##### Table of Contents





UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549





FORM 10-Q





(Mark One)

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

For the quarterly period ended September 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  x    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   |  |  ̈  (Do not check if a smaller reporting company) |  | Smaller reporting company |  | x

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

As of October 31, 2009 there were 9,580,587 shares of common stock, par value $.0001 per share, outstanding.









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##### Table of Contents

NOVARAY MEDICAL, INC.

(A Development Stage Company)

Form 10-Q for the Quarter Ended September 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 |  | 21
|                               |  |                                                                                      
|Item 3.                        |  | Quantitative and Qualitative Disclosures About Market Risk                            |  | 25
|                               |  |                                                                                      
|Item 4T.                       |  | Controls and Procedures                                                               |  | 25
|                               | 
|PART II  OTHER INFORMATION    |  |                                                                                      
|                               |  |                                                                                      
|Item 1.                        |  | Legal Proceedings                                                                     |  | 25
|                               |  |                                                                                      
|Item 1A.                       |  | Risk Factors                                                                          |  | 25
|                               |  |                                                                                      
|Item 2.                        |  | Unregistered Sales of Equity Securities and Use of Proceeds                           |  | 26
|                               |  |                                                                                      
|Item 3.                        |  | Defaults Upon Senior Securities                                                       |  | 26
|                               |  |                                                                                      
|Item 4.                        |  | Submission of Matters to a Vote of Security Holders                                   |  | 26
|                               |  |                                                                                      
|Item 5.                        |  | Other Information                                                                     |  | 27
|                               |  |                                                                                      
|Item 6.                        |  | Exhibits                                                                              |  | 27
|                               | 
|SIGNATURES                     |  | 30                                                                                   
|                               | 
|EXHIBIT 31.1                   |  |                                                                                      
|                               | 
|EXHIBIT 31.2                   |  |                                                                                      
|                               | 
|EXHIBIT 32.1                   |  |                                                                                      
|                               | 
|EXHIBIT 32.2                   |  |                                                                                      



2



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##### 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)

(Unaudited)



|                                                                                                                                                                           |  |                   |         |   |                  |   |         |  
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ----------------- | ------- | - | ---------------- | - | ------- | -
|                                                                                                                                                                           |  | September 30,2009 |         |   | December 31,2008 |  
|ASSETS                                                                                                                                                                     |  |                   |         |   |                  |   |         |  
|Current assets:                                                                                                                                                            |  |                   |         |   |                  |   |         |  
|Cash and cash equivalents                                                                                                                                                  |  | $                 | 384     |   |                  | $ | 5,691   |  
|Receivables from Triple Ring                                                                                                                                               |  |                   |        |   |                  |   | 42      |  
|Other receivables                                                                                                                                                          |  |                   | 10      |   |                  |   |        |  
|Security deposit with Triple Ring                                                                                                                                          |  |                   | 355     |   |                  |   | 500     |  
|Inventory                                                                                                                                                                  |  |                   | 132     |   |                  |   | 132     |  
|Prepaid expenses to Triple Ring                                                                                                                                            |  |                   | 135     |   |                  |   | 141     |  
|Prepaid expenses and other current assets                                                                                                                                  |  |                   | 90      |   |                  |   | 62      |  
|                                                                                                                                                                           |  |                   |         |   |                  |   |         |  
|Total current assets                                                                                                                                                       |  |                   | 1,106   |   |                  |   | 6,568   |  
|Property and equipment, net                                                                                                                                                |  |                   | 894     |   |                  |   | 1,059   |  
|Restricted cash                                                                                                                                                            |  |                   |        |   |                  |   | 135     |  
|                                                                                                                                                                           |  |                   |         |   |                  |   |         |  
|Total assets                                                                                                                                                               |  | $                 | 2,000   |   |                  | $ | 7,762   |  
|                                                                                                                                                                           |  |                   |         |   |                  |   |         |  
|LIABILITIES AND STOCKHOLDERS (DEFICIT) EQUITY                                                                                                                             |  |                   |         |   |                  |   |         |  
|Current liabilities:                                                                                                                                                       |  |                   |         |   |                  |   |         |  
|Accounts payable to Triple Ring                                                                                                                                            |  | $                 | 1,050   |   |                  | $ | 2,109   |  
|Accounts payable trade                                                                                                                                                     |  |                   | 22      |   |                  |   | 172     |  
|Accrued liabilities to Triple Ring                                                                                                                                         |  |                   | 58      |   |                  |   | 508     |  
|Accrued liabilities                                                                                                                                                        |  |                   | 343     |   |                  |   | 287     |  
|Deferred rent - short term portion                                                                                                                                         |  |                   | 118     |   |                  |   | 112     |  
|Convertible note, net of debt discount of $1,081                                                                                                                           |  |                   | 1,669   |   |                  |   |        |  
|Notes payable                                                                                                                                                              |  |                   | 95      |   |                  |   | 95      |  
|                                                                                                                                                                           |  |                   |         |   |                  |   |         |  
|Total current liabilities                                                                                                                                                  |  |                   | 3,355   |   |                  |   | 3,283   |  
|Deferred rent-less short-term portion                                                                                                                                      |  |                   | 375     |   |                  |   | 463     |  
|Warrant liabilities                                                                                                                                                        |  |                   | 8,253   |   |                  |   |        |  
|                                                                                                                                                                           |  |                   |         |   |                  |   |         |  
|Total liabilities                                                                                                                                                          |  |                   | 11,983  |   |                  |   | 3,746   |  
|                                                                                                                                                                           |  |                   |         |   |                  |   |         |  
|Commitments and Contingencies (Note 4)                                                                                                                                     |  |                   |         |   |                  |   |         |  
|                                                                                                                                                                           |  |                  
|Stockholders (deficit) equity:                                                                                                                                            |  |                   |         |   |                  |   |         |  
|Preferred stock, $0.0001 par value, Authorized shares - 10,000,000                                                                                                         |  |                   |        |   |                  |   | 1       |  
|Authorized Series A convertible shares - 8,700,000; issued and outstanding shares - 0 at September 30, 2009 and 8,692,208 at
December 31, 2008 (no liquidation preference) |  |                   |         |   |                  |   |         |  
|Authorized Series A-1 convertible shares - 870,000; issued and outstanding shares - 869,217 at September 30, 2009 and 0 at
December 31, 2008 (no liquidation preference)   |  |                   |         |   |                  |   |         |  
|Common stock, $0.0001 par value                                                                                                                                            |  |                   |         |   |                  |   |         |  
|Authorized shares - 100,000,000; issued and outstanding shares - 9,767,853 at September 30, 2009 and December 31, 2008                                                     |  |                   | 1       |   |                  |   | 1       |  
|Additional paid-in capital                                                                                                                                                 |  |                   | 21,248  |   |                  |   | 24,898  |  
|Deficit accumulated during the development stage                                                                                                                           |  |                   | (31,228 | ) |                  |   | (20,880 | )
|Less: treasury stock, at cost, 1,239,000 shares at September 30, 2009 and December 31, 2008                                                                                |  |                   | (4      | ) |                  |   | (4      | )
|                                                                                                                                                                           |  |                   |         |   |                  |   |         |  
|Total stockholders (deficit) equity                                                                                                                                       |  |                   | (9,983  | ) |                  |   | 4,016   |  
|                                                                                                                                                                           |  |                   |         |   |                  |   |         |  
|Total liabilities and stockholders (deficit) equity                                                                                                                       |  | $                 | 2,000   |   |                  | $ | 7,762   |  
|                                                                                                                                                                           |  |                   |         |   |                  |   |         |  

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



3



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##### Table of Contents

NOVARAY MEDICAL, INC.

