##### Table of Contents





UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)



|þ | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ---------------------------------------------------------------------------------------

For the quarterly period ended June 30, 2009



| ̈ | 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 0-52731





NOVARAY MEDICAL, INC.

(Exact name of
registrant as specified in its charter)







|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|DELAWARE                                                       |  | 16-1778998                          
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification No.)

39655 Eureka Drive

Newark, California 94560

(Address of principal executive offices including
zip code)

Registrants telephone number, including area code: (510) 619-9200





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.    Yes  þ    No   ̈.

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

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

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the
Exchange Act).    Yes   ̈    No  þ

As of July 31, 2009 there were 9,767,853 shares of common stock, par value $.0001 per share, outstanding.









---

##### Table of Contents

NOVARAY MEDICAL, INC.

(A Development Stage Company)

Form 10-Q for the Quarter Ended June 30,
2009

Table of Contents



|                               |  |                                                                                       |  |   
|------------------------------ |  | ------------------------------------------------------------------------------------- |  | --
|PART I  FINANCIAL INFORMATION |  |                                                                                      
|                               |  |                                                                                      
|Item 1.                        |  | Financial Statements (unaudited)                                                      |  | 3 
|                               |  |                                                                                      
|                               |  | Condensed Balance Sheets                                                              |  | 3 
|                               |  |                                                                                      
|                               |  | Condensed Statements of Operations                                                    |  | 4 
|                               |  |                                                                                      
|                               |  | Condensed Statements of Cash Flows                                                    |  | 5 
|                               |  |                                                                                      
|                               |  | Notes to Financial Statements                                                         |  | 6 
|                               |  |                                                                                      
|Item 2.                        |  | Managements Discussion and Analysis of Financial Condition and Results of Operations |  | 19
|                               |  |                                                                                      
|Item 3.                        |  | Quantitative and Qualitative Disclosures About Market Risk                            |  | 24
|                               |  |                                                                                      
|Item 4T.                       |  | Controls and Procedures                                                               |  | 24
|                               | 
|PART II  OTHER INFORMATION    |  |                                                                                      
|                               |  |                                                                                      
|Item 1.                        |  | Legal Proceedings                                                                     |  | 24
|                               |  |                                                                                      
|Item 1A.                       |  | Risk Factors                                                                          |  | 24
|                               |  |                                                                                      
|Item 2.                        |  | Unregistered Sales of Equity Securities and Use of Proceeds                           |  | 25
|                               |  |                                                                                      
|Item 3.                        |  | Defaults Upon Senior Securities                                                       |  | 25
|                               |  |                                                                                      
|Item 4.                        |  | Submission of Matters to a Vote of Security Holders                                   |  | 25
|                               |  |                                                                                      
|Item 5.                        |  | Other Information                                                                     |  | 26
|                               |  |                                                                                      
|Item 6.                        |  | Exhibits                                                                              |  | 27
|                               | 
|SIGNATURES                     |  | 29                                                                                   
|                               | 
|EXHIBIT 31.1                   |  |                                                                                      
|                               | 
|EXHIBIT 31.2                   |  |                                                                                      
|                               | 
|EXHIBIT 32.1                   |  |                                                                                      
|                               | 
|EXHIBIT 32.2                   |  |                                                                                      



2



---

##### Table of Contents

PART I  FINANCIAL INFORMATION



|Item 1. | Financial Statements
|------- | --------------------

NOVARAY MEDICAL, INC.

(A Development Stage Company)

CONDENSED BALANCE SHEETS

(In
thousands, except share and per share data)



|                                                                                                                                             |  |                         |         |   |                           |   |         |  
|-------------------------------------------------------------------------------------------------------------------------------------------- |  | ----------------------- | ------- | - | ------------------------- | - | ------- | -
|                                                                                                                                             |  | June 30,2009(Unaudited) |         |   | December 31,2008(Audited) |  
|ASSETS                                                                                                                                       |  |                         |         |   |                           |   |         |  
|Current assets:                                                                                                                              |  |                         |         |   |                           |   |         |  
|Cash and cash equivalents                                                                                                                    |  | $                       | 158     |   |                           | $ | 5,691   |  
|Receivables from Triple Ring                                                                                                                 |  |                         |        |   |                           |   | 42      |  
|Other receivables                                                                                                                            |  |                         | 12      |   |                           |   |        |  
|Security deposit with Triple Ring                                                                                                            |  |                         | 500     |   |                           |   | 500     |  
|Inventory                                                                                                                                    |  |                         | 132     |   |                           |   | 132     |  
|Prepaid expenses to Triple Ring                                                                                                              |  |                         | 135     |   |                           |   | 141     |  
|Prepaid expenses and other current assets                                                                                                    |  |                         | 141     |   |                           |   | 62      |  
|                                                                                                                                             |  |                         |         |   |                           |   |         |  
|Total current assets                                                                                                                         |  |                         | 1,078   |   |                           |   | 6,568   |  
|Property and equipment, net                                                                                                                  |  |                         | 957     |   |                           |   | 1,059   |  
|Restricted cash                                                                                                                              |  |                         |        |   |                           |   | 135     |  
|                                                                                                                                             |  |                         |         |   |                           |   |         |  
|Total assets                                                                                                                                 |  | $                       | 2,035   |   |                           | $ | 7,762   |  
|                                                                                                                                             |  |                         |         |   |                           |   |         |  
|LIABILITIES AND STOCKHOLDERS DEFICIT                                                                                                        |  |                         |         |   |                           |   |         |  
|Current liabilities:                                                                                                                         |  |                         |         |   |                           |   |         |  
|Accounts payable to Triple Ring                                                                                                              |  | $                       | 696     |   |                           | $ | 2,109   |  
|Accounts payable trade                                                                                                                       |  |                         | 21      |   |                           |   | 172     |  
|Accrued liabilities to Triple Ring                                                                                                           |  |                         | 14      |   |                           |   | 508     |  
|Accrued liabilities                                                                                                                          |  |                         | 315     |   |                           |   | 287     |  
|Deferred rent - short term portion                                                                                                           |  |                         | 116     |   |                           |   | 112     |  
|Notes payable to Triple Ring                                                                                                                 |  |                         | 1,462   |   |                           |   |        |  
|Notes payable                                                                                                                                |  |                         | 95      |   |                           |   | 95      |  
|                                                                                                                                             |  |                         |         |   |                           |   |         |  
|Total current liabilities                                                                                                                    |  |                         | 2,719   |   |                           |   | 3,283   |  
|Deferred rent-less short-term portion                                                                                                        |  |                         | 404     |   |                           |   | 463     |  
|Warrant liabilities                                                                                                                          |  |                         | 4,403   |   |                           |   |        |  
|                                                                                                                                             |  |                         |         |   |                           |   |         |  
|Total liabilities                                                                                                                            |  |                         | 7,526   |   |                           |   | 3,746   |  
|                                                                                                                                             |  |                         |         |   |                           |   |         |  
|Commitments and Contingencies (Note 4)                                                                                                       |  |                         |         |   |                           |   |         |  
|Stockholders (deficit) equity:                                                                                                              |  |                         |         |   |                           |   |         |  
|Series A convertible preferred stock, $0.0001 par value                                                                                      |  |                         |         |   |                           |   |         |  
|Authorized shares - 10,000,000; issued and outstanding shares - 8,692,208 at June 30, 2009 and December 31, 2008 (no liquidation
preference) |  |                         | 1       |   |                           |   | 1       |  
|Common stock, $0.0001 par value                                                                                                              |  |                         |         |   |                           |   |         |  
|Authorized shares - 100,000,000; issued and outstanding shares - 9,767,853 at June 30, 2009 and December 31, 2008                            |  |                         | 1       |   |                           |   | 1       |  
|Additional paid-in capital                                                                                                                   |  |                         | 21,200  |   |                           |   | 24,898  |  
|Deficit accumulated during the development stage                                                                                             |  |                         | (26,689 | ) |                           |   | (20,880 | )
|Less: treasury stock, at cost, 1,239,000 shares at June 30, 2009 and December 31, 2008                                                       |  |                         | (4      | ) |                           |   | (4      | )
|                                                                                                                                             |  |                         |         |   |                           |   |         |  
|Total stockholders (deficit) equity                                                                                                         |  |                         | (5,491  | ) |                           |   | 4,016   |  
|                                                                                                                                             |  |                         |         |   |                           |   |         |  
|Total liabilities and stockholders (deficit) equity                                                                                         |  | $                       | 2,035   |   |                           | $ | 7,762   |  
|                                                                                                                                             |  |                         |         |   |                           |   |         |  

The accompanying notes are an integral part of these condensed financial statements.



3



---

##### Table of Contents

NOVARAY MEDICAL, INC.

(A Development Stage Company)

CONDENSED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(Unaudited)



|                                                                                                          |  |                             |       |   |                           |   |        |                                                 |  |   |        |   |  |   |        |   |  |   |         |  
|--------------------------------------------------------------------------------------------------------- |  | --------------------------- | ----- | - | ------------------------- | - | ------ | ----------------------------------------------- |  | - | ------ | - |  | - | ------ | - |  | - | ------- | -
|                                                                                                          |  | Three Months Ended June 30, |       |   | Six Months Ended June 30, |   |        | From Inception(June 7, 2005) toto June 30, 2009 | 
|                                                                                                          |  | 2009                        |       |   | 2008                      |   |        | 2009                                            |  |   | 2008   |   | 
|Operating expenses:                                                                                       |  |                             |       |   |                           |   |        |                                                 |  |   |        |   |  |   |        |   |  |   |         |  
|Sales and marketing                                                                                       |  | $                           | 50    |   |                           | $ | 108    |                                                 |  | $ | 202    |   |  | $ | 183    |   |  | $ | 622     |  
|Research and development (Note 7)                                                                         |  |                             | (627  | ) |                           |   | 3,008  |                                                 |  |   | 2,681  |   |  |   | 4,284  |   |  |   | 14,891  |  
|General and administrative                                                                                |  |                             | 631   |   |                           |   | 790    |                                                 |  |   | 1,687  |   |  |   | 1,488  |   |  |   | 9,382   |  
|                                                                                                          |  |                             |       |   |                           |   |        |                                                 |  |   |        |   |  |   |        |   |  |   |         |  
|Total operating expenses                                                                                  |  |                             | 54    |   |                           |   | 3,906  |                                                 |  |   | 4,570  |   |  |   | 5,955  |   |  |   | 24,895  |  
|                                                                                                          |  |                             |       |   |                           |   |        |                                                 |  |   |        |   |  |   |        |   |  |   |         |  
|Loss from operations                                                                                      |  |                             | (54   | ) |                           |   | (3,906 | )                                               |  |   | (4,570 | ) |  |   | (5,955 | ) |  |   | (24,895 | )
|Other income (expense):                                                                                   |  |                             |       |   |                           |   |        |                                                 |  |   |        |   |  |   |        |   |  |   |         |  
|Interest income                                                                                           |  |                             | 1     |   |                           |   | 13     |                                                 |  |   | 5      |   |  |   | 32     |   |  |   | 82      |  
|Other income                                                                                              |  |                             |      |   |                           |   |       |                                                 |  |   |       |   |  |   |       |   |  |   | 282     |  
|Net loss on change in fair value of warrant liabilities                                                   |  |                             | (387  | ) |                           |   |       |                                                 |  |   | (144   | ) |  |   |       |   |  |   | (144    | )
|Interest expense                                                                                          |  |                             | (9    | ) |                           |   | (3     | )                                               |  |   | (12    | ) |  |   | (6     | ) |  |   | (926    | )
|                                                                                                          |  |                             |       |   |                           |   |        |                                                 |  |   |        |   |  |   |        |   |  |   |         |  
|Total other income (expense)                                                                              |  |                             | (395  | ) |                           |   | 10     |                                                 |  |   | (151   | ) |  |   | 26     |   |  |   | (706    | )
|                                                                                                          |  |                             |       |   |                           |   |        |                                                 |  |   |        |   |  |   |        |   |  |   |         |  
|Net loss                                                                                                  |  | $                           | (449  | ) |                           | $ | (3,896 | )                                               |  | $ | (4,721 | ) |  | $ | (5,929 | ) |  | $ | (25,601 | )
|Deemed dividend                                                                                           |  |                             |      |   |                           |   |       |                                                 |  |   |       |   |  |   |       |   |  |   | (2,178  | )
|                                                                                                          |  |                             |       |   |                           |   |        |                                                 |  |   |        |   |  |   |        |   |  |   |         |  
|Net loss allocable to common stockholders                                                                 |  | $                           | (449  | ) |                           | $ | (3,896 | )                                               |  | $ | (4,721 | ) |  | $ | (5,929 | ) |  | $ | (27,779 | )
|                                                                                                          |  |                             |       |   |                           |   |        |                                                 |  |   |        |   |  |   |        |   |  |   |         |  
|Basic and diluted loss per share allocable to common stockholders                                         |  | $                           | (0.05 | ) |                           | $ | (0.42  | )                                               |  | $ | (0.50  | ) |  | $ | (0.63  | ) |  | $ | (4.15   | )
|Weighted average shares used to compute basic and diluted loss per share allocable to common stockholders |  |                             | 9,527 |   |                           |   | 9,366  |                                                 |  |   | 9,507  |   |  |   | 9,346  |   |  |   | 6,687   |  

The accompanying notes are an integral part of these condensed financial statements.



4



---

##### Table of Contents

NOVARAY MEDICAL, INC.

