimLipo handpiece is used to melt unwanted
fat           efficiently and effectively by selectively targeting adipose tissue. Our
          optimized wavelengths and unique tip design provide excellent results with
          minimal downtime for the patient. Laser-assisted lipolysis can provide skin
          tightening, smoother skin with less contour deformities, and faster treatments
          with small incisions, less bruising, reduced pain, and minimal blood loss and
          swelling. The SlimLipo handpiece also offers tremendous benefits to physicians,
          including less fatigue as the SlimLipo treatment tip moves easily through
          treatment areas  even fibrous tissue. Physicians can also treat patients
          in areas that are not normally treated with traditional liposuction, such as
          small areas and contour deformities. The SlimLipo handpiece features (i)
          continuous wave technology for superior control of thermal effects versus
competing           high peak power lasers, (ii) dual laser wavelengths of 924 nm and 975
nm for           optimized fat and dermal tissue lasing, (iii) interchangeable treatment
tip           designs for specific treatment areas, and (iv) an aiming beam for precise
          visualization of the treatment tip during treatment. The SlimLipo is
          significantly faster than competing laser-assisted lipolysis devices.


8






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,
South and Central America, the Far East, and the Middle East. As of December 31, 2008, we
utilized 37 distributors in 53 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. However, due to the downturn in the
world-wide economic environment, Q-MEDs efforts concentrated on their own product
line of dermal fillers. Both Palomar and Q-MED agreed that we would be better served by
separately continuing to expand our existing distribution channel. Palomar and Q-MED
mutually terminated the international distribution agreement on January 8, 2009 without any
financial penalty. We are currently in the process of working with current distributors
and seeking new distributors to improve our international sales and marketing efforts.


To
further improve our international sales and marketing efforts, in 2008, we opened a new
subsidiary in Australia. This location oversees the sale and marketing of our products in
Australia and New Zealand as well as provides certain services of our products for those
countries. In 2007, we opened a 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 for those regions.



9






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

|Year ended December 31,   | 2008 | 2007 | 2006
|------------------------- | ---- | ---- | ----
|North America             |      | 68   | %   
|Europe                    |      | 15   | %   
|South and Central America |      | 8    | %   
|Asia / Pacific Rim        |      | 5    | %   
|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, body sculpting, wrinkle reduction, 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 as well as 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 body sculpting, 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 three United States patents and the non-exclusive licensee of four 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. We also have rights to other patents under exclusive and non-exclusive
licenses. In November 2008, we entered into a Non-Exclusive Patent Cross-License Agreement
with Reliant Technologies, Inc. (now Solta Medical, Inc.) under which Reliant granted to
us non-exclusive licenses and other intellectual property rights to certain fractional
technology owned and licensed by Reliant. Similarly, we granted to Reliant non-exclusive
licenses and other intellectual property rights to certain of our fractional technology.
In addition to thelicense agreement, in November 2008, together with Massachusetts
General Hospital and Reliant, we announced the formation of a Fractional Technology Open
Patent Program (F-TOPP) to offer licenses to third parties in the professional
field to six key patent families in the fractional space.






10


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. (now Solta Medical, 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.





11



Number of Employees


As
of December 31, 2008, we employed 246 people. In January 2009, in response to the downturn
in the global economy, we reduced our work force to approximately 200 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.


Recent disruptions in the global
economy, the financial markets, currency markets and energy markets, as well as government
responses to these disruptions, may adversely impact our business and results of
operations.


Recent
distress in the financial markets has had an adverse impact on the availability of credit
and liquidity resources. Some of our customers may face issues gaining access to
sufficient credit, which could result in an impairment of their ability to make timely
payments to us. Lack of availability of consumer credit and the general economic downturn
could adversely impact the market in which we operate. As a result of recent fluctuations
in currency markets and the strong dollar relative to many other major currencies, our
products priced in United States dollars may be more expensive relative to products of our
foreign competitors, which could result in lower sales. In addition, the non-dollar
denominated earnings of our foreign operations may be lower when reported by us in
dollars. A slowdown in economic activity caused by a recession would likely reduce
worldwide demand for our products.


Our new Aspire System with
SlimLipo handpiece requires the use of consumable treatment tips and fiber delivery
assemblies. In the future, we may derive substantial revenue from sales of those
consumable components. These products were recently introduced and could fail to generate
significant revenue or achieve market acceptance.




12


In
April 2008, we launched the Aspire body sculpting system and SlimLipo handpiece. Shipments
began in the third quarter of 2008. The SlimLipo handpiece is our first minimally invasive
product and provides laser-assisted lipolysis during liposuction procedures. The SlimLipo
handpiece requires the use of consumable, single-use treatment tips and a limited-use
fiber delivery assembly. In the future, we could receive substantial revenue from sales of
the Aspire system with SlimLipo handpiece as well as the consumable components. Our future
success will depend on a number of factors, including our ability to increase and maintain
sales of the Aspire system with SlimLipo handpiece as well as the consumable components.
Several competing systems also require the use of consumable components, while others do
not or their consumable components allow for more usage before needing to be replaced.
Competing against such systems may be more difficult.


If third parties are able to
supply our customers with consumable treatment tips and fiber delivery assemblies for the
Aspire system with SlimLipo handpiece, our business could be adversely impacted.


Our
consumable treatment tips and fiber delivery assemblies are protected by an encryption
technology that is designed to authenticate that the tips are supplied by us or by a
supplier authorized by us. It is possible that a third party may be able to find methods
of circumventing our encryption technology and other technological barriers that we have
employed to ensure that only our tips are used with the Aspire system with SlimLipo
handpiece. If a third party is able to supply consumable treatment tips and fibers to our
customers, this could result in a reduction in the rate of sales and price of consumable
treatment tips and fiber delivery assemblies. It could also lead to a reduction in the
safety or efficacy of treatments performed with the Aspire system and SlimLipo handpiece
as we cannot control the quality of such third party products. This could damage the
Aspire brand and result in loss of confidence in our products.


We have limited experience
manufacturing the Aspire system, SlimLipo handpiece and consumable treatment tips and
fiber laser assemblies in commercial quantities, which could adversely impact our
business.


We
began manufacturing our Aspire system, SlimLipo handpiece and consumable treatment tips
and fiber delivery assemblies in during the second half of 2008. Because we have only
limited experience in manufacturing in commercial quantities, we may encounter unforeseen
situations that would result in delays or shortfalls. We face significant challenges and
risk in manufacturing the Aspire laser system, SlimLipo handpiece and consumable treatment
tips and fibers, including that production processes may have to change to accommodate any
significant future expansion of our manufacturing operations and growth; key components
are currently provided by a single supplier or limited number of suppliers, and we do not
maintain large inventory levels of these components; and we have limited experience
manufacturing the Aspire system, SlimLipo handpiece and consumable treatment tips and
fiber delivery assemblies in compliance with FDAs Quality System Regulation. If we
are unable to keep up with or generate demand for the Aspire system, SlimLipo handpiece
and consumable components, our revenue could be impaired, market acceptance for the Aspire
system, SlimLipo handpiece and consumable components could be adversely affected and our
customers might instead purchase competitors products.


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 treatments and products, prescription drugs and cosmetic topicals
and 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
therefrom 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.




13


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:
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------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-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | 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.





14






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.



15






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.


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. In
January 2008, we entered into an international distribution agreement with Q-MED AB and
began the process of evaluating a transition to Q-MED as our exclusive distributor outside
of North America. However, due to the downturn in the world-wide economic environment,
Palomar and Q-MED mutually terminated their international distribution agreement on
January 8, 2009. During this period, some of our existing distributors were disrupted. We
are in the process of working with existing distributors and seeking new distributors to
improve our international sales and marketing efforts. If this process is not
successful 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. We began working 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 some of our
distributors was disrupted. Due to the downturn in the world-wide economic environment,
Q-MED concentrated on their own product line of dermal fillers. Both Palomar and Q-MED
agreed that we would be better served by separately continuing to expand our existing
distribution channel. Palomar and Q-MED mutually terminated the international distribution
agreement on January 8, 2009. We are currently in the process of working with current
distributors and seeking new distributors to improve our international sales and marketing
efforts. If the current and new distributors do not commit the necessary resources to
effectively market and sell our products and collect receivables due for past sales, 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.


16

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.


We purchased land and began
construction of a new operational facility during the fourth quarter of 2008. We are in
the process of coordinating the transition from the current facility to the new facility.
During this process, our operations may be disrupted during the move to our new facility
and our business and operating results could be harmed.


In the fourth quarter of 2008, we closed on the purchase of land for $10.7 million and entered into a
construction management agreement for construction of a new operational facility on that land at a guaranteed
maximum price of $22.5 million.  We began construction in the fourth quarter. The lease for this facility was to
expire in August 2009.  However, we have negotiated a 12 month lease extension, expiring in August 2010, at an
increase over our current rate to coordinate the timing between the construction of our new facility and the
expiration of our current facility lease.   During
this time, we may incur many issues which would negatively affect our business and operating results, including:
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | o |  | higher
rental expenses after the lease on our current operational facility expires;
| |  |  | - |  | -----------------------------------------------------------------------------------

| |  |  | o |  | permitting
difficulties for our new operational facility;
| |  |  | - |  | ---------------------------------------------------------

| |  |  | o |  | construction
cost overruns; and
| |  |  | - |  | -------------------------------

| |  |  | o |  | disruption of operations during the move from our current facility
to our new operational facility.
| |  |  | - |  | ---------------------------------------------------------------------------------------------------

|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,
stock option grants, 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.

17






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.


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:
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | o |  | consumer
awareness of and demand for 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 short-term or long-term economic and other
conditions.
| |  |  | - |  | ----------------------------------------------------------------------------------------------------

|If
there is not sufficient demand for the procedures performed with our products, a weakening
in the economy, or other factors, practitioner demand for our products may be reduced or
buying decisions postponed, which would adversely affect our operating results.


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



18



We
have experienced rapid change in the scope of our operations and the industry in which we
operate. This change has placed significant demands on our management, as well as our
financial and operational resources. If we do not effectively manage the changing market
and its effect on our business, 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 change, we will need to continue to:
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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

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

| |  |  | o |  | change
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.


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 Syneron, Inc. 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 Part I, Item 3
Legal Proceedings.)



19






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.


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 one pending patent infringement lawsuit against us. (For more information
about our patent litigation, see Part I, Item 3 Legal Proceedings.) 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 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 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.


20

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.


Managing our relationships with
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 relationship with Johnson & Johnson Consumer Companies, Inc. and our
past relationship with The Gillette Company (now a wholly owned subsidiary of Procter
& Gamble Company) 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 term of
the agreements, both Johnson & Johnson and Procter & Gamble have the ability to
choose not to continue and may terminate the agreements.  If Johnson & Johnson or
Procter & Gamble should terminate their agreement with us, we will not receive certain
payments, and the price of our common stock could fall significantly. If Johnson &
Johnson should terminate their agreement with us, we may proceed to develop and
commercialize the devices on our own or with a third party. We are currently developing
devices on our own which may compete with products sold by Procter & Gamble. 
However, there can be no assurance that we will be able to successfully implement such a
strategy.  In addition, after commercialization of such devices, Johnson &
Johnson and Procter & Gamble 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. In
addition, a certain portion of the proceeds received on such sales may be owed to
Massachusetts General Hospital.  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.




21






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 200 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.


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 United States. 
International product revenue consists of sales from our foreign subsidiary, distributors
in Japan, Europe, Australia, Asia\Pacific Rim and South and Central America and sales
shipped directly to international locations from the United States. 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 are subject to fluctuations in
the exchange rate of the U.S. dollar and foreign currencies.


We
do not actively hedge our exposure to currency rate fluctuations. While we transact
business primarily in U.S. dollars, and a significant proportion of our revenue is
denominated in U.S. dollars, a portion of our costs and revenue is denominated in other
currencies, such as the Euro and Australian dollar. As a result, changes in the exchange
rates of these currencies to the U.S. dollar will affect our net income.








22


To successfully grow our
international presence, we must address many issues with which we have little or no
experience. We may not be able to properly manage our foreign subsidiaries which may have
an adverse effect on our business and operating results.


We
have two international subsidiaries which are located in The Netherlands and Australia. In
managing foreign operations, we must address many issues with which we have little or no
experience which exposes our business to additional risk. Our foreign operations redirect
managements time from other operating issues. We may not be successful in operating
our foreign subsidiaries. If we are unsuccessful in managing our foreign subsidiaries, the
foreign subsidiaries could be unprofitable and negatively impact our resources and
financial position.


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 incurred a loss in during 2008 and
have a history of losses. We may not be able to regain, sustain or increase profitability
on a quarterly or annual basis due to many factors including lower demand for our products
by practitioners, including practitioners postponing their buying decisions due to the
weakening economy, the tightening of the credit market, and other factors. 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 and market
value of our investments may decrease.


As
of December 31, 2008, we held approximately $4.5 million of auction-rate securities.
Recently, there have been disruptions in the market for auction-rate securities related to
liquidity which has caused substantially all auctions to fail. All of our securities held
as of December 31, 2008 failed in their last auction. We will not be able to access our
investments in ARS until future auctions are successful, ARS are called for redemption by
the issuers, or until we sell the securities in a secondary market. In the event that we
are unable to sell the underlying securities at or above par, these securities may not
provide us a liquid source of cash in the future. At December 31, 2008, due to the
uncertainty and illiquidity in this market, we have classified our auction-rate securities
as non-current assets and have recorded an unrealized loss of $588,000 in accumulated
other comprehensive (loss) income. The recovery of these investments is based upon market
factors which are not within our control. We will continue to evaluate whether the
impairment is temporary. We have both the intent and ability to hold the remaining
securities until either a market recovery, redemptions at par value, or maturity occurs.


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.


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.

23






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 agreement or poison pill. This is
intended to protect shareholders from unfair or coercive takeover practices. On October
28, 2008, we amended and restated the April 1999 shareholder rights agreement to (i)
extend the expiration date to October 28, 2018, (ii) increase the purchase price to
$200.00, (iii) amend the definition of Acquiring Person to exclude a
Person qualified to file Schedule 13G as provided in the definition, (iv)
amend the recitals to take account of the Recapitalization that occurred May
7, 1999, and (v) make any other additional changes deemed necessary. For more information,
please see the Amended and Restated Rights Agreement dated October 28, 2008 filed as an
exhibit to our Current Report on Form 8-K filed October 31, 2008.


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:
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | o |  | acceptance
and success of new products or technologies;
| |  |  | - |  | -------------------------------------------------------

| |  |  | 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.
| |  |  | - |  | -------------------------------------------------

|24


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 for this facility was to expire in
August 2009. However, we have negotiated a 12 month lease extension, expiring in August 2010, at an increase over
our current rate to coordinate the timing between the construction of our new facility and
the expiration of our current facility lease. We also lease a facility totaling
approximately 1,300 square feet of office and service space in Amsterdam, The Netherlands.
The lease expires in March 2009. We also lease approximately 1,700 square feet of office
and service space near Sydney, Australia. The lease expires in August 2009. We believe
that all facilities are in good condition and are suitable and adequate for our current
operations.