(A Development Stage Company)

CONDENSED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(Unaudited)



|                                                                                                          |  |                                 |        |   |                                |   |        |                                              |  |   |        |   |  |   |         |   |  |   |         |  
|--------------------------------------------------------------------------------------------------------- |  | ------------------------------- | ------ | - | ------------------------------ | - | ------ | -------------------------------------------- |  | - | ------ | - |  | - | ------- | - |  | - | ------- | -
|                                                                                                          |  | Three Months EndedSeptember 30, |        |   | Nine Months EndedSeptember 30, |   |        | From Inception(June 7, 2005) toSep. 30, 2009 | 
|                                                                                                          |  | 2009                            |        |   | 2008                           |   |        | 2009                                         |  |   | 2008   |   | 
|Operating expenses:                                                                                       |  |                                 |        |   |                                |   |        |                                              |  |   |        |   |  |   |         |   |  |   |         |  
|Sales and marketing                                                                                       |  | $                               | 18     |   |                                | $ | 113    |                                              |  | $ | 220    |   |  | $ | 296     |   |  | $ | 640     |  
|Research and development (Note 7)                                                                         |  |                                 | 1,071  |   |                                |   | 3,445  |                                              |  |   | 3,752  |   |  |   | 7,729   |   |  |   | 15,962  |  
|General and administrative                                                                                |  |                                 | 531    |   |                                |   | 596    |                                              |  |   | 2,218  |   |  |   | 2,084   |   |  |   | 9,913   |  
|                                                                                                          |  |                                 |        |   |                                |   |        |                                              |  |   |        |   |  |   |         |   |  |   |         |  
|Total operating expenses                                                                                  |  |                                 | 1,620  |   |                                |   | 4,154  |                                              |  |   | 6,190  |   |  |   | 10,109  |   |  |   | 26,515  |  
|                                                                                                          |  |                                 |        |   |                                |   |        |                                              |  |   |        |   |  |   |         |   |  |   |         |  
|Loss from operations                                                                                      |  |                                 | (1,620 | ) |                                |   | (4,154 | )                                            |  |   | (6,190 | ) |  |   | (10,109 | ) |  |   | (26,515 | )
|                                                                                                          |  |                                 |        |   |                                |   |        |                                              |  |   |        |   |  |   |         |   |  |   |         |  
|Other income (expense):                                                                                   |  |                                 |        |   |                                |   |        |                                              |  |   |        |   |  |   |         |   |  |   |         |  
|Interest income                                                                                           |  |                                 | 1      |   |                                |   | 30     |                                              |  |   | 6      |   |  |   | 62      |   |  |   | 83      |  
|Other income (expense)                                                                                    |  |                                 | (1     | ) |                                |   |       |                                              |  |   | (1     | ) |  |   |        |   |  |   | 281     |  
|Interest expense                                                                                          |  |                                 | (150   | ) |                                |   | (3     | )                                            |  |   | (162   | ) |  |   | (9      | ) |  |   | (1,076  | )
|Net loss on change in fair value of warrant liabilities                                                   |  |                                 | (1,687 | ) |                                |   |       |                                              |  |   | (1,831 | ) |  |   |        |   |  |   | (1,831  | )
|Amortization of debt discount                                                                             |  |                                 | (1,082 | ) |                                |   |       |                                              |  |   | (1,082 | ) |  |   |        |   |  |   | (1,082  | )
|                                                                                                          |  |                                 |        |   |                                |   |        |                                              |  |   |        |   |  |   |         |   |  |   |         |  
|Total other income (expense)                                                                              |  |                                 | (2,919 | ) |                                |   | 27     |                                              |  |   | (3,070 | ) |  |   | 53      |   |  |   | (3,625  | )
|                                                                                                          |  |                                 |        |   |                                |   |        |                                              |  |   |        |   |  |   |         |   |  |   |         |  
|Net loss                                                                                                  |  | $                               | (4,539 | ) |                                | $ | (4,127 | )                                            |  | $ | (9,260 | ) |  | $ | (10,056 | ) |  | $ | (30,140 | )
|Deemed dividend                                                                                           |  |                                 |       |   |                                |   | (2,178 | )                                            |  |   |       |   |  |   | (2,178  | ) |  |   | (2,178  | )
|                                                                                                          |  |                                 |        |   |                                |   |        |                                              |  |   |        |   |  |   |         |   |  |   |         |  
|Net loss allocable to common stockholders                                                                 |  | $                               | (4,539 | ) |                                | $ | (6,305 | )                                            |  | $ | (9,260 | ) |  | $ | (12,234 | ) |  | $ | (32,318 | )
|                                                                                                          |  |                                 |        |   |                                |   |        |                                              |  |   |        |   |  |   |         |   |  |   |         |  
|Basic and diluted loss per share allocable to common stockholders                                         |  | $                               | (0.47  | ) |                                | $ | (0.67  | )                                            |  | $ | (0.97  | ) |  | $ | (1.31   | ) |  | $ | (4.71   | )
|                                                                                                          |  |                                 |        |   |                               
|Weighted average shares used to compute basic and diluted loss per share allocable to common stockholders |  |                                 | 9,567  |   |                                |   | 9,406  |                                              |  |   | 9,527  |   |  |   | 9,366   |   |  |   | 6,856   |  

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



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##### Table of Contents

NOVARAY MEDICAL, INC.

(A Development Stage Company)

CONDENSED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)



