**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C.  20549**

 

**FORM 10-K**

 

| **ý** | **ANNUAL  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934  (FEE REQUIRED)** |
|------------|-----------------------------------------------------------------------------------------------------------|

** **

**Forfiscal year ended December 31, 2001**

 

**OR**

 

| **o** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF  1934 (NO FEE REQUIRED)** |
|-------|-------------------------------------------------------------------------------------------------------------------|

 

**For thetransition period from                to                    .**

** **

**CommissionFile Number:  0-22743**

 

**VISTA MEDICAL TECHNOLOGIES, INC.**

(Exact name of Registrantas specified in its charter)

 

| **DELAWARE**                                                      |   | **94-3184035**                        |
|-------------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of   incorporation or organization) |   | (I.R.S. Employer   dentification No.) |
|                                                              |   |                                  |
| **5451  Avenida Encinas, Suite A,**                               |
| **Carlsbad,  California 92008**                                   |
| (Address of principal  executive offices)                         |
|                                                              |
| **(760)  603-9120**                                               |
| (Registrant’s telephone  number, including area code)        |

 

Securities registeredpursuant to Section 12(b) of  theAct:  None

 

Securities registered pursuant to Section 12(g)  of the Act: Common Stock, par value $.01 per share

 

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days. Yes ýNo o

 

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K is not contained herein, and willnot be contained, to the best of registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of this Form 10-Kor any amendment to this Form 10-K. o

 

The aggregate market value of the voting stock held bynonaffiliates of the registrant as of January 31, 2002 was approximately$8,696,000.  For the purposes of thiscalculation, shares owned by officers, directors and 10% stockholders known tothe registrant have been deemed to be owned by affiliates. This determinationof affiliate status is not necessarily a conclusive determination for otherpurposes.

 

The number of shares outstanding of the registrant’sCommon Stock as of March 22, 2002 was 4,913,031.

 

DOCUMENTS INCORPORATED BYREFERENCE

 

Portions of Registrant’s Proxy Statement for the AnnualMeeting of Stockholders scheduled to be held on June 5, 2002, to be filed on orabout April 29, 2002 and referred to herein as the “Proxy Statement”, areincorporated as provided in Part III.

 

Certain exhibits filed with the Registrant’s priorregistration statements and forms 10-Q and 10-K are incorporated herein byreference into Part III of this Report.

 

 

**Vista Medical Technologies, Inc.**

**Form 10-K**

**For the Fiscal Year Ended December 31, 2001**

 

**TABLE OF CONTENTS**

 
| Part I    |                                                                                        |
|-----------|---------------------------------------------------------------------------------------------|
| Item 1.   | Business                                                                                    |
| Item 2.   | Properties                                                                                  |
| Item 3.   | Legal  Proceedings                                                                          |
| Item 4.   | Submission  of Matters to a Vote of Security Holders                                        |
|      |                                                                                        |
| Part  II  |                                                                                        |
| Item 5.   | Market  for the Registrant’s Common Equity and Related Stockholder Matters             |
| Item 6.   | Selected  Financial Data                                                                    |
| Item 7.   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |
| Item 7A.  | Quantitative  and Qualitative Disclosures About Market Risk                                 |
| Item 8.   | Financial  Statements and Supplementary Data                                                |
| Item 9.   | Changes  in and Disagreements with Accountants on Accounting and Financial Disclosure       |
|      |                                                                                        |
| Part  III |                                                                                        |
| Item 10.  | Directors  and Executive Officers of the Registrant                                         |
| Item 11.  | Executive  Compensation                                                                     |
| Item 12.  | Security  Ownership of Certain Beneficial Owners and Management                             |
| Item 13.  | Certain  Relationships and Related Transactions                                             |
|      |                                                                                        |
| Part  IV  |                                                                                        |
| Item 14.  | Exhibits,  Financial Statement Schedules, and Reports on Form 8-K                           |
|      | Signatures                                                                                  |
|      | Financial Statements                                                                        |

 

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PART I

 

Forward Looking Statements

 

From time to time we have made and may continue tomake “forward looking statements” within the meaning of the federal securitieslaws.  This report on Form 10-K maycontain forward-looking statements. These statements, which represent our expectations or beliefs concerningvarious future events, may contain words such as “expects,” “anticipates,”“intends,” “plans,” “believes,” “estimates,” or other words indicating futureresults.  Actual results may differmaterially from results anticipated in such forward-looking statements.  We assume no obligation to update anyforward-looking statements to reflect events or circumstances arising after thedate of this report.