(A Development Stage Company)

CONDENSED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)



|                                                                                     |  |                           |        |   |                                              |   |        |   |  |   |         |  
|------------------------------------------------------------------------------------ |  | ------------------------- | ------ | - | -------------------------------------------- | - | ------ | - |  | - | ------- | -
|                                                                                     |  | Six Months Ended June 30, |        |   | From Inception(June 7, 2005) toJune 30, 2009 |  
|                                                                                     |  | 2009                      |        |   | 2008                                         |   |       
|Cash Flows From Operating Activities:                                                |  |                           |        |   |                                              |   |        |   |  |   |         |  
|Net loss                                                                             |  | $                         | (4,721 | ) |                                              | $ | (5,929 | ) |  | $ | (25,601 | )
|Adjustments to reconcile net loss to net cash used in operating activities:          |  |                           |        |   |                                              |   |        |   |  |   |         |  
|Depreciation and amortization                                                        |  |                           | 124    |   |                                              |   | 9      |   |  |   | 198     |  
|Stock-based compensation expense                                                     |  |                           | 495    |   |                                              |   |       |   |  |   | 495     |  
|Non-cash research and development expenses associated with performance based warrant |  |                           | (1,124 | ) |                                              |   | 444    |   |  |   |        |  
|Net loss on change in fair value of warrant liabilities                              |  |                           | 144    |   |                                              |   |       |   |  |   | 144     |  
|Gain on extinguishment of debt                                                       |  |                           |       |   |                                              |   |       |   |  |   | (452    | )
|Loss on conversion of preferred debt                                                 |  |                           |       |   |                                              |   |       |   |  |   | 252     |  
|Beneficial conversion of convertible debt                                            |  |                           |       |   |                                              |   |       |   |  |   | 264     |  
|Write-down of purchased intellectual property                                        |  |                           |       |   |                                              |   |       |   |  |   | 2,016   |  
|Interest expense capitalized as long term debt                                       |  |                           |       |   |                                              |   |       |   |  |   | 255     |  
|Interest expense converted to preferred stock                                        |  |                           |       |   |                                              |   |       |   |  |   | 273     |  
|Changes in operating assets and liabilities:                                         |  |                           |        |   |                                              |   |        |   |  |   |         |  
|Receivables from Triple Ring                                                         |  |                           | 42     |   |                                              |   | (1     | ) |  |   |        |  
|Other receivables                                                                    |  |                           | (12    | ) |                                              |   | (380   | ) |  |   | (12     | )
|Inventory                                                                            |  |                           |       |   |                                              |   |       |   |  |   | (131    | )
|Prepaid expenses to Triple Ring                                                      |  |                           | 5      |   |                                              |   | (185   | ) |  |   | (136    | )
|Prepaid expenses and other current assets                                            |  |                           | 40     |   |                                              |   | (135   | ) |  |   | (23     | )
|Accounts payable to Triple Ring                                                      |  |                           | 48     |   |                                              |   | 1,805  |   |  |   | 2,157   |  
|Accounts payable trade                                                               |  |                           | (151   | ) |                                              |   | 74     |   |  |   | 21      |  
|Accrued liabilities to Triple Ring                                                   |  |                           | (494   | ) |                                              |   | 23     |   |  |   | 14      |  
|Accrued liabilities                                                                  |  |                           | 131    |   |                                              |   | 19     |   |  |   | 418     |  
|Deferred rent                                                                        |  |                           | (55    | ) |                                              |   |       |   |  |   | 520     |  
|                                                                                     |  |                           |        |   |                                              |   |        |   |  |   |         |  
|Net cash used in operating activities                                                |  |                           | (5,528 | ) |                                              |   | (4,256 | ) |  |   | (19,328 | )
|                                                                                     |  |                           |        |   |                                              |   |        |   |  |   |         |  
|Cash Flows From Investing Activities:                                                |  |                           |        |   |                                              |   |        |   |  |   |         |  
|Property and equipment                                                               |  |                           | (21    | ) |                                              |   | (72    | ) |  |   | (1,154  | )
|Restricted cash                                                                      |  |                           | 135    |   |                                              |   | (135   | ) |  |   |        |  
|Security deposit with Triple Ring                                                    |  |                           |       |   |                                              |   | (500   | ) |  |   | (500    | )
|                                                                                     |  |                           |        |   |                                              |   |        |   |  |   |         |  
|Net cash provided by (used in) investing activities                                  |  |                           | 114    |   |                                              |   | (707   | ) |  |   | (1,654  | )
|                                                                                     |  |                           |        |   |                                              |   |        |   |  |   |         |  
|Cash Flows From Financing Activities:                                                |  |                           |        |   |                                              |   |        |   |  |   |         |  
|Proceeds from subscriptions receivable                                               |  |                           |       |   |                                              |   |       |   |  |   | 100     |  
|Proceeds from issuance of short term debt                                            |  |                           |       |   |                                              |   |       |   |  |   | 2,044   |  
|Proceeds from sale of common stock                                                   |  |                           |       |   |                                              |   |       |   |  |   | 154     |  
|Proceeds from sale of Series A convertible preferred stock                           |  |                           |       |   |                                              |   |       |   |  |   | 20,430  |  
|Repayment of notes payable                                                           |  |                           |       |   |                                              |   | (30    | ) |  |   | (30     | )
|Payment on extinguishment of debt                                                    |  |                           |       |   |                                              |   |       |   |  |   | (10     | )
|Issuance costs incurred in sale of Series A convertible preferred stock              |  |                           |       |   |                                              |   |       |   |  |   | (1,425  | )
|Issuance costs incurred in issuance of convertible debt                              |  |                           | (119   | ) |                                              |   |       |   |  |   | (119    | )
|Purchase of treasury stock                                                           |  |                           |       |   |                                              |   |       |   |  |   | (4      | )
|                                                                                     |  |                           |        |   |                                              |   |        |   |  |   |         |  
|Net cash provided by (used in) financing activities                                  |  |                           | (119   | ) |                                              |   | (30    | ) |  |   | 21,140  |  
|                                                                                     |  |                           |        |   |                                              |   |        |   |  |   |         |  
|Net (decrease) increase in cash and cash equivalents                                 |  |                           | (5,533 | ) |                                              |   | (4,993 | ) |  |   | 158     |  
|Cash and cash equivalents  beginning of period                                      |  |                           | 5,691  |   |                                              |   | 9,234  |   |  |   |        |  
|                                                                                     |  |                           |        |   |                                              |   |        |   |  |   |         |  
|Cash and cash equivalents  end of period                                            |  | $                         | 158    |   |                                              | $ | 4,241  |   |  | $ | 158     |  
|                                                                                     |  |                           |        |   |                                              |   |        |   |  |   |         |  
|Supplemental disclosures of cash flow information:                                   |  |                           |        |   |                                              |   |        |   |  |   |         |  
|Cash paid for interest                                                               |  | $                         |       |   |                                              | $ |       |   |  | $ | 27      |  
|Cash paid for taxes                                                                  |  | $                         |       |   |                                              | $ |       |   |  | $ | 39      |  
|Supplemental disclosures of non-cash financing activities:                           |  |                           |        |   |                                              |   |        |   |  |   |         |  
|Accounts payable to Triple Ring exchanged for notes payable to Triple Ring           |  | $                         | 1,462  |   |                                              | $ |       |   |  | $ | 1,462   |  
|Modification of Series J and Series J-A stock warrants                               |  | $                         |       |   |                                              | $ |       |   |  | $ | 2,178   |  
|Common stock issued as offering costs                                                |  | $                         |       |   |                                              | $ |       |   |  | $ | 1,683   |  
|Warrants issued in connection with financing                                         |  | $                         |       |   |                                              | $ |       |   |  | $ | 3,768   |  
|Convertible preferred stock issued in exchange for cancellation of debt              |  | $                         |       |   |                                              | $ |       |   |  | $ | 4,001   |  
|Long term debt assumed at inception in connection with intellectual property         |  | $                         |       |   |                                              | $ |       |   |  | $ | 2,016   |  
|Interest expense capitalized as long term debt                                       |  | $                         |       |   |                                              | $ |       |   |  | $ | 255     |  
|Interest expense converted to preferred stock                                        |  | $                         |       |   |                                              | $ |       |   |  | $ | 273     |  

The accompanying notes are an integral part of these condensed financial statements.



5



---

##### Table of Contents

NOVARAY MEDICAL, INC.

(A Development Stage Company)

NOTES
TO FINANCIAL STATEMENTS

(Unaudited)

1. Description of Business

NovaRay Medical, Inc. (the Company, NovaRay, we, or
our), a Delaware corporation, is a development stage medical imaging company focused on developing unique innovations in proprietary digital cardiac x-ray technology. NovaRays initial clinical offering, the ScanCath cardiac
catheterization system, is expected to offer advanced imaging capabilities, coupled with reductions in radiation exposure to patients, operators, and staff. We have 23 issued U.S. patents with claims as to our system and its underlying technologies.

2. Summary of Significant Accounting Policies

Basis of Presentation

The Company prepares its financial statements in accordance with accounting principles
generally accepted in the United States (GAAP). The Company is a development stage company since it has not generated revenue from the sale of its products and its efforts from its inception on June 7, 2005 have principally been
devoted to developing its product as well as raising capital. Accordingly the financial statements have been prepared in accordance with the provisions of SFAS No. 7, Accounting and Reporting by Development Stage Enterprises, (SFAS
7).

The accompanying condensed financial statements have been prepared by the Company, without audit, pursuant to the rules and
regulations of the Securities and Exchange Commission (SEC). Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. GAAP have been condensed or omitted pursuant to such
rules and regulations. The condensed balance sheet at December 31, 2008 was derived from audited financial statements, but does not include all disclosures required by U.S. GAAP; however, the Company believes that the disclosures are adequate
to make the information presented not misleading. These unaudited condensed financial statements should be read in conjunction with the audited Financial Statements and the notes thereto for the fiscal year ended December 31, 2008 included in
the Companys Annual Report on Form 10-K filed with the SEC on March 27, 2009.

In the opinion of management, all adjustments,
consisting principally of normal recurring adjustments, which are necessary to present fairly the financial position, results of operations and cash flows for the interim periods, have been made. The results of operations for the interim periods are
not necessarily indicative of the operating results for the full fiscal year or any future periods

Going Concern

We require additional funds to continue operations. As reflected in the accompanying financial statements, the Company is in the development stage, has
a net loss since inception of $25.6 million and has used cash in operations of $19.3 million since inception. This raises substantial doubt about our ability to continue as a going concern. Our ability to continue as a going concern is dependent on
our ability to raise additional capital and implement our business plan. The financial statements do not include any adjustments that might be necessary if we are unable to continue as a going concern.

During the first six months ended June 30, 2009, our net loss was $4.7 million, and at June 30, 2009, our cash and equivalents were $158,000.
On July 2, 2009, we entered into a Note and Warrant Purchase Agreement, pursuant to which we raised $2.8 million. After paying off the credit line with Triple Ring and paying transaction fees, we received net proceeds for working capital of
$1.2 million (See Note 8. Subsequent events). Even though we raised this capital we believe we will need additional funds to meet our anticipated cash needs for working capital and capital expenditures for the next six months. Because we have
never generated revenue and do not expect to do so until 2010 or later, we will most likely be required to raise these additional funds through convertible debt, debt or equity financings or by selling our assets.

Management believes that actions presently being taken to obtain additional funding and implement its strategic plans provide the opportunity for the
Company to continue as a going concern. However, this additional financing may not be available on a timely basis or on terms acceptable to us, or at all. Our ability to obtain such financing may be impaired by the current economic conditions and
the lack of liquidity in the credit markets. If we are unable to secure additional funding, we may have to discontinue operations;



6



---

##### Table of Contents

delay development or commercialization of our system; license to third parties the rights to commercialize products or technologies that we would otherwise
seek to commercialize; reduce marketing, customer support, or other resources devoted to our system: or any combination of these activities. Any of these results would materially harm our business, financial condition, and results of operations, and
there can be no assurance that any of these results will result in cash flows that will be sufficient to fund our current or future operating needs. We may also need to seek protection under the U.S. Bankruptcy Code or otherwise liquidate our
assets, which may result in the failure of our stockholders to receive value for their ownership of our stock.

Reclassifications

Certain amounts reported in the accompanying condensed financial statements for 2008 and inception to date information have been
reclassified to conform to the 2009 presentation. Such reclassifications had no material effect on previously reported results of operations, total assets or the deficit accumulated during the development stage.

Uses of Estimates

The
preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Estimates are used for the valuation of the
Companys stock, as the Companys stock is not currently trading; the valuation of equity and equity-linked instruments such as options and warrants using the Black-Scholes model; and for the probability of the delivery date in connection
with the common performance warrants with Triple Ring. Actual results could materially differ from these estimates.

Cash and Cash
Equivalents

The Company maintains cash balances at various financial institutions. Accounts at each institution are insured by the
Federal Deposit Insurance Corporation. The Companys accounts at these institutions may, at times, exceed the federally insured limits. The Company has not experienced any losses in such accounts. Cash equivalents consist primarily of money
market funds.

Inventory

Inventory is valued at the lower of cost or market. The Company periodically reviews its inventory for obsolete items and provides a reserve upon identification of potential obsolete items. Through the three and six month periods ended
June 30, 2009, there have been no obsolete items identified.

Property and Equipment

Property and equipment are recorded at cost less accumulated depreciation and amortization. Depreciation is calculated using the straight-line method over
the estimated useful lives of the related assets. Leasehold improvements are amortized on a straight-line basis over the life of the lease or the estimated useful life of the asset, whichever is shorter. Machinery and equipment and furniture and
fixtures are depreciated over five years. Computer and office equipment are depreciated over three years.

Property and equipment consisted
of the following (in thousands):



|                                                |  |              |       |   |                  |   |       |  
|----------------------------------------------- |  | ------------ | ----- | - | ---------------- | - | ----- | -
|                                                |  | June 30,2009 |       |   | December 31,2008 |  
|Computer and office equipment                   |  | $            | 15    |   |                  | $ | 13    |  
|Machinery and equipment                         |  |              | 105   |   |                  |   | 91    |  
|Furniture and fixtures                          |  |              | 200   |   |                  |   | 200   |  
|Leasehold improvements                          |  |              | 835   |   |                  |   | 829   |  
|                                                |  |              |       |   |                  |   |       |  
|                                                |  |              | 1,155 |   |                  |   | 1,133 |  
|Less: accumulated depreciation and amortization |  |              | (198  | ) |                  |   | (74   | )
|                                                |  |              |       |   |                  |   |       |  
|Property and equipment, net                     |  | $            | 957   |   |                  | $ | 1,059 |  
|                                                |  |              |       |   |                  |   |       |  

Depreciation and amortization expense related to property and equipment for the three and six
month periods ended June 30, 2009 was $62,000 and $124,000, respectively. Depreciation and amortization expense related to property and equipment for the three and six month periods ended June 30, 2008 was $5,000 and $9,000, respectively.