|                                                                                                       |  |                                |        |   |                                                   |   |         |   |  |   |         |  
|------------------------------------------------------------------------------------------------------ |  | ------------------------------ | ------ | - | ------------------------------------------------- | - | ------- | - |  | - | ------- | -
|                                                                                                       |  | Nine Months EndedSeptember 30, |        |   | From Inception(June 7, 2005) toSeptember 30, 2009 |  
|                                                                                                       |  | 2009                           |        |   | 2008                                              |   |        
|Cash Flows From Operating Activities:                                                                  |  |                                |        |   |                                                   |   |         |   |  |   |         |  
|Net loss                                                                                               |  | $                              | (9,260 | ) |                                                   | $ | (10,056 | ) |  | $ | (30,140 | )
|Adjustments to reconcile net loss to net cash used in operating activities:                            |  |                                |        |   |                                                   |   |         |   |  |   |         |  
|Depreciation and amortization                                                                          |  |                                | 185    |   |                                                   |   | 21      |   |  |   | 259     |  
|Stock-based compensation expense                                                                       |  |                                | 547    |   |                                                   |   |        |   |  |   | 547     |  
|Non-cash research and development expense (expense reversal) associated with performance based warrant |  |                                | (1,124 | ) |                                                   |   | 668     |   |  |   |        |  
|Loss on change in fair value of warrant liabilities                                                    |  |                                | 1,831  |   |                                                   |   |        |   |  |   | 1,831   |  
|Amortization of debt discount                                                                          |  |                                | 1,082  |   |                                                   |   |        |   |  |   | 1,082   |  
|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     |  
|Loss on sales of assets                                                                                |  |                                | 1      |   |                                                   |   |        |   |  |   | 1       |  
|Changes in operating assets and liabilities:                                                           |  |                                |        |   |                                                   |   |         |   |  |   |         |  
|Receivables from Triple Ring                                                                           |  |                                | 42     |   |                                                   |   | (34     | ) |  |   |        |  
|Other receivables                                                                                      |  |                                | (10    | ) |                                                   |   | (576    | ) |  |   | (10     | )
|Inventory                                                                                              |  |                                |       |   |                                                   |   |        |   |  |   | (131    | )
|Prepaid expenses to Triple Ring                                                                        |  |                                | 5      |   |                                                   |   | (161    | ) |  |   | (136    | )
|Prepaid expenses and other current assets                                                              |  |                                | 92     |   |                                                   |   | (36     | ) |  |   | 29      |  
|Accounts payable to Triple Ring                                                                        |  |                                | 403    |   |                                                   |   | 1,650   |   |  |   | 2,512   |  
|Accounts payable trade                                                                                 |  |                                | (150   | ) |                                                   |   | (71     | ) |  |   | 22      |  
|Accrued liabilities to Triple Ring                                                                     |  |                                | (450   | ) |                                                   |   | 158     |   |  |   | 58      |  
|Accrued liabilities                                                                                    |  |                                | 159    |   |                                                   |   | 13      |   |  |   | 446     |  
|Deferred rent                                                                                          |  |                                | (82    | ) |                                                   |   | 622     |   |  |   | 493     |  
|                                                                                                       |  |                                |        |   |                                                   |   |         |   |  |   |         |  
|Net cash used in operating activities                                                                  |  |                                | (6,729 | ) |                                                   |   | (7,802  | ) |  |   | (20,529 | )
|                                                                                                       |  |                                |        |   |                                                   |   |         |   |  |   |         |  
|Cash Flows From Investing Activities:                                                                  |  |                                |        |   |                                                   |   |         |   |  |   |         |  
|Property and equipment                                                                                 |  |                                | (21    | ) |                                                   |   | (916    | ) |  |   | (1,154  | )
|Restricted cash                                                                                        |  |                                | 135    |   |                                                   |   | (135    | ) |  |   |        |  
|Security deposit with Triple Ring                                                                      |  |                                | 145    |   |                                                   |   | (500    | ) |  |   | (355    | )
|                                                                                                       |  |                                |        |   |                                                   |   |         |   |  |   |         |  
|Net cash provided by (used in) investing activities                                                    |  |                                | 259    |   |                                                   |   | (1,551  | ) |  |   | (1,509  | )
|                                                                                                       |  |                                |        |   |                                                   |   |         |   |  |   |         |  
|Cash Flows From Financing Activities:                                                                  |  |                                |        |   |                                                   |   |         |   |  |   |         |  
|Proceeds from subscriptions receivable                                                                 |  |                                |       |   |                                                   |   |        |   |  |   | 100     |  
|Net proceeds from issuance of short term debt                                                          |  |                                | 2,625  |   |                                                   |   |        |   |  |   | 4,669   |  
|Proceeds from sale of common stock                                                                     |  |                                |       |   |                                                   |   |        |   |  |   | 154     |  
|Proceeds from sale of Series A convertible preferred stock                                             |  |                                |       |   |                                                   |   | 4,708   |   |  |   | 20,430  |  
|Repayment of notes payable                                                                             |  |                                |       |   |                                                   |   | (30     | ) |  |   | (30     | )
|Repayment of Triple Ring line of credit                                                                |  |                                | (1,462 | ) |                                                   |   |        |   |  |   | (1,462  | )
|Payment on extinguishment of debt                                                                      |  |                                |       |   |                                                   |   |        |   |  |   | (10     | )
|Issuance costs incurred in sale of Series A convertible preferred stock                                |  |                                |       |   |                                                   |   |        |   |  |   | (1,425  | )
|Purchase of treasury stock                                                                             |  |                                |       |   |                                                   |   |        |   |  |   | (4      | )
|                                                                                                       |  |                                |        |   |                                                   |   |         |   |  |   |         |  
|Net cash provided by financing activities                                                              |  |                                | 1,163  |   |                                                   |   | 4,678   |   |  |   | 22,422  |  
|                                                                                                       |  |                                |        |   |                                                   |   |         |   |  |   |         |  
|Net (decrease) increase in cash and cash equivalents                                                   |  |                                | (5,307 | ) |                                                   |   | (4,675  | ) |  |   | 384     |  
|Cash and cash equivalents  beginning of period                                                        |  |                                | 5,691  |   |                                                   |   | 9,234   |   |  |   |        |  
|                                                                                                       |  |                                |        |   |                                                   |   |         |   |  |   |         |  
|Cash and cash equivalents  end of period                                                              |  | $                              | 384    |   |                                                   | $ | 4,559   |   |  | $ | 384     |  
|                                                                                                       |  |                                |        |   |                                                   |   |         |   |  |   |         |  
|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 debt financing                                                      |  | $                              | 2,163  |   |                                                   | $ |        |   |  | $ | 5,931   |  
|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



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##### 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
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 for accounting and reporting by development stage enterprises.

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 substantial additional funds to continue operations, even in the short term. As reflected in the accompanying financial statements, the Company is in the development stage, has a net loss since
inception of $30.1 million and has used cash in operations of $20.5 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 nine months ended September 30, 2009, our net loss was $9.3 million, and at September 30, 2009, our cash and
equivalents were $384,000. On October 27, 2009, we entered into a Series B Convertible Participating Preferred Stock and Warrant Purchase Agreement, pursuant to which we initially raised gross proceeds $3 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 twelve 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 funds through additional 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,
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; delay development or commercialization of our system; license to third parties the rights to commercialize products or technologies



6



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##### Table of Contents

NOVARAY MEDICAL, INC.

(A Development Stage Company)

NOTES TO FINANCIAL
STATEMENTS(Continued)

(Unaudited)



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.

Use 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 nine month periods ended September 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):



|                                                |  |                   |       |   |                  |   |       |  
|----------------------------------------------- |  | ----------------- | ----- | - | ---------------- | - | ----- | -
|                                                |  | September 30,2009 |       |   | December 31,2008 |  
|Computer and office equipment                   |  | $                 | 13    |   |                  | $ | 13    |  
|Machinery and equipment                         |  |                   | 105   |   |                  |   | 91    |  
|Furniture and fixtures                          |  |                   | 200   |   |                  |   | 200   |  
|Leasehold improvements                          |  |                   | 835   |   |                  |   | 829   |  
|                                                |  |                   |       |   |                  |   |       |  
|                                                |  |                   | 1,153 |   |                  |   | 1,133 |  
|Less: accumulated depreciation and amortization |  |                   | (259  | ) |                  |   | (74   | )
|                                                |  |                   |       |   |                  |   |       |  
|Property and equipment, net                     |  | $                 | 894   |   |                  | $ | 1,059 |  
|                                                |  |                   |       |   |                  |   |       |  

Depreciation and amortization expense related to property and equipment for the three
and nine month periods ended September 30, 2009 was $62,000 and $185,000, respectively. Depreciation and amortization expense related to property and equipment for the three and nine month periods ended September 30, 2008 was $12,000 and
$21,000, respectively.



7



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##### Table of Contents

NOVARAY MEDICAL, INC.