 

You should carefully review and consider the variousdisclosures in this report regarding factors that could cause actual results todiffer materially from anticipated results, including those factors under thecaption “Risks and Uncertainties” at pages 17 through 24 below, and elsewherein this report.

 

Item 1.BUSINESS

 

THE DISCUSSION OF THE COMPANY’S BUSINESS CONTAINED INTHIS ANNUAL REPORT ON FORM 10-K MAY CONTAIN CERTAIN FORWARD-LOOKINGSTATEMENTS.  FOR A DISCUSSION OF FACTORSWHICH MAY AFFECT THE OUTCOME PROJECTED IN SUCH STATEMENTS, PLEASE SEE “RISKSAND UNCERTAINTIES” AT PAGES 17 THROUGH 24 OF THIS REPORT.

 

OVERVIEW OF OUR BUSINESS

 

We develop, manufacture and market products thatprovide information to doctors performing minimally invasive general surgical,cardiac surgical and other selected microsurgical procedures.  We also develop and sponsor training andsupport programs for medical personnel which enhance the adoption of proceduresincorporating use of our visualization technology. Our products combine a headmounted display with video cameras to provide surgeons with critical visualinformation during these microsurgical procedures, combined with the ability toview new additional information in a voice-controlled, picture-in-pictureformat, to facilitate real-time decision making during surgery.  Our product lines include the ORPC AdvancedVisualization and Information System for general surgery and other complexendoscopic procedures and the Series 8000 Advanced Visualization andInformation System, for use in cardiac surgery. In general terms, endoscopicsurgery involves a telescopic viewing device which is inserted into a smallincision in the body and which allows the surgeon an adequate view of  the internal part of the body beingrepaired.

 

**Background**

 

***Minimally invasive surgery***

 

The development and subsequent widespread adoption ofminimally invasive surgical procedures have revolutionized many surgicalfields, including general surgery, orthopedics, gynecology and urology.  Minimally invasive surgical procedures areperformed through strategically placed ports or mini-incisions as opposed tousing large incisions to gain surgical access. These procedures are designed to be as safe and effective asconventional surgery.  The goal in usinga minimally invasive procedure is to substantially reduce trauma, and pain andsuffering, speed recovery, shorten the length of hospital stays and decreasemany of the costs associated with patient care.  A minimally invasive procedure is most advantageous in cases inwhich significant trauma would otherwise result from gaining surgical access toan affected organ or site through the use of a large incision.  This movement toward minimally invasivesurgery has been driven by advances in both device technology and surgicaltechnique, as well as patient demand.

 

***Minimally invasive microsurgery***

 

Minimally invasive microsurgery is an extension ofminimally invasive surgery, characterized by greater complexity andprecision.  Minimally invasivemicrosurgical procedures have been made possible primarily by recent advancesin medical technology.  These proceduresare usually performed in very confined areas of the body, involve criticalparts of the body, and often require dissection, reconstruction and removal ofbody parts.  As a result 

 

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of the inherent complexity involved in these procedures, we believethat for surgeons to adopt the procedures, they must have access to specializedinstruments and technology, including technology which will provide them withbetter visualization of the procedure being performed.  Examples of minimally invasive microsurgeryare emerging in general surgery and cardiac surgery, as well as in the fieldsof gynecology and urology.

** **

**Applicationof our Products to Different Surgical Procedures**

 

***General surgery/gynecology/urology***

* *

*Conventional treatments.*

 

Minimally invasiveprocedures are well accepted in general surgery, gynecology and urology.  For less complex procedures such asgallbladder removal or tubal ligation, minimally invasive endoscopic techniqueshave become the standard of care, being used in approximately 90% ofcases.  For more complex procedures,however, the penetration rate of minimally invasive techniques has beenconsiderably lower, principally because the instruments available make performanceof the procedure difficult and uncomfortable.