Impairment of Long-Lived Assets

In accordance with the provisions of SFAS No. 144, Accounting for the Impairment or Disposal of Long-lived Assets, (SFAS 144) the Company reviews long-lived assets, including property and
equipment, for impairment whenever events or changes in



7



---

##### Table of Contents

business circumstances indicate that the carrying amount of the assets may not be fully recoverable. Under SFAS 144, an impairment loss would be recognized
when estimated undiscounted future cash flows expected to result from the use of the asset and its eventual disposition is less than its carrying amount. Impairment, if any, is measured as the amount by which the carrying value of a long-lived asset
exceeds its fair value. Through June 30, 2009, there have been no such impairment losses.

Restricted Cash

Restricted cash at December 31, 2008 reflected a security deposit for the landlord of our headquarters facility in the form of an
irrevocable standby letter of credit with our bank. On March 12, 2009, the Company and Triple Ring entered into an Assignment and Assumption of Lease Agreement under which the Company assigned its interest in the headquarters office lease
and Triple Ring assumed the Companys obligations under the lease. During April 2009, Triple Ring replaced the letter of credit that the Company had with the landlord and the landlord released the letter of credit from the Company. The
restriction on the Companys cash associated with this letter of credit was subsequently removed.

Research and Development
Costs

Research and development costs are expensed in the period incurred. Advance payments to Triple Ring for their material
vendors requiring deposits are included in prepaid expenses until the materials are delivered and the deposit is applied toward the final purchase amount.

Common Stock Warrants

The Company from time to time issues common stock or common stock
warrants to acquire services or goods from non-employees. Common stock and common stock warrants issued to other than employees or directors are recorded on the basis of their fair value, which is measured as of the date required by Emerging Issues
Task Force (EITF) Issue 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services, (EITF 96-18).

In accordance with EITF 96-18, the common stock warrants are valued using the Black-Scholes model on the basis of the market price of the underlying
common stock on the valuation date, which for warrants related to contracts that have substantial disincentives for non-performance is the date of the contract, and for all other contracts is the vesting date. Expense related to the
warrants is recognized on a straight-line basis over the shorter of the period over which services are to be received or the vesting period. Where expense must be recognized prior to a valuation date, the expense is computed under the Black-Scholes
option-pricing model on the basis of the market price of the underlying common stock at the end of the period, and any subsequent changes in the market price of the underlying common stock through the valuation date is reflected in the expense
recorded in the subsequent period in which that change occurs.

Stock-based Compensation

The Company recognizes stock-based compensation expense in accordance with SFAS No. 123(R), Share-Based Payment (SFAS 123R). Under
SFAS 123R, the Company estimates the fair value of each option award on the date of grant using the Black-Scholes option-pricing model using the assumptions noted in the table below. Expected volatility was based on the historical volatility of a
peer group of publicly traded companies. The expected term of options was based upon the simplified method provided by the SEC in Staff Accounting Bulletin No. 107, Share-Based Payments, (SAB 107). The risk-free rate for the
expected term of the option is based on the U.S. Treasury Constant Maturity rate.

Loss per share

Basic loss per share is computed by dividing loss allocable to common shareholders by the weighted average number of common shares outstanding for the
period. Diluted loss per share includes the effects of the potential dilution of outstanding warrants, restricted stock and convertible debt and preferred stock (common stock equivalents) on the Companys common stock. Loss per
share is as follows (in thousands, except per share data):



|                                                                                                           |  |                             |       |   |                           |   |        |      |  |   |        |   |  |   |        |  
|---------------------------------------------------------------------------------------------------------- |  | --------------------------- | ----- | - | ------------------------- | - | ------ | ---- |  | - | ------ | - |  | - | ------ | -
|                                                                                                           |  | Three months ended June 30, |       |   | Six months ended June 30, |  
|                                                                                                           |  | 2009                        |       |   | 2008                      |   |        | 2009 |  |   | 2008   |  
|Basic and Diluted:                                                                                         |  |                             |       |   |                           |   |        |      |  |   |        |   |  |   |        |  
|Net loss allocable to common stockholders                                                                  |  | $                           | (449  | ) |                           | $ | (3,896 | )    |  | $ | (4,721 | ) |  | $ | (5,929 | )
|Basic and diluted loss per share allocable to common stockholders                                          |  | $                           | (0.05 | ) |                           | $ | (0.42  | )    |  | $ | (0.50  | ) |  | $ | (0.63  | )
|Weighted average shares used to compute basic and diluted loss per share allocable to common stockholders. |  |                             | 9,527 |   |                           |   | 9,366  |      |  |   | 9,507  |   |  |   | 9,346  |  



8



---

##### Table of Contents

Outstanding common stock equivalents that are excluded from the calculation of diluted net loss per share
as their effect is anti-dilutive totaled 14,303,167 and 10,676,539 for the three and six month periods ended June 30, 2009, respectively. Outstanding common stock equivalents that are excluded from the calculation of diluted net loss per share
as their effect is anti-dilutive totaled 14,323,155 and 10,696,637 for the three and six month periods ended June 30, 2008, respectively.

Recent Accounting Pronouncements

In June 2009, the FASB issued SFAS No. 168, The FASB Accounting Standards
Codification and the Hierarchy of Generally Accepted Accounting Principles (SFAS 168). SFAS 168 establishes the FASB Accounting Standards Codification (the Codification) as the source of authoritative accounting
principles recognized by the FASB to be applied by nongovernmental entities in the preparation of financial statements in conformity with U.S. GAAP. Rules and interpretive releases of the SEC under authority of federal securities laws are also
sources of authoritative U.S. GAAP for SEC registrants. All guidance contained in the Codification carries an equal level of authority. SFAS 168 is effective for financial statements issued for interim and annual periods ending after
September 15, 2009. The Codification will supersede all existing non-SEC accounting and reporting standards. All other non-grandfathered, non-SEC accounting literature not included in the Codification will become non-authoritative. Following
SFAS 168, the FASB will not issue new standards in the form of Statements, FASB Staff Positions, or Emerging Issues Task Force Abstracts. Instead, it will issue Accounting Standards Updates. The FASB will not consider Accounting Standards Updates as
authoritative in their own right. Accounting Standards Updates will serve only to update the Codification, provide background information about the guidance and provide the bases for conclusions on the change(s) in the Codification. The Company will
update its disclosures to conform to the Codification in its Form 10-Q for the third quarter of 2009.

In June 2009, the FASB issued SFAS
No. 167, Amendments to FASB Interpretation No. 46(R) (SFAS 167), which amends the consolidation guidance applicable to variable interest entities. The amendments to the consolidation guidance affect all entities
currently within the scope of FIN 46(R), as well as qualifying special-purpose entities that are currently excluded from the scope of FIN 46(R). SFAS 167 is effective as of the beginning of the first fiscal year that begins after November 15,
2009. The adoption of SFAS 167 is not expected to have a material effect on the Companys financial statements.

In June 2009, the
FASB issued SFAS No. 166, Accounting for Transfers of Financial Assets  an Amendment of FASB Statement No. 140(SFAS 166). SFAS 166 amends the de-recognition accounting and disclosure guidance relating to SFAS 140.
SFAS 166 eliminates the exemption from consolidation for qualifying special-purpose entities, it also requires a transferor to evaluate all existing qualifying special-purpose entities to determine whether it must be consolidated in accordance with
SFAS 167. SFAS 166 is effective for financial asset transfers occurring after the beginning of an entitys first fiscal year that begins after November 15, 2009. The adoption of SFAS 166 is not expected to have a material effect on the
Companys financial statements.

In May 2009, the FASB issued SFAS No. 165, Subsequent Events(SFAS 165),
which establishes general standards of accounting for, and disclosure of, events that occur after the balance sheet date but before financial statements are issued. SFAS 165 is for interim or annual periods ending after June 15, 2009. The
adoption of SFAS 165 did not have a material impact on the Companys financial statements.

In December 2008, the FASB issued FASB
Staff Position (FSP) FAS 140-4 and Financial Interpretations (FIN) 46(R)-8, Disclosures by Public Entities (Enterprises) about Transfers of Financial Assets and Interest is in Variable Interest Entities (FSP FAS
140-4). This disclosure-only FSP improves the transparency of transfers of financial assets and an enterprises involvement with variable interest entities, including qualifying special-purpose entities. This FSP is effective for the
first reporting period (interim or annual) ending after December 15, 2008, with earlier application encouraged. The adoption of FSP FAS 140-4 and FIN 46(R)-8 did not have a material impact on the Companys financial statements.

In October 2008, the FASB issued FSP No. FAS 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not
Active (FSP FAS 157-3). FSP FAS 157-3 provides examples to illustrate key considerations in determining the fair value of a financial asset when the market for that financial asset is not active. FSP FAS 157-3 was effective upon
issuance and did not have a material impact on the Companys financial statements.



9



---

##### Table of Contents

Impact of Recently Adopted Accounting Standards

In June 2008, the FASB ratified EITF Issue 07-5, Determining Whether an Instrument (or Embedded Feature) Is Indexed to an Entitys Own Stock,
(EITF 07-5). Paragraph 11(a) of SFAS No 133, Accounting for Derivatives and Hedging Activities, (SFAS 133) specifies that a contract that would otherwise meet the definition of a derivative but is both (a) indexed
to the Companys own stock and (b) classified in stockholders equity in the statement of financial position would not be considered a derivative financial instrument. EITF 07-5 provides a new two-step model to be applied in
determining whether a financial instrument or an embedded feature is indexed to an issuers own stock and thus able to qualify for the SFAS 133 paragraph 11(a) scope exception. EITF 07-5 became effective for the first annual reporting period
beginning after December 15, 2008. The Company adopted EITF 07-5 on January 1, 2009.

As a result of adopting EITF 07-5,
4,770,060 of our issued and outstanding common stock purchase warrants previously treated as equity pursuant to the derivative treatment exemption were no longer afforded equity treatment. The warrants impacted are the Series A, Amended Series J-A
and Series J-A additional shares (See Note 5. Stockholders (deficit) equity). Upon adoption, we reclassified the fair value of these common stock purchase warrants, which have exercise price reset features, from equity to liability
status as if these warrants were treated as a derivative liability since their date of issue. On January 1, 2009, as a cumulative effect adjustment, we reduced additional paid-in capital by $3.2 million, increased beginning accumulated deficit
by $1.1 million and recorded $4.3 million to a long-term warrant liability to recognize the fair value of such warrants on the date of adoption. The fair value of these common stock purchase warrants declined to approximately $4 million as
of March 31, 2009 and increased to approximately $4.4 million as of June 30, 2009. We recognized a $387,000 and $144,000 net loss on change in fair value of warrant liabilities for the three and six month periods ended June 30, 2009,
respectively.

These common stock purchase warrants were initially issued in connection with our previous private placements of equity
securities during fiscal years 2007 and 2008. The common stock purchase warrants were not issued with the intent of effectively hedging any future cash flow, fair value of any asset, liability or any net investment in a foreign operation. The
warrants do not qualify for hedge accounting, and as such, all future changes in the fair value of these warrants will be recognized currently in earnings until such time as the warrants are exercised or expire. These common stock purchase warrants
do not trade in an active securities market, and as such, we estimate the fair value of these warrants using the Black-Scholes option pricing model using the following assumptions:



|                        |  |              |  |               
|----------------------- |  | ------------ |  | --------------
|                        |  | June 30,2009 |  | January 1,2009
|Risk-free interest rate |  | 2.09%        |  | 1.28%  1.55% 
|Dividend yield          |  |             |  |              
|Expected life (years)   |  | 3.5  4.3    |  | 4.0  4.8     
|Expected volatility     |  | 62.42%       |  | 57.99%        

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements,
(SFAS 157), which defines fair value, establishes a framework for measuring fair value in GAAP, and expands disclosures about fair value measurements. SFAS 157 does not require any new fair value measurements, but provides guidance on
how to measure fair value by providing a fair value hierarchy used to classify the source of the information. In February 2008, the FASB deferred the effective date of SFAS 157 by one year for certain non-financial assets and non-financial
liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). On January 1, 2008, we adopted the provisions of SFAS 157, except as it applies to those nonfinancial
assets and nonfinancial liabilities for which the effective date has been delayed by one year, which we adopted on January 1, 2009. The adoption of SFAS 157 did not have a material effect on our financial position or results of operations. The
book values of cash and accounts payable approximate their respective fair values due to the short-term nature of these instruments.

The
fair value hierarchy distinguishes between assumptions based on market data (observable inputs) and an entitys own assumptions (unobservable inputs). The hierarchy consists of three levels:



| |  |  | Level one  Quoted market prices in active markets for identical assets or liabilities;
| | - |  | ---------------------------------------------------------------------------------------



| |  |  | Level two  Inputs other than level one inputs that are either directly or indirectly observable; and
| | - |  | -----------------------------------------------------------------------------------------------------



| |  |  | Level three  Unobservable inputs developed using estimates and assumptions, which are developed by the reporting entity and reflect those assumptions that a
market participant would use.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Determining which category an asset or liability falls within the hierarchy requires
significant judgment. We evaluate our hierarchy disclosures each quarter. Liabilities measured at fair value on a recurring basis are summarized as follows (unaudited):



|                       |  |         |   |         |   |         |  |              |       |  |   |      
|---------------------- |  | ------- | - | ------- | - | ------- |  | ------------ | ----- |  | - | -----
|                       |  | Level 1 |   | Level 2 |   | Level 3 |  | June 30,2009
|Fair value of warrants |  | $       |  |         | $ |        |  | $            | 4,403 |  | $ | 4,403



10



---

##### Table of Contents

We have no assets that are measured at fair value on a recurring basis.