On
November 19, 2008, we purchased land in Burlington, Massachusetts for $10.7 million on
which we intend to build our new operational facility. Construction of the building is
expected to be completed during the first half of 2010.



Item 3. Legal Proceedings



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.


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.


On
November 17, 2008 the Judge stayed the lawsuit pending the outcome of reexamination
procedures requested by a third party on both U.S. Patent Nos. 5,735,844 and 5,595,568 in
the United States Patent and Trademark Office. Consequently, this lawsuit against Candela
will be delayed until the reexaminations are complete. On December 9, 2008, Candela also
filed requests for re-examination of both patents. Generally, a reexamination proceeding
is one which re-opens patent prosecution to ensure that the claims in an issued patent are
valid over prior art references. Requests for reexamination of patents are common and
granted by the Patent Office 92% of the time. The granting of a request for reexamination
does not indicate that the claims of the patents will be cancelled or altered in any way.
We will vigorously respond to the reexamination, including by citing all prior art which
Candela and others have relied upon in their contentions that the patents are not valid.
We believe that at the end of the process, it should be clear, as we and many of our
licensees have already concluded, that the patent claims are valid. However, the patent
office could disagree with us and find some or all of the claims invalid over prior art or
we may need to modify the claims as part of the reexamination process. In either event, it
is possible that Candelas products would no longer infringe the claims that result
from the reexamination process and this lawsuit would be terminated. In addition, the
products of our current licensees may no longer infringe the claims that result from the
reexamination process in which case the licensees would stop paying us royalties. While we
intend to vigorously respond to the reexamination procedures,
each reexamination is inherently uncertain and unpredictable as
to its ultimate outcome. An adverse outcome would materially hurt our
business, financial condition, results of operations and cash flows.


25






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.


In
February 2008, we filed a request for reexamination and then an amended request for
reexamination of Candelas 222 patent with the United States Patent and
Trademark Office (PTO). In our request, we argued that Candelas
222 patent is unpatentable over our own United States Patent No. 6,605,080 alone or
in combination with other prior art. About the same time, we filed a motion to stay all
proceedings in this action related to the 222 patent pending resolution of the
amended request for reexamination of the 222 patent. In March 2008, the PTO granted
our request for reexamination of the 222 patent. On June 11, 2008, the Court ordered
the parties to report back to the Court after the PTO makes its decision in the
reexamination of the 222 patent, after which a claim construction hearing (i.e., a
Markman Hearing) will be scheduled for both the 222 and 395 patents. On
June 12, 2008, the parties informed the Court that the total time the reexamination will
remain pending is not known. 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 alleged that our StarLux System with
the LuxY handpiece willfully infringed U.S. Patent No. 6,659,999 and that our StarLux
System with the Lux1540 handpiece willfully infringed related U.S. Patent Nos. 5,810,801
and 6,120,497. The three asserted patents are directed to wrinkle treatment. Candela
sought 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 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 300, StarLux 500, MediLux and EsteLux Systems of infringing the three
asserted patents. On June 20, 2008, Candela dropped its accusations against the LuxB
handpiece. A claim construction hearing, sometimes called a Markman Hearing,
was held November 13, 2007, and we received what we consider to be a favorable Markman
ruling on August 6, 2008. On September 22, 2008, Candela (i) dropped its accusations
against the LuxY, LuxYs, and LuxG handpieces, (ii) dropped two of its patents from the
lawsuit, specifically 6,120,497 and 6,659,999, and (iii) dropped from the lawsuit all
method claims in 5,810,801. Consequently, Candela went to trial on September 29, 2008
accusing only the Lux1540, Lux1540z, LuxIR and LuxDeepIR when used with the StarLux 500 or
300 of infringement of only claims 11-14 of 5,810,801. In addition, Candela significantly
reduced the amount of damages it was seeking. The trial ended on October 7, 2008 with a
jury verdict that none of the accused products infringe the asserted claims and that the
asserted claims were invalid over prior art for both anticipation and obviousness.
Following trial, Candela filed a Judgment as a Matter of Law motion with the Court in an
attempt to reverse the invalidity ruling. On December 30, 2008, the Court
entered final judgment in favor of Palomar.

26







Alma Lasers, Inc.,
Delaware Litigation


On
September 11, 2008, Alma Lasers, Inc. filed a complaint requesting a declaratory judgment
that our fractional patent, U.S. Patent No. 6,997,923, is not infringed by Almas
products and is invalid over prior art. Alma served this lawsuit on us on November 6,
2008, and on November 21, 2008, we filed an answer which denied Almas allegations
that the patent is invalid and not infringed. We also filed a counterclaim accusing
Almas Pixel C02 Omnifit Fractional C02 Handpiece and Pixel
C02 Fractional C02 Skin Resurfacing System of infringing the
patent. On December 16, 2008, upon the request of both parties, a mediation conference was
scheduled for June 30, 2009 before Magistrate Judge Mary Pat Thynge. On December 18, 2008,
upon the request of both parties, the Judge presiding over the lawsuit, stayed the lawsuit
and later closed the lawsuit pending the outcome of the mediation.



Syneron, Inc., Massachusetts Litigation

On November 14, 2008, we commenced an action for patent infringement against Syneron, Inc. in
the United States District Court for the District of Massachusetts seeking both monetary damages and
injunctive relief. The complaint alleges Synerons eLight, eMax, eLaser, Aurora DS, Polaris DS, Comet
and Galaxy Systems, which use light-based technology for hair removal, willfully infringe U.S. patent
Nos. 5,595,568 and 5,735,844, which are exclusively licensed to us by the Massachusetts General
Hospital.  In March 2009, we served Syneron with this suit.





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 2007 |         
|-------------------------------- | ---------------- | --------
|
|Quarter ended March 31, 2007     |                  | $     55
|Quarter ended June 30, 2007      |                  | 43      
|Quarter ended September 30, 2007 |                  | 39      
|Quarter ended December 31, 2007  |                  | 30      

|                                 | Fiscal Year 2008 |         
|-------------------------------- | ---------------- | --------
|
|Quarter ended March 31, 2008     |                  | $     15
|Quarter ended June 30, 2008      |                  | 15      
|Quarter ended September 30, 2008 |                  | 15      
|Quarter ended December 31, 2008  |                  | 13      

|As
of March 2, 2009, we had 3,028 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, 2008, we have
repurchased 640,500 shares of common stock at an average price of $14.03 per share. We
repurchased 535,500 shares during fiscal 2008. We may buy back additional shares of our
common stock on the open market from time to time.


27
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Period                                     | Total
number of
shares
purchased | Average
price paid
per share | Total number of
shares purchased
as part of
publicly
announced
program | Maximum number
of shares that
may yet be
purchased
under program
|------------------------------------------ | -------------------------------- | ---------------------------- | ---------------------------------------------------------------------- | ----------------------------------------------------------------
|October 1, 2008 through October 31, 2008   | --                               | $            --              | --                                                                     | 495,000                                                         
|November 1, 2008 through November 30, 2008 | 83,000                           | 10.60                        | 83,000                                                                 | 412,000                                                         
|December 1, 2008 through December 31, 2008 | 52,500                           | 8.88                         | 52,500                                                                 | 359,500                                                         
|                                           |                                  |                              |                                                                        |                                                                 
|Total                                      | 135,500                          | $       9.94                 | 135,500                                                                | 359,500                                                         
|                                           |                                  |                              |                                                                        |                                                                 

|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                             | $248 | $333 | $482 | $146 | $110 
|NASDAQ Stock Market Total Return   | $100                             | $109 | $111 | $122 | $132 | $  64
|NASDAQ Medical Devices Stocks      | $100                             | $117 | $129 | $136 | $172 | $  93

|* Hypothetical $100 invested on
December 31, 2003 in Palomar Medical Technologies, Inc. Stock, NASDAQ Stock Market Total
Return Index, and NASDAQ Medical Devices Stock Index, assuming reinvestment of dividends,
if any.


28


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                                      |                                  |  | $ | 69,379 |  
|Royalty revenues                                      |                                  |  |   | 10,520 |  
|Funded product development revenues                   |                                  |  |   | 2,434  |  
|Other revenues                                        |                                  |  |   | 5,248  |  
|                                                      |                                  |  |   |        |  
|Total revenues                                        |                                  |  |   | 87,581 |  
|                                                      |                                  |  |   |        |  
|Costs and expenses:                                   |                                  | 
|Cost of product revenues                              |                                  |  |   | 25,218 |  
|Cost of royalty revenues                              |                                  |  |   | 4,208  |  
|Research and development                              |                                  |  |   | 17,693 |  
|Selling and marketing                                 |                                  |  |   | 23,340 |  
|General and administrative                            |                                  |  |   | 20,516 |  
|                                                      |                                  |  |   |        |  
|Total cost and expenses                               |                                  |  |   | 90,975 |  
|                                                      |                                  |  |   |        |  
|                                                      |                                  |  |   |        |  
|(Loss) income from operations                         |                                  |  |   | (3,394 | )
|                                                      |                                  |  |   |        |  
|Interest income                                       |                                  |  |   | 3,653  |  
|Other (loss) income, net                              |                                  |  |   | (317   | )
|                                                      |                                  |  |   |        |  
|                                                      |                                  |  |   |        |  
|(Loss) income before income taxes                     |                                  |  |   | (58    | )
|Provision (benefit) for income taxes                  |                                  |  |   | 10     |  
|                                                      |                                  |  |   |        |  
|Net (loss) income                                     |                                  |  | $ | (68    | )
|                                                      |                                  |  |   |        |  
|Net income per common share:                          |                                  | 
|Basic                                                 |                                  |  | $ | --     |  
|                                                      |                                  |  |   |        |  
|Diluted                                               |                                  |  | $ | --     |  
|                                                      |                                  |  |   |        |  
|Weighted average number of common shares outstanding: |                                  | 
|Basic                                                 |                                  |  |   | 18,161 |  
|                                                      |                                  |  |   |        |  
|Diluted                                               |                                  |  |   | 18,161 |  
|                                                      |                                  |  |   |        |  
|                                                      |                                  |  |   |        |  

|                                                     | As of December 31, |  |   |         | 
|---------------------------------------------------- | ------------------ |  | - | ------- | 
|
|
|Consolidated Balance Sheet Data:                     |                    |  |   |         | 
|Cash and cash equivalents                            |                    |  | $ | 122,601 | 
|Available-for-sale investments, at fair market value |                    |  |   | --      | 
|Working capital                                      |                    |  |   | 130,901 | 
|Marketable securities, at fair value                 |                    |  |   | 4,487   | 
|Total assets                                         |                    |  |   | 171,722 | 
|Debt                                                 |                    |  |   | 6,000   | 
|Total stockholders' equity                           |                    |  |   | 146,805 | 

|29





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:
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | o |  | 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;
| |  |  | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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

| |  |  | o |  | 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.




30






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 Johnson &
Johnson, Procter & Gamble/Gillette, and the United States Department of the Army. For
both Johnson & Johnson and Gillette, we have received payments in accordance with the
work plans that were developed with both Johnson & Johnson and Gillette. 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
have provided 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 was a cost plus fee arrangement whereby we
were reimbursed for the expenses incurred in connection with PFB research plus an 8% fee.
Revenue was recognized under the contract as the costs were incurred and the services were
rendered. Our revenue from the contract is subject to government audit.


Investments.
          Investment securities, which primarily consist of state and municipal
          auction-rate securities and variable rate demand obligations, are classified as
          available-for-sale or marketable securities under
          provisions of Statement of Financial Accounting Standards No. 115, Accounting
          for Certain Investments in Debt and Equity Securities and are recorded at
          fair market value. We generally invest in short-term investments that are 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. We evaluate unrealized losses to determine if the
          loss is other-than-temporary. If an unrealized loss is deemed
          other-than-temporary, we record the loss in the statement of operations.


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 an additional
reserve for doubtful accounts based on the aging of our accounts receivable balances,
historical experiences of write-offs and defaults.



31



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.


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 either a one or three-year warranty for 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.


32



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; 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.


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.


Fair
Value Measurements.The performance of fair value measurements is an
integral part of the preparation of financial statements in accordance with generally
accepted accounting principles. Fair value is defined as the price that would be received
to sell the asset or paid to transfer the liability in an orderly transaction between
market participants to sell or transfer such an asset or liability. Selection of the
appropriate valuation technique, as well as determination of assumptions, risks and
estimates used by market participants in pricing the asset or liability requires
significant judgment. Although we believe that the inputs used in our valuation techniques
are reasonable, a change in one or more of the inputs could result in an increase or
decrease in the fair value of certain assets and certain liabilities and could have an
impact on both our Consolidated Balance Sheets and Consolidated Statements of Operations.


To
value our auction-rate securities, we determined the present value of the auction-rate
securities at the balance sheet date by discounting the estimated future cash flows based
on a fair value rate of interest and an expected time horizon to liquidity. As there is
currently no active market for these investments, their valuation required
managements judgment.


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 2008, we
incurred operating losses in foreign jurisdictions. We believe that it is more likely than
not that the associated tax asset will expire prior to utilization. Therefore, we have
established a full valuation allowance in 2008 against this deferred tax asset.


33



In
addition to the tax assets described above, we have deferred tax assets totaling $22
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 2008, 2007 and 2006, the impact to paid-in capital resulting from the exercise
of employee stock options was $1.8 million, $4.8 million and $1.2 million, 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.

Contingencies.
          In accordance with SFAS No. 5, Accounting for Contingencies, we accrue for all
          direct costs associated with the estimated resolution of contingencies at the
          earliest date at which it is deemed probable that a liability has been incurred
          and the amount of such liability can be reasonably estimated. At December 31,
          2008, we have not recorded any material loss contingencies.



Overview


We
are engaged in research, development, manufacturing and distribution of proprietary
light-based systems for medical and cosmetic treatments. Since our inception, we have been
able to develop a differentiated product mix of light-based systems for various 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 light-based treatments.


Our
total revenues for the year ended December 31, 2008, decreased by 29% as compared to the
same period in 2007. The factors driving this decrease were threefold: 1) a decline in
product revenues was the result of challenging economic conditions which have caused many
prospective customers to be unable to obtain financing and prompting others to delay their
capital equipment purchases until economic conditions improve; 2) a decline in royalty
revenues was due to a smaller back-owed royalties payment received of $0.7 million in 2008
as compared to $3.1 million in 2007 as well as our competitors being affected by the same
challenging economic conditions which have depressed their product revenue sales which
decreases the amount of royalties they owe us; and 3) a decline in funded product
development revenues occurred as since January 2008, we are no longer receiving such
payments from Procter & Gamble. Offsetting the decrease in product, royalty, and
funded product development revenues, other revenues increased by 487% as compared to the
same period in 2007 due to $5 million of technology transfer payments in 2008 from Procter
& Gamble.