(A Development Stage Company)

NOTES TO FINANCIAL
STATEMENTS(Continued)

(Unaudited)



Impairment of Long-Lived Assets

The Company reviews long-lived assets, including property and equipment, for impairment whenever events or changes in business circumstances
indicate that the carrying amount of the assets may not be fully recoverable. 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 September 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 Issued for Services

The Company from time to
time issues 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
applicable valuation date.

The Companys 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. No expense is recorded for warrants for which vesting is based on defined performance criteria until such vesting is more likely than not to occur based on the
achievement of milestones.

Warrant Liabilities at Fair Value

The Company from time to time issues common stock warrants in connection with private placements of equity securities and convertible debt
instruments. Common stock purchase warrant liabilities are recorded on the basis of their fair value, which is measured as of the date of the balance sheet in the accompanying financial statements.

Stock-based Compensation

The Company recognizes stock-based compensation expense by estimating 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. The risk-free rate for the expected term
of the option is based on the U.S. Treasury Constant Maturity rate.



8



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##### Table of Contents

NOVARAY MEDICAL, INC.

(A Development Stage Company)

NOTES TO FINANCIAL
STATEMENTS(Continued)

(Unaudited)



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 endedSeptember 30, |        |   | Nine months endedSeptember 30, |  
|                                                                                                           |  | 2009                            |        |   | 2008                           |   |        | 2009 |  |   | 2008   |  
|Basic and Diluted:                                                                                         |  |                                 |        |   |                                |   |        |      |  |   |        |   |  |   |         |  
|Net loss allocable to common stockholders                                                                  |  | $                               | (4,539 | ) |                                | $ | (6,305 | )    |  | $ | (9,260 | ) |  | $ | (12,234 | )
|Basic and diluted loss per share allocable to common stockholders                                          |  | $                               | (0.47  | ) |                                | $ | (0.67  | )    |  | $ | (0.97  | ) |  | $ | (1.31   | )
|Weighted average shares used to compute basic and diluted loss per share allocable to common stockholders. |  |                                 | 9,567  |   |                                |   | 9,406  |      |  |   | 9,527  |   |  |   | 9,366   |  

Outstanding common stock equivalents that are excluded from the calculation of
diluted net loss per share as their effect is anti-dilutive totaled 15,746,703 and 14,799,292 for the three and nine month periods ended September 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 11,968,296 and 11,120,400 for the three and nine month periods ended September 30, 2008, respectively.

Recent Accounting Pronouncements

In June 2009, the Financial Accounting Standards Board (FASB) issued new guidance that established 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. The Codification is effective for financial statements issued for interim and annual
periods ending after September 15, 2009 and supersedes all existing non-SEC accounting and reporting standards. All other non-grandfathered, non-SEC accounting literature not included in the Codification became non-authoritative. The FASB is
not issuing new standards in the form of Statements, FASB Staff Positions, or Emerging Issues Task Force Abstracts. Instead, it is issuing Accounting Standards Updates. The FASB does not consider Accounting Standards Updates as authoritative in
their own right. Accounting Standards Updates 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 updated its disclosures to
conform to the Codification in this Quarterly Report on Form 10-Q for the third quarter of 2009.

In June 2009, the FASB
issued new guidance that amends the consolidation guidance applicable to variable interest entities. The amendments to the consolidation guidance are effective as of the beginning of the first fiscal year that begins after November 15, 2009.
The adoption of this new guidance is not expected to have a material effect on the Companys financial statements.

In
June 2009, the FASB issued new guidance that 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. This new guidance 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 this new guidance is not expected to have a
material effect on the Companys financial statements.

In May 2009, the FASB issued new guidance which establishes
general standards of accounting for, and disclosure of, events that occur after the balance sheet date but before financial statements are issued. This new guidance is for interim or annual periods ending after June 15, 2009, and: (i) sets
forth the period after the balance sheet date during which management of a reporting entity should evaluate events or transactions that may occur for potential recognition in the financial statements, (ii) identifies the circumstances under
which an entity should recognize events or transactions occurring after the balance sheet date in its financial statements and (iii) the disclosures that should be made about events or transactions that occur after the balance sheet date. This
new guidance provides largely the same framework for the evaluation of subsequent events which previously existed only in auditing literature. The Company has performed an evaluation of subsequent events through November 12, 2009, which is the
day the financial statements were issued.



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##### Table of Contents

NOVARAY MEDICAL, INC.

(A Development Stage Company)

NOTES TO FINANCIAL
STATEMENTS(Continued)

(Unaudited)



In June 2008, the FASB ratified previous guidance and specified 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. This new guidance provided 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 scope exception. This new
guidance became effective for the first annual reporting period beginning after December 15, 2008. The Company adopted the guidance on January 1, 2009.

In May 2008, the FASB issued guidance related to accounting for convertible debt instruments which may be settled in cash upon conversion. This guidance requires entities with convertible debt instruments
that may be settled in cash upon conversion, including partial cash settlement, to separately account for the liability and equity components in a manner that reflects the entitys nonconvertible debt borrowing rate when interest expense is
recognized in subsequent periods.

In September 2006, the FASB issued guidance which defined fair value, established a
framework for measuring fair value in GAAP, and expanded disclosures about fair value measurements. The guidance 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 this guidance 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 this guidance, 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 this guidance 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 |  | Sep. 30,2009
|Fair value of warrants |  | $       |  |         | $ |        |  | $            | 8,253 |  | $ | 8,253

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

3. Notes payable and convertible note

The Company received certain assets subject to a prior security interest 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 September 30, 2009, the aggregate principal balance due
under the 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 amended Professional Services Agreement between the Company and Triple
Ring. The Credit Line was secured by all of the Companys assets on a first priority security interest. The Credit Line was paid off on July 2, 2009, and the security interest held by Triple Ring was terminated, releasing the lien on all
Company assets.



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##### Table of Contents

NOVARAY MEDICAL, INC.

(A Development Stage Company)

NOTES TO FINANCIAL
STATEMENTS(Continued)

(Unaudited)



In July 2009, the Company entered into a Note and Warrant Purchase Agreement (the
Note and Warrant Purchase Agreement) with Purchasers (as defined therein) to issue and sell senior secured 12% convertible bridge notes (individually, a Convertible Note and collectively, the Convertible Notes) in
the aggregate principal amount of up to $4.3 million. Under the terms of the Note and Warrant Purchase Agreement, the Company issued a Convertible Note to Vision Opportunity Master Fund, Ltd. (Vision) in the principal amount of $2.8
million on July 2, 2009. Unless otherwise converted into shares of Qualified Financing Stock (as defined in the Convertible Note) 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 Convertible Note is secured by all the Companys assets with a security agreement in favor of the holder of the Convertible Note. Upon the occurrence of an Event of
Default (as defined in the Convertible 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. Effective as of the closing of a Qualified Financing (as defined in the
Convertible Note), 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 in the Convertible Note). As of September 30, 2009, the principal
balance due under the Convertible Note was $2.8 million.