3. Notes payable

The Company received certain assets
subject to a security interest securing obligations under a series of promissory notes issued to stockholders and financial institutions in connection with the initial organization of NovaRay, Inc., in the aggregate amount of $728,000 for the
purpose of developing intellectual property that will be utilized in the Companys planned product. These notes bear interest at rates ranging from 9% to 12% annually, are secured by the assigned assets, and are payable upon demand of the
holders. In October 2007, most of these notes were converted into NovaRay, Inc.s Series A Convertible Preferred Stock. As of June 30, 2009, the aggregate principal balance due under two remaining promissory notes was $95,000, and the
interest rate of such notes is 12% per annum.

In March 2009, the Company and Triple Ring entered into a Credit and Security
Agreement. Under the Credit and Security Agreement, Triple Ring agreed to make available to the Company, on a revolving basis, a line of credit in an amount of up to $1.5 million (the Credit Line) with an annual interest rate of 2%. The
Credit Line consisted of Triple Rings forbearance of partial payments due by the Company under the Professional Services Agreement, as amended (the Services Agreement) between the Company and Triple Ring. After an initial credit
extension of $175,000, each monthly forbearance of certain payments due under the Services Agreement resulted in an extension of credit, which in the aggregate comprised the Credit Line. The Credit Line was secured by all of the Companys
assets on a first priority security interest. The termination date of the credit extension under the Credit and Security Agreement was the earliest to occur of: (a) December 15, 2009, (b) termination of the Services Agreement, or
(c) receipt of gross proceeds from equity or debt or other financing obtained by NovaRay of at least $5 million in the aggregate. As of June 30, 2009, the principal balance due under the Credit Line was $1.5 million. The Credit Line was
paid off on July 2, 2009, and the security interest held by Triple Ring was terminated (See Note 8. Subsequent events).

4. Commitments and
contingencies

Operating Lease

Prior to March 2009, NovaRay leased its headquarters office facility under a non-cancelable operating lease expiring in July 2013. The Company recognizes rent expense on a straight-line basis over the lease period, and has accrued for
rent expense incurred but not paid. In March 2009, the Company assigned its interest in the office lease and Triple Ring assumed the Companys obligations under the office lease. Concurrently, the Company and Triple Ring entered into a sublease
agreement whereby the Company would sublease 58.5% of the premises under the lease term through July 2013. Under the sublease, the Company will pay a portion of the base rent, additional rent pro-rated to cover the subleased space and its share of
operating expenses. All the terms and conditions set forth in the office lease are in effect and binding upon the Company and Triple Ring.

Contingencies

From time to time and in the ordinary course of business, the Company may be subject to various claims,
charges, and litigation. In the opinion of management, final judgments from such pending claims, charges, and litigation, if any, against the Company, would not have a material adverse effect on the Companys financial position, result of
operations, or cash flows.

Indemnification

As permitted under Delaware law, the Company has agreements whereby the Company has indemnified our officers, directors and certain employees for certain events or occurrences while the employee, officer or director is, or was serving, at
the Companys request in such capacity. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is unlimited; however, the Company has a Director and Officer insurance policy
that limits the Companys exposure and may enable the Company to recover a portion of any future amounts paid. As a result of insurance policy coverage, the Company believes the estimated fair value of these indemnification agreements is
minimal. Accordingly, the Company has no liabilities recorded for these agreements as of June 30, 2009 and December 31, 2008.

The Company enters into standard indemnification agreements in our ordinary course of business. Pursuant to these agreements, the Company agrees to indemnify, defend, hold harmless, and to reimburse the indemnified party for losses suffered
or incurred by the indemnified party, generally the Companys business partners or customers. The term of these indemnification agreements is generally



11



---

##### Table of Contents

perpetual after execution of the agreement. The maximum potential amount of future payments the Company could be required to make under these indemnification
agreements is unlimited. The Company has not incurred any costs to defend lawsuits or settle claims related to these indemnification agreements. The Company believes the estimated fair value of these agreements is minimal. Accordingly, the Company
has no liabilities recorded for these agreements as of June 30, 2009.

5. Stockholders (deficit) equity

The Company has authorized capital of 110,000,000 shares, of which 100,000,000 are designated as common stock, par value $0.0001 per share (the
Common Stock), and 10,000,000 are designated as preferred stock, par value $0.0001 per share (the Preferred Stock). As of June 30, 2009, all shares of Preferred Stock were designated as Series A Convertible Preferred
Stock which are convertible at the current rate of one share for one share of our Common Stock. As of June 30, 2009, the Company had outstanding 9,767,853 shares of Common Stock and 8,692,208 shares of Preferred Stock. Additionally, there are
outstanding warrants to purchase an aggregate of up to 6,702,060 shares of our Common Stock as of June 30, 2009.

On July 1,
2009, the Company reduced the authorized number of shares of Series A Convertible Preferred Stock by amending the certificate of designation defining its rights. The Company subsequently filed a certificate of designation to authorize the creation
of a new class of Series A-1 Convertible Preferred Stock with 870,000 authorized shares (See Note 8. Subsequent events).

Common Stock

The holders of common stock are entitled one vote for each share held and to receive dividends whenever
funds are legally available and when declared by the Board of Directors subject to the prior rights of holders of all classes of stock having priority rights as dividends. No dividends have been declared or paid as of June 30, 2009 and
December 31, 2008, although the Company has recorded non-cash expense for deemed dividends.

In October 2006, the Company entered into
a restricted stock purchase agreement for the 642,000 shares of common stock (See Note 7. Related party transactions).

Series A Convertible Preferred Stock

In December 2007, September 2008 and October 2008, the Company completed
the private placements of 4,946,888 shares, 1,872,660 shares and 1,872,660 shares, respectively, of Series A Convertible Preferred Stock. Subject to conversion restriction which restricts the preferred stockholder and its affiliates from
beneficially owning more than 4.99% of the then issued and outstanding shares of Common Stock unless a 61-day waiver notice had been provided, the Series A Convertible Preferred Stock is convertible into Common Stock at the option of the preferred
stockholder. Upon our issuance of certain shares of Common Stock at prices less than $2.67 per share, subject to certain exclusions, the conversion rate of the Series A Convertible Preferred Stock is subject to upward adjustment on the basis of a
broadly based weighted average so as to cause a share of outstanding Series A Convertible Preferred Stock to be potentially convertible into more than one share of Common Stock.

In the event of a liquidation, dissolution or winding up of the Company, the conversion rights shall terminate at the close of business on the last full
day preceding the date fixed for the payment of any such amounts distributable on such event to the holders of our Series A Convertible Preferred Stock.

The Series A Convertible Preferred Stock has no liquidation preference, is convertible one-to-one to Common Stock subject to certain adjustments, has no redemption features, has dividend rights on a pari passu basis
with the Common Stock and is non-voting. No dividends have been declared to date on the Common Stock or the Series A Convertible Preferred Stock, although the Company has recorded non-cash expense for deemed dividends.

Warrants

At June 30,
2009, warrants consisted of the following:



|                             |  |                   |  |               |     
|---------------------------- |  | ----------------- |  | ------------- | ----
|                             |  | June 30, 2009    
|Warrant Group                |  | Number ofWarrants |  | ExercisePrice
|Series A                     |  | 1,648,960         |  | $             | 4.25
|Amended Series J-A           |  | 1,248,440         |  | $             | 4.25
|Series J-A additional shares |  | 1,872,660         |  | $             | 5.00
|Consultant                   |  | 600,000           |  | $             | 4.25
|Triple Ring(1)               |  | 1,332,000         |  |               | N/A 
|                             |  |                   |  |               |     
|                             |  | 6,702,060         |  |               |     
|                             |  |                   |  |               |     



|(1) | The Company believes that these warrants will expire prior to being exercised since acceptance of certain Triple Ring deliverables by the Company will likely occur after
February 28, 2010. (See Note 7. Related party transactions.)
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



12



---

##### Table of Contents

All of the warrants outstanding at June 30, 2009 are for the purchase of our Common Stock. As
further discussed in Note 1. Summary of Significant Accounting Policies, 4,770,060 of the above Series A, Amended Series J-A and Series J-A additional share warrants were reclassified from equity to warrant liabilities on January 1, 2009
as a result of the adoption of EITF 07-5, and subsequent changes in fair value of these warrant liabilities have been reflected in operations.

On December 27, 2007, pursuant to the Series A Convertible Preferred Stock and Warrant Purchase Agreement (the Purchase Agreement), by and among the Company, Vision Opportunity Master Fund Ltd. (Vision),
Lynda Wijcik, Commerce and Industry Insurance Company, AIU Insurance Company, AIG Private Equity Portfolio, L.P., AIG Horizon Partners Fund L.P., AIG Horizon Side-by-Side Fund L.P., Wheatley MedTech Partners, L.P., Lloyd Investments, L.P.,
Heartstream Capital B.V., BioBridge LLC, and Arie Jacob Manintveld (each a Purchaser and collectively the Purchasers), the Company issued (i) Series A Warrants to the Purchasers to purchase 1,648,960 shares of
Common Stock at an exercise price of $4.25 per share, (ii) a Series J Warrant to Vision to purchase 2,309,469 shares of Series A Convertible Preferred Stock at an exercise price of $4.33 per share, and (iii) a
Series J-A Warrant to Vision to purchase up to 769,823 shares of Common Stock at an exercise price of $6.91 per share.

On
August 29, 2008, the Company entered into an amendment with Vision of the Series J Warrant to: (i) increase the number of shares exercisable from 2,309,469 to 3,745,320; (ii) decrease the initial exercise price from $4.33 to $2.67 per
share and (iii) amend the term such that 1,872,660 shares exercisable would expire at 11:59 p.m., eastern time, on September 8, 2008 and the remaining 1,872,660 shares exercisable would expire at 11:59 p.m., Eastern time, on
November 1, 2008.

On August 29, 2008, the Company also entered into an amendment with Vision of the Series J-A Warrant to:
(i) increase the maximum number of shares exercisable from 769,823 to 1,248,440; (ii) decrease the initial exercise price from $6.91 to $4.25 per share; (iii) issue an additional warrant for up to 936,330 shares at an initial exercise
price of $5.00 and a term of five years until September 8, 2013 subject to both the exercise of the Series J Warrant as amended for 1,872,660 shares and receipt by the Company of proceeds of at least $5 million on or prior to September 8,
2008 and (iv) issue an additional warrant for up to 936,330 shares at an initial exercise price of $5.00 and a term of five years until November 1, 2013 subject to both the cumulative exercise of the Series J Warrant as amended for
3,745,320 shares and receipt by the Company of cumulative proceeds of at least $10 million on or prior to November 1, 2008.

The fair
value of $2.2 million for the amended Series J and J-A warrants which were issued at a premium to the original J and J-A warrants was recorded as a deemed dividend in the statements of operations for the quarter ended September 30, 2008.

On September 5, 2008, Vision exercised the Series J Warrant for 1,872,660 shares of Series A Convertible Preferred Stock, and on
October 31, 2008, Vision and its affiliate exercised the remaining Series J Warrant for 1,872,660 shares of Series A Convertible Preferred Stock. The Company received combined proceeds of $9.7 million, net of issuance costs of $299,000.

Consultant Warrants

On December 20, 2007, pursuant to a Consulting Agreement with Fountainhead Capital Partners Limited, dated October 2, 2007, the Company issued a warrant to purchase 600,000 shares of Common Stock at a price of $4.25 per share
exercisable in whole or in part over a period of five years from issuance in exchange for their consulting services. The warrant value charged against additional paid in capital as closing costs in 2007 was $378,000 utilizing the Black-Scholes Model
with an exercise price of $4.25 per share, expected term of 5 years and a risk free rate of 3.63%.



13



---

##### Table of Contents

Triple Ring Warrants

On December 19, 2007, we entered into an agreement with Triple Ring (See Note 7. Related Party Transactions) to perform ongoing product
development work, final assembly and test for the cardiac imaging system (the Professional Services Agreement). As partial consideration for these services, we agreed to issue a warrant to Triple Ring to purchase 1,332,000 shares of
Common Stock. The warrant will not be exercisable until the acceptance by NovaRay of the deliverables from Triple Ring in accordance with the terms of the Professional Services Agreement. The original exercise price for the warrant was established
based on the timing of the acceptance by NovaRay of such deliverables as set forth below:



|                                                                   |  |                         |     
|------------------------------------------------------------------ |  | ----------------------- | ----
|Date of Acceptance of the Deliverables                             |  | Exercise Priceper Share
|On or prior to March 30, 2009                                      |  | $                       | 0.06
|On or after March 31, 2009 but on or prior to July 30, 2009        |  | $                       | 0.15
|On or after July 31, 2009 but on or prior to December 30, 2009     |  | $                       | 1.33
|On or after December 31, 2009 but on or prior to February 28, 2010 |  | $                       | 2.67

In the event the acceptance by NovaRay of the deliverables does not occur by February 28,
2010, the warrant shall terminate and not be exercisable. As required by EITF 96-18, the warrant has been expensed as research and development costs on a monthly basis. Under Issue 4 of EITF 96-18, transactions where quantity of any of the terms are
not known up front and involve counter party performance conditions which are outside the control of the counterparty and result in a range of aggregate fair values for the warrants depending on the delivery date are to be recorded at the lowest
aggregate amount and adjusted for changes in aggregate fair value at interim reporting dates. However, if the performance conditions are within the control of the counterparty, the measurement date is based upon the probability that the counterparty
will perform.

Based on the Companys financial position as of June 30, 2009, it does not believe it can provide the funding
necessary to allow Triple Ring to meet a delivery date prior to February 28, 2010. However, as a result of the related party relationship between the two companies, the delivery date is considered within the control of Triple Ring. Accordingly,
the Company believes that the most probable acceptance date under the Professional Services Agreement will be after February 28, 2010, and the warrant is expected to terminate and not be exercisable. The Company anticipates it will discuss a
new or amended warrant with Triple Ring for a revised delivery date and deliverables, but the specific terms of the warrant cannot be determined at this time, and there is no guarantee that discussions will result in a new or amended warrant. As a
result, during the second quarter ended June 30, 2009, the Company reversed $1.3 million of warrant costs for Triple Ring services previously recorded as research and development expense.