Although
2008 was a very challenging year, we were able to maintain a strong balance sheet. As of
December 31, 2008, we had $122.6 million of cash and cash equivalents and $4.5 million in
marketable securities. As of December 31, 2007, we had $132.4 million of cash, cash
equivalents, and available-for-sale securities. Our stockholders equity increased
year over year. Our current ratio is 6.9x, down from 8.2x at the end of 2007. We had $6.0
million of short-term debt as of December 31, 2008. At December 31, 2007, we had no
borrowings.


Sales
from our Lux family of products weakened throughout 2008 due to the tightening of the
credit market and prospective customers delaying buying decisions due to the downturn of
the global economy. 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. During the third quarter of 2008, we began shipping our
latest technology platform, the Aspire body sculpting system coupled with the SlimLipo
handpiece. The SlimLipo handpiece is our first minimally invasive product designed to
provide laser-assisted lipolysis.


34


Results of operations



Year 2008 Compared to
Year 2007


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, 2008 and
2007 (in thousands, except for percentages):
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                    | 2008 | 2007 | 2008 vs. 2007 |        |   | 
|----------------------------------- | ---- | ---- | ------------- | ------ | - | 
|
|Revenues:                           |      |      |               |        |   | 
|Product revenues                    |      |      | $             | 69,379 |   | 
|Royalty revenues                    |      |      |               | 10,520 |   | 
|Funded product development revenues |      |      |               | 2,434  |   | 
|Other revenues                      |      |      |               | 5,248  |   | 
|                                    |      |      |               |        |   | 
|Total revenues                      |      |      |               | 87,581 |   | 
|                                    |      |      |               |        |   | 
|Cost and expenses:                  |      |     
|Cost of product revenues            |      |      |               | 25,218 |   | 
|Cost of royalty revenues            |      |      |               | 4,208  |   | 
|Research and development            |      |      |               | 17,693 |   | 
|Selling and marketing               |      |      |               | 23,340 |   | 
|General and administrative          |      |      |               | 20,516 |   | 
|                                    |      |      |               |        |   | 
|Total costs and expenses            |      |      |               | 90,975 |   | 
|                                    |      |      |               |        |   | 
|(Loss) income from operations       |      |      |               | (3,394 | ) | 
|Interest income                     |      |      |               | 3,653  |   | 
|Other (loss) income                 |      |      |               | (317   | ) | 
|                                    |      |      |               |        |   | 
|(Loss) income before income taxes   |      |      |               | (58    | ) | 
|Provision for income taxes          |      |      |               | 10     |   | 
|                                    |      |      |               |        |   | 
|Net (loss) income                   |      |      | $             | (68    | ) | 
|                                    |      |      |               |        |   | 

|Product
revenues. The downturn in the global economy in 2008 considerably affected
the aesthetic laser industry and our product revenues. A swift and severe decrease in
revenue was seen across the sector in 2008 driven by the inability of many prospective
customers to obtain financing and prompting others to delay their capital equipment
purchases until economic conditions improve. Sales of our StarLux Laser and Pulsed Light
Systems, including a base unit and multiple, optional handpieces were the leading
contributor to our product revenues. Product revenues were unfavorably impacted by a
decrease of 44% in sales related to the StarLux Laser and Pulsed Light System, a decrease
of 49% in revenue related to our other Lux family of products, which includes
the MediLux and EsteLux, a decrease of 61% from sales related to the Q-Yag 5 product line
as compared to the same period in 2007. In April 2008, we launched the Aspire body
sculpting system and SlimLipo handpiece. Shipments began in the third quarter of 2008. The
SlimLipo handpiece is our first minimally invasive product which was designed to provide
laser-assisted lipolysis during liposuction procedures. During the second half of 2008, we
recognized product revenue related to the Aspire system and SlimLipo handpiece. Customer
service increased by 26% as compared to the same period in 2007.


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 32% of total product revenue for the year ended 2008 in
comparison to 29% for the same period in 2007.


Royalty
revenues. Royalty revenues decreased during 2008 in comparison to the same
period in 2007, mainly due to the recognition of $3.1 million in back-owed royalties
received in 2007 offset by $0.7 million in back-owed royalties received in 2008. The
back-owed royalties in both years were from a patent settlement agreement executed in 2007
and these amounts were recognized as they became determinable based on the completion of
an audit by an independent accounting firm during the first quarter of 2008. Excluding
back-owed royalties in both periods, royalty revenues remained constant.





35






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 were determined based on an audit by an
independent accounting firm which was completed in the first quarter of 2008. We
recognized royalty revenue as amounts became 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 years ended December 31, 2008 and 2007, we recognized
$0.7 million and $3.1 million, respectively, for back-owed royalties from Alma.


Funded
product development revenues.Funded development revenue decreased during
2008 as compared to the same period in 2007. Funded product development revenue is
generated from the development agreements with Johnson & Johnson Consumer Companies,
Inc., Procter & Gamble (and its wholly owned subsidiary The Gillette Company), and the
United States Department of the Army.


During
2008, we recognized approximately $2.2 million and $0.2 million of funded product
development revenue from Johnson & Johnson and Procter & Gamble, respectively.
During 2007, we recognized approximately $2.5 million and $3.8 million of funded product
development revenue from Johnson & Johnson and Gillette, respectively. The decrease in
funded product development revenue from Johnson & Johnson during 2008 was the result
of the completion of several agreement amendments, offset by a new agreement amendment
which started in the third quarter of 2007. The decrease in funded product development
revenue from Gillette during 2008 was the result of the termination of the Development and
License Agreement with Gillette in 2008. In 2007, funded product development revenues
consisted 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 and 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
2008 and 2007, we recognized approximately $0 and $390,000, respectively, of funded
product development revenues from the United States Department of the Army. We provided
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 was a cost plus fee arrangement whereby we were reimbursed for the expenses
incurred in connection with PFB research plus an 8% fee. Revenue was recognized under the
contract as the costs were incurred and the services were rendered. The contract was
completed on March 31, 2008.


Other
revenues.Other revenues increased during 2008 as compared to the same
period in 2007. Other revenues of $5.2 million in 2008 consisted of four quarterly
payments of $1.25 million relating to a new License Agreement with The Procter &
Gamble Company and the recognition of the remaining portion of trade dress infringement
fees associated with the Alma Lasers, Ltd. settlement agreement. Other revenues of $894,000 in 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 decreased in absolute
dollars, but increased as a percentage of product revenues to 36% in 2008 from 32% in 2007
which includes a $1.7 million reduction related to royalties due to Massachusetts General
Hospital after finalizing licensing negotiations. Excluding the $1.7 million, the cost of
product revenues as a percentage of product revenues was 34% in 2007. The decrease in
absolute dollars was attributed to lower product revenues. The increase as a percentage of
product revenues is due to a shift in product sales to outside North America where we sell
our products at fixed transfer prices.

36






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, 2008 and 2007. The
decrease in the cost of royalty revenues in absolute dollars during 2008 as compared to
2007 is attributed to the decrease in royalty revenue recognized from our licensees,
mainly due to the change in back-owed royalties received in 2007 as compared to 2008.


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 our
continued commitment to introducing new platforms and enhancing our current family of
products, offset by reduced expenses related to the completion of research contract with
the United States Department of the Army and the termination of the Development and
License Agreement with Gillette both in 2008.


For
our Johnson & Johnson Joint Development and License Agreement, costs related to other
clinical, consulting and overhead expenses increased by $491,000, additional labor hours
worked increased by $342,000, and material costs decreased by $36,000 as compared to the
same period in 2007.


For
our Development and License Agreement with Gillette, costs decreased in 2008 by $1.9
million as compared to 2007 due to the termination of the Development and License
Agreement on February 29, 2008.


For
our Research Agreement with the United States Department of the Army, costs decreased in
2008 by $358,000 as compared to 2007 due to the completion of the Research Agreement on
March 31, 2008.


Expenses
relating to the introduction of new products, enhancements made to our current family of
products and research and development overhead increased by $868,000 in comparison to the
same period in 2007. This increase is attributed to increases in additional labor hours,
material costs, other clinical, consulting and overhead expenses.


For
the years ended December 31, 2008 and 2007, research and development expense included $2.8
million and $194,000, respectively of stock-based compensation expense.


Selling
and marketing expense. The decrease in selling and marketing expense is primarily
comprised of $2.2 million of commissions and $426,000 from consultants, offset by an
increase of $1.4 million from payroll and payroll related expenses of which $1.1 million
is due to higher stock-based compensation expense. Included in these expenses for 2008 is
approximately $1.1 million related to our two foreign subsidiaries.


General
and administrative expense. The increase in general and administrative
expense is mainly attributed to increases in our corporate legal expenses of $4.7 million
which excludes a $227,000 reimbursement (net of payments owed to the Massachusetts General
Hospital) from Alma in 2007 and payroll and payroll related expenses of $2.5 million as
well as a $843,000 decrease in allocated expenses. Offsetting these increases is a $4.0
million decrease in incentive compensation and a $1.6 million decrease in bad debt expense
in comparison to the same period in 2007.


For
the years ended December 31, 2008 and 2007, general and administrative expense included
$1.5 million and $99,000, respectively of stock-based compensation expense.


Interest
income. In comparison to the same period in 2007, interest income in 2008
decreased due to a reduction in our cash balances and lower interest rates, offset by
$52,000 (net of payments owed to the Massachusetts General Hospital) received related to
back-owed royalties from a new patent license agreement in 2007 under which we recognized
$259,000 (net of payments owed to the Massachusetts General Hospital) related to back-owed
royalties in 2007.


Other
income. Other income for the year ended December 31, 2008 includes the
foreign exchange loss as a result of transactions in currencies other than the U.S.
dollar. 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 as a
result of transactions in currencies other than the U.S. dollar.

37






Provision
for income taxes. The effective tax rate for the year ended December 31,
2008 was 17% as compared to an effective tax rate 38% for the year ended December 31,
2007. In 2008 and 2007, our effective tax rate was less than the combined federal and
state statutory rates primarily due to the benefit of research and development credits
generated. In addition, in 2008, our effective tax rate was impacted by the valuation
allowance we recorded related to foreign net operating losses. Although in 2008, we have
determined that a valuation allowance is not required with respect to our remaining
deferred tax assets of $5.3 million, their 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.



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, (in thousands, except for percentages):
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                     | 2007 | 2006 | 2007 vs. 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 and development             |      |      |               | 16,673  |  | 
|Selling and marketing                |      |      |               | 24,886  |  | 
|General and 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.

38






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.


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 were determined based on an audit by an
independent accounting firm which was completed in the first quarter of 2008. We
recognized royalty revenue as amounts became 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.

39






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.


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
provided 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 was a cost plus fee arrangement whereby we were reimbursed for the
expenses incurred in connection with PFB research plus an 8% fee. Revenue was recognized
under the contract as the costs were incurred and the services were 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.

40






For
our Development and License Agreement with Gillette, costs related to additional labor
hours 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 Johnson & Johnson Joint Development and License Agreement, costs related to
additional labor hours 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
labor hours 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.


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 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
loss as a result of transactions in currencies other than the U.S. dollar.


Provision
for (benefit from) income taxes. The effective tax rate for the year ended
December 31, 2007 was 38% as compared to a tax benefit rate 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.


41


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).
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                        |  |  | 2008 to 2007 |       
|------------------------------------------------------- |  |  | ------------ | ------
|
|Cash flows from operating activities                    |  |  | $            | 6,809 
|Cash flows from investing activities                    |  |  |              | 23,160
|Cash flows from financing activities                    |  |  |              | 2,172 
|Capital expenditures, including construction in process |  |  |              | 13,675

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

|                                                     |  |  | 2008 to 2007 |        
|---------------------------------------------------- |  |  | ------------ | -------
|
|Cash and cash equivalents                            |  |  | $            | 122,601
|Available-for-sale investments, at fair market value |  |  |              | --     
|Accounts receivable, net                             |  |  |              | 6,395  
|Inventories, net                                     |  |  |              | 16,046 
|Working capital                                      |  |  |              | 130,901
|Non-current marketable securities                    |  |  |              | 4,487  
|Debt                                                 |  |  |              | 6,000  

|As
of December 31, 2008, we had $123 million in cash and cash equivalents. 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, 2008, we had $6.0 million of
short-term debt outstanding under a $30 million revolving note agreement, which was repaid
on January 2, 2009.


At
December 31, 2008, we held $4.5 million in auction-rate securities (ARS). The ARS we
invest in are high quality securities, none of which are mortgage-backed. At December 31,
2007, because of the short-term nature of our investment in these securities, they were
classified as available-for-sale and included in short-term investments on our
consolidated balance sheets. Subsequent to December 31, 2007, our securities failed at
auction due to a decline in liquidity in the ARS and other capital markets. We will not be
able to access our investments in ARS until future auctions are successful, ARS are called
for redemption by the issuers, or until sold in a secondary market.  As our investments in ARS currently lack short-term liquidity, we have
reclassified these investments as non-current as of December 31, 2008. During fiscal 2008,
we sold $38.1 million of the ARS held at December 31, 2007.


We
have determined that the fair value of our ARS was temporarily impaired as of December 31,
2008. For the twelve months ended December 31, 2008, we marked to market our ARS and
recorded an unrealized loss of $588,000 in accumulated other comprehensive (loss) income
in stockholders equity to reflect the temporary impairment of our ARS. The recovery
of these investments is based upon market factors which are not within our control. We
have both the intent and ability to hold the remaining securities until either a market
recovery, redemptions at par value, or maturity occurs.



42






Cash
provided by operating activities decreased for the year ended December 31, 2008 compared
to the same period in 2007. This decrease primarily reflects the effects of a decrease in
net profit, an increase in working capital requirements, and a decrease in the provision
for bad debt, offset by an increase in FAS 123R stock-based compensation expense and a
decrease in tax benefits from stock option exercises. Cash from investing activities
decreased during 2008 compared to the same period in 2007. 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 year ended December 31, 2008 compared
to the same period in 2007. This decrease was primarily due to decreases in exercises
of stock options and tax benefits from the exercise of stock options and an increase in
buyback of treasury stock, offset by an increase in proceeds from borrowing.


In
December 2008, we secured access to a $30 million revolving note through December 17,
2013. Outstanding balances on the revolving note bear interest at a rate equal to the sum
of the LIBOR Advantage rate plus 0.75% per annum. At December 31, 2008, we had outstanding
debt of $6 million at an average interest rate of 1.22%. The interest expense was
capitalized into Property and Equipment on the consolidated balance sheets and was
immaterial for the year ended December 31, 2008. Any outstanding debt is due on December 17, 2013. On January 2, 2009, we repaid the $6
million and had no further debt outstanding.


Our
revolving note requires that we maintain certain financial covenants. In order to be in
compliance with the covenants, unencumbered cash and marketable securities less
outstanding debt must be greater than the credit limit. At December 31, 2008, we were in
compliance with the financial covenants. If we were to default on our debt, the building
would be used as collateral.


Excluding
the construction of our new operational facility, as discussed below, we anticipate that
capital expenditures for 2009 will total approximately $800,000 consisting primarily of
leasehold improvements, machinery, equipment, computers, and peripherals. We expect to
finance these expenditures with cash on hand.