In conjunction with the issuance of the Notes, the Company issued
common stock warrants to the purchaser of the Note. These common stock warrants do not trade in an active securities market, and as such, we estimated the fair value of these common stock warrants to be $2.2 million using the Black-Scholes option
pricing model using the following assumptions:



|                        |  |       |  
|----------------------- |  | ----- | -
|Risk-free interest rate |  | 2.31  | %
|Dividend yield          |  |      |  
|Expected life (years)   |  | 4.76  |  
|Expected volatility     |  | 64.30 | %

The fair value of $2.2 million was recorded as a debt discount, representing
additional financing costs, as of the issuance date with the corresponding amount as a warrant liability. The debt discount is being amortized to interest expense over the six-month period to the due date of the Note on December 31, 2009,
resulting in an increase in non-cash interest expense in current and future periods. Warrant liability is subject to re-measurement on a quarterly basis until the warrant has been exercised.

At September 30, 2009, the carrying amount of the Note is as follows (in thousands):



|                                       |  |   |        |  
|-------------------------------------- |  | - | ------ | -
|Principal amount                       |  | $ | 2,750  |  
|Unamortized discount                   |  |   | (1,081 | )
|Convertible note, net of debt discount |  | $ | 1,669  |  
|                                       |  |   |        |  

The unamortized debt discount of $1.1 million will be amortized through
December 31, 2009. Interest and amortization expense of the debt discount and issuance costs for the Note are as follows (in thousands):



|                               |  |                                     |       |                                    |   |      
|------------------------------ |  | ----------------------------------- | ----- | ---------------------------------- | - | -----
|                               |  | Three Months EndedSeptember 30,2009 |       | Nine Months EndedSeptember 30,2009
|Interest expense recognized    |  | $                                   | 83    |                                    | $ | 83   
|Amortization of discount       |  |                                     | 1,082 |                                    |   | 1,082
|Amortization of issuance costs |  |                                     | 64    |                                    |   | 64   
|                               |  |                                     |       |                                    |   |      
|                               |  | $                                   | 1,229 |                                    | $ | 1,229
|                               |  |                                     |       |                                    |   |      

See Note 8. Subsequent events for amendments in the terms of Notes and
Warrants.

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



11



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##### Table of Contents

NOVARAY MEDICAL, INC.

(A Development Stage Company)

NOTES TO FINANCIAL
STATEMENTS(Continued)

(Unaudited)



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 September 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, suppliers or customers. The term of these indemnification
agreements is generally 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
September 30, 2009 and December 31, 2008.

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 September 30, 2009, 8,700,000 shares of Preferred Stock were designated as Series A
Convertible Preferred Stock and 870,000 shares of Preferred Stock were designated as Series A-1 Convertible Preferred Stock. As of September 30, 2009, the Series A Convertible Preferred Stock was convertible at the rate of one share for one
share of our Common Stock and the Series A-1 Convertible Preferred Stock was convertible at the rate of one share for ten shares of our Common Stock. As of September 30, 2009, the Company had outstanding 9,767,853 shares of Common Stock, 0
shares of Series A Convertible Preferred Stock and 869,217 shares of Series A-1 Convertible Preferred Stock. Additionally, there are outstanding warrants to purchase an aggregate of up to 6,702,060 shares of our Common Stock as of September 30,
2009, as well as an additional warrant to purchase shares of our Common Stock issued as of July 2, 2009.

Common
Stock

As of September 30, 2009, 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
September 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).



12



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##### Table of Contents

NOVARAY MEDICAL, INC.

(A Development Stage Company)

NOTES TO FINANCIAL
STATEMENTS(Continued)

(Unaudited)



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 and Series A-1 Convertible Preferred Stock are 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 and Series A-1 Convertible Preferred Stock are subject to upward
adjustment so as to cause a share of outstanding Series A Convertible Preferred Stock and Series A-1 Convertible Preferred Stock to be potentially convertible into additional shares 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 and Series A-1 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. The Series A-1 Convertible Preferred Stock has no liquidation preference, is convertible one-to-ten 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.

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.

On July 2, 2009, the Company 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 Convertible Preferred Stock for 749,063 shares of the Companys Series A-1 Convertible Preferred Stock and 9 shares of
the Companys Series A Preferred Stock for $24.03 in cash.

On August 21, 2009, the Company entered into an Exchange
Agreement with Wheatley Medtech Partners, L.P., W Capital Partners II, L.P., Heartstream Capital B.V., Lloyd Investments L.P., Biobridge LLC and Lynda Wijcik to exchange 1,201,569 shares of the Companys Series A Convertible Preferred Stock for
120,154 shares of the Companys Series A-1 Convertible Preferred Stock and 29 shares of the Companys Series A Preferred Stock for $77.43 in cash.

To the extent any holder of the Companys Series A Convertible Preferred Stock has any rights under the Series A Convertible Preferred Stock and Warrant Purchase Agreement dated as of
December 27, 2007, such rights apply with the necessary changes to the Companys Series A-1 Convertible Preferred Stock. No dividends have been declared to date on the Series A Convertible Preferred Stock or the Series A-1 Convertible
Preferred Stock.

Warrants

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



|                             |  |                   |  |               |     
|---------------------------- |  | ----------------- |  | ------------- | ----
|Warrant Group                |  | Number ofWarrants |  | ExercisePrice
|Series A                     |  | 1,648,960         |  | $             | 2.67
|Amended Series J-A           |  | 1,248,440         |  | $             | 2.67
|Series J-A additional shares |  | 1,872,660         |  | $             | 2.67
|Consultant                   |  | 600,000           |  | $             | 4.25
|Triple Ring(1)               |  | 1,332,000         |  |               | N/A 
|Bridge(2)                    |  | 1,500,000         |  | $             | 2.67
|                             |  |                   |  |               |     
|                             |  | 8,202,060         |  |               |     
|                             |  |                   |  |               |     



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

|(2) | These warrants are for a minimum of 1.5 million shares of the Companys Common Stock and have a maximum price equal to $2.67 per share.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------



13



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##### Table of Contents

NOVARAY MEDICAL, INC.

(A Development Stage Company)

NOTES TO FINANCIAL
STATEMENTS(Continued)

(Unaudited)



All of the warrants outstanding at September 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. Warrants for 1.5 million shares issued in conjunction with the July 2009 bridge
financing have also been recorded as warrant liabilities.

Series A Warrants, Amended Series J-A Warrants and Series J-A
Additional Shares

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.

On July 2, 2009, the Company 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.

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%.



14



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##### Table of Contents

NOVARAY MEDICAL, INC.

(A Development Stage Company)

NOTES TO FINANCIAL
STATEMENTS(Continued)

(Unaudited)



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 September 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
and the Company has no liabilities recorded for these warrants as of September 30, 2009.

Bridge Warrants

On July 2, 2009, pursuant to a Note and Warrant Purchase Agreement (the Note and Warrant Purchase
Agreement), the Company issued a five year warrant to Vision Opportunity Master Fund Ltd. to purchase up to the greater of (a) 1,500,000 or (b) 100% of that number of shares of the Companys Common Stock into which the
Convertible Note issued to the applicable purchaser converts or if such Note converts into Conversion Securities (as defined in the Note and Warrant Purchase Agreement), the initial principal amount of such Note divided by the per unit price of the
Conversion Securities of the duly authorized, validly issued, fully paid and non-assessable Common Stock of the Issuer, at an exercise price per share equal to the warrant price then in effect. This warrant has an initial price equal to the lesser
of (a) $2.67 per share or (b) the Conversion Price after the issuance of Conversion Securities (as defined in the Note and Warrant Purchase Agreement), as such price may be adjusted from time to time as shall result from the adjustments
specified in the Note and Warrant Purchase Agreement (See Note 8. Subsequent eventsfor adjustments in the exercise price and terms of the warrants).