Treasury Stock

In October
2006, NovaRay purchased 1,239,000 shares of Common Stock from one of its investors at the original issue price of $0.003 per share.

Stock Option Plan

In November 2008, the stockholders approved and ratified the 2008 Stock Incentive Plan (2008
Plan). The 2008 Plan provides for the grant of stock options, restricted stock, restricted stock units, dividend equivalent rights and stock appreciation rights (collectively referred to as awards). A total of 3,750,000 shares of
Common Stock are reserved for issuance under the 2008 Plan and the number of shares of Common Stock available will be subject to adjustment in the event of a stock split, stock or other extraordinary dividend, or other similar change in the Common
Stock or our capital structure.

The Companys initial grant of stock options to employee and board members was during the three
months ended March 31, 2009. The estimated fair value of the stock options granted as of June 30, 2009, was $1.3 million, calculated at the date of the grants using the Black-Scholes option pricing model, using a fair value of Common Stock
of $2.66 - $2.67 per share. The fair value of the Common Stock was determined by the Companys Board of Directors on the date of grants.

The following weighted-average assumptions were used to value options granted during the three and six month periods ended June 30, 2009:



|                        |  |                                |  |                             
|----------------------- |  | ------------------------------ |  | ----------------------------
|                        |  | Three monthsendedJune 30, 2009 |  | Six monthsendedJune 30, 2009
|Risk-free interest rate |  | 1.96%                          |  | 1.73% - 1.99%               
|Dividend yield          |  |                               |  |                            
|Expected life (years)   |  | 5.0                            |  | 5.0 - 6.25                  
|Expected volatility     |  | 57.22%                         |  | 57.22 - 57.48%              

During the three months ended June 30, 2009, the Company granted no stock options to
employees and 76,951 stock options to board members and recognized $144,000 of stock-based compensation expense for options granted. During the six months ended June 30, 2009, the Company granted 262,000 stock options to employees and 661,843
stock options to board members and recognized $495,000 of stock-based compensation expense for options granted. The Company had no stock-based compensation expense during the three or six month periods ended June 30, 2008 as no options were
granted during fiscal 2008. No options have been exercised as of June 30, 2009.



14



---

##### Table of Contents

6. Income taxes

The Company has not incurred any income tax liabilities during the periods ended June 30, 2009 and 2008, except for state and local franchise taxes recorded as sales, general and administrative expenses.
Accordingly, the Company has no provision for income taxes during the periods ended June 30, 2009 and 2008.

The Company recognizes
deferred income tax liabilities and assets for the expected future tax consequences of events that have been recognized in the financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based on the
differences between the financial statement carrying amounts and the tax basis of assets and liabilities using enacted tax rates in effect in the years in which the differences are expected to reverse. The Company records a valuation allowance to
reduce the deferred tax assets to the amount currently expected to be realized.

In June 2006, the FASB issued FASB Interpretation
No. 48, Accounting for Uncertainty in Income Taxes,(FIN 48). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprises financial statements in accordance with SFAS No. 109,
Accounting for Income Taxes, (SFAS 109), and prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The
Company adopted FIN 48 effective January 1, 2007. The Company has evaluated its tax positions for the periods ended June 30, 2009 and 2008 and determined that it has no uncertain tax positions requiring financial statement recognition.

Under FIN 48, the impact of an uncertain income tax position on income tax expense must be recognized at the largest amount that is
more-likely-than-not to be sustained. An uncertain income tax position will not be recognized if it has less than a 50% likelihood of being sustained. Because of the Companys recent history of operating losses, management believes that
recognition of the deferred tax assets arising from the above-mentioned future tax benefits is currently not likely to be realized and, accordingly, has provided a 100% valuation allowance against its net deferred tax assets due to the uncertainty
surrounding the realization of such assets.

7. Related party transactions

Triple Ring Technologies, Inc.

The following directors, officers and stockholders of the Company hold the following equity ownership interests in Triple Ring:



|                |  |                                       |  |                               |  
|--------------- |  | ------------------------------------- |  | ----------------------------- | -
|Name            |  | NovaRay Medical Affiliation           |  | Triple RingInterest Ownership |  
|Marc Whyte      |  | CEO, President, Director, Stockholder |  | 21.15                         | %
|Edward Solomon  |  | CTO, Director, Stockholder            |  | 21.15                         | %
|Joseph Heanue   |  | Stockholder                           |  | 21.15                         | %
|Augustus Lowell |  | Stockholder                           |  | 21.15                         | %
|Brian Wilfey    |  | Stockholder                           |  | 15.40                         | %

Professional Services Agreement

On December 19, 2007, the Company entered into the Professional Services Agreement with Triple Ring to perform ongoing product development work,
final assembly and test for the cardiac imaging system. On March 12, 2009, the Company and Triple Ring entered into a first amendment to the Professional Services Agreement, under which they agreed to extend payment terms to be net thirty
days.

Receivable from Triple Ring and headquarters lease

The Company previously sub-leased a portion of its headquarters facility to Triple Ring for 41.5% of the rent paid. Triple Ring was also the guarantor of the headquarters lease agreement. On March 12, 2009,
the Company and Triple Ring entered into an Assignment and Assumption of Lease Agreement under which the Company assigned its interest in the headquarters office lease and Triple Ring assumed the Companys obligations under the lease.
Concurrently, the Company and Triple Ring entered into a Sublease Agreement whereby the Company would sublease 58.5% of the premises under the Lease. The Company remains jointly and severably liable for all obligations under the lease. As of
June 30, 2009 and December 31, 2008, the Company had rents receivable from Triple Ring under the previous sublease agreement for $0 and $42,000, respectively.



15



---

##### Table of Contents

Security deposit with Triple Ring

On January 10, 2008, the Company paid a deposit in the amount of $500,000 to Triple Ring for services and certain expenses to be rendered in accordance with the terms of the Professional Services Agreement and
the amendment to the Professional Services Agreement. As of June 30, 2009 and December 31, 2008, the deposit amount to Triple Ring was $500,000.

Prepaid expenses to Triple Ring

The Company reimburses Triple Ring for pre-payments made to their vendors for services and
supplies under the Professional Services Agreement. The pre-payments are applied to the cost of the services and supplies upon completion or delivery. As of June 30, 2009 and December 31, 2008, the Companys prepaid expenses to Triple
Ring were $135,000 and $141,000, respectively.

Accounts payable and accrued liabilities to Triple Ring

As of June 30, 2009 and December 31, 2008, the Companys accounts payable and accrued liabilities balances to Triple Ring were as follows
(in thousands):



|                                   |  |              |     |                  |   |      
|---------------------------------- |  | ------------ | --- | ---------------- | - | -----
|                                   |  | June 30,2009 |     | December 31,2008
|Accounts payable to Triple Ring    |  | $            | 696 |                  | $ | 2,109
|Accrued liabilities to Triple Ring |  | $            | 14  |                  | $ | 508  

Accounts payable to Triple Ring are for services and supplies purchased under the Professional
Services Agreement. Accrued liabilities to Triple Ring are for liabilities to Triple Ring for accrued services and supplies purchased under the Professional Services Agreement.

Notes payable to Triple Ring

In March 2009, the Company and Triple Ring entered into a Credit and
Security Agreement. Under the Credit and Security Agreement, Triple Ring agreed to make available to the Company, on a revolving basis, a line of credit in an amount of up to $1.5 million with an annual interest rate of 2%. As of June 30, 2009,
the principal balance due under the Credit Line was $1.5 million. The Credit Line was paid off on July 2, 2009 (See Note 8. Subsequent events).

Professional Services Agreement and Warrants

The Company issued a warrant to Triple Ring to purchase 1,332,000 shares of
common stock as partial consideration for services under the Professional Services Agreement. The warrant will not be exercisable until the acceptance by NovaRay of the deliverables from Triple Ring in accordance with the terms of the Professional
Services Agreement. The exercise price for the warrant is established based on the timing of the acceptance by NovaRay of such deliverables as set forth below:



|                                                                   |  |                         |     
|------------------------------------------------------------------ |  | ----------------------- | ----
|Date of Acceptance of the Deliverables                             |  | Exercise Priceper Share
|On or prior to March 30, 2009                                      |  | $                       | 0.06
|On or after March 31, 2009 but on or prior to July 30, 2009        |  | $                       | 0.15
|On or after July 31, 2009 but on or prior to December 30, 2009     |  | $                       | 1.33
|On or after December 31, 2009 but on or prior to February 28, 2010 |  | $                       | 2.67

In the event the acceptance by NovaRay of the deliverables does not occur by February 28,
2010, the warrant shall terminate and not be exercisable. The Company does not believe that the delivery will occur prior to February 28, 2010

The Company recorded research and development expense of approximately ($714,000) with Triple Ring during the second quarter of 2009 compared with $3 million during the second quarter of 2008. Included in these amounts is warrant expense
for Triple Ring services of ($1.3 million) and $222,000 during the three months ended June 30, 2009 and 2008, respectively.

The
Company recorded research and development expense of approximately $2.4 million with Triple Ring during the first six months of 2009 compared with $4.3 million during the first six months of 2008. Included in these amounts is warrant expense for
Triple Ring services of ($1.1 million) and $444,000 during the six months ended June 30, 2009 and 2008, respectively.



16



---

##### Table of Contents

Series A Warrants

On December 27, 2007, the Company issued Series A Warrants to purchase 1,648,960 shares of Common Stock at an exercise price of $4.25 per share
pursuant to the Purchase Agreement. The following related parties are holders of Series A Warrants:



|                              |  |                          
|----------------------------- |  | -------------------------
|Name                          |  | Number ofSeries AWarrants
|W Capital Partners II, L.P.   |  | 147,647                  
|Heartstream Capital B.V       |  | 90,632                   
|Wheatley MedTech Partners, LP |  | 47,544                   
|Lynda Wijcik                  |  | 40,646                   
|BioBridge LLC                 |  | 33,044                   
|                              |  |                          
|                              |  | 359,513                  
|                              |  |                          

Promissory Note issued to Chairman and Director Lynda Wijcik

On November 5, 2007, NovaRay issued a promissory note to its Chairman and director, Lynda Wijcik, in the principal amount of $30,000, at an interest
rate of 6% per annum. The balance outstanding on this note was paid off in January 2008.

Restricted Stock Purchase Agreement

NovaRay is a party to a restricted stock purchase agreement dated October 23, 2006 (the Purchase Agreement), with
Jack Price, whereby Mr. Price purchased 642,000 shares of Common Stock (the Restricted Stock) for a consideration of $0.06 per share. In accordance with the terms of the Purchase Agreement, 25% of the Restricted Stock vested on
November 1, 2007, and the remaining balance vests in equal monthly instalments over three years so long as Mr. Price continues to provide services to NovaRay. The Purchase Agreement also includes terms for accelerated vesting upon a change
of control or should Mr. Price no longer provide services to the Company in a consulting capacity or as a director. The purchase price and valuation of the restricted stock were based on market conditions, the value of the Companys assets
and its general financial position at the time of the restricted stock sale, and the price of recent sales of the Companys securities. As of June 30, 2009 and December 31, 2008, the Restricted Stock was 65% and 52% vested,
respectively.

NRCT LLC

NovaRay entered into a license agreement dated October 23, 2006 with NRCT LLC (NRCT), pursuant to which NovaRay granted to NRCT certain exclusive and non-exclusive licenses to NovaRays current portfolio of patents and
patent applications. These licenses include (i) an exclusive, world-wide license related to certain of NovaRays patents for closed-gantry health-care, closed-gantry CT and vascular applications and closed-gantry life science applications
and (ii) a non-exclusive, worldwide license for certain of NovaRays patents for (a) all open-gantry healthcare applications except open-gantry cardiac, electrophysiology, neurological, CT and peripheral applications and
(b) industrial applications (security, industrial inspection and non-destructive testing). We do not anticipate that these licenses are for applications that are competitive with NovaRays products. In consideration for such licenses,
NovaRay was granted a 10% equity ownership interest in NRCT. The following directors, officers and stockholders of the Company hold the following membership interests in NRCT:



|                              |  |                                       |  |                        |  
|----------------------------- |  | ------------------------------------- |  | ---------------------- | -
|Name                          |  | NovaRay Medical Affiliation           |  | NRCTOwnership Interest |  
|Lynda Wijcik (BioBridge LLC)  |  | Chairman of the Board, Stockholder    |  | 34.07                  | %
|Wheatley MedTech Partners, LP |  | Director, Stockholder                 |  | 21.28                  | %
|Marc C. Whyte                 |  | CEO, President, Director, Stockholder |  | 9.43                   | %
|Edward Solomon                |  | CTO, Director, Stockholder            |  | 9.43                   | %
|Joseph Heanue                 |  | Stockholder                           |  | 7.07                   | %
|Lloyd Investments, L.P.       |  | Stockholder                           |  | 4.00                   | %
|Augustus Lowell               |  | Stockholder                           |  | 1.89                   | %
|Brian Wilfey                  |  | Stockholder                           |  | 1.89                   | %
|Eugene Floyd                  |  | Stockholder                           |  | 0.47                   | %
|Gerald Pretti                 |  | Stockholder                           |  | 0.47                   | %

As of June 30, 2009, no value has been attributed to this ownership interest because NRCT has
substantially no assets or operations.



17



---

##### Table of Contents

8. Subsequent events

Amendment to Articles of Incorporation

On July 1, 2009, the Company filed (i) a Certificate of Amendment of
Certificate of Designation of the Relative Rights and Preferences of the Series A Convertible Preferred Stock to decrease the maximum number of shares of Series A Preferred Stock from 10,000,000 shares to 8,700,000 shares and (ii) a Certificate
of Designation of the Relative Rights and Preferences of the Series A-1 Convertible Preferred Stock to create out of the shares of the Companys preferred stock, a series of preferred stock of the Company, to be named Series A-1
Convertible Preferred Stock, consisting of 870,000 shares, which series shall have the designations, powers, preferences and rights and the qualifications, limitations and restrictions provided in such Certificate of Designation.