On
November 19, 2008, we purchased land for $10.7 million on which we intend to build our new
operational facility. Construction of the building is expected to be completed during the
first half of 2010. We anticipate that capital expenditures related to the building for
2009 will be approximately $23 million. The total cost of the building (exclusive of land)  is expected to cost
approximately $25 million. We are financing this project by using cash on hand and drawing
down on our line of credit.


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,
2008, we used $6.0 million to purchase 535,500 shares of our common stock at an average
price of $11.15.



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, 2008, we were not involved in any unconsolidated
transactions.



Contractual obligations


We
are a party to three 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 a percentage of royalties received from third parties. Royalty
expense in 2008 totaled approximately $5.0 million.




43






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.  On July 30, 2007, we signed an amendment to our lease to add an additional 13,600 square feet.
The lease for this facility was to expire in August 2009.  However, we have negotiated a 12 month lease
extension, expiring in August 2010, at an increase over our current rate to coordinate the timing
between the construction of our new facility and the expiration of our current facility lease. Rent
expense, including these lease amendments, will total approximately $1.4 million per year.


The
following table summarizes our estimated contractual cash obligations as of December 31,
2008, excluding royalty and employment obligations because they are variable and/or
subject to uncertain timing (in thousands).
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                              |            | Payments due by period |                 |               |              
|----------------------------- | ---------- | ---------------------- | --------------- | ------------- | -------------
|
|Operating lease               | $    2,494 | $    1,410             | $        1,084  | $          -- | $          --
|Purchase commitments          | 3,721      | 3,721                  | --              | --            | --           
|Building commitments          | 23,207     | 23,207                 | --              | --            | --           
|                              |            |                        |                 |               |              
|Total contractual obligations | $29,422    | $28,338                | $         1,084 | $          -- | $          --
|                              |            |                        |                 |               |              

|Recently issued
accounting standards


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, which we
adopted on January 1, 2008.  In February 2008, the FASB issued FSP SFAS No. 157-2.
This FSP permits the delayed application of SFAS 157 for all non-recurring fair value
measurements of non-financial assets and non-financial liabilities until fiscal years
beginning after November 15, 2008. See Note 1 of our Notes to Consolidated Financial
Statements for the impact of adopting SFAS 157 for recurring fair value measurements of
financial assets.




In
February 2007, the FASB issued SFAS No. 159, Fair Value Option for Financial Assets and
Financial Liabilities. SFAS 159 provides entities with an option to report selected
financial assets and liabilities at fair value and establishes presentation and disclosure
requirements designed to facilitate comparisons between companies that select different
measurement attributes. SFAS 159 is effective for fiscal years beginning after November
15, 2007. We chose not to adopt SFAS 159 for the year ended December 31, 2008.


In
June 2007, the Emerging Issues Task Force (EITF) issued Issue No. 07-3,
Accounting for Nonrefundable Advance Payments for Goods or Services To Be Used in Future
Research and Development Activities(EITF 07-3) which concluded that
nonrefundable advance payments for goods or services to be received in the future for use
in research and development activities should be deferred and capitalized. The capitalized
amounts should be expensed as the related goods are delivered or services are performed.
Such capitalized amounts should be charged to expense if expectations change such that the
goods will not be delivered or services will not be performed. The provisions of EITF 07-3
are effective for new contracts entered into during fiscal years beginning after December
15, 2007. The consensus on EITF 07-3 may not be applied to earlier periods and early
adoption is not permitted.  We adopted EITF 07-3 on January 1, 2008. The
adoption of EITF 07-3 did not impact our consolidated financial statements for the year
ended December 31, 2008 nor do we currently expect an impact on our future consolidated
financial statements.


In
December 2007, the FASB ratified EITF Issue 07-1, Accounting for Collaborative
Arrangements, or EITF 07-1. EITF 07-1 focuses on defining a collaborative
arrangement as well as the accounting for transactions between participants in a
collaborative arrangement and between the participants in the arrangement and third
parties. The EITF concluded that both types of transactions should be reported in each
participants respective income statement. EITF 07-1 is effective for financial
statements issued for fiscal years beginning after December 15, 2008, and interim
periods within those fiscal years and should be applied retrospectively to all prior
periods presented for all collaborative arrangements existing as of the effective date. We
do not expect the adoption of EITF 07-1 to have an impact on our consolidated
financial statements.

44






In
May 2008, the FASB issued SFAS No. 162, The Hierarchy of Generally Accepted
Accounting Principles, or SFAS 162. SFAS 162 identifies the sources of
accounting principles to be used in the preparation of financial statements of
nongovernmental entities that are presented in conformity with generally accepted
accounting principles, or GAAP, in the U.S. SFAS 162 is effective 60 days
following the SEC approval of the Public Company Accounting Oversight Board amendments to
AU Section 411, The Meaning of Present Fairly in Conformity with Generally Accepted
Accounting Principles.We currently adhere to the hierarchy of GAAP as presented in
SFAS 162, and adoption is not expected to have a material impact on our consolidated
financial statements.


In
December 2007, the FASB issued Statement No. 141(R), Business Combinations, a replacement
for Statement No. 141. SFAS 141(R) retains the fundamental requirements of
SFAS 141, but requires the recognition of all assets acquired and liabilities
assumed in a business combination at their fair values as of the acquisition date. It also
requires the recognition of assets acquired and liabilities assumed arising from
contractual contingencies at their acquisition date fair values. Additionally, SFAS 141(R) supersedes FASB Interpretation No. 4, Applicability of FASB Statement No. 2 to
Business Combinations Accounted for by the Purchase Method, which required research and
development assets acquired in a business combination that had no alternative future use
to be measured at their fair values and expensed at the acquisition date. SFAS
141(R) now requires that purchased research and development be recognized as an intangible
asset. We are required to adopt SFAS 141(R) prospectively for any acquisitions on
or after January 1, 2009 and are currently evaluating the impact that SFAS 141(R)
will have, if any, on our consolidated financial statements.


In
December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated
Financial Statements, an amendment of Accounting Research Bulletin (ARB) No. 51. SFAS
 160 clarifies the classification of noncontrolling interests in consolidated
statements of financial position and the accounting for, and reporting of, transactions
between the reporting entity and holders of such noncontrolling interests. Under SFAS 160,
noncontrolling interests are considered equity and should be reported as an element of
consolidated equity. Net income will encompass the total income of all consolidated
subsidiaries, and there will be separate disclosure on the face of the statement of
operations of the attribution of that income between the controlling and noncontrolling
interests; increases and decreases in the noncontrolling ownership interest amount will be
accounted for as equity transactions. SFAS 160 is effective for the first annual reporting
period beginning on or after December 15, 2008, and earlier application is
prohibited. SFAS 160 is required to be adopted prospectively, except for reclassifying
noncontrolling interests to equity, separate from the parents shareholders
equity, in the consolidated balance sheets and recasting consolidated net income (loss) to
include net income (loss) attributable to both the controlling and noncontrolling
interests, both of which are required to be adopted retrospectively. As our subsidiaries
are 100% owned, we do not expect the adoption of SFAS  160 to have an impact on
our financial statements.



Item 7A. Quantitative
and Qualitative Disclosures About Market Risk


Market
risk is the potential loss arising from adverse changes in market rates and prices, such
as foreign currency exchange rates, interest rates and a decline in the stock market. The
current turbulence in the U.S. and global financial markets has caused a decline in stock
values across all industries. We are exposed to market risks related to changes in
interest rates and foreign currency exchange rates.


Our
investment portfolio of cash equivalents, corporate preferred securities, and municipal
debt securities is subject to interest rate fluctuations, but we believe this risk is
immaterial because of the historically short-term nature of these investments. At December
31, 2008, we held $4.5 million in auction-rate securities (ARS). The ARS we invest in are
high quality securities, none of which are mortgage-backed. At December 31, 2007, because
of the short-term nature of our investment in these securities, they were classified as
available-for-sale and included in short-term investments on our consolidated balance
sheets. Subsequent to December 31, 2007, our securities failed at auction due to a decline
in liquidity in the ARS and other capital markets. We will not be able to access our
investments in ARS until future auctions are successful, ARS are called for redemption by
the issuers, or until sold in a secondary market. As our investments in ARS currently lack
short-term liquidity, we have reclassified these investments as non-current as of December
31, 2008. During fiscal 2008, we sold $38.1 million of the ARS held at December 31, 2007.
The recovery of the remaining $4.5 million ARS held is based upon market factors which are
not within our control.




45






Our
international subsidiaries in The Netherlands and Australia conduct 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 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.
46




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                                         |  | 48  
| | Consolidated Balance Sheets - December 31, 2008 and 2007                                        |  | 49  
| | Consolidated Statements of Operations - Years ended December 31, 2008, 2007 and 2006            |  | 50  
| | Consolidated Statements of Stockholders' Equity - Years ended December 31, 2008, 2007, and 2006 |  | 51  
| | Consolidated Statements of Cash Flows - Years ended December 31, 2008, 2007 and 2006            |  | 52  
| | Notes to Consolidated Financial Statements                                                      |  | 53  

|47


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, 2008 and 2007, and the related consolidated statements of operations,
stockholders equity and cash flows for each of the three years in the period ended
December 31, 2008. 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,
2008 and 2007, and the consolidated results of their operations and their cash flows for
each of the three years in the period ended December 31, 2008, in conformity with U.S.
generally accepted accounting principles.


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, 2008, 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, 2009 expressed an
unqualified opinion thereon.
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                      |                      
|--------------------- | ---------------------
|                      | /s/ Ernst & Young LLP
|Boston, Massachusetts |                      
|March 4, 2009         |                      

|48

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

|                                                                                        | December 31,
2008 | December 31,
2007
|--------------------------------------------------------------------------------------- | ----------------- | -----------------
|Assets                                                                                  |                   |                  
|Assets:                                                                                 |                   |                  
|Cash and cash equivalents                                                               |                   |                  
|Available-for-sale investments, at fair market value                                    |                   |                  
|Accounts receivable, net of allowance of $1,235,005 and $1,470,360,        respectively |                   |                  
|Inventories                                                                             |                   |                  
|Deferred tax assets                                                                     |                   |                  
|Other current assets                                                                    |                   |                  
|                                                                                        |                   |                  
|Total current assets                                                                    |                   |                  
|                                                                                        |                   |                  
|Marketable securities, at fair value                                                    |                   |                  
|                                                                                        |                   |                  
|Property and equipment, net                                                             |                   |                  
|                                                                                        |                   |                  
|Other assets                                                                            |                   |                  
|                                                                                        |                   |                  
|Total assets                                                                            |                   |                  
|                                                                                        |                   |                  
|Liabilities and Stockholders' Equity                                                    |                   |                  
|Liabilities:                                                                            |                   |                  
|Notes payable                                                                           |                   |                  
|Accounts payable                                                                        |                   |                  
|Accrued liabilities                                                                     |                   |                  
|Deferred revenue                                                                        |                   |                  
|                                                                                        |                   |                  
|Total current liabilities                                                               |                   |                  
|                                                                                        |                   |                  
|Deferred income taxes                                                                   |                   |                  
|                                                                                        |                   |                  
|Total liabilities                                                                       |                   |                  
|                                                                                        |                   |                  
|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 - 18,479,345 and 18,442,846 shares, respectively                                 |                   |                  
|Additional paid-in capital                                                              |                   |                  
|Accumulated other comprehensive (loss) income                                           |                   |                  
|Accumulated deficit                                                                     |                   |                  
|Treasury stock, at cost - 413,255 and 105,000 shares, respectively                      |                   |                  
|                                                                                        |                   |                  
|Total stockholders' equity                                                              |                   |                  
|                                                                                        |                   |                  
|Total liabilities and stockholders equity                                              |                   |                  
|                                                                                        |                   |                  

|See accompanying notes to
consolidated financial statements.

49






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

|                                               | 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                       |                          |  |  
|                                               |                          |  |  
|                                               |                          |  |  
|(Loss) income from operations                  |                          |  |  
|                                               |                          |  |  
|Interest income                                |                          |  |  
|Other (loss) income                            |                          |  |  
|                                               |                          |  |  
|(Loss) income before income taxes              |                          |  |  
|                                               |                          |  |  
|Provision for (benefit from) income taxes      |                          |  |  
|                                               |                          |  |  
|Net (loss) income                              |                          |  | $
|                                               |                          |  |  
|                                               |                          |  |  
|Net (loss) income per share:                   |                          | 
|Basic                                          |                          |  | $
|                                               |                          |  |  
|Diluted                                        |                          |  | $
|                                               |                          |  |  
|Weighted average number of shares outstanding: |                          | 
|Basic                                          |                          |  |  
|                                               |                          |  |  
|Diluted                                        |                          |  |  
|                                               |                          |  |  
|Comprehensive (loss) income:                   |                          | 
|Net (loss) income                              |                          |  | $
|Unrealized loss on auction-rate securities     |                          |  |  
|Currency translation adjustment                |                          |  |  
|                                               |                          |  |  
|Comprehensive (loss) income                    |                          |  | $
|                                               |                          |  |  
|                                               |                          |  |  

|See accompanying notes to
consolidated financial statements.

50



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

|                                                                  | Common Stock |  |  |            |  |   |        
|----------------------------------------------------------------- | ------------ |  |  | ---------- |  | - | -------
|
|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
|                                                                  |              |  |  |            |  |   |        
|                                                                  |              |  |  |            |  |   |        
|Net loss                                                          |              |  |  | --         |  |   | --     
|Issuance of stock for employer 401(k)       matching contribution |              |  |  | --         |  |   | --     
|Costs incurred related to the issuance       of common stock      |              |  |  | --         |  |   | --     
|Tax benefit from the exercise of stock       options              |              |  |  | --         |  |   | --     
|Exercise of stock options and warrants                            |              |  |  | 36,499     |  |   | 365    
|Stock-based compensation expense                                  |              |  |  | --         |  |   | --     
|Unrealized loss on marketable securities                          |              |  |  | --         |  |   | --     
|Currency translation adjustment                                   |              |  |  | --         |  |   | --     
|Treasury stock buyback                                            |              |  |  | --         |  |   | --     
|                                                                  |              |  |  |            |  |   |        
|Balance, December 31, 2008                                        |              |  |  | 18,479,345 |  | $ | 184,794
|                                                                  |              |  |  |            |  |   |        
|                                                                  |              |  |  |            |  |   |        

|See
accompanying notes to consolidated financial statements.