 

*Minimally invasive microsurgery*.

 

Complex minimallyinvasive procedures in general surgery, gynecology and urology have evolvedrelatively slowly over the past few years, slowing considerably from 1995.  According to the journal *InVivo*,“Though the benefits of MIS (Minimally Invasive Surgery) - shorter recoverytimes and less pain and trauma for the patient, lower costs and less time lostfrom work for employers - are widely applicable across a range of procedures,realizing those benefits beyond gallbladder removal proved tricky.  Worse, for more complex procedures, MISactually proved problematic for surgeons, notwithstanding its other benefits -longer procedure times, more difficult manipulation of instruments, moretorturous ergonomics.”

* *

*The Vista Medical solution*.

 

We believe thatthe general technology required to drive renewed growth in complex minimallyinvasive procedures for general surgery is now being undertaken by manycompanies in fields complementary to ours, for example, in surgical robotics,electrosurgery and surgical instrument design. We believe that our advanced visualization and information technologywill contribute to this renewed growth by providing the surgeon with enhanceddepth perception when performing complicated, physically intricate tasks, andwill provide the surgeon with the ability to view additional information in avoice-controlled, picture-in-picture format, to facilitate real-time decisionmaking during a procedure.  We believethat conventional 2-D visualization systems compromise the ability of a surgeonto maneuver, especially in complex reconstructive surgery, and that our natural3-D picture will provide the surgeon with an advantage in these cases.

*** ***

***Cardiac Surgery***

* *

*Conventional**t**reatments*

 

Heart disease, the leading cause of death in theUnited States, is typically treated with drugs, surgical procedures orboth.  Methods of accessing the heartfor treatment include surgically opening the chest, threading a balloon-tipped catheter through a major artery, or, most recently,gaining surgical access via a small incision in the chest.  Although procedures involving the insertionof a catheter are less invasive than the conventional method of opening thechest, a major drawback is the high rate of re-narrowing of the blood vessel atthe treatment site.  Traditionalopen-heart surgical procedures, including coronary artery bypass graft andvalve replacement or repair procedures typically involve the surgeon making a12 to 18 inch incision in the patient’s chest, cutting the sternum in half witha bone saw, and then spreading the rib cage open with a steel retractor toperform the grafting procedures or to replace or repair the heart valves.  Although relatively effective in treatingthe heart condition, these procedures result in severe trauma to thepatient.  Results of studies have shownthat approximately one-third of all angioplasties experience restenosis orre-narrowing of the blood vessel at the treatment site within seven months,while most traditional cardiac bypass procedures remain effective for more thana decade.  Worldwide we believe thatthere are more than 1 million cardiac bypass surgical procedures performed eachyear.

 

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*** ***

*Minimally invasive cardiac surgery*

 

The application of minimally invasive techniques tocardiac surgery is regarded as a potentially revolutionarydevelopment in modern surgery. Minimally invasive heart bypass and heart valve replacement or repairprocedures avoid the trauma caused by cracking the chest open and promise tosignificantly decrease pain and trauma and shorten recovery times.  The minimally invasive approaches may alsobe performed on either a beating or arrested heart, giving the surgeon moreflexibility to treat a patient’s condition. While there is still professional debate on the ultimate form orstandard of care and techniques and practices are still under development,nearly all of those involved believe that minimally invasive procedures willchange the future practice of heart surgery, just as laparoscopy hasrevolutionized general surgery. However, minimally invasive heart microsurgery requires the surgeon toperform technically challenging procedures, including working on tiny delicatestructures, such as a one millimeter heart vessel with highly restrictedaccess, through small incisions.  Webelieve that one of the current limitations to widespread adoption of minimallyinvasive heart microsurgery is the restricted visibility through the smallincisions currently used.  While newretractor systems are being introduced to open the incision and thereforeimprove the surgeon’s access and ability to visualize the anatomy directly,restricted visibility, particularly for more complex cases, remains an issue.  However, the goal of truly minimizing theincision to reduce trauma, can only be achieved effectively with products andtechnology that enhance visualization of the affected area through the smallestaccess.