Financing

On July 2, 2009, the Company
entered into a Note and Warrant Purchase Agreement (the Purchase Agreement) with Purchasers (as defined therein) to (i) issue and sell senior secured 12% convertible bridge notes (individually, a Note and collectively,
the Notes) in the aggregate principal amount of up to $4,250,000 and (ii) issue warrants (the Warrants) to each Purchaser to purchase up to the greater of (a) the number of shares of the Companys Common Stock
equal to the initial principal amount of the Note of such Purchaser times 6/$11, rounded to the nearest whole share or (b) the number of shares of Companys Common Stock equal to such initial principal amount divided by the price per share
paid for the Qualified Financing Stock (as defined in the Note) at an exercise price equal to the Warrant Price (as defined in the Warrants) then in effect. Such warrants shall expire July 2, 2014. The initial closing under the Purchase
Agreement took place on July 2, 2009. The Company granted to Vision Opportunity Master Fund, Ltd. (Vision) the right of first offer to purchase additional Notes and Warrants which the Company may propose to sell and issue from
September 1, 2009 until October 31, 2009. Until the earlier of (i) such time that no outstanding principal balance remains under the Notes or (ii) two persons selected by Vision are appointed to the Companys Board of
Directors, the Company shall permit a representative of Vision to attend all meetings of its Board of Directors in a nonvoting observer capacity. Within ten days following receipt of a written request from Vision, the Company shall ensure that two
persons selected by Vision be appointed to replace two seats on its Board of Directors. The Company shall enter into exchange agreements (the Exchange Agreements) with the holders of its Series A Preferred Stock and shall issue its
Series A-1 Preferred Stock in exchange for its Series A Preferred Stock pursuant to such Exchange Agreements.

On July 2, 2009, the
Company also issued Warrants and a Note to Vision in the principal amount of $2,750,000. Unless otherwise converted into shares of Qualified Financing Stock or exchanged for a warrant to purchase the Companys Common Stock, the outstanding
principal balance and all accrued interest shall be due and payable on December 31, 2009. The Note is secured by a security agreement in favor of the holder of the Note. The outstanding principal balance shall bear interest, at a rate per annum
equal to 12%. Upon the occurrence of an Event of Default (as defined in the Note), the Company will pay interest, on demand, at a new rate of the lesser of 15% and the maximum applicable legal rate per annum. If an Event of Default shall have
occurred and shall be continuing, the holder of the Note may at any time, declare the entire unpaid principal balance, together with all accrued interest, due and payable; provided, however, that upon the occurrence of an Event of Default described
in Sections 2.1(d) or (e) of the Note, the outstanding principal balance and accrued interest shall be automatically due and payable. Effective as of the closing of a Qualified Financing, all outstanding principal and accrued interest shall
automatically convert into the securities of the Company issued or issuable in the Qualified Financing by dividing (x) the outstanding principal balance and accrued interest by (y) a conversion price which shall be equal to the lesser of
(i) 85% of the price of Qualified Financing Stock or (ii) the Conversion Price (as defined the Note).

On July 2, 2009, the
Company also entered into a security agreement (the Security Agreement) with Vision Capital Advisors, LLC, in its capacity as the collateral agent (the Collateral Agent). The Company granted to the Collateral Agent, security
interests in all of its right, title and interest in, to and under all personal property and other assets described in the Security Agreement (the Collateral). If any Event of Default (as defined in the Notes) shall have occurred and be
continuing, the Collateral Agent may exercise all rights and remedies of a secured party. In any such event, the Collateral Agent may enter upon the premises of the Company through self-help, without judicial process, without first obtaining a final
judgment or giving the Company or any other person notice and opportunity for a hearing on the secured parties claim or action and may collect, receive, assemble, process, appropriate and realize upon the Collateral, or any part thereof, and
may forthwith sell, lease, license, assign, give an option or options to purchase, or sell or otherwise dispose of and deliver said Collateral (or contract to do so), or any part thereof, at any exchange at such prices as it may deem acceptable.

On July 2, 2009, the Company also entered into Exchange Agreements with Vision and Vision Capital Advantage Fund, L.P. to exchange
7,490,630 shares of the Companys Series A Preferred Stock for 749,063 shares of the Companys Series A-1 Preferred Stock and 9 shares of the Companys Series A Preferred Stock for $24.03 in cash. To the extent any holder of the
Companys Series A Preferred Stock has any rights under the Series A Convertible Preferred Stock and Warrant Purchase Agreement dated as of December 27, 2007, such rights shall apply mutatis mutandis to the Companys Series A-1
Preferred Stock.



18



---

##### Table of Contents

On July 2, 2009, the Company also entered into (i) amendments with Vision to the Series A
Warrant to Purchase Shares of Common Stock and to the Series J-A Warrant to Purchase Shares of Common Stock and (ii) amendments with Vision Capital Advantage Fund, L.P. to the Series A Warrant to Purchase Shares of Common Stock and to the
Series J-A Warrant to Purchase Shares of Common Stock, in each case to amend the definition of Additional Shares of Common Stock and to decrease the initial exercise price to $2.67 per share.

In connection with these transactions, the Company paid off the remaining balance of its $1.5 million credit line with Triple Ring and Triple Ring
terminated its secured interest in the Companys assets.

Employment Agreements

As previously reported on our Form 8-K filed with the Securities and Exchange Commission on July 7, 2009, the Company entered into amendments to
Executive Employment Agreements with Marc Whyte, William Frederick and Edward Solomon on July 2, 2009.

The amendments provide that
until the receipt of gross proceeds from equity or debt or other financing obtained by Company of at least $5 million in the aggregate after July 7, 2009, 80% of the Base Salary (as defined therein) less applicable withholdings, shall be paid
in accordance with the Companys regularly established payroll practice. The remaining 20% of the Base Salary less applicable withholdings, shall be paid in the event of (i) a receipt of such gross proceeds, (ii) a termination of
employment by the Company without Cause (as defined therein) or (iii) a termination of employment by Executive (as defined therein) for Good Reason (as defined therein). After the receipt of such gross proceeds, the Base Salary shall be paid in
accordance with the Companys regularly established payroll practice. In the event the Company receives aggregate gross proceeds not less than $3,000,000 after July 7, 2009 and prior to December 31, 2010 (excluding proceeds from funds
managed by Vision Capital Advisors, LLC) from equity financings, incentive compensation will be initially based on a percentage of Base Salary (from 9% to 100%) listed in Table 1 therein. In the event the Company receives such gross proceeds from
straight debt financings, such compensation will be initially based on a percentage of Base Salary listed in the $80 million pre-money valuation row in Table 1 therein (from 30% to 100%). In the event the Company receives such gross proceeds from
convertible debt financings, such compensation will be initially based on a percentage of Base Salary listed in Table 1 therein taking into account the amount raised and the pre-money valuation assuming conversion of such convertible debt. Such
incentive compensation may be payable in either (i) cash or (ii) a combination of cash and up to 60 to 70% of such incentive compensation in Incentive Stock Options issued pursuant to the Companys 2008 Stock Incentive Plan in lieu of
cash with the value of such options determined by the Black-Scholes Model used by the Company to value stock options in its audited financial statements. Provided that Company has not terminated employment for Cause and Executive has not terminated
his employment other than for Good Reason, the Company shall grant Marc Whyte, William Frederick and Edward Solomon an option to purchase 425,000, 300,000 and 275,000 shares of the Common Stock of the Company, respectively, upon receipt of gross
proceeds from equity or debt or other financing obtained by Company of at least $5 million in the aggregate after July 7, 2009. In the event of termination without Cause, Executive will receive the Standard Entitlements (as defined therein)
plus the following: (a) twelve (12) months of Base Salary, payable in the form of salary continuation, and twelve (12) months of health care benefits and (b) the vesting of any stock options held at the time of such termination
will accelerate as to the shares that would have vested as of the date twenty-four (24) months from the termination date.

Triple Ring Credit Line

On July 2, 2009, the $1.5 million balance outstanding to Triple Ring under the Credit and Security Agreement was paid off. The
Company received a UCC termination statement from Triple Ring releasing the lien on all Company assets.



|Item 2. | Managements Discussion and Analysis of Financial Condition and Results of Operations.
|------- | --------------------------------------------------------------------------------------

This Quarterly Report on Form 10-Q 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. Such statements contain words such as may, will, might, expect, believe, anticipate, could,
would, estimate, continue, pursue, or the negative thereof or comparable terminology, and may include (without limitation) information regarding our intentions, beliefs, expectations, strategies,
predictions or any other statements relating to our future activities or other future events or conditions. These statements are based on current expectations, estimates and projections about our business based, in part, on assumptions made by
management and include, without limitation, those statements regarding the features of our ScanCath cardiac catheterization system including



19



---

##### Table of Contents

advanced imaging capabilities and reductions in radiation exposure to patients, operators, and staff; our expectation that we will have revenue in 2010 or
later; our expected operating costs; our ability to continue as a going concern; our ability to raise additional capital and implement our business plan; availability of additional financing; the effect on the Companys financial position,
result of operations, or cash flows of final judgments of pending claims, charges, and litigation, if any, against the Company; the ability of the Company to recover a portion of any future amounts paid under indemnification agreements; the expected
acceptance date of the deliverables under the Professional Services Agreement; our expectations regarding Triple Rings ability to exercise its warrant; our anticipation that we will renegotiate the terms of the warrant; our expectations
regarding our ability to provide funding under the Professional Services Agreement; our anticipation that licenses to NRCT will not competitive with NovaRays products; incurring manufacturing expenses in future years for personnel and
equipment costs required for our product introduction and distribution; increased selling, general, and administrative expenses in connection with the development of our sales and marketing organization, the expansion of our facilities and staff,
and the commercial launch of our system; the success of early placements being critical to gathering strong customer references for future sales; our for need additional financial resources to meet our anticipated cash needs for working capital and
capital expenditures for the next ninety days and our plans to evaluate the need for additional resources in fiscal 2009.

These statements
are not guarantees of future performance and involve risks, uncertainties and assumptions that are difficult to predict. Therefore, actual outcomes and results may, and are likely to, differ materially from what is expressed or forecasted in the
forward-looking statements due to numerous factors, including those factors described under Risk Factors, in our Form 10-K for the year ended December 31, 2008, and other filings we file with the Securities and Exchange Commission
(the SEC), and those factors discussed under Risk Factors in this Quarterly Report on Form 10-Q. In addition, such statements could be affected by risks and uncertainties related to our ability to raise any financing which we
may require for our operations; competition; our ability to protect and market our intellectual property; the success of our cost-cutting measures; government regulations, requirements and approvals; pricing, development and manufacturing
difficulties; our ability to make acquisitions and successfully integrate those acquisitions with our business; general industry and market conditions and growth rates; our ability to transition from a development stage company; our ability to
market and distribute our products and general economic conditions. Any forward-looking statements speak only as of the date on which they are made, and we do not undertake any obligation to update any forward-looking statement to reflect events or
circumstances after the date of this document.

The financial statements related to this discussion and analysis have been prepared
assuming that we will continue as a going concern. As discussed in Note 2 to the financial statements under the heading Risk Factors, in our Form 10-K for the year ended December 31, 2008, our recurring losses from operations and
our dependence on receiving additional funding to continue operations raise substantial doubt about our ability to continue as a going concern. Our financial statements do not include any adjustments that might result from the outcome of this
uncertainty.

Overview

NovaRay, Inc.
was incorporated in June 2005. Shortly thereafter, the assets subject to security interests of underlying debt of NexRay were contributed to NovaRay, Inc. in connection with the foreclosure proceedings initiated by certain lenders of NexRay. Those
lenders are our current investors. See Note 7. Related Party Transactions in the attached Financial Statements. We have incurred ongoing losses totalling approximately $25.6 million since the date of inception of NovaRay,
Inc. through June 30, 2009. To date, substantially all of our expenditures have primarily been related to development of the ScanCath cardiac catheterization system and administrative costs. We expect to incur manufacturing expenses
in future years for personnel and equipment costs required for our product introduction and distribution. We also expect to incur increased sales and marketing and general and administrative expenses in connection with the development of our sales
and marketing organization, the expansion of our facilities and staff, and the commercial launch of our system.

We have achieved no
revenues to date. Our goal is to begin commercial sales for our cardiac catheterization imaging system in 2010. We believe that the success of early placements will be critical to gathering strong customer references for future sales. Our efforts
are subject to the risks inherent in the development of innovative products, including the risk that the product will be found to be ineffective, or that the product, if effective, will be difficult to manufacture on a large scale, or will be
uneconomical to market. No assurance can be given that we will be able to produce our system in commercial quantities at acceptable costs or without delays, or that we will be able to market our system successfully. Any failure of our device to
achieve acceptable market performance or the identification of technical deficiencies could lead to delays in the introduction and market acceptance of our product and could jeopardize the viability of our company. In addition, we will need to
obtain additional regulatory approvals before our system can be sold in a number of significant international markets, and we may encounter delays in obtaining such approvals or other regulatory delays to the commercial productions of our system.



20



---

##### Table of Contents

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations are based on our financial statements, which have been prepared in
accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses and related
disclosures. We review our estimates and judgments on an on-going basis. We base our estimates and judgments on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results may
differ from these estimates. We believe the following accounting policies are critical to the judgments and estimates we use in preparing our financial statements.

Common and Preferred Stock Warrants

The Company from time to time issues preferred and common stock
warrants as compensation for services or goods from non-employees. Preferred and Common Stock warrants issued to other than employees or directors are recorded on the basis of their fair value, which is measured as of the date required by Emerging
Issues Task Force (EITF) Issue 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services.