51


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

|                                                                                               | 2008 | 2007 | 2006
|---------------------------------------------------------------------------------------------- | ---- | ---- | ----
|Operating activities:                                                                          |      |      |     
|Net (loss) income                                                                              |      |      | $   
|Adjustments to reconcile net (loss) 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                                                 |      |      |     
|Change in deferred tax asset                                                                   |      |      |     
|Other non-cash items                                                                           |      |      |     
|Changes in assets and liabilities:                                                             |      |     
|Accounts receivable                                                                            |      |      |     
|Inventories                                                                                    |      |      |     
|Deferred tax assets                                                                            |      |      |     
|Other current assets                                                                           |      |      |     
|Other assets                                                                                   |      |      |     
|Accounts payable                                                                               |      |      |     
|Accrued liabilities                                                                            |      |      |     
|Deferred revenue                                                                               |      |      |     
|                                                                                               |      |      |     
|Net cash from operating activities                                                             |      |      |     
|                                                                                               |      |      |     
|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                                                   |      |      |     
|                                                                                               |      |      |     
|Financing activities:                                                                          |      |     
|Proceeds from the exercise of stock options and warrants                                       |      |      |     
|Tax benefit from the exercise of stock options and warrants                                    |      |      |     
|Costs incurred related to issuance of common stock                                             |      |      |     
|Costs incurred related to purchase of stock for treasury                                       |      |      |     
|Proceeds from short-term borrowings on credit facilities                                       |      |      |     
|                                                                                               |      |      |     
|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.

52







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 medical and 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.



Marketable Securities


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 market
value. We generally invest in short-term investments that are 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. We evaluate
unrealized losses to determine if the loss is other-than-temporary. If an unrealized loss
is deemed other-than-temporary, we record the loss in the statement of operations.
Substantially all of our short-term investments have contractual maturities of twelve
months or less. Because of the short term to maturity, amortized cost approximates fair
market value for all of these securities. Unrealized gains and losses at December 31, 2007
were not material.




53


Our
available-for-sale investments are comprised of auction-rate securities (ARS). Our
holdings of ARS for the year ended December 31, 2007 were $41.9 million. The ARS we invest
in are high quality securities, none which are mortgaged-backed. At December 31, 2007,
because of the short-term nature of our investment in these securities, they were
classified as available-for-sale and included in short-term investments on our
consolidated balance sheets.


Subsequent
to December 31, 2007, several of our ARS failed at auction due to a decline in liquidity
in the ARS and other capital markets. In the year ended December 31, 2008, we sold $38.1
million of the ARS held at December 31, 2007. Our holdings of ARS at December 31, 2008
were $4.5 million. We will not be able to access our investments in ARS until future
auctions are successful, ARS are called for redemption by the issuers, or until sold in a
secondary market. As our investments in ARS currently lack short-term liquidity, we have
reclassified these investments as non-current marketable securities as of December 31,
2008.


To
value our ARS, we determined the present value of the ARS at the balance sheet date by
discounting the estimated future cash flows based on a fair value rate of interest and an
expected time horizon to liquidity. We have determined that the fair value of our ARS was
temporarily impaired as of December 31, 2008. For the year ended December 31, 2008, we
marked to market our ARS and recorded an unrealized loss of $588,000 in accumulated other
comprehensive (loss) income in stockholders equity to reflect the temporary
impairment of our ARS. The recovery of these investments is based upon market factors
which are not within our control. We have both the intent and ability to hold the
remaining securities until either a market recovery, redemptions at par value, or maturity
occurs.



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, 2008, 2007 and 2006, respectively.
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|At December 31,              | 2008 | 2007 | 2006
|---------------------------- | ---- | ---- | ----
|Balance at beginning of year |      |      | $   
|Additions                    |      |      |     
|Deductions                   |      |      |     
|                             |      |      |     
|Balance at end of year       |      |      | $   
|                             |      |      |     

|54


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, 2008 and 2007, inventories
consisted of the following:
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|At December 31, | 2008         | 2007        
|--------------- | ------------ | ------------
|Raw materials   | $  7,757,417 | $  5,541,725
|Work in process | 1,517,400    | 1,383,689   
|Finished goods  | 6,770,908    | 5,970,740   
|                |              |             
|                | $16,045,725  | $12,896,154 
|                |              |             
|               

|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 $1.6 million in 2008 and $1.6 million in 2007 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.



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, 2008 and 2007,
property and equipment consist of the following:
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|At December 31,               | 2008        | 2007              | Estimated
Useful Life                            
|----------------------------- | ----------- | ----------------- | -------------------------------------------------
|Land                          | $10,680,000 | $              -- |                                                  
|Machinery and equipment       | 2,100,331   | 1,902,425         | 3 - 8 years                                      
|Furniture and fixtures        | 3,248,093   | 2,956,610         | 5 years                                          
|Leasehold improvements        | 537,648     | 517,673           | Shorter of estimated useful life or term of lease
|Construction in progress      | 2,485,864   | --               
|                              |             |                   |                                                  
|                              | 19,051,936  | 5,376,708        
|Less accumulated depreciation | 4,826,539   | 4,126,271        
|                              |             |                   |                                                  
|Total                         | $14,225,397 | $  1,250,437     
|                              |             |                   |                                                  

|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.




55



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 Johnson & Johnson and Procter &
Gamble/Gillette in accordance with the work plan that was developed with both Johnson
& Johnson and Procter & Gamble/Gillette. 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 Johnson & Johnson or Procter & Gamble/Gillette
are recorded as deferred revenue.As of December 31, 2008, we have deferred
$726,000 and $0 relating to Johnson & Johnson and Gillette, respectively.Payments are not refundable if the development is not successful. During 2008, we
recognized approximately $2.2 million and $216,000 of funded product development revenue
from Johnson & Johnson and Procter & Gamble/Gillette, respectively. During 2007,
we recognized approximately $2.5 million and $3.8 million of funded product development
revenue from Johnson & Johnson and Procter & Gamble/Gillette, respectively. During
2006, we recognized approximately $1.5 million and $1.1 million of funded product
development revenue from Johnson & Johnson and Gillette, respectively.


We
provided 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 was a cost plus fee arrangement whereby we were reimbursed for the
expenses incurred in connection with PFB research plus an 8% fee. Revenue was recognized
under the contract as the costs were incurred and the services were rendered. Our revenue
from the contract is subject to government audit. During the years ended December 31,
2008, 2007 and 2006, we recognized approximately $0, $388,000 and $1.3 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$244,000, $291,000 and $304,000 of reimbursed
shipping and handling costs during the years ended December 31, 2008, 2007 and 2006,
respectively.



Product Warranty Costs


We
typically offer a one or three-year warranty for 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.




56


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, 2008 and 2007.
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|At December 31,                                     | 2008         | 2007       
|--------------------------------------------------- | ------------ | -----------
|Warranty accrual, beginning of year                 | $ 1,051,432  | $ 1,120,420
|Charged to costs and expenses relating to new sales | 1,822,196    | 2,144,463  
|Costs of product warranty claims                    | (2,017,470)  | (2,213,451)
|                                                    |              |            
|Warranty accrual, end of year                       | $    856,158 | $ 1,051,432
|                                                    |              |            

|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, 2008, 2007 and 2006, were $557,000,
$473,000 and $485,000, respectively.



Net (Loss) Income per
Common Share


Basic
net (loss) income per share was determined by dividing net (loss) income by the weighted
average common shares outstanding during the period. Diluted net (loss) income per share
was determined by dividing net (loss) 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,                                                      | 2008       | 2007       | 2006      
|-------------------------------------------------------------------- | ---------- | ---------- | ----------
|Basic weighted average common shares outstanding                     | 18,160,700 | 18,277,324 | 17,519,242
|Potential common shares pursuant to stock options, SARs and warrants | --         | 976,699    | 2,689,445 
|                                                                     |            |            |           
|Diluted weighted average common shares outstanding                   | 18,160,700 | 19,254,023 | 20,208,687
|                                                                     |            |            |           

|For
the year ended December 31, 2008, 3.8 million weighted average stock options,
stock-settled stock appreciation rights, and warrants to purchase shares of our common
stock were excluded from the computation of diluted earnings per share because the effect
of including the options would have been antidilutive. For the years ended December 31,
2007 and 2006, all potential shares related to outstanding common stock options,
stock-settled 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.





57






Our
loss before taxes and net loss was $5.9 million higher for the twelve month period ended
December 31, 2008 due to the recognition of stock-based compensation expense as a result
of the adoption of SFAS 123(R). Our income before taxes and net income was $0.5 million
and $0.5 million 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 years ended December 31, 2008 and 2007, the
compensation expense reduced basic and diluted earnings per share by $0.33 and $0.03,
respectively. 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, 2008,
there was $8.4 million of unrecognized compensation expense related to non-vested share
awards. The expense is expected to be recognized over a weighted-average period of 2.8
years.


During
the years ended December 31, 2008 and 2007, 350,000 and 482,500, respectively,
stock-settled stock appreciation rights 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.


We
granted 1,440,000 performance based stock options in 2004 to employees and directors with
exercise prices equal to the fair market value of our common stock 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 as defined under the original
Development and License Agreement, and the remaining 625,000 of these options would vest
twelve months after the Launch Decision. On February 29, 2008, we entered into a new
License Agreement, to replace the existing one, with The Procter and Gamble Company
(P&G), Gillettes parent 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. 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 compensation expense was never incurred.


On
February 29, 2008, we granted 1,315,000 stock options to employees and directors with
exercise prices equal to the fair market value of our common stock 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. On May 14, 2008, 472,734 unvested incentive stock options
(ISO) granted on February 29, 2008 were modified for non-qualified option
(NQ) treatment. These modified NQs have the same terms and conditions as the
ISOs granted on February 29, 2008. There was no additional compensation expense created by
the modification. We expect our stock-based compensation expense related to these options
to be approximately $160,000 a quarter through February 27, 2011.


There
were no options, warrants or SARs granted during the year ended December 31, 2006.


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 award term, the expected volatility
of our stock over the awards expected term, the risk-free interest rate over the
awards expected term, and our expected annual dividend yield. Expected volatilities
are based on historical volatilities of our common stock; the expected life represents the
weighted average period of time that awards granted are expected to be outstanding giving
consideration to vesting schedules and our historical exercise and forfeiture 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 award was estimated on the grant date using the Black-Scholes option-pricing
model with the following weighted-average assumptions:


58
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Year ended December 31,                               | 2008         | 2007        | 2006
|----------------------------------------------------- | ------------ | ----------- | ----
|Risk-free interest rate                               | 2.05%        | 4.21%       | N/A 
|Expected dividend yield                               | --           | --          | N/A 
|Expected lives                                        | 3 years      | 3 years     | N/A 
|Expected volatility                                   | 44%          | 47%         | N/A 
|Grant date fair value of awards granted during period | $       4.32 | $     17.29 | N/A 

|Based
on our historical turnover rates, we assumed an annual estimated forfeiture rate of 5%
when we calculated the estimated compensation cost for the year ended December 31, 2008. A
recovery of prior expense will be recorded if the actual forfeitures are higher than
estimated and vice versa. Ultimately, we will only recognize compensation expense for
those awards that actually vest, consistent with SFAS 123(R). 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, marketable
securities, and accounts receivable. We place cash and cash equivalents and marketable
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 or customer group. 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.



Contingencies


In
accordance with SFAS No. 5, Accounting for Contingencies, we accrue for all direct costs
associated with the estimated resolution of contingencies at the earliest date at which it
is deemed probable that a liability has been incurred and the amount of such liability can
be reasonably estimated. At December 31, 2008, we have not recorded any material loss contingencies.



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. In
September 2006, the Financial Accounting Standards Board issued Statement on Financial
Accounting Standards No. 157, Fair Value Measurements (SFAS 157). This
standard establishes a single authoritative definition of fair value, sets out a framework
for measuring fair value and requires additional disclosures about fair value
measurements. SFAS 157 applies to fair value measurements already required or
permitted by existing standards. SFAS 157 is effective for financial statements
issued for fiscal years beginning after November 15, 2007 and interim periods within
those fiscal years.


At
December 31, 2008 and 2007, financial instruments consisted of cash, cash equivalents, and
marketable securities. Fair values have been determined through information obtained from
market sources and management estimates.





59






As
of January 1, 2008, we adopted SFAS 157. We performed an analysis of our investments held
at December 31, 2008 to determine the significance and character of all inputs to their
fair value determination. The adoption of the standard requires additional disclosures
about the inputs used to develop the measurements and the effect of certain measurements
on changes in fair value for each reporting period.


SFAS 157
establishes a fair value hierarchy that prioritizes the inputs to valuation techniques
used to measure fair value into the following three broad categories.
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | o |  | Level
1  Inputs are unadjusted, quoted prices in active markets for identical assets or
liabilities at the measurement date.
| |  |  | - |  | -----------------------------------------------------------------------------------------------------------------------------

| |  |  | o |  | Level
2  Inputs (other than quoted prices included in Level 1) are either directly or
indirectly observable for the asset or liability through correlation with market data at
the measurement date and for the duration of the instruments anticipated life.
| |  |  | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | o |  | Level
3  Inputs reflect managements best estimate of what market participants would
use in pricing the asset or liability at the measurement date. Consideration is given to
the risk inherent in the valuation technique and the risk inherent in the inputs to the
model.
| |  |  | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Assets
and liabilities measured at fair value on a recurring basis are categorized in the tables
below based upon the lowest level of significant input to the valuations. The following
table presents our assets measured at fair value on a recurring basis as of December 31,
2008 and December 31, 2007.
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Assets                            | Fair Value as of December 31, 2008 |                       |                    |                     
|--------------------------------- | ---------------------------------- | --------------------- | ------------------ | --------------------
|
|Auction-rate preferred securities | $                    -             | $                -    | $            3,166 | $              3,166
|Auction-rate municipal securities | -                                  | -                     | 1,321              | 1,321               
|                                  |                                    |                       |                    |                     
|Total                             | $                   -              | $                   - | $            4,487 | $            4,487  
|                                  |                                    |                       |                    |                     

|Assets                            | Fair Value as of December 31, 2007 |                       |                |                      
|--------------------------------- | ---------------------------------- | --------------------- | -------------- | ---------------------
|
|Auction-rate preferred securities | $                  16,850          | $                -    | $            - | $              16,850
|Auction-rate municipal securities | 25,060                             | -                     | -              | 25,060               
|                                  |                                    |                       |                |                      
|Total                             | $                  41,910          | $                   - | $            - | $            41,910  
|                                  |                                    |                       |                |                      

|The
table presented below summarizes the change in balance sheet carrying values associated
with Level 3 financial instruments for the year ended December 31, 2008.
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(In thousands)                    | Auction-rate
preferred securities | Auction-rate
municipal securities | Total
|--------------------------------- | --------------------------------- | --------------------------------- | -----
|Balance at December 31, 2007      |                                   |                                   | $    
|                                  |                                   |                                   |      
|Net transfers in/(out)            |                                   |                                   |      
|Net payments, purchases and sales |                                   |                                   |      
|Gains/(losses)                    |                                   |                                  
|Realized                          |                                   |                                   |      
|Unrealized                        |                                   |                                   |      
|                                  |                                   |                                   |      
|Balance at December 31, 2008      |                                   |                                   | $    
|                                  |                                   |                                   |      
|                                  |                                   |                                  

|Historically,
the ARS market was an active and liquid market where we could purchase and sell our ARS on
a regular basis through auctions. As such, we classified our ARS has Level 1 investments
in accordance with SFAS 157 at December 31, 2007. Subsequent to December 31, 2007, several
of our ARS failed at auction due to a decline in liquidity in the ARS and other capital
markets. At December 31, 2007, because of the short-term nature of our investment in these
securities, they were classified as available-for-sale and included in short-term
investments on our consolidated balance sheets. We will not be able to access our
investments in ARS until future auctions are successful, ARS are called for redemption by
the issuers, or until sold in a secondary market. As our investments in ARS currently lack
short-term liquidity, we have reclassified these investments as non-current marketable
securities as of December 31, 2008.