*** ***

*The Vista Medical solution.*

 

We believe that our visualization technology whichprovides the heart surgeon with an intuitive and ergonomicallydesigned product to solve the inherent vision restrictions of the minimallyinvasive cardiac  procedure, will enablethe use of minimally invasive microsurgery techniques with the required levelof safety, efficacy and precision.  Ourtechnologies are equally effective whether the surgeon elects to use either abeating or arrested heart approach, giving the surgeon increased flexibility intreatment options.  We believe that theenhanced visualization provided by our products will enable a significantnumber of surgeons, who otherwise might be reluctant to perform minimallyinvasive cardiac surgery, to adopt the procedures, particularly ascomplementary products are developed to provide a complete technologicalsolution.  There is also continuingevidence of patient interest and demand for these procedures.

** **

**OurBusiness Strategy**

 

Our businessstrategy is to become the leading developer and marketer of advancedvisualization and information systems forcomplex minimally invasive applications in general surgery, cardiac surgery andother selected surgical specialties. Key elements of our strategy include:

*** ***

***Develop applications for our technologywhich are specific to each surgical or medical specialty which we target.***

 

We approach target market segments by configuring ourmodular visualization system for the specific requirementsof the surgical specialty and procedure for which our product will beused.  We seek to use dedicated clinicalevaluation programs, clinical advisory boards, and appropriate strategicdistribution partners for the introduction and support of our products.  Our strategy is to optimize our fundamentaltechnology platform for each of our target medical specialties and to developpartnership and distribution systems both in the United States andinternational markets.

*** ***

***Identify specific high-value procedures tofacilitate our entry into the general surgery market***

 

Our strategy for entering the general surgery marketinvolves identification of high value procedures where our visualizationtechnology uniquely enhances procedure performance.  The first of these is laparoscopic gastric bypass, a surgical techniquewhich addresses morbid or extreme obesity. Morbid obesity affects approximately 8-10 million adults in the UnitedStates.  We have been working closelywith surgeons pioneering the approach and in January 2000 launched theLaparascopic Bariatric Surgery (LBS) Program to establish a national network ofcenters to perform minimally invasive gastric bypass surgery.  The LBS program is designed to provideparticipating

 

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hospitals with the complete information, training and technologynecessary to perform this surgery, and also includes a national patientreferral campaign.  We began signing up,training and delivering equipment to hospitals interested in participating inthe program in the first quarter of 2000.  When the LBS  program is fullyestablished, we plan to use it as a model for subsequent procedures which weare in the process of identifying and developing.

*** ***

***Establish advanced visualizationtechnologies as standard practice in minimally invasive cardiac surgery.***

 

We believe that we have the only visualization systemspecifically used for minimally invasive cardiac surgery.  We are currently working with members of ourclinical advisory boards, other leading surgeons and a strategic partner todevelop operating protocols which incorporate advanced visualizationtechnologies as standard practice.  Weintend to participate with our strategic partner for cardiac surgery inproviding training in these procedures, which include the use of our visualizationsystem.

*** ***

***Increase the surgeon’s real-time access to critical data.***

 

The surgeon’s access to operative data, on demand, inreal time and integrated with the anatomical image, enhances procedureperformance.  Our head mounted display,incorporating picture-in-picture capability and voice control, is designed togive the surgeon this real-time access to critical information integrated withthe anatomical images generated by our camera systems.

*** ***

***Develop original equipment manufacturecustomers with volume sales potential for endoscopic cameras.***

 

We presently have two original equipment manufacturecustomers for our design of conventional, two dimensional single and three-chipendoscopic cameras.  These products haveaccounted historically for a substantial amount of our revenues and assist inbuilding relationships with prospective partners for our advanced  technology.

*** ***

***Enter into strategic relationships whichensure distributionor complement technology resources.***

 

We intend to leverage our position in both technology and distribution by forming strategicalliances with appropriate partners. For a description of our current partners and our strategic alliances,see “—Strategic Alliances.”