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.



15



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##### Table of Contents

NOVARAY MEDICAL, INC.

(A Development Stage Company)

NOTES TO FINANCIAL
STATEMENTS(Continued)

(Unaudited)



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 September 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 September 30, 2009:



|                        |  |                                 |  |                               
|----------------------- |  | ------------------------------- |  | ------------------------------
|                        |  | Three months endedSep. 30,
2009 |  | Nine months endedSep. 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 September 30, 2009, the Company granted no stock
options and recognized $52,000 of stock-based compensation expense for options previously granted. During the nine months ended September 30, 2009, the Company granted 262,000 stock options to employees and 661,843 stock options to non-employee
board members and recognized $547,000 of stock-based compensation expense for options granted. The Company had no stock-based compensation expense during the three or nine month periods ended September 30, 2008 as no options were granted during
fiscal 2008. No options have been exercised as of September 30, 2009.

6. Income taxes

The Company has not incurred any income tax liabilities during the periods ended September 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 September 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 guidance that clarified the accounting for uncertainty in income taxes recognized in an enterprises
financial statements and prescribed 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 this guidance
effective January 1, 2007. The Company has evaluated its tax positions for the periods ended September 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.



16



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##### Table of Contents

NOVARAY MEDICAL, INC.

(A Development Stage Company)

NOTES TO FINANCIAL
STATEMENTS(Continued)

(Unaudited)



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, 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 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 September 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.

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 September 30, 2009 and December 31, 2008, the deposit amount to Triple Ring was $355,000 and $500,000, respectively.

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



|                                   |  |                   |       |                  |   |      
|---------------------------------- |  | ----------------- | ----- | ---------------- | - | -----
|                                   |  | September 30,2009 |       | December 31,2008
|Accounts payable to Triple Ring    |  | $                 | 1,050 |                  | $ | 2,109
|Accrued liabilities to Triple Ring |  | $                 | 58    |                  | $ | 508  



17



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##### Table of Contents

NOVARAY MEDICAL, INC.

(A Development Stage Company)

NOTES TO FINANCIAL
STATEMENTS(Continued)

(Unaudited)



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%. The credit line was paid off on July 2, 2009 and the security agreement was subsequently cancelled.

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 $1 million with Triple Ring during the third quarter of 2009 compared with $3.4 million during the third quarter of 2008. Included in
these amounts is warrant expense for Triple Ring services of $0 and $224,000 during the three months ended September 30, 2009 and 2008, respectively.

The Company recorded research and development expense of approximately $3.4 million with Triple Ring during the first nine months of 2009 compared with $7.7 million during the first nine months of 2008.
Included in these amounts is warrant expense for Triple Ring services of ($1.1 million) and $668,000 during the nine months ended September 30, 2009 and 2008, respectively.

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 Series A 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       |  | 123,484                  
|Wheatley MedTech Partners, LP |  | 47,544                   
|Lynda Wijcik                  |  | 40,646                   
|BioBridge LLC                 |  | 33,044                   
|                              |  |                          
|                              |  | 392,365                  
|                              |  |                          



18



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##### Table of Contents

NOVARAY MEDICAL, INC.

(A Development Stage Company)

NOTES TO FINANCIAL
STATEMENTS(Continued)

(Unaudited)



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
Restricted Stock 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
Restricted Stock Purchase Agreement, 25% of the Restricted Stock vested on November 1, 2007, and the remaining balance vests in equal monthly installments over three years so long as Mr. Price continues to provide services to NovaRay. The
Restricted Stock 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
September 30, 2009 and December 31, 2008, the Restricted Stock was 71% 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, 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 September 30, 2009, no value has been attributed to this ownership
interest because NRCT has substantially no assets or operations.

8. Subsequent events

Amendment to Articles of Incorporation

On October 22, 2009, the Company filed (i) a Certificate of Elimination of Series A Convertible Preferred Stock to eliminate all matters set forth in the Certificate of Designation of the
Relative Rights and Preferences of the Series A Convertible Preferred Stock with respect to the Series A Convertible Preferred Stock from the Companys Certificate of Incorporation and eliminate the Companys Series A Preferred Stock and
(ii) a Certificate of Designation of the Relative Rights and Preferences of the Series B 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 B Convertible Preferred Stock, consisting of 3,900,000 shares, which series shall have the designations, powers, preferences and rights and the qualifications, limitations and restrictions provided in such Certificate of
Designation.



19



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##### Table of Contents

NOVARAY MEDICAL, INC.

(A Development Stage Company)

NOTES TO FINANCIAL
STATEMENTS(Continued)

(Unaudited)



Financing

On October 27, 2009, the Company entered into a Series B Convertible Participating Preferred Stock and Warrant Purchase Agreement (the
Purchase Agreement) with Vision Opportunity Master Fund, Ltd. (Vision) as a Purchaser (as defined therein) to (i) issue and sell the Companys Series B Convertible Participating Preferred Stock (the Series B
Stock) in the aggregate purchase price of up to $10,000,000 at a per share purchase price of $15.00 and (ii) issue Series B Warrants to Purchase Shares of Common Stock of the Company (the Warrants) to each Purchaser to
purchase up to 100% of the number of shares of the Companys Common Stock issuable upon conversion of the Series B Stock purchased at an exercise price equal to the Warrant Price (as defined in the Warrants) then in effect. The Warrants may be
exercised on a net issuance basis as set forth therein and the Warrant Price is subject to adjustment including without limitation, reduction to a price equal to the consideration per share paid (if any) for Additional Shares of Common Stock (as
defined in the Warrants). Such Warrants shall expire October 27, 2014. The initial closing under the Purchase Agreement took place on October 27, 2009 with Vision for a purchase price of $3 million in cash and $2.9 million from conversion
of principal and interest under notes previously issued by the Company. The Company granted the Purchasers certain piggyback registration rights as further provided in the Purchase Agreement. Within ten days following receipt of a written request
from Vision, the Company shall expand its Board of Directors by one seat and ensure that one person selected by Vision be appointed for such seat on the Board of Directors of the Company subject to approval of the Board of Directors of the Company
which approval shall not be unreasonably withheld. The Company shall enter into an exchange agreement (the Exchange Agreement) with all holders of its Series A-1 Preferred Stock and Common Stock who purchase Series B Stock pursuant to
the Purchase Agreement and shall issue Series B Stock in exchange for its Series A-1 Preferred Stock and Common Stock pursuant to such Exchange Agreement. The Company and Vision Capital Advisors LLC also terminated the Security Agreement dated as of
July 2, 2009 in connection with the conversion of previously issued notes of the Company underlying the security interest thereof.

On October 27, 2009, the Company also entered into the Exchange Agreement with Vision and Vision Capital Advantage Fund, L.P. to exchange the Companys Series A-1 Preferred Stock and Common
Stock held for Series B Stock up to the number of shares of Series A-1 Preferred Stock held multiplied by the Purchase Ratio (as defined in the Exchange Agreement) and up to the number of shares of Common Stock held multiplied by the Purchase Ratio,
as follows: for every one whole share of Series A-1 Preferred Stock, 1.78 shares of Series B Stock, and for every one whole share of Common Stock, 0.178 shares of Series B Stock.