60


Our
holdings of ARS at December 31, 2008 were $4.5 million. To value our ARS, we determined
the present value of the ARS at the balance sheet date by discounting the estimated future
cash flows based on a fair value rate of interest and an expected time horizon to
liquidity. As a result of our valuation analysis, we have determined that the fair value
of our ARS was temporarily impaired as of December 31, 2008. For the year ended December
31, 2008, we marked to market our ARS and recorded an unrealized loss of $588,000 in
accumulated other comprehensive (loss) income in stockholders equity to reflect the
temporary impairment of our ARS.


We
regularly review the status of the ARS market, including factors which affect future
liquidity and the significance and character of all inputs used in their fair value
determination. During the period in which there is reliable data which indicates that the
ARS valuation inputs significance and character has changed, we will transfer the
ARS into the appropriate level under SFAS 157. In early 2008, after the ARS market became
illiquid, we transferred our ARS from Level 1 to Level 3 investments. At the time of the
transfer, there was no realized or unrealized gain or loss recognized on our consolidated
statements of operations. Subsequent to the transfer to Level 3, we have determined that
the fair value of our ARS was temporarily impaired as of December 31, 2008. The recovery
of these investments is based upon market factors which are not within our control.


We
continue to monitor the market for ARS and consider its impact, if any, on the fair value
of our investments. If current market conditions deteriorate further, we may be required
to record additional unrealized losses in accumulated other comprehensive (loss) income.
If the credit rating of the security issuers deteriorates, or the anticipated recovery in
market values does not occur, we may be required to adjust the carrying value of these
investments through impairment charges in our Consolidated Statements of Operations.
However, at this time, we believe that the ARS will recover their full par value either
through successful future auctions, redemptions by the issuers, or an active secondary
market. During the year ended December 31, 2008, we sold $38.1 million of the ARS held at
December 31, 2007. As we have been able to redeem a majority of our securities held in
2008 for par value and as we have both the intent and ability to hold the remaining
securities until either a market recovery, redemptions at par value, or maturity occurs,
we believe that these securities are not other-than-temporarily impaired.



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 subsidiaries 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. For the year ended December 31, 2008,
we recognized a foreign currency transaction loss of $317,000 which was included in other
income (expense). Foreign currency transaction gains or losses were not material for the
years ended December 31, 2007 and 2006.



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.


In
June 2006, the Financial Accounting Standards Board issued FASB Interpretation No. 48,
Accounting for Uncertainty in Income Taxes (an interpretation of FASB Statement No. 109),
(FIN 48).  FIN 48 clarifies the criteria that an individual tax position must
satisfy for some or all of the benefits of that position to be recognized in a
companys financial statements.  FIN 48 prescribes a recognition threshold
of more-likely-than-not and a measurement attribute for all tax positions
taken or expected to be taken on a tax return in order for those tax positions to be
recognized in the financial statements.  We adopted the provisions of FIN 48
effective January 1, 2007.  The adoption of this standard did not have a
material impact on our financial statements.
61







Recently issued
accounting standards


In
February 2007, the FASB issued SFAS No. 159, Fair Value Option for Financial Assets and
Financial Liabilities. SFAS 159 provides entities with an option to report selected
financial assets and liabilities at fair value and establishes presentation and disclosure
requirements designed to facilitate comparisons between companies that select different
measurement attributes. SFAS 159 is effective for fiscal years beginning after November
15, 2007. We chose not to adopt SFAS 159 for the year ended December 31, 2008.


In
June 2007, the Emerging Issues Task Force (EITF) issued Issue No. 07-3,
Accounting for Nonrefundable Advance Payments for Goods or Services To Be Used in Future
Research and Development Activities(EITF 07-3) which concluded that
nonrefundable advance payments for goods or services to be received in the future for use
in research and development activities should be deferred and capitalized. The capitalized
amounts should be expensed as the related goods are delivered or services are performed.
Such capitalized amounts should be charged to expense if expectations change such that the
goods will not be delivered or services will not be performed. The provisions of EITF 07-3
are effective for new contracts entered into during fiscal years beginning after December
15, 2007. The consensus on EITF 07-3 may not be applied to earlier periods and early
adoption is not permitted.  We adopted EITF 07-3 on January 1, 2008. The
adoption of EITF 07-3 did not impact our consolidated financial statements for the year
ended December 31, 2008 nor do we currently expect an impact on our future consolidated
financial statements.


In
December 2007, the FASB ratified EITF Issue 07-1, Accounting for Collaborative
Arrangements, or EITF 07-1. EITF 07-1 focuses on defining a collaborative
arrangement as well as the accounting for transactions between participants in a
collaborative arrangement and between the participants in the arrangement and third
parties. The EITF concluded that both types of transactions should be reported in each
participants respective income statement. EITF 07-1 is effective for financial
statements issued for fiscal years beginning after December 15, 2008, and interim
periods within those fiscal years and should be applied retrospectively to all prior
periods presented for all collaborative arrangements existing as of the effective date. We
do not expect the adoption of EITF 07-1 to have an impact on our consolidated
financial statements.


In
May 2008, the FASB issued SFAS No. 162, The Hierarchy of Generally Accepted
Accounting Principles, or SFAS 162. SFAS 162 identifies the sources of
accounting principles to be used in the preparation of financial statements of
nongovernmental entities that are presented in conformity with generally accepted
accounting principles, or GAAP, in the U.S. SFAS 162 is effective 60 days
following the SEC approval of the Public Company Accounting Oversight Board amendments to
AU Section 411, The Meaning of Present Fairly in Conformity with Generally Accepted
Accounting Principles.We currently adhere to the hierarchy of GAAP as presented in
SFAS 162, and adoption is not expected to have a material impact on our consolidated
financial statements.


In
December 2007, the FASB issued Statement No. 141(R), Business Combinations, a replacement
for Statement No. 141. SFAS 141(R) retains the fundamental requirements of
SFAS 141, but requires the recognition of all assets acquired and liabilities
assumed in a business combination at their fair values as of the acquisition date. It also
requires the recognition of assets acquired and liabilities assumed arising from
contractual contingencies at their acquisition date fair values. Additionally, SFAS
 141(R) supersedes FASB Interpretation No. 4, Applicability of FASB Statement No. 2 to
Business Combinations Accounted for by the Purchase Method, which required research and
development assets acquired in a business combination that had no alternative future use
to be measured at their fair values and expensed at the acquisition date. SFAS
141(R) now requires that purchased research and development be recognized as an intangible
asset. We are required to adopt SFAS 141(R) prospectively for any acquisitions on
or after January 1, 2009 and are currently evaluating the impact that SFAS 141(R)
will have, if any, on our consolidated financial statements.




62


In
December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated
Financial Statements, an amendment of Accounting Research Bulletin (ARB) No. 51. SFAS
 160 clarifies the classification of noncontrolling interests in consolidated
statements of financial position and the accounting for, and reporting of, transactions
between the reporting entity and holders of such noncontrolling interests. Under SFAS 160,
noncontrolling interests are considered equity and should be reported as an element of
consolidated equity. Net income will encompass the total income of all consolidated
subsidiaries, and there will be separate disclosure on the face of the statement of
operations of the attribution of that income between the controlling and noncontrolling
interests; increases and decreases in the noncontrolling ownership interest amount will be
accounted for as equity transactions. SFAS 160 is effective for the first annual reporting
period beginning on or after December 15, 2008, and earlier application is
prohibited. SFAS 160 is required to be adopted prospectively, except for reclassifying
noncontrolling interests to equity, separate from the parents shareholders
equity, in the consolidated balance sheets and recasting consolidated net income (loss) to
include net income (loss) attributable to both the controlling and noncontrolling
interests, both of which are required to be adopted retrospectively. As our subsidiaries
are 100% owned, we do not expect the adoption of SFAS  160 to have an impact on
our financial statements.



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 managed our business as principally one
segment, medical and cosmetic products and services, and substantially all of 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.


The
following table represents percentages of product revenue by geographic destination for
2008, 2007, and 2006:
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Year ended December 31,   | 2008 | 2007 | 2006
|------------------------- | ---- | ---- | ----
|North America             |      | 68   | %   
|Europe                    |      | 15   | %   
|South and Central America |      | 8    | %   
|Asia / Pacific            |      | 5    | %   
|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.


63


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 for (benefit from) income taxes in the accompanying Consolidated Statements of Operations consists of the following:
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Year ended December 31, | 2008 | 2007 | 2006
|----------------------- | ---- | ---- | ----
|Federal:                |      |      |     
|Current                 |      |      | $   
|Deferred                |      |      |     
|                        |      |      |     
|                        |      |      |     
|State:                  |      |     
|Current                 |      |      |     
|Deferred                |      |      |     
|                        |      |      |     
|                        |      |      |     
|                        |      |      |     
|Total                   |      |      | $   
|                        |      |      |     

|(Loss) income before income tax provision for (benefit from) income taxes consists of
          the following:
|--------------------------------------------------------------------------------------------------------------

|Year ended December 31, | 2008      | 2007        | 2006       
|----------------------- | --------- | ----------- | -----------
|Domestic                | $ 616,844 | $33,077,729 | $48,005,833
|Foreign                 | (675,086) | 5,449       | --         
|                        |           |             |            
|Total                   | $(58,242) | $33,083,178 | $48,005,833

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

|Year ended December 31,                                       | 2008 | 2007 | 2006
|------------------------------------------------------------- | ---- | ---- | ----
|Income tax (benefit)/provision at federal statutory rate      |      |      |     
|Increase (decrease) in tax resulting from:                    |      |     
|State income taxes, net of federal benefit                    |      |      |     
|Decrease in federal statutory rate                            |      |      |     
|Federal research credit                                       |      |      |     
|Foreign rate differential                                     |      |      |     
|Foreign rate differential - valuation allowance               |      |      |     
|Change in valuation allowance, net operating loss utilization |      |      |     
|Permanent items                                               |      |      |     
|                                                              |      |      |     
|Provision for (benefit from) income taxes                     |      |      |     
|                                                              |      |      |     

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

|At December 31,                   | 2008 | 2007
|--------------------------------- | ---- | ----
|Net operating loss carry forwards |      |     
|Nondeductible accruals            |      |     
|Nondeductible reserves            |      |     
|Stock based compensation          |      |     
|Tax credits                       |      |     
|Valuation allowance               |      |     
|                                  |      |     
|Total                             |      |     
|                                  |      |     

|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. In 2008, we incurred operating losses in
foreign jurisdictions. We believe that it is more likely than not that the associated tax
asset will expire prior to utilization. Therefore, we have established a full valuation
allowance in 2008 on this deferred tax asset.

64






Although
we have determined that a valuation allowance is not required with respect to our
remaining net deferred tax assets of $5.3 million at December 31, 2008, their 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 $22
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 2008, 2007, and 2006, the impact to paid-in capital resulting from the exercise
of employee stock options was $1.8 million, $4.8 million, and $1.2 million, respectively.


At
December 31, 2008, 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 $52.9 million and $3.9 million, respectively, to be used to
offset future taxable income. These net operating loss carry forwards are attributable to
the excess tax benefit of stock option grants and will expire through 2024. We also have
$0.7 million of Australian net operating loss carry forwards that do not expire.


In
June 2006, the Financial Accounting Standards Board issued FASB Interpretation No. 48,
Accounting for Uncertainty in Income Taxes (an interpretation of FASB Statement No. 109),
(FIN 48).  FIN 48 clarifies the criteria that an individual tax position must
satisfy for some or all of the benefits of that position to be recognized in a
companys financial statements.  FIN 48 prescribes a recognition threshold
of more-likely-than-not and a measurement attribute for all tax positions
taken or expected to be taken on a tax return in order for those tax positions to be
recognized in the financial statements.  We adopted the provisions of FIN 48
effective January 1, 2007.  The adoption of this standard did not have a
material impact on our financial statements. 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, 2008, we have $2.8 million of unrecognized tax
benefits, all of which would affect our effective tax rate if recognized.


A
reconciliation of our total gross unrecognized tax benefits for the year ended December
31, 2008 is below.
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|At December 31,                        | 2008 | 2007
|-------------------------------------- | ---- | ----
|Balance at beginning of year           |      |     
|Tax positions related to current year: |      |     
|Additions                              |      |     
|Reductions                             |      |     
|                                       |      |     
|Balance at end of year                 |      |     
|                                       |      |     
|                                       |      |     

|We
establish reserves for uncertain tax positions based on managements assessment of
exposure associated with tax deductions, 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, 2008, we had approximately $26,000 of accrued interest and penalties
related to uncertain tax positions.




65






The
tax years 2005-2008 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
2008, 2007 and 2006, we matched in Palomar common stock 50% of all employee contributions
by issuing 53,779, 41,865 and 9,355 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, 2008, 184,806 shares of common stock remained available for
issuance thereunder. For the years ended December 31, 2008, 2007, and 2006, we recognized
$644,000, $655,000, and $544,000, respectively as compensation expense related to the
401(k) Palomar common stock match.



Note 6  Accrued
Liabilities

At December 31, 2008 and 2007, accrued liabilities consisted of the following:
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|At December 31,               | 2008       | 2007        
|----------------------------- | ---------- | ------------
|Payroll and employee benefits | $1,283,943 | $  5,269,567
|Commissions                   | 931,826    | 2,318,674   
|Royalties                     | 2,348,827  | 3,006,818   
|Warranties                    | 856,158    | 1,051,432   
|Other                         | 1,267,383  | 959,931     
|                              |            |             
|Total                         | $6,688,137 | $12,606,422 
|                              |            |             
|                             

|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.
The lease for this facility was to expire in August 2009.  However, we have negotiated a 12 month lease
extension, expiring in August 2010, at an increase over our current rate to coordinate the timing
between the construction of our new facility and the expiration of our current facility lease.  Rent
expense, including these lease amendments, will total approximately $1.4 million per year.


On
November 19, 2008, we purchased land for $10.7 million on which we intend to build our new
operational facility. Construction of the building is expected to be completed during the
first half of 2010. We anticipate that capital expenditures related to the building for
2009 will be approximately $23 million. The total cost of the building (exclusive of land)
is expected to be approximately $25 million. We are financing this project by using cash
on hand and drawing down on our line of credit.