** **

**AdvancedVisualization Principles and our Product Platform**

 

Our technology provides a 3-D visualization solution to the inherent vision restrictions anddemands of minimally invasive microsurgery. Our technology provides the surgeon with a clear view of the anatomywith the ability to view additional information in a voice-controlled,picture-in-picture format, which facilitates real-time decision making duringthe procedure.

 

Our technology is based on the following principles which we believe are essential in advancingthe techniques of minimally invasive microsurgery.  We believe these principles offerseveral key advantages over other visualization approaches:

 

*3-D View*.  The surgeon’s ability to view the principal image of the anatomy in 3-D provides theaccurate depth perception necessary so that vital anatomical structures areaccurately identified and located.  Thisimproves safety, precision and speed of the procedure.  Also, a secondary video image is availablein picture-in-picture format, when the procedure will benefit from twodifferent views of the anatomy.

* *

*HighResolution Images*. The availability of a high resolutionimage which can be electronically managed by the surgeon significantly enhancesthe surgeon’s ability to differentiate critical tissues in a confined settingand perform intricate dissection, reconstruction and removal.

 

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*Access*.  The surgeon benefits from technology which allows for the direct insertion of a camera intothe body cavities or organs and provides high quality images that are easy tosee and understand.

 

*Ergonomics*.  Due to the complex and time consuming nature of minimally invasive microsurgeryprocedures, the surgeon requires an ergonomic display system which allowscomfortable operating posture and maximizes hand-eye coordination withoutstrain.

 

*InformationIntegration*.  Thesurgeon’s access to critical monitoring and diagnostic data, on demand, in realtime and integrated with the anatomical image within the surgeon’s visualfield, enhances procedure performance.

 

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***Head mounted display***

 

The head mounted display device was originallydeveloped for critical applications in military aerospace by KaiserAerospace.  We subsequently determinedthat the head mounted display was the optimal solution to the challenge ofdisplaying information during minimally invasive microsurgery.  The fundamental technology and human factorsexperience incorporated in our surgical head mounted display is the result ofsubstantial investment and development by Kaiser Aerospace, originally for militaryapplications.  This human factorsknowledge, derived from many years of analysis of the display characteristicswhich enable pilots performing critical physical tasks to simultaneously absorband react to crucial information, is a key element in our head mounted displaydesign.  Kaiser’s original know-how andtechnical knowledge have been transferred to us under our development agreementwith Kaiser Electro-Optics, Inc., a subsidiary of Kaiser Aerospace.  We have performed significant additional developmentwork, and have proprietary rights, in the surgical head mounted displaydesign.  Our head mounted display, whichwe believe is the first specifically designed for surgical use, provides 3-Dvisualization of small delicate body structures, has the capability ofintegrating relevant data and presents the image seen by the surgeon in themost correct, intuitive and ergonomic way. Wearing the head mounted display, the surgeon can also perform surgery“in-line”— meaning with the eyes, hands, instruments and subject in-line.  In-line surgery cannot be performed when thesurgeon is observing the anatomy on a remotely-positioned video monitor.

 

Our head mounted display is a proprietary,lightweight, high resolution display designed to allow the surgeon to viewinformation on demand, whether such information is generated from attachedendoscopes, microscopes or monitoring equipment in the operating room.  Further enhancements to the head mounteddisplay allow for voice-activated control and information display from otherdiagnostic equipment in the hospital or from remote locations via informationnetworks.  The video display in the headmounted display is fixed in relation to the surgeon’s eyes, but his or her headmay move into any position necessary for comfort.  The display design allows the surgeon to have a constant view ofthe surgical anatomy required for the procedure as well as full awareness ofthe surroundings in the operating room. Our head mounted display is designed to provide a true 3-D image byreplicating the way the human visual system works — left and right acquiredimages are delivered directly to left and right liquid crystal displays.  It is also designed so that it can be wornwith conventional surgical loupes.