On October 27, 2009, the Company also entered into the Omnibus Amendment to the Warrants to Purchase Shares of Common Stock with Vision
and Vision Capital Advantage Fund, L.P. (the Warrants Amendment) to amend the exercise price of warrants held to $1.50 and to amend the expiration date of warrants held to October 27, 2014.



20



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|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 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 belief that Triple Ring will not meet a delivery date prior to February 28,
2010; our expectation that Triple Rings warrant will terminate and not be exercisable; our anticipation regarding a discussion with Triple Ring for revised delivery date and deliverables; our belief that recognition of the deferred tax assets
is not likely to be realized; 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 six months 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 Annual Report on 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 Annual Report on 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 net losses totalling approximately
$30.1 million since the date of inception of NovaRay, Inc. through September 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.



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We have achieved no revenues to date. Our goal is to begin commercial sales for our cardiac
catheterization imaging system in 2010 or later. 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.

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 Stock
Warrants

The Company from time to time issues 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 the FASB guidance.

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 prior to the valuation date. 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 from the. 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 FASB guidance provisions required to determine whether an instrument (or embedded feature) is
indexed to an entitys own stock. These provisions apply to any freestanding financial instruments or embedded features that have the characteristics of a derivative and to any freestanding financial instruments that are potentially settled in
an entitys own common stock.

As a result of adopting this guidance, 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) equity). 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 these common stock warrants increased to approximately $4.4 million as of June 30, 2009 and increased to approximately $6.1 million as of
September 30, 2009, primarily due to a reduction in the price of the warrants (See Note 5. Stockholders (deficit) equity) . We recognized a $1.7 million and $1.8 million net loss on change in fair value of warrant liabilities for the
three and nine month periods ended September 30, 2009, respectively.



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Income Taxes

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.

The FASB The Company determined that it had no uncertain tax positions
requiring financial statement recognition as of September 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 $95,000 from $113,000
during the three months ended September, 30, 2008 to $18,000 during the three months ended September, 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 decreased approximately $76,000 from $296,000 during the nine months ended September 30, 2008 to $220,000 during the nine months ended September, 30, 2009.
The decrease was primarily due to a reduction in third-party consulting expenses due to the elimination of third-party consultants in the second quarter of 2009, partially offset by increased activity with Triple Ring for business development
activities.

Approximately $12,000 was spent on business development activities with Triple Ring during the three months ended
September, 30, 2009 compared with $0 during the three months ended September, 30, 2008. Approximately $90,000 was spent on business development activities with Triple Ring during the nine months ended September, 30, 2009 compared with $0 during the
nine months ended September 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 $2.4 million from $3.4 million during the
three months ended September 30, 2008 to $1.1 million during the three months ended September 30, 2009. The decrease was primarily due to a reduction in development activity with Triple Ring and the accompanying 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 $4 million from $7.7 million during the nine months ended
September 30, 2008 to $3.8 million during the nine months ended September 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 $1 million was spent on research and development with Triple Ring during the three months ended September 30, 2009
compared with $3.4 million during the three months ended September 30, 2008. Included in these amounts is warrant expense for Triple Ring services of $0 during the three months ended September 30, 2009 and $224,000 during the three months
ended September, 30 2008. Approximately $3.4 million was spent on research and development with Triple Ring during the nine months ended September 30, 2009 compared with $7.7 million during the nine months ended September 30, 2008.
Included in these amounts is the reversal of warrant expense for Triple Ring services of $1.1 million during the nine months ended September 30, 2009 resulting from our expectation that certain warrants for which we had previously recorded
expenses would expire unvested and $668,000 of warrant expense during the nine months ended September 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 $65,000 from $596,000 during the three months ended
September 30, 2008 to $531,000 during the three months ended September 30, 2009. The decrease was primarily due the transfer of one employee to research and development; a reduction of one employee during the first quarter of 2009 and
$149,000 in decreased third-party consultant expense. These decreases were partially



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offset by the hiring of two employees in the fourth quarter of 2008; $92,000 in increased legal fees; $45,000 in increased depreciation expense for tenant improvements placed in service in fiscal
2009; and $53,000 in stock-based compensation expense for stock options granted to employees and board members.

General and
administrative costs increased approximately $134,000 from $2.1 million during the nine months ended September 30, 2008 to $2.2 million during the nine months ended September 30, 2009. The increase was primarily due to the hiring of two
employees in the fourth quarter of 2008; $154,000 in increased audit costs for the Companys new independent registered public accounting firm engaged during the third quarter of 2008; $149,000 in increased depreciation expense for tenant
improvements placed in service in fiscal 2009; and $482,000 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; $55,000 in decreased travel and entertainment expense; $419,000 in decreased third-party consultant expense; and $156,000 in decreased legal fees.

Other Income (Expense)

Other expense during the three months ended September 30, 2009, was $2.9 million, compared with other income of $27,000 during the three months ended September 30, 2008. Other expense during the
nine months ended September 30, 2009, was $3.1 million compared with other income of $53,000 during the nine months ended September 30, 2008. Other expense during the three and nine month periods ended September 30, 2009 was primarily
due to $1.7 million and $1.8 million, respectively, for the net loss on change in fair value of warrant liabilities. Other expense during the three and nine month periods ended September 30, 2009 was also primarily due to $1.1 million for the
amortization of debt discount during the third quarter of 2009. There were no expenses during fiscal 2008 for net loss on change in fair value of warrant liabilities or amortization of debt discount. Other income during the three and nine month
periods ended September 30, 2008, was primarily due to interest income on funds received from our financing activities during fiscal 2008.

Liquidity and Capital Resources

We require substantial additional
funds to continue current operations, even in the short term. In addition, 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 September 30, 2009, we have obtained proceeds of approximately $21 million through private placements of equity securities and
approximately $5 million through the issuance of short term debt instruments. At September 30, 2009, our principal source of liquidity included cash and equivalents of approximately $384,000, compared with approximately $158,000 at
June 30, 2009 and $5.7 million at December 31, 2008.

During the three and nine months ended September 30,
2009, our net loss was approximately $4.5 million and $9.3 million, 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. In July 2009, we raised gross proceeds of 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 repay in full and terminate the credit line and other transactional costs, the net proceeds of the financing were approximately $1.2 million.

In October 2009, we raised approximately $3 million through the sale of convertible participating preferred stock. Despite this
financing, we do not have sufficient capital to attain our operational goal to begin commercial sales for our cardiac catheterization imaging system in 2010 or later and will need to raise additional funds in the first quarter of 2010. Accordingly,
we need substantial additional funds to meet our anticipated cash needs for working capital and capital expenditures. 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, if at all.

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 would result
in substantial dilution to our stockholders. If additional funds are raised through the issuance of convertible debt securities, these securities would have rights senior to those associated with our Common Stock and Preferred Stock and would
contain covenants that could 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 in
either the short term or the long term. 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.



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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.



|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 Rules 13a-15 or 15d-15 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

There was no change in our internal control over financial reporting during the third quarter of fiscal 2009 that has materially affected, or is reasonably likely to materially affect, our internal
control over financial reporting.

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 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.



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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 registered public accounting firm on our financial statements for the year ended December 31, 2008 includes an emphasis
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.