Preferred and common stock warrants are valued using the Black-Scholes Model on the basis of the market price of the underlying common and preferred
stock on the valuation date. We estimated the current stock price, which as a non-trading public company is not readily available. We valued the preferred stock using the last price at which a sale of Series A Convertible Preferred Stock
was sold. With respect to our common stock we used a value consistent with the value of our Series A Convertible Preferred Stock. The Series A Convertible Preferred Stock has no liquidation preference, is convertible one-to-one to common, has no
redemption features and is non-voting. Its features closely resemble that of our common stock. Volatility is estimated based on an average of six similar public companies. Expected term is the contract term, consistent with the guidance in the SEC
Staff Accounting Bulletin (SAB) No. 107, (SAB 107). The dividend yield of 0% is based on the dividend trend for most development stage companies. Risk free rates are based on US Treasury Bill rates.

The warrant issued to Triple Ring will not be exercisable until the acceptance by NovaRay of the deliverables from Triple Ring in accordance with the
terms of the Professional Services Agreement. In the event the acceptance by NovaRay of the deliverables does not occur by February 28, 2010, the warrant shall terminate and not be exercisable. The Company does not believe that the delivery
will occur prior to February 28, 2010.

Change in Fair Value of Warrants

Effective January 1, 2009 we adopted the provisions of EITF Issue 07-5, Determining Whether an Instrument (or Embedded Feature) Is Indexed to an
Entitys Own Stock, (EITF 07-5). EITF 07-5 applies to any freestanding financial instruments or embedded features that have the characteristics of a derivative, as defined by SFAS No. 133, Accounting for Derivative
Instruments and Hedging Activities, and to any freestanding financial instruments that are potentially settled in an entitys own common stock.

As a result of adopting EITF 07-5, 4,770,060 of our issued and outstanding Common Stock warrants previously treated as equity pursuant to the derivative treatment exemption were no longer afforded equity treatment.
The warrants impacted are the Series A, Amended Series J-A and Series J-A additional shares (See Note 5. Stockholders deficit). Upon adoption, we reclassified the fair value of the warrants, which have exercise price reset features,
from equity to liability status as if these warrants were treated as a derivative liability since their date of issue. On January 1, 2009, as a cumulative effect adjustment, we reduced additional paid-in capital by $3.2 million, increased
beginning accumulated deficit by $1.1 million and recorded $4.3 million to a long-term warrant liability to recognize the fair value of such warrants on the date of adoption. The fair value of the warrants declined to approximately
$4 million as of March 31, 2009 and increased to approximately $4.4 million as of June 30, 2009. We recognized a $387,000 and $144,000 net loss on change in fair value of warrant liabilities for the three and six month periods ended
June 30, 2009.

Income Taxes

In accordance with SFAS No. 109, Accounting for Income Taxes, (SFAS 109), a deferred income tax asset or liability is determined based on the difference between the financial statement and tax
basis of assets and liabilities as measured by the enacted tax rates that will be in effect when these differences reverse. The Company provides a valuation allowance against net deferred income tax assets unless, based upon available evidence, it
is more likely than not the deferred income tax assets will be realized.

FASB Interpretation No. 48, Accounting for Uncertainty in
Income Taxes, (FIN 48), clarifies the accounting for uncertainty in income taxes recognized in an enterprises financial statements in accordance with SFAS 109, and prescribes a recognition threshold and measurement attribute
for the financial statement recognition and measurement of a tax position taken or expected to be taken in a



21



---

##### Table of Contents

tax return. The Company determined that it had no uncertain tax positions requiring financial statement recognition as of June 30, 2009 and has provided
a 100% valuation allowance against its net deferred tax assets due to the uncertainty surrounding the realization of such assets.

Results of Operations

Sales and Marketing

Sales and marketing expenses consist primarily of payroll, payroll related expenses, third-party consulting expenses, corporate marketing costs and business development activities performed by Triple Ring for the Company. Sales and
marketing costs decreased approximately $58,000 from $108,000 during the three months ended June, 30, 2008 to $50,000 during the three months ended June, 30, 2009. The decrease was primarily due to the reduction of one employee and elimination of
third-party consultants, partially offset by increased activity with Triple Ring for business development activities. Sales and marketing costs increased approximately $19,000 from $183,000 during the six months ended June 30, 2008 to $202,000
during the six months ended June, 30, 2009. The increase was primarily due to the hiring of one employee in the second quarter of 2008, who was subsequently laid off in the second quarter of 2009, and increased activity with Triple Ring for business
development activities, partially offset by a reduction in third-party consulting expenses due to the elimination of third-party consultants in the second quarter of 2009.

Approximately $31,000 was spent on business development activities with Triple Ring during the three months ended June, 30, 2009 compared with $0 during
the three months ended June, 30, 2008. Approximately $79,000 was spent on business development activities with Triple Ring during the six months ended June, 30, 2009 compared with $0 during the six months ended June, 30, 2008.

Research and Development

Research
and development expenses consist primarily of payroll, payroll related expenses, expenses for Triple Ring performing research and development activities for the Company and expenses associated with the warrants issued to Triple Ring (See Note 7.
Related Party Transactions). Research and development costs decreased approximately $3.6 million from $3 million during the three months ended June, 30, 2008 to ($627,000) during the three months ended June, 30, 2009. The decrease was primarily
due to a reduction in development activity with Triple Ring and the reversal of warrant expense for Triple Ring services, partially offset by the cost of one employee previously classified as general and administrative expense. Research and
development costs decreased approximately $1.6 million from $4.3 million during the six months ended June, 30, 2008 to $2.7 million during the six months ended June, 30, 2009. The decrease was primarily due to a reduction in development activity
with Triple Ring and the reversal of warrant expense for Triple Ring services, partially offset by the cost of one employee previously classified as general and administrative expense and $47,000 in stock-based compensation expense for stock options
granted during the first quarter of 2009.

Approximately ($714,000) was spent on research and development with Triple Ring during the three
months ended June, 30, 2009 compared with $3 million during the three months ended June, 30, 2008. Included in these amounts is warrant expense for Triple Ring services of ($1.3 million) during the three months ended June, 30, 2009 and $222,000
during the three months ended June, 30, 2008. Approximately $2.4 million was spent on research and development with Triple Ring during the six months ended June, 30, 2009 compared with $4.3 million during the six months ended June, 30, 2008.
Included in these amounts is warrant expense for Triple Ring services of ($1.1 million) during the six months ended June, 30, 2009 and $444,000 during the six months ended June, 30, 2008.

General and Administrative

General
and administrative expenses consist primarily of payroll, payroll related expenses, third-party consulting expenses, legal and accounting fees, facilities, insurance, investor relations and regulatory costs. General and administrative costs
decreased approximately $159,000 from $790,000 during the three months ended June, 30, 2008 to $631,000 during the three months ended June, 30, 2009. The decrease was primarily due the cost of one employee moved to research and development; a
reduction of one employee during the first quarter of 2009; $56,000 in decreased travel and entertainment expense; $141,000 in decreased third-party consultant expense; and $191,000 in decreased legal fees. These decreases were partially offset by
the hiring of two employees in the fourth quarter of 2008; $68,000 in increased audit costs for the Companys new independent registered public accounting firm engaged during the third quarter of 2008; $50,000 in increased rent and common area
maintenance costs; $52,000 in increased depreciation expense for tenant improvements placed in service in fiscal 2009; and $144,000 in stock-based compensation expense for stock options granted to employees and board members.

General and administrative costs increased approximately $199,000 from $1.5 million during the six months ended June, 30, 2008 to $1.7 million during the
six months ended June, 30, 2009. The increase was primarily due to the hiring of two employees in the fourth quarter of 2008; $125,000 in increased audit costs for the Companys new independent registered public accounting firm



22



---

##### Table of Contents

engaged during the third quarter of 2008; $104,000 in increased depreciation expense for tenant improvements placed in service in fiscal 2009; and $448,000
in stock-based compensation expense for stock options granted to employees and board members. These increases were partially offset by the cost of one employee moved to research and development; a reduction of one employee during the first quarter
of 2009; $60,000 in decreased travel and entertainment expense; $233,000 in decreased third-party consultant expense; and $181,000 in decreased legal fees.

Other Income (Expense)

Other expense during the three months ended June, 30, 2009, was $395,000,
compared with other income of $10,000 during the three months ended June, 30, 2008. Other expense during the six months ended June, 30, 2009, was $151,000, compared with other income of $26,000 during the six months ended June, 30, 2008. Other
expense during the three and six month periods ended June 30, 2009 was primarily due to the Companys adoption of EITF Issue 07-5 during the first quarter. The adoption resulted in the reclassification of certain Company warrants from
equity to liabilities recorded at fair value and a gain on change in fair value of warrant liability during the first quarter of 2009 that was offset by a loss on change in fair value of warrant liability during the second quarter of 2009. Other
income during the three and six month periods ended June 30, 2008 was primarily due to interest income on funds received from our financing activities.

Liquidity and Capital Resources

We require additional funds to continue current operations. Our need for funds will
increase from period to period as we increase the scope of our development, marketing, and manufacturing activities including increased costs and resources necessary to meet our public company reporting requirements. From inception of NovaRay, Inc.
through June 30, 2009, we have obtained gross proceeds of approximately $21 million through private placements of equity securities and approximately $2 million through the issuance of short term debt instruments. At June 30, 2009, our
principal source of liquidity included cash and equivalents of approximately $158,000, compared with approximately $5.7 million at December 31, 2008.

During the fiscal quarter and the six months ended June 30, 2009, our net loss was approximately $4.7 million and $449,000, respectively. On March 12, 2009, we entered into an agreement with Triple Ring,
whereby Triple Ring agreed to make available to us a revolving line of credit in the aggregate amount of $1.5 million at a 2% annual interest rate. Triple Ring initially extended us $175,000 under the credit line and the principal balance due as of
June 30, 2009, was $1.5 million.

In July 2009, we raised approximately $2.8 million through the sale of notes and warrants. In
connection with this financing, the $1.5 million credit line established with Triple Ring in March 2009 was paid in full and terminated. After taking account of the funds used to terminate the credit line and other transactional costs, the net
proceeds of the financing are approximately $1.2 million. Despite this financing, we believe that we do not have sufficient capital to continue current operations. Accordingly, we believe we need additional funds to meet our anticipated cash needs
for working capital and capital expenditures for the next ninety days. Because we have never generated revenue and do not expect to do so until 2010 or later, we will most likely be required to raise these additional funds through convertible debt,
debt or equity financings or by selling our assets.

Because we have never generated revenue, and do not expect to generate revenue until
2010 or later, we may seek to sell additional equity or debt securities or obtain additional credit facilities to raise sufficient funds to meet our working capital and capital expenditure requirements. The sale of additional equity or convertible
debt securities could result in dilution to our stockholders. If additional funds are raised through the issuance of convertible debt securities, these securities could have rights senior to those associated with our Common Stock and Preferred Stock
and could contain covenants that would restrict our operations. Additional financing may not be available at all, or in amounts or on terms acceptable to us. If we are unable to obtain this additional financing, we may be required to discontinue
operations which would have a material adverse effect on our business, financial condition and results of operations. There can be no assurances that these actions, if taken, would result in cash flows sufficient to meet our ongoing operating needs.
We may also need to seek protection under the U.S. Bankruptcy Code or otherwise liquidate our assets, which may result in the failure of our stockholders to receive value for their ownership of our stock.

Our dependence on additional funds to continue our operations and the uncertainty of our ability to raise such funds, as described above, raise a
substantial doubt about our ability to continue as a going concern. The accompanying financial statements do not include any adjustments that might result from the outcome of this uncertainty. (See Note 8. Subsequent events).

Off-Balance Sheet Arrangements

We do not have any
off-balance sheet arrangements.



23



---

##### Table of Contents

|Item 3. | Quantitative and Qualitative Disclosures About Market Risk.
|------- | -----------------------------------------------------------

Not Applicable.



|Item 4T. | Controls and Procedures.
|-------- | ------------------------

Evaluation of Disclosure Controls and
Procedures

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our
Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the United States Securities and Exchange Commission rules and forms, and that such information is accumulated and communicated to our
management; including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.

We carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of
our disclosure controls and procedures pursuant to Exchange Act Rule 13a-14 as of the end of the period covered by this report. Based on that evaluation, our Chief Executive Officer and our Chief Financial Officer concluded that as of the end
of the period covered by this report, the Companys disclosure controls and procedures were effective.

Changes in Internal Controls

To address the material weaknesses in our internal control over financial reporting previously identified during the year ended
December 31, 2008, management designed a remediation plan which would supplement the existing controls of the Company. The remediation plan addressed the following corrective actions:



| |  |  | implementation of additional controls over the preparation and review of key spreadsheets;
| | - |  | ------------------------------------------------------------------------------------------



| |  |  | implementation of automated general ledger reports to replace existing key spreadsheets where possible;
| | - |  | -------------------------------------------------------------------------------------------------------



| |  |  | implementation of additional review procedures; and
| | - |  | ---------------------------------------------------



| |  |  | enhancement of the current capabilities of the finance function.
| | - |  | ----------------------------------------------------------------

During the course of the second quarter ended June 30, 2009, management was able to implement the remediation plan and address the previous material weaknesses in our internal control over financial reporting.
However, because of inherent limitations in the Companys financial resources, 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.

PART II  Other Information



|Item 1. | Legal Proceedings
|------- | -----------------

We are not currently engaged in
legal proceedings that require disclosure under this Item.



|Item 1A. | Risk Factors
|-------- | ------------

A description of the risk factors
associated with our business is included under Risk Factors contained in Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2008 and is incorporated herein by reference. Other than the item discussed
below, there have been no material changes in our risk factors since such filing.

Our auditors have expressed substantial doubt
about our ability to continue as a going concern.