*** ***

***Three-dimensional image acquisition***

 

We believe that three-dimensionalvisualization capability is critical in minimally invasive microsurgeryprocedures such as cardiac surgery and complex endoscopic procedures in generalsurgery, gynecology and urology.  Ourtechnology for stereo visualization consists of the following proprietaryelements: the optical system, the stereo camera and the stereo processor.  The first 3-D endoscopic optical system weemployed was originally developed and patented by a noted optical designer,Mr. H. McKinley, and is licensed exclusively to us for medicalapplications.  We have also acquiredrights to the stereo endoscope technology of Carl Zeiss.  Both McKinley and Zeiss systems are designedto replicate the view that the surgeon would have if the procedures were beingperformed open and he or she had direct sight of the anatomy.  We believe that the McKinley and Zeissoptical systems will provide us with a significant and enduring competitiveadvantage because they provide natural depth perception, and can be packagedwith twin cameras in a very compact design. The twin cameras acquire the image in a manner analogous to the humanvisual system.

 

Our technology can package thetwin cameras in two ways.  In the firstmethod, a stereo micro-camera is attached to the end of a flexible or rigidguide which can then be inserted directly into the body cavity and organs.  The image is directly captured by the camerachips without being transmitted through multiple rod lenses as in aconventional design.  The elimination ofoptical surfaces produces several important advantages, including increasedimage quality, improved contrast, better reliability and improved ability tosterilize the instrument. Alternatively, for applications where standard endoscopic surgicaltechnique remains preferable, a stereo camera is mounted externally on a stereoendoscope.  This second method is thecurrent preferred approach for the procedures in which we are primarilyinvolved. The image acquired by either approach is then processed for displayby control electronics which we have developed.  The controller also includes image management features whichcontribute

 

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significantly to procedure performance, such as dual image presentationand picture-in-picture.

*** ***

***Information management***

 

Medicine is an information richdiscipline, but the ability of a surgeon to obtain relevant information inreal-time during a procedure has not been developed to the levels attained, forexample, in military aviation.  The headmounted display is designed to give the surgeon real-time access on demand tocritical information integrated with the anatomical images generated by ourcamera systems.  In addition toreal-time display, the information can be stored or transmitted within thehospital or transmitted to remote locations for training, advisory oradministrative purposes.  Theapplications software to control this flow of information is a key element inour long-term product strategy which positions visualization within the contextof a total information management system for the surgeon.

 

The data integration capability of our products hasbeen enhanced through a perpetual, exclusive license from GDE which has addedhigh speed image-based information processing and networking software to ourtechnology platform. We believe that our technology will demonstrate thatreal-time access to relevant information, along with enhanced visualization, isa critical requirement of performing minimally invasive microsurgery and othersurgical procedures. We anticipate incorporating appropriate elements of thissoftware package into future products.

** **

**ProductLines**

 

We develop products based on our core technology andproduct platform described above, that are customized for the specific generalsurgical, cardiac surgical and other procedures to which they aredirected.  Our product lines are asfollows:

*** ***

***ORPC: 3-D visualization and information system for general surgery and other complexendoscopic procedures***

 

The most recent application of our platform technologyis complex procedures in general surgery. Our first public demonstration of this platform was in October 1999,principally targeted at the emerging procedure of minimally invasive gastricbypass to control morbid obesity. Our general surgical system is designed onmodular principles and consists of the following major components:

 
| **Component**             |   | **Description**                                                                                                                                                                                                                                        |
|---------------------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Head mounted display/ORPC |   | Head-mounted display and operating room personal  computer which integrates multiple video images in a picture-in-picture  format using voice commands from the head mounted display.  Up to three head mounted displays can be  used per system. |
|                      |   |                                                                                                                                                                                                                                                   |
| Stereo laparoscopes       |   | Ten millimeter diameter stereo laparoscopes in both  0o and 30o angles of view.                                                                                                                                                              |
|                      |   |                                                                                                                                                                                                                                                   |
| StereoScope               |   | Three-dimensional camera head for attachment to our  stereo laparoscopes.                                                                                                                                                                              |
|                      |   |                                                                                                                                                                                                                                                   |
| Camera Controller         |   | High resolution stereo image processor.                                                                                                                                                                                                                |
| Xenon Lightsource         |   | High intensity 300 watt xenon light source to  illuminate the Stereo Laparoscopes.                                                                                                                                                                     |
|                      |   |                                                                                                                                                                                                                                                   |
| Endoscopy Cart            |   | Cart which holds the Advanced System for  Laparoscopy.                                                                                                                                                                                                 |

 

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All necessary510(k) clearances which are required tomarket the components of the ORPC have been received.