During the nine month period ended September 30, 2009, our net
loss was $9.3 million, and at September 30, 2009, our cash and equivalents were $384,000. On October 27, 2009, we entered into a Series B Convertible Participating Preferred Stock and Warrant Purchase Agreement and raised gross proceeds of
approximately $3 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. 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
|------- | ---------------------------------------------------

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



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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 Participating 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.

On October 27, 2009, each of the holders of shares of our Series A-1 Preferred Stock executed a written consent:
(i) acknowledging and consenting to all of the provisions of the Certificate of Designation of the Relative Rights and Preferences of the Series B Convertible Participating Preferred Stock and (ii) acknowledging, consenting, voting and
agreeing that shares of the Companys Common Stock issued or issuable in connection with the conversion of the Companys Series B Preferred Stock issued pursuant to the Series B Convertible Participating Preferred Stock and Warrant
Purchase Agreement or the Exchange Agreement shall be excepted from the definition Additional Shares of Common Stock set forth in the Certificate of Designation of the Relative Rights and Preferences of the Series A-1 Convertible
Preferred Stock of NovaRay Medical, Inc. No holders of shares of our Series A-1 Convertible Preferred Stock withheld from the consent.



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

None.



|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 of NovaRay Medical,
Inc.(4)
|     | 
|3.5  |  | Certificate of Designation of the Relative Rights and Preferences of the Series A-1 Convertible Preferred Stock of NovaRay Medical, Inc.(5)                          
|     | 
|3.6  |  | Certificate of Elimination of Series A Convertible Preferred Stock of NovaRay Medical, Inc.(6)                                                                       
|     | 
|3.7  |  | Certificate of Designation of the Relative Rights and Preferences of the Series B Convertible Preferred Stock of NovaRay Medical, Inc.(7)                            
|     | 
|4.1  |  | Senior Secured 12% Convertible Bridge Note issued to Vision Opportunity Master Fund, Ltd. dated as of July 2, 2009.(8)                                               
|     | 
|4.2  |  | Warrant to Purchase Shares of Common Stock issued to Vision Opportunity Master Fund, Ltd. dated as of July 2, 2009.(9)                                               
|     | 
|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.(10)            
|     | 
|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.(11)             
|     | 
|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.(12) 
|     | 
|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.(13)  
|     | 
|4.7  |  | Form of Series B Warrant to Purchase Shares of Common Stock of NovaRay Medical, Inc.(14)                                                                             
|     | 
|4.8  |  | Omnibus Amendment to the Warrants to Purchase Shares of Common Stock of NovaRay Medical, Inc. dated as of October 27, 2009.(15)                                      
|     | 
|10.1 |  | Note and Warrant Purchase Agreement by and among NovaRay Medical, Inc. and the Purchasers dated as of July 2,2009.(16)                                               



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|       |  |                                                                                                                                                                                                         
|------ |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|10.2   |  | Security Agreement with Vision Capital Advisors, LLC dated as of July 2, 2009.(17)                                                                                                                      
|       | 
|10.3   |  | Exchange Agreement with Vision Opportunity Master Fund, Ltd. dated as of July 2, 2009.(18)                                                                                                              
|       | 
|10.4   |  | Exchange Agreement with Vision Capital Advantage Fund, L.P. dated as of July 2, 2009.(19)                                                                                                               
|       | 
|10.5 * |  | Amendment to Executive Employment Agreement with Marc C. Whyte dated as of July 2, 2009.(20)                                                                                                            
|       | 
|10.6 * |  | Amendment to Executive Employment Agreement with William Frederick dated as of July 2, 2009.(21)                                                                                                        
|       | 
|10.7 * |  | Amendment to Executive Employment Agreement with Edward Solomon dated as of July 2, 2009.(22)                                                                                                           
|       | 
|10.8   |  | Exchange Agreement with Wheatley Medtech Partners, L.P., W Capital Partners II, L.P., Heartstream Capital B.V., Lloyd Investments L.P., Biobridge LLC and Lynda Wijcik dated as of
August 21, 2009. (23)
|       | 
|10.9   |  | Series B Convertible Participating Preferred Stock and Warrant Purchase Agreement by and among NovaRay Medical, Inc. and the Purchasers (as defined therein) dated as of October 27,
2009.(24)          
|       | 
|10.10  |  | Exchange Agreement with Purchasers dated as of October 27, 2009.(25)                                                                                                                                    
|       | 
|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.                                                                                 



|* | Denotes management contract or compensatory plan or arrangement.
|- | ----------------------------------------------------------------

|(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.
|--- | ------------------------------------------------------------------------------------------------------------------------------

|(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 3.1 to the Registrants Current Report on Form 8-K filed with the SEC on October 28, 2009.
|--- | -------------------------------------------------------------------------------------------------------------------------------

|(7) | Incorporated by reference to Exhibit 3.2 to the Registrants Current Report on Form 8-K filed with the SEC on October 28, 2009.
|--- | -------------------------------------------------------------------------------------------------------------------------------

|(8) | 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.
|--- | ----------------------------------------------------------------------------------------------------------------------------

|(9) | 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.
|--- | ----------------------------------------------------------------------------------------------------------------------------

|(10) | 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.
|---- | ----------------------------------------------------------------------------------------------------------------------------

|(11) | 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.
|---- | ----------------------------------------------------------------------------------------------------------------------------

|(12) | 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.
|---- | ----------------------------------------------------------------------------------------------------------------------------

|(13) | 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.
|---- | -----------------------------------------------------------------------------------------------------------------------------

|(14) | Incorporated by reference to Exhibit 10.2 to the Registrants Current Report on Form 8-K filed with the SEC on November 2, 2009.
|---- | --------------------------------------------------------------------------------------------------------------------------------

|(15) | Incorporated by reference to Exhibit 10.4 to the Registrants Current Report on Form 8-K filed with the SEC on November 2, 2009.
|---- | --------------------------------------------------------------------------------------------------------------------------------

|(16) | 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.
|---- | ----------------------------------------------------------------------------------------------------------------------------

|(17) | 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.
|---- | ----------------------------------------------------------------------------------------------------------------------------

|(18) | 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.
|---- | ----------------------------------------------------------------------------------------------------------------------------

|(19) | 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.
|---- | ----------------------------------------------------------------------------------------------------------------------------

|(20) | 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.
|---- | -----------------------------------------------------------------------------------------------------------------------------

|(21) | 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.
|---- | -----------------------------------------------------------------------------------------------------------------------------

|(22) | 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



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##### Table of Contents

|(23) | Incorporated by reference to Exhibit 10.1 to the Registrants Current Report on Form 8-K filed with the SEC on August 27, 2009.
|---- | -------------------------------------------------------------------------------------------------------------------------------

|(24) | Incorporated by reference to Exhibit 10.1 to the Registrants Current Report on Form 8-K filed with the SEC on November 2, 2009.
|---- | --------------------------------------------------------------------------------------------------------------------------------

|(25) | Incorporated by reference to Exhibit 10.3 to the Registrants Current Report on Form 8-K filed with the SEC on November 2, 2009.
|---- | --------------------------------------------------------------------------------------------------------------------------------



29



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##### 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 November 12, 2009.



NOVARAY MEDICAL, INC.By:

/s/    MARC C.
WHYTEMarc C. WhytePresident and Chief Executive OfficerBy:

/s/    WILLIAM
FREDERICKWilliam FrederickChief Financial Officer




30



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##### 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.                                   



31