66

The
following table summarizes our estimated contractual cash obligations as of December 31,
2008, excluding royalty and employment obligations because they are variable and/or
subject to uncertain timing:
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|At December 31,      | 2009         | 2010                | 2011             | 2012             | 2013              | Thereafter      
|-------------------- | ------------ | ------------------- | ---------------- | ---------------- | ----------------- | ----------------
|Purchase commitments | $  3,721,000 | $                -- | $             -- | $            --  | $             --  | $             --
|Building commitments | 23,207,000   | --                  | --               | --               | --                | --              
|Operating lease      | 1,410,000    | 1,084,000           | --               | --               | --                | --              
|                     |              |                     |                  |                  |                   |                 
|Total                | $28,338,000  | $        1,084,000  | $            --  | $             -- | $              -- | $            -- 
|                     |              |                     |                  |                  |                   |                 
|                    

|We
incurred rent expense of $1,639,000, $1,358,000 and $1,147,000 for the years ended
December 31, 2008, 2007 and 2006, respectively.


In
December 2008, we secured access to a $30 million revolving note through December 17,
2013. Outstanding balances on the revolving note bear interest at a rate equal to the sum
of the LIBOR Advantage rate plus 0.75% per annum. At December 31, 2008, we had outstanding
debt of $6 million at an average interest rate of 1.22%. The interest expense was
capitalized into Property and Equipment on the consolidated balance sheets and was
immaterial for the year ended December 31, 2008. Any outstanding debt is due on December 17, 2013. On January 2, 2009, we repaid the $6
million and had no further debt outstanding.



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 a percentage of royalties received from third parties related to
certain patents. For the years ended December 31, 2008, 2007 and 2006, approximately
$4,989,000, $5,918,000 and $13,465,000 of royalty expense, respectively, was incurred
under this agreement.



Litigation


In
accordance with SFAS No. 5, Accounting for Contingencies, we accrue for all direct costs
associated with the estimated resolution of contingencies at the earliest date at which it
is deemed probable that a liability has been incurred and the amount of such liability can
be reasonably estimated. At December 31, 2008, we have not recorded any material loss
contingencies.



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.


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.

67






On
November 17, 2008 the Judge stayed the lawsuit pending the outcome of reexamination
procedures requested by a third party on both U.S. Patent Nos. 5,735,844 and 5,595,568 in
the United States Patent and Trademark Office. Consequently, this lawsuit against Candela
will be delayed until the reexaminations are complete. On December 9, 2008, Candela also
filed requests for re-examination of both patents. Generally, a reexamination proceeding
is one which re-opens patent prosecution to ensure that the claims in an issued patent are
valid over prior art references. Requests for reexamination of patents are common and
granted by the Patent Office 92% of the time. The granting of a request for reexamination
does not indicate that the claims of the patents will be cancelled or altered in any way.
We will vigorously respond to the reexamination, including by citing all prior art which
Candela and others have relied upon in their contentions that the patents are not valid.
We believe that at the end of the process, it should be clear, as we and many of our
licensees have already concluded, that the patent claims are valid. However, the patent
office could disagree with us and find some or all of the claims invalid over prior art or
we may need to modify the claims as part of the reexamination process. In either event, it
is possible that Candelas products would no longer infringe the claims that result
from the reexamination process and this lawsuit would be terminated. In addition, the
products of our current licensees may no longer infringe the claims that result from the
reexamination process in which case the licensees would stop paying us royalties. While we
intend to vigorously respond to the reexamination procedures,
each reexamination is inherently uncertain and unpredictable as
to its ultimate outcome. An adverse outcome would materially hurt our
business, financial condition, results of operations and cash flows.


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.


In
February 2008, we filed a request for reexamination and then an amended request for
reexamination of Candelas 222 patent with the United States Patent and
Trademark Office (PTO). In our request, we argued that Candelas
222 patent is unpatentable over our own United States Patent No. 6,605,080 alone or
in combination with other prior art. About the same time, we filed a motion to stay all
proceedings in this action related to the 222 patent pending resolution of the
amended request for reexamination of the 222 patent. In March 2008, the PTO granted
our request for reexamination of the 222 patent. On June 11, 2008, the Court ordered
the parties to report back to the Court after the PTO makes its decision in the
reexamination of the 222 patent, after which a claim construction hearing (i.e., a
Markman Hearing) will be scheduled for both the 222 and 395 patents. On
June 12, 2008, the parties informed the Court that the total time the reexamination will
remain pending is not known. 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 alleged that our StarLux System with
the LuxY handpiece willfully infringed U.S. Patent No. 6,659,999 and that our StarLux
System with the Lux1540 handpiece willfully infringed related U.S. Patent Nos. 5,810,801
and 6,120,497. The three asserted patents are directed to wrinkle treatment. Candela
sought 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 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 300, StarLux 500, MediLux and EsteLux Systems of infringing the three
asserted patents. On June 20, 2008, Candela dropped its accusations against the LuxB
handpiece. A claim construction hearing, sometimes called a Markman Hearing,
was held November 13, 2007, and we received what we consider to be a favorable Markman
ruling on August 6, 2008. On September 22, 2008, Candela (i) dropped its accusations
against the LuxY, LuxYs, and LuxG handpieces, (ii) dropped two of its patents from the
lawsuit, specifically 6,120,497 and 6,659,999, and (iii) dropped from the lawsuit all
method claims in 5,810,801. Consequently, Candela went to trial on September 29, 2008
accusing only the Lux1540, Lux1540z, LuxIR and LuxDeepIR when used with the StarLux 500 or
300 of infringement of only claims 11-14 of 5,810,801. In addition, Candela significantly
reduced the amount of damages it was seeking. The trial ended on October 7, 2008 with a
jury verdict that none of the accused products infringe the asserted claims and that the
asserted claims were invalid over prior art for both anticipation and obviousness.
Following trial, Candela filed a Judgment as a Matter of Law motion with the Court in an
attempt to reverse the invalidity ruling. On December 30, 2008, the Court
entered final judgment in favor of Palomar.




68



Alma Lasers, Inc.,
Delaware Litigation


On
September 11, 2008, Alma Lasers, Inc. filed a complaint requesting a declaratory judgment
that our fractional patent, U.S. Patent No. 6,997,923, is not infringed by Almas
products and is invalid over prior art. Alma served this lawsuit on us on November 6,
2008, and on November 21, 2008, we filed an answer which denied Almas allegations
that the patent is invalid and not infringed. We also filed a counterclaim accusing
Almas Pixel C02 Omnifit Fractional C02 Handpiece and Pixel
C02 Fractional C02 Skin Resurfacing System of infringing the
patent. On December 16, 2008, upon the request of both parties, a mediation conference was
scheduled for June 30, 2009 before Magistrate Judge Mary Pat Thynge. On December 18, 2008,
upon the request of both parties, the Judge presiding over the lawsuit, stayed the lawsuit
and later closed the lawsuit pending the outcome of the mediation.



Alma Lasers, Inc.,
Massachusetts 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
amounts due to us were determined based on an audit by an independent accounting firm
which was completed in the first quarter of 2008. We recognized royalty revenue as amounts
became 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.


69


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  Debt


In
December 2008, we secured access to a $30 million revolving note. Outstanding balances on
the revolving note bear interest at a rate equal to the sum of the LIBOR Advantage rate
plus 0.75% per annum. At December 31, 2008, we had outstanding debt of $6 million at an
average interest rate of 1.22%. The interest expense was capitalized into Property and
Equipment on the consolidated balance sheets and was immaterial for the year ended
December 31, 2008. Any outstanding debt is due on December 17, 2013. On January 2, 2009,
we repaid the $6 million and had no further debt outstanding.


Our
revolving note requires that we maintain certain financial covenants. In order to be in
compliance with the covenants, unencumbered cash and marketable securities less
outstanding debt must be greater than the credit limit. At December 31, 2008, we were in
compliance with the financial covenants. If we were to default on our debt, the building
would be used as collateral.



Note 9 
Stockholders Equity



Common Stock


During
1998, we sold 1,457,142 shares of common stock to a group of investors for $10,200,000. At
the time of this transaction in 1998, short sellers were a significant problem for the
Company, which was struggling financially. In an effort to inhibit short selling, we
elected to encourage this group of investors to maintain their form of ownership as
certificated stock in their own names, which we believed would work to prevent the
investors from lending their shares to short sellers. 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. As of December 31, 2008, there were three individuals who
received this fee and none of whom has any other relationship with the Company. During
2008, 2007, and 2006, we paid $59,600, $62,100 and $83,077, 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.



70




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. On
October 28, 2008, we amended and restated the April 1999 shareholder rights agreement to
(i) extend the expiration date to October 28, 2018, (ii) increase the purchase price to
$200.00, (iii) amend the definition of Acquiring Person to exclude a
Person qualified to file Schedule 13G as provided in the definition, (iv)
amend the recitals to take account of the Recapitalization that occurred May
7, 1999, and (v) make any other additional changes deemed necessary. For more information,
please see the Amended and Restated Rights Agreement dated October 28, 2008 filed as an
exhibit to our Current Report on Form 8-K filed October 31, 2008.



Note 10  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.


71

The
following table summarizes all stock option activity for the years ended December 31,
2008, 2007, and 2006:
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                     | Number of
Shares | Exercise Price   | Weighted
Average
Exercise
Price | Average
Remaining
Contractual
Term
(in Years) | Aggregate
Intrinsic Value
|------------------------------------ | ---------------- | ---------------- | ------------------------------- | --------------------------------------------- | -------------------------
|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               
|Granted                              | 1,315,000        | 13.31            | 13.31                           |                                              
|Exercised                            | (144,965)        | 0.90 -     5.05  | 1.73                            |                                               |                          
|Canceled                             | (1,422,225)      | 1.00 -   26.00   | 16.50                          
|                                     |                  |                  |                                 |                                               |                          
|Outstanding, December 31, 2008       | 3,228,299        | $0.90 - $26.00   | $     15.81                     | 6.88                                          | $2,208,789               
|                                     |                  |                  |                                 |                                               |                          
|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               
|                                     |                  |                  |                                 |                                               |                          
|Exercisable, December 31, 2008       | 2,630,174        | $0.90 - $26.00   | $     16.37                     | 6.36                                          | $2,208,789               
|                                     |                  |                  |                                 |                                               |                          
|Vested and expected to vest at      
|December 31, 2008                    | 3,194,201        |                  |                                 | 6.86                                          | $2,208,789               
|                                     |                  |                  |                                 |                                               |                          
|Available for future issuances under
|the plans as of December 31, 2008    | 385,160         
|                                     |                  |                  |                                 |                                               |                          

|The
total intrinsic value for options exercised during the years ended December 31, 2008, 2007
and 2006 was $1,494,579, $10,390,187 and $30,116,146, respectively.


The
following table summarizes information about stock options outstanding as of December 31,
2008:
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Options Outstanding | Options Exercisable |            |        |           |       
|------------------- | ------------------- | ---------- | ------ | --------- | ------
|
|$0.90  - $10.72     | 245,266             | 2.73 years | $2.52  | 245,266   | $2.52 
|13.31  -    13.31   | 1,294,375           | 9.15 years | 13.31  | 696,250   | 13.31 
|13.66  -   16.53    | 1,034,158           | 5.36 years | 16.49  | 1,034,158 | 16.49 
|23.61  -    26.00   | 654,500             | 6.35 years | 24.64  | 654,500   | 24.64 
|                    |                     |            |        |           |       
|$0.90  - $26.00     | 3,228,299           | 6.88 years | $15.81 | 2,630,174 | $16.37
|                    |                     |            |        |           |       

|72






We
granted 1,440,000 performance based stock options in 2004 to employees and directors with
exercise prices equal to the fair market value of our common stock 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 as defined under the original
Development and License Agreement, and the remaining 625,000 of these options would vest
twelve months after the Launch Decision. On February 29, 2008, we entered into a new
License Agreement, to replace the existing one, with The Procter and Gamble Company
(P&G), Gillettes parent 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. 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 compensation expense was never incurred.


On
February 29, 2008, we granted 1,315,000 stock options to employees and directors with
exercise prices equal to the fair market value of our common stock 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. On May 14, 2008, 472,734 unvested incentive stock options
 granted on February 29, 2008 were modified for non-qualified option
(NQ) treatment. These modified NQs have the same terms and conditions as the
ISOs granted on February 29, 2008. There was no additional compensation expense created by
the modification. We expect our stock-based compensation expense related to these options
to be approximately $160,000 a quarter through February 27, 2011. The total compensation
expense for the options granted on February 29, 2008 is expected to be approximately $4.8
million.



Stock-Settled Stock
Appreciation Rights


Beginning
in 2007, we granted stock-settled stock appreciation rights which are awards that
allow the recipient to receive a number of shares 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 in 2007 and 2008, 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 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.


The
following table summarizes the SARs activity for the years ended December 31, 2008 and
2007:
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                               | 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                             | 2.61                                                   |                          
|Converted                      | --               | --                                |                                                        |                          
|Canceled                       | (5,000)          | 14.40                             |                                                        |                          
|                               |                  |                                   |                                                        |                          
|Outstanding, December 31, 2007 | 477,500          | $     14.40                       | 2.61                                                   | $439,300                 
|Granted                        | 350,000          | 7.91                             
|Converted                      | --               | --                               
|Canceled                       | (30,000)         | 12.90                            
|                               |                  |                                   |                                                        |                          
|Outstanding, December 31, 2008 | 797,500          | $     11.61                       | 2.17                                                   | $1,240,814               
|                               |                  |                                   |                                                        |                          
|Vested, December 31, 2008      | --               | --                                | --                                                     | --                       
|                               |                  |                                   |                                                        |                          

|73


Warrants


The
following table summarizes all warrant activity for the years ended December 31, 2008,
2007 and 2006:
|-------------------------------------------------------------------------------------------------------------------------

|                               | Number of
Shares | Exercise Price | Weighted
Average
Exercise
Price | Weighted
Average
Remaining
Contractual
Term | Aggregate
Intrinsic Value
|------------------------------ | ---------------- | -------------- | ------------------------------- | ------------------------------------------- | -------------------------
|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                 
|Exercised                      | (65,000)         | 1.97 -   3.19  | 2.75                            |                                            
|                               |                  |                |                                 |                                             |                          
|Outstanding, December 31, 2008 | 10,000           | $         2.81 | $     2.81                      | 1.43                                        | $87,175                  
|                               |                  |                |                                 |                                             |                          
|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                 
|                               |                  |                |                                 |                                             |                          
|Exercisable, December 31, 2008 | 10,000           | $         2.81 | $     2.81                      | 1.43                                        | $87,175                  
|                               |                  |                |                                 |                                             |                          

|The
total intrinsic value for warrants exercised during the years ended December 31, 2008,
2007 and 2006 was $814,938, $0 and $2,288,312, respectively.