 

***Series 8000 advanced visualization and information systemfor heart surgery***

 

We have developedthe Series 8000 for minimally invasive and other procedures in cardiac surgery.The components of the Series 8000 are individual modules, rack mounted in acustom console, and supplied as an integrated, upgradeable system.

 
| **Component**       |   | **Description**                                                                                                                                                                                                                                                                                    |
|---------------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| CardioView          |   | Head-mounted display and information processing  computer which integrates three-dimensional visualization of surgical anatomy  and related diagnostic and monitoring data.   Beginning in 2001, CardioView will include the image management  features of the ORPC, including voice control. |
|                |   |                                                                                                                                                                                                                                                                                               |
| Stereo Endoscope    |   | 10mm diameter stereo endoscopes in both 0o and 30o  angles of view.                                                                                                                                                                                                                      |
|                |   |                                                                                                                                                                                                                                                                                               |
| CardioCamera        |   | Three-dimensional miniature high resolution digital  cameras. Cameras can be delivered directly into the surgical field by  CardioGuide or externally by attachment to retractor systems (available by  special order only).                                                                       |
|                |   |                                                                                                                                                                                                                                                                                               |
| StereoScope         |   | Three-dimensional camera head for attachment to our  stereo endoscopes.                                                                                                                                                                                                                            |
|                |   |                                                                                                                                                                                                                                                                                               |
| 2D Endoscope Camera |   | Camera for attachment to conventional  two-dimensional endoscopes.                                                                                                                                                                                                                                 |
|                |   |                                                                                                                                                                                                                                                                                               |
| CardioController    |   | High resolution stereo image processor which drives  all the CardioCameras in the operating room.                                                                                                                                                                                                  |
|                |   |                                                                                                                                                                                                                                                                                               |
| CardioLight         |   | High intensity 300 watt xenon light source to  illuminate the Stereo Endoscopes.                                                                                                                                                                                                                   |
|                |   |                                                                                                                                                                                                                                                                                               |
| CardioConsole       |   | Console for rack mounting of all Series 8000  modules.                                                                                                                                                                                                                                             |

 

All necessary 510(k) clearances which arerequired to market the components of the Series8000 have been received.

 

***OEM Endoscopic Cameras***

 

Our endoscopic cameras are the state-of-the-art intwo-dimensional endoscopic imaging.  We currently manufacture compact, highresolution endoscopic cameras for original equipment manufacture customers andstrategic partners.

 

**StrategicAlliances**

 

Our strategy is to leverage our position in bothtechnology and distribution by forming strategicalliances with corporations and research institutions with respect to thedevelopment, regulatory approval and marketing of some of our products. We haveentered into strategic partnering arrangements as follows: 

 

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***Ethicon Endo-Surgery, Inc.***

 

InJune 2001, we entered into an agreement with Ethicon Endo-Surgery, Inc. (EES)providing that the companies will work together in developing the surgicalweight reduction market.  This allianceprimarily involves sales and marketing support by EES of our LaparascopicBariatric Surgery (LBS) program and other Vista products and services relatedto the surgical weight reduction market. Also, we will receive payments in return for the Company’s commitment topromote use of EES equipment in certain training programs sponsored by theCompany for the benefit of its customers with no obligation by the Company orits customers to purchase any EES equipment. The agreement also provides that the companies will evaluate othercomplex minimally invasive surgical procedures which may benefit from the typeof combined training and technology involved in the LBS program and gives EESthe right of first negotiation to acquire certain technology from us.  The agreement with EES is renewableannually, and has been renewed for the period commencing in 2002.

*** ***

***Richard Wolf, GmbH***

 

In December 1999, we entered into a three yearagreement whereby Richard Wolf, GmbH, a leading company in the worldwideendoscopic instrumentation market, will exclusively distribute our 3Dvisualization and integration platform for minimally invasive applications ingeneral surgery, gynecology and urology, in all markets outside the UnitedStates.  In connection with theagreement, Richard Wolf placed an initial order for systems of variousconfigurations, with deliveries beginning in the first quarter of 2000.  This agreement is directly related to ourchange of strategic emphasis to target the largest potential near-term marketsegments for our 3D visualization technology - complex endoscopic procedures ingeneral surgery, gynecology and urology.