The financial statements contained in our Annual Report on Form 10-K for the year
ended December 31, 2008, were prepared under the assumption that we will continue to operate as a going concern. The report of our independent public accounting firm on our financial statements for the year ended December 31, 2008 includes
a paragraph discussing conditions that raise a substantial doubt about our ability to continue as a going concern. We incurred losses of $15.2 million for the 2008 fiscal year and $1.9 million for the 2007 fiscal year. At December 31, 2008, our
cash and equivalents were approximately $5.7 million.



24



---

##### Table of Contents

During the six month period ended June 30, 2009, our net loss was $4.7 million, and at June 30,
2009, our cash and equivalents were $158,000. As we previously reported, on July 2, 2009, we entered into a Note and Warrant Purchase Agreement and raised approximately $2.8 million. After paying off the credit line with Triple Ring and paying
transaction costs, we received net proceeds for working capital of $1.2 million (See Note 8. Subsequent events). Despite raising these funds, we continue to believe we need additional funds to meet our anticipated cash needs for working
capital and capital expenditures for the next six months. Because we have never generated revenue and do not expect to do so until 2010 or later, we will most likely be required to raise these additional funds through convertible debt, debt or
equity financings or by selling our assets.

These funds, if available, may be from one or more public or private stock offerings,
borrowings under bank or lease lines of credit, or other sources. This additional financing may not be available on a timely basis on terms acceptable to us, or at all. Our ability to obtain such financing may be impaired by the current economic
conditions and the lack of liquidity in the credit markets. Such financing, if available, may also be dilutive to stockholders or may require us to grant a lender an additional security interest in our assets. The amount of money we will need will
depend on many factors, including:



| |  |  | revenues, if any, generated by future sales of our system and any of our future products;
| | - |  | -----------------------------------------------------------------------------------------



| |  |  | expenses we incur in developing and selling our system;
| | - |  | -------------------------------------------------------



| |  |  | the commercial success of our research and development efforts; and
| | - |  | -------------------------------------------------------------------



| |  |  | the emergence of competing technological developments.
| | - |  | ------------------------------------------------------

If we are unable to secure additional funding, we may have to discontinue operations; delay development or commercialization of our system; license to third parties the rights to commercialize products or technologies
that we would otherwise seek to commercialize; reduce marketing, customer support, or other resources devoted to our system or any combination of these activities. Any of these results would materially harm our business, financial condition, and
results of operations, and there can be no assurance that any of these results will result in cash flows that will be sufficient to fund our current or future operating needs. We may also need to seek protection under the U.S. Bankruptcy Code or
otherwise liquidate our assets, which may result in the failure of our stockholders to receive value for their ownership of our stock.

Our stockholders may be diluted in subsequent financings.

To raise the funds necessary to meet our anticipated cash
needs for working capital and capital expenditures, we may need to issue convertible debt, warrants to purchase our equity securities or shares of our Common Stock or Preferred Stock. If we were to issue such securities, the percentage ownership of
our current stockholders may be diluted, and the issued securities may have more senior rights, privileges and preferences. Furthermore, if we were to sell securities at a price per share that is less than the conversion price of Preferred Stock or
the exercise price of our warrants, the respective conversion price or exercise price may be subject to antidilution adjustments. The issuance additional equity securities may also have the effect of lowering the value of our outstanding stock. We
can provide no assurances that we will be able to obtain financing on terms favorable to us or our current stockholders, if at all.



|Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds
|------- | -----------------------------------------------------------

None.



|Item 3. | Defaults Upon Senior Securities
|------- | -------------------------------

None.



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

We held our Annual Meeting of Stockholders (Annual Meeting) on June 4, 2009. Stockholders representing 6,637,581, or 68%, of the total outstanding shares as of the record date of the Annual Meeting were present in person or
by proxy. The following is a brief description of each matter voted upon at the Annual Meeting and a statement of the number of votes cast for or against and the number of abstentions with respect to each matter.



25



---

##### Table of Contents

|1) | The stockholders elected the following individuals to serve on the Board of Directors for a term of one year:
|-- | -------------------------------------------------------------------------------------------------------------



|                     |  |           |  |          
|-------------------- |  | --------- |  | ---------
|                     |  | For       |  | Withheld 
|David Dantzker, M.D. |  | 6,637,581 |  | 3,130,272
|David J. Foster      |  | 6,637,581 |  | 3,130,272
|George J.M. Hersbach |  | 6,637,581 |  | 3,130,272
|Jack E. Price        |  | 6,637,581 |  | 3,130,272
|Edward G. Solomon    |  | 6,637,581 |  | 3,130,272
|Marc C. Whyte        |  | 6,637,581 |  | 3,130,272
|Lynda L. Wijcik      |  | 6,637,581 |  | 3,130,272



|2) | The stockholders approved the selection of BDO Seidman LLP as the independent registered public accounting firm of the Company for its fiscal year ending December 31, 2009:
|-- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|          |  |         |  |          
|--------- |  | ------- |  | ---------
|For       |  | Against |  | Abstain  
|6,637,581 |  |        |  | 3,130,272

On July 1, 2009, the holders of 7,490,639 shares of our Series A Preferred Stock executed an
action by written consent of our Series A Preferred Stockholders authorizing and approving: (i) the amendment to the Companys Certificate of Designation of the Relative Rights and Preferences of the Series A Convertible Preferred Stock to
reduce the maximum number of Series A Preferred Stock of the Company from 10,000,000 to 8,700,000; (ii) the Certificate of Designation of the Relative Rights and Preferences of the Series A- 1 Convertible Preferred Stock and (iii) issuance
of Series A-1 Preferred Stock of the Company in exchange for Series A Preferred Stock of the Company. The holders of 1,201,569 shares of our Series A Convertible Preferred Stock withheld from the consent.



|Item 5. | Other Information
|------- | -----------------

None.



26



---

##### Table of Contents

|Item 6. | Exhibits
|------- | --------

Exhibits



|     |  |                                                                                                                                                                        
|---- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------
|3.1  |  | Complete Copy of Certificate of Incorporation, as amended.(1)                                                                                                          
|     | 
|3.2  |  | Bylaws.(2)                                                                                                                                                             
|     | 
|3.3  |  | Certificate of Designation of the Relative Rights and Preferences of the Series A Convertible Preferred Stock of NovaRay Medical, Inc.(3)                              
|     | 
|3.4  |  | Certificate of Amendment of Certificate of Designation of the Relative Rights and Preferences of the Series A Convertible Preferred Stock.(4)                          
|     | 
|3.5  |  | Certificate of Designation of the Relative Rights and Preferences of the Series A-1 Convertible Preferred Stock.(5)                                                    
|     | 
|4.1  |  | Senior Secured 12% Convertible Bridge Note issued to Vision Opportunity Master Fund, Ltd. dated as of July 2, 2009.(6)                                                 
|     | 
|4.2  |  | Warrant to Purchase Shares of Common Stock issued to Vision Opportunity Master Fund, Ltd. dated as of July 2, 2009.(7)                                                 
|     | 
|4.3  |  | Amendment to Series A Warrant to Purchase Shares of Common Stock Number WA-07-12a with Vision Opportunity Master Fund, Ltd. dated as of July 2, 2009.(8)               
|     | 
|4.4  |  | Amendment to Series A Warrant to Purchase Shares of Common Stock Number WA-07-12b with Vision Capital Advantage Fund, L.P. dated as of July 2, 2009.(9)                
|     | 
|4.5  |  | Second Amendment to Series J-A Warrant to Purchase Shares of Common Stock Number W-JA- 07-1a with Vision Opportunity Master Fund, Ltd. dated as of July 2, 2009.(10)   
|     | 
|4.6  |  | Second Amendment to Series J-A Warrant to Purchase Shares of Common Stock Number W-JA- 07-1b with Vision Capital Advantage Fund, L.P. dated as of July 2, 2009.(11)    
|     | 
|10.1 |  | Note and Warrant Purchase Agreement (the Purchase Agreement) by and among NovaRay Medical, Inc. and the Purchasers (as defined therein) dated as of July 2,
2009.(12)
|     | 
|10.2 |  | Security Agreement with Vision Capital Advisors, LLC dated as of July 2, 2009.(13)                                                                                     
|     | 
|10.3 |  | Exchange Agreement with Vision Opportunity Master Fund, Ltd. dated as of July 2, 2009.(14)                                                                             
|     | 
|10.4 |  | Exchange Agreement with Vision Capital Advantage Fund, L.P. dated as of July 2, 2009.(15)                                                                              
|     | 
|10.5 |  | Amendment to Executive Employment Agreement with Marc C. Whyte dated as of July 2, 2009.(16)                                                                           
|     | 
|10.6 |  | Amendment to Executive Employment Agreement with William Frederick dated as of July 2, 2009.(17)                                                                       
|     | 
|10.7 |  | Amendment to Executive Employment Agreement with Edward Solomon dated as of July 2, 2009.(18)                                                                          
|     | 
|31.1 |  | Certification of Marc C. Whyte, Chief Executive Officer, pursuant to Rules 13a-14(a) and 15d-14(a) of the Securities Exchange Act of 1934, as amended.                 
|     | 
|31.2 |  | Certification of William Frederick, Chief Financial Officer, pursuant to Rules 13a-14(a) and 15d-14(a) of the Securities Exchange Act of 1934, as amended.             
|     | 
|32.1 |  | Certification of Marc C. Whyte, Chief Executive Officer, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                    
|     | 
|32.2 |  | Certification of William Frederick, Chief Financial Officer, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                



|(1) | Incorporated by reference to Exhibit 3.1 to the Registrants Quarterly Report on Form 10-Q filed with the SEC on May 14, 2008.
|--- | ------------------------------------------------------------------------------------------------------------------------------



27



---

##### Table of Contents

|(2) | Incorporated by reference to Exhibit 3.2 to the Registrants Registration Statement on Form 10-SB (No. 000-52731) filed with the SEC on July 20, 2007.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------



|(3) | Incorporated by reference to Exhibit 3.4 to the Registrants Current Report on Form 8-K filed with the SEC on December 28, 2007.
|--- | --------------------------------------------------------------------------------------------------------------------------------



|(4) | Incorporated by reference to Exhibit 3.1 to the Registrants Current Report on Form 8-K filed with the SEC on July 8, 2009.
|--- | ---------------------------------------------------------------------------------------------------------------------------



|(5) | Incorporated by reference to Exhibit 3.2 to the Registrants Current Report on Form 8-K filed with the SEC on July 8, 2009.
|--- | ---------------------------------------------------------------------------------------------------------------------------



|(6) | Incorporated by reference to Exhibit 10.2 to the Registrants Current Report on Form 8-K filed with the SEC on July 8, 2009.
|--- | ----------------------------------------------------------------------------------------------------------------------------



|(7) | Incorporated by reference to Exhibit 10.3 to the Registrants Current Report on Form 8-K filed with the SEC on July 8, 2009.
|--- | ----------------------------------------------------------------------------------------------------------------------------



|(8) | Incorporated by reference to Exhibit 10.7 to the Registrants Current Report on Form 8-K filed with the SEC on July 8, 2009.
|--- | ----------------------------------------------------------------------------------------------------------------------------



|(9) | Incorporated by reference to Exhibit 10.8 to the Registrants Current Report on Form 8-K filed with the SEC on July 8, 2009.
|--- | ----------------------------------------------------------------------------------------------------------------------------



|(10) | Incorporated by reference to Exhibit 10.9 to the Registrants Current Report on Form 8-K filed with the SEC on July 8, 2009.
|---- | ----------------------------------------------------------------------------------------------------------------------------



|(11) | Incorporated by reference to Exhibit 10.10 to the Registrants Current Report on Form 8-K filed with the SEC on July 8, 2009.
|---- | -----------------------------------------------------------------------------------------------------------------------------



|(12) | Incorporated by reference to Exhibit 10.1 to the Registrants Current Report on Form 8-K filed with the SEC on July 8, 2009.
|---- | ----------------------------------------------------------------------------------------------------------------------------



|(13) | Incorporated by reference to Exhibit 10.4 to the Registrants Current Report on Form 8-K filed with the SEC on July 8, 2009.
|---- | ----------------------------------------------------------------------------------------------------------------------------



|(14) | Incorporated by reference to Exhibit 10.5 to the Registrants Current Report on Form 8-K filed with the SEC on July 8, 2009.
|---- | ----------------------------------------------------------------------------------------------------------------------------



|(15) | Incorporated by reference to Exhibit 10.6 to the Registrants Current Report on Form 8-K filed with the SEC on July 8, 2009.
|---- | ----------------------------------------------------------------------------------------------------------------------------



|(16) | Incorporated by reference to Exhibit 10.11 to the Registrants Current Report on Form 8-K filed with the SEC on July 8, 2009.
|---- | -----------------------------------------------------------------------------------------------------------------------------



|(17) | Incorporated by reference to Exhibit 10.12 to the Registrants Current Report on Form 8-K filed with the SEC on July 8, 2009.
|---- | -----------------------------------------------------------------------------------------------------------------------------



|(18) | Incorporated by reference to Exhibit 10.13 to the Registrants Current Report on Form 8-K filed with the SEC on July 8, 2009.
|---- | -----------------------------------------------------------------------------------------------------------------------------



28



---

##### Table of Contents

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by
the undersigned, thereunto duly authorized, on August 12, 2009.



NOVARAY MEDICAL, INC.By:

/s/ Marc C. WhyteMarc C. Whyte President and Chief Executive OfficerBy:

/s/ William FrederickWilliam Frederick Chief Financial
Officer




29



---

##### Table of Contents

INDEX TO EXHIBITS



|     |  |                                                                                                                                                           
|---- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------
|31.1 |  | Certification of Marc C. Whyte, Chief Executive Officer, pursuant to Rules 13a-14(a) and 15d-14(a) of the Securities Exchange Act of 1934, as amended.    
|     | 
|31.2 |  | Certification of William Frederick, Chief Financial Officer, pursuant to Rules 13a-14(a) and 15d-14(a) of the Securities Exchange Act of 1934, as amended.
|     | 
|32.1 |  | Certification of Marc C. Whyte, Chief Executive Officer, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                       
|     | 
|32.2 |  | Certification of William Frederick, Chief Financial Officer, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                   



30