Reserved Shares


At
December 31, 2008, we have reserved shares of our common stock for the following:
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                          |          
|----------------------------------------- | ---------
|Stock option and stock appreciation plans | 4,410,959
|Warrants                                  | 10,000   
|Employee 401(k) plan                      | 184,806  
|                                          |          
|Total                                     | 4,605,765
|                                          |          
|                                         

|74


Note 11  Quarterly
Results of Operations (Unaudited)


The
following tables present a condensed summary of quarterly results of operations for the
years ended December 31, 2007 and 2008 (in thousands, except per share data).
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                      | 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

|                             | 2008      |           |           |           
|---------------------------- | --------- | --------- | --------- | ----------
|
|Revenues                     | $ 23,030  | $23,125   | $24,206   | $ 17,220  
|Cost and expenses            | 26,292    | 22,531    | 23,994    | 18,158    
|Net (loss) income            | $(1,005)  | $     760 | $     596 | $    (420)
|Net (loss) income per share:
|Basic                        | $  (0.05) | $    0.04 | $    0.03 | $  (0.02) 
|Diluted                      | $  (0.05) | $    0.04 | $    0.03 | $  (0.02) 

|This
financial information includes several transactions which affect the comparability of the
quarterly results for the years ended December 31, 2007 and 2008. 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.
| |  |  | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | 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.
| |  |  | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|For
the year ended December 31, 2008, the following transactions are included:
|------------------------------------------------------------------------------

| |  |  | o |  | First
quarter: As a result of our successful resolution of our patent infringement and
trade dress lawsuits against Alma, we recognized $682,000 in royalty revenues for
back-owed royalties, $248,000 in other revenues related to trade dress, $273,000 in cost
of royalties related to the back-owed royalties, and $52,000 reduction to interest
expense related to the back-owed royalties. In addition, we recognized a $1 million
investment banking fee related to an international distributor agreement in general and
administrative expenses.
| |  |  | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Note 12  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, The Procter &
Gamble Company (P&G) (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
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).




75


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 was 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 home-use, light-based hair removal
device for women, and we also announced that we had executed an amended and restated joint
development agreement to incorporate other amendments, including several new amendments to
allow for more open collaboration through commercialization. With regard to the additional
home-use, light-based hair removal device 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 which was recognized over an eleven month period as costs were incurred and
services were 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 P&G for a new agreement to replace the existing one.
On February 29, 2008, we entered into a License Agreement with P&G 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 terminated
and replaced the prior Development and License Agreement.


For
the years ended December 31, 2008, 2007 and 2006, we recognized $216,000, $3.8 million and
$1.1 million, respectively, of funded product development revenues from P&G and
Gillette under the Development and License Agreement and various other agreements. As of
December 31, 2008 and 2007, $0 and $48,000, respectively, of advance payments received
from P&G and Gillette for which services were not yet provided were included in
deferred revenue, under the Development and License Agreement and various other
agreements.


For
the year ended December 31, 2008, we recognized $5.0 million of other revenues from
P&G under the new License Agreement, consisting of four quarterly technology transfer
payments (TTP Quarterly Payment as defined in the License Agreement) of $1.25
million. TTP Quarterly Payments will be made by P&G during the term of the License
Agreement up to and including the quarter in which P&G launches the first Licensed
Product (as defined in the License Agreement). Thereafter, TTP and royalty payments will
be based on product sales as set forth in the License Agreement. TTPs, including the TTP
Quarterly Payments, are non-creditable and non-refundable and there is no right of offset.
As of December 31, 2008, $1.25 million of advance payments received from P&G for which
services were not yet provided were included in deferred revenue, under the new License
Agreement.


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.


76


Note 13  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, 2008, 2007 and 2006, we recognized approximately $2.2
million, $2.5 million and $1.4 million, respectively, of funded product development
revenues from Johnson & Johnson. As of December 31, 2008 and 2007, $726,000 and
$477,000, 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 14  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. Subsequent to April 30, 2007, the contract was extended on multiple
occasions, the last of which was through March 31, 2008. The contract was a cost plus fee
arrangement whereby we were 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, 2008, 2007 and 2006, we recognized $0, $388,000 and $1.3
million of funded product development revenues under this agreement, respectively.

77







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.



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, in the third quarter of 2006, we recognized 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
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, which we recognized
during 2006 as back-owed royalty revenue. 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.





78






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. The rights included in the Non-Exclusive Patent License
Agreement, such as Almas agreement not to challenge such infringement, validity, and
enforceability, and various other terms and conditions, do not have any stand alone value
and they have no substance apart from the ongoing royalty. 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 were determined based on an audit by
an independent accounting firm which was completed in the first quarter of 2008. We
recognized royalty revenue as amounts became 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.


For
the year ended December 31, 2007, we recognized $3.1 million of back-owed royalty
revenues, $894,000 of other revenues for trade dress infringement, and $432,000 of
interest on back-owed royalties. As the result of the completion of the independent audit
during the three months ended March 31, 2008, we recognized $682,000 of back-owed royalty
revenues, $248,000 of other revenues for trade dress infringement, and $87,000 of interest
on back-owed royalties. At December 31, 2008, we had no deferred revenue 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.

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.

79






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.



Changes in internal
controls


There
have been no changes in our internal control over financial reporting that occurred during
the quarter ended December 31, 2008 that have materially affected or are reasonably
likely to materially affect our internal control over financial reporting.



Managements report
on internal control 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, 2008.


Our
internal controls over financial reporting as of December 31, 2008 have been audited
by Ernst & Young LLP, an independent registered public accounting firm, as stated in
their attestation report which appears on the following page.


80


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,
2008, 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, 2008, 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, 2008 and 2007, and the related consolidated statements of operations,
stockholders equity and cash flows for each of the three years in the period ended
December 31, 2008 and our report dated March 4, 2009 expressed an unqualified opinion
thereon.
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------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-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                      |                      
|--------------------- | ---------------------
|
|                      | /s/ Ernst & Young LLP
|Boston, Massachusetts |                      
|March 4, 2009         |                      

|81










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 2009 annual proxy statement to be filed prior to April 30, 2009.



Item 11. Executive
Compensation


On March 4, 2009, the Board of Directors of Palomar Medical Technologies, Inc. (the Company) adopted a 2009
Incentive Compensation Program  Executive Level (the Program) for fiscal year 2009. Under the Program, if the
Company meets a certain base level profit milestone, these officers would be eligible to receive a cash bonus of
up to 36.29% of such officers annual base salary. In addition, these officers would be eligible to receive an
additional cash bonus of up to 1.82% of such officers annual base salary for each additional $100,000 achieved
by the Company above the base level milestone up to a maximum of 200% of each officers annual base salary.




We
incorporate the information required by this item by reference to the sections responsive
hereto of our 2009 annual proxy statement to be filed prior to April 30, 2009.



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 2009 annual proxy statement to be filed prior to April 30, 2009.



Item 13. Certain
Relationships and Related Transactions


We
incorporate the information required by this item by reference to the sections responsive
hereto of our 2009 annual proxy statement to be filed prior to April 30, 2009.



Item 14. Principal
Accountant Fees and Services


We
incorporate the information required by this item by reference to the sections responsive
hereto of our 2009 annual proxy statement to be filed prior to April 30, 2009.





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, 2008 and December 31, 2007
| | -------------------------------------------------------------------------

| | Consolidated
Statements of Operations for the years ended December 31, 2008, December 31, 2007 and
December 31, 2006
| | --------------------------------------------------------------------------------------------------------------------

| | Consolidated
Statements of Stockholders Equity for the years ended December 31, 2008, December
31, 2007 and December 31, 2006
| | ------------------------------------------------------------------------------------------------------------------------------

| | Consolidated
Statements of Cash Flows for the years ended December 31, 2008, December 31, 2007 and
December 31, 2006
| | --------------------------------------------------------------------------------------------------------------------

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

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

|82
|--

| | 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   | Certificate of Amendment to the Certificate of Designation,
             Preferences and Rights of the Series A Participating
             Cumulative Preferred Stock of Palomar Medical Technologies,
             Inc., as filed with the Delaware Secretary of State April 21,
             1999                                                                                                                                                                                                                                                                                                                           |  | 8-K                       | October 31, 2008
|      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |  |                          
|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  
|      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |  |                          
|4.4   | Amended and Restated Rights Agreement dated as of October 28,
             2008 between Palomar Medical Technologies, Inc. and American
             Stock Transfer & Trust Company LLC, as Rights Agent,
             including Exhibit A, Certificate of Amendment to the
             Certificate of Designation, Preferences and Rights of the
             Series A Participating Cumulative Preferred Stock of Palomar
             Medical Technologies, Inc., as filed with the Delaware
             Secretary of State October 28, 2008, and Exhibit B, Amended
             and Restated Form of Right Certificate |  | 8-K                       | October 31, 2008
|      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |  |                          
|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  
|      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |  |                          

|83
|--

|        |                                                                                                       |  | Incorporated by Reference |                  
|------- | ----------------------------------------------------------------------------------------------------- |  | ------------------------- | -----------------
|
|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    
|        |                                                                                                       |  |                          
|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
|        |                                                                                                       |  |                          

|84
|--

|       |                                                                                                                                            |  | Incorporated by Reference |                  
|------ | ------------------------------------------------------------------------------------------------------------------------------------------ |  | ------------------------- | -----------------
|
|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    
|       |                                                                                                                                            |  |                          
|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
|       |                                                                                                                                            |  |                          

|85
|--

|       |                                                                                                                                                                                                                  |  | Incorporated by Reference |                  
|------ | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------- | -----------------
|
|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
|       |                                                                                                                                                                                                                  |  |                          
|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  | Third Amendment to Lease for 80/82 Cambridge Street, Burlington, MA dated July 30, 2007                                                                                                                          |  | 10-Q                      | November 2, 2007 
|       |                                                                                                                                                                                                                  |  |                          
|10.52+ | Third Amendment to Joint Development and License Agreement with Johnson & Johnson Consumer Companies,
Inc. dated August 15, 2007                                                                                 |  | 10-Q                      | November 2, 2007 
|       |                                                                                                                                                                                                                  |  |                          
|10.53+ | Fourth Amendment to Joint Development and License Agreement with Johnson & Johnson Consumer Companies,
Inc. dated August 22, 2007                                                                                |  | 10-Q                      | November 2, 2007 
|       |                                                                                                                                                                                                                  |  |                          
|10.54+ | 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
|       |                                                                                                                                                                                                                  |  |                          
|10.55+ | International Distributor Agreement, effective as of January 8,
2008 between Palomar Medical Technologies, Inc. and Q-MED AB
(Publ).                                                                             |  | 8-K                       | January 9, 2008  
|       |                                                                                                                                                                                                                  |  |                          

|86
|--

|        |                                                                                                                                                                         |   | Incorporated by Reference |                  
|------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------- | - | ------------------------- | -----------------
|
|10.56*+ | 2008 Incentive Compensation Program  Executive Level                                                                                                                   |   | 8-K                       | February 11, 2008
|        |                                                                                                                                                                         |   |                          
|10.57*+ | 2008 Incentive Compensation Program with Louis P. Valente                                                                                                               |   | 10-K                      | March 6, 2008    
|        |                                                                                                                                                                         |   |                          
|10.58*+ | 2008 Incentive Compensation Program with Joseph P. Caruso                                                                                                               |   | 10-K                      | March 6, 2008    
|        |                                                                                                                                                                         |   |                          
|10.59*+ | 2008 Incentive Compensation Program with Paul S. Weiner                                                                                                                 |   | 10-K                      | March 6, 2008    
|        |                                                                                                                                                                         |   |                          
|10.60+  | License Agreement, executed February 29, 2008, effective as of February 14, 2003                                                                                        |   | 8-K                       | March 3, 2008    
|        |                                                                                                                                                                         |   |                          
|10.61   | Termination of International Distribution Agreement, effective as of January 8, 2009, between Palomar
Medical Technologies, Inc. and Q-MED AB (Publ)                    |   | 8-K                       | January 8, 2009  
|        |                                                                                                                                                                         |   |                          
|10.62   | Loan Agreement, effective as of December 17, 2008, between Palomar Medical Technologies, Inc. and RBS
Citizens, National Association                                    |   | 8-K                       | January 8, 2009  
|        |                                                                                                                                                                         |   |                          
|10.63   | Mortgage and Security Agreement, effective as of December 17,
2008, between Palomar Medical Technologies, Inc. and RBS
Citizens, National Association                   |   | 8-K                       | January 8, 2009  
|        |                                                                                                                                                                         |   |                          
|10.64   | Collateral Agreement of Leases and Rents, effective as of December 17, 2008, between Palomar Medical
Technologies, Inc. and RBS Citizens, National Association          |   | 8-K                       | January 8, 2009  
|        |                                                                                                                                                                         |   |                          
|10.65   | Indemnity Agreement Regarding Hazardous Materials, effective as of December 17, 2008, between Palomar
Medical Technologies, Inc. and RBS Citizens, National Association |   | 8-K                       | January 8, 2009  
|        |                                                                                                                                                                         |   |                          
|10.66   | Unlimited Guaranty, effective as of December 17, 2008, between Palomar Medical Technologies, Inc. and
RBS Citizens, National Association                                |   | 8-K                       | January 8, 2009  
|        |                                                                                                                                                                         |   |                          
|10.67   | Revolving Note, effective as of December 17, 2008, between Palomar Medical Technologies, Inc. and RBS
Citizens, National Association                                    |   | 8-K                       | January 8, 2009  
|        |                                                                                                                                                                         |   |                          
|10.68   | Construction Management Agreement                                                                                                                                       | X | 10-K                      | March 5, 2009    
|        |                                                                                                                                                                         |   |                          
|10.69   | Fourth Amendment to Lease for 80/82 Cambridge Street, Burlington, MA dated February 27, 2009                                                                            | X | 10-K                      | March 5, 2009    
|        |                                                                                                                                                                         |   |                          
|10.70*  | 2009 Incentive Compensation Program  Executive Officer Level                                                                                                           | X | 10-K                      | March 5, 2009    
|        |                                                                                                                                                                         |   |                          

|87
|--

|     |                                                                                                                                     |   | Incorporated by Reference | 
|---- | ----------------------------------------------------------------------------------------------------------------------------------- | - | ------------------------- | 
|
|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                                                                             |   |                           | 
|     |                                                                                                                                     |   |                          

|88

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 5, 2009
|Louis P. Valente         |                                                 |              
|                         |                                                 |              
|/s/Joseph P. Caruso      | President, Chief Executive Officer and Director | March 5, 2009
|Joseph P. Caruso         |                                                 |              
|                         |                                                 |              
|/s/Paul S. Weiner        | Chief Financial Officer                         | March 5, 2009
|Paul S. Weiner           |                                                 |              
|                         |                                                 |              
|/s/ Nicholas P. Economou | Director                                        | March 5, 2009
|Nicholas P. Economou     |                                                 |              
|                         |                                                 |              
|/s/ A. Neil Pappalardo   | Director                                        | March 5, 2009
|A. Neil Pappalardo       |                                                 |              
|                         |                                                 |              
|/s/ James G. Martin      | Director                                        | March 5, 2009
|James G. Martin          |                                                 |              
|                         |                                                 |              
|/s/ Jeanne Cohane        | Director                                        | March 5, 2009
|Jeanne Cohane            |                                                 |              
|                         |                                                 |              

|89
|--