*** ***

***Jomed***

 

In May 2000, we entered into an exclusive distributionagreement and a cooperative technology agreement with Jomed International.  Under the exclusive distribution agreement,Jomed became the exclusive distributor of our Series 8000 product in cardiacand related interventional radiology markets. In connection with this agreement, Jomed agreed not to market or sellany product directly competitive with our products in these fields.  Jomed agreed to pay us a fixed amount foreach product ordered, as well as royalties based on gross profits of unitssold.  We agreed to supply products toJomed at a price that is at least as favorable as that charged to othercustomers.  Each year during the term ofthe distribution agreement, we will agree upon a marketing plan with Jomed andwill be allowed to terminate Jomed’s exclusive rights if they, by negligence,fail to implement the marketing plans in any material respect.  In this event, Jomed would then retainnon-exclusive rights to distribute our product for a period of time.  The distribution agreement is to remain ineffect until December 31, 2004 and is automatically renewable for additionalone-year periods if Jomed has met at least 70% of its projected sales for theprevious year.  The distribution agreementmay be terminated for material breach by either party or if either party ceasedto do business or seeks protection under any bankruptcy proceeding.

 

Under the terms of the cooperative technologyagreement with Jomed, we agreed to cooperate with Jomed on developingenhancements for our Series 8000 product to optimize its utilization as thestandard visualization platform for the placement of Jomed’s SOLEMGraftConnectorTM.  This agreement willterminate when the exclusive distribution agreement terminates or if Jomed’sexclusive rights under that agreement terminate.

*** ***

***GDE Systems***

 

In February 1997, GDE Systems, a leading militaryelectronics and information management company, granted us an exclusiveworldwide license to software, documentation and trademarks of GDE for use inthe medical field.  Since 1993, GDE’ssubsidiary, Healthcom, had been adapting the software licensed to us to providehigh-speed, image-based information processing and networking capabilitiesspecifically for medical applications. In connection with the license, we issued to GDE shares of our commonstock with a value based on the initial public offering price, of $250,000and will pay GDE a royalty on revenues derived from any products based upon orderived from the GDE software.  We alsomade a non-refundable payment of $250,000 in December 1998 as a combination ofroyalty payments earned through such date and a royalty advance creditableagainst future royalties.  Under thislicense agreement, we hired three of GDE’s software development engineers, noneof whom are currently employed by us. GDE has a right of first refusal to license our improvements to thesoftware for use in non-medical markets, subject to the payment of a royalty tous.

 

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***Kaiser Aerospace***

 

In July 1995, we entered into a Manufacturing SupplyAgreement with Kaiser Electro-Optics, a subsidiary of Kaiser Aerospace.  This agreement was then amended in December1997.  In December 1997, we entered intoa Technology Strategic Alliance: Memorandum of Understanding with KaiserAerospace, which superseded a similar agreement entered into with KaiserElectro-Optics in July 1995.  Thetechnology strategic alliance provides that Kaiser Aerospace will cooperatewith us in joint development programs related to our current generation headmounted display to be negotiated on an arms-length and project-by-project basisfor a five-year term.  We will alsocontract with Kaiser Electro-Optics for development and manufacturing servicesrelated to the head mounted display, including initial productionquantities.  The manufacturing supplyagreement with Kaiser Electro-Optics provides that they will be our preferredsupplier for a five-year period for not less than 75% of our requirements forthe optical subassembly of the head mounted display, provided that pricing andother terms are competitive and mutually agreed upon.  Under the technology strategic alliance with Kaiser Aerospace,they granted us a right of first refusal to exclusively license independentlydeveloped new technology or devices for medical applications.  Reciprocally, in December 1997, we enteredinto a License Agreement with Kaiser Aerospace under which we exclusivelylicensed to Kaiser Aerospace the right to manufacture and distribute industrialand professional versions of our head mounted display in market segments otherthan medicine in return for an up-front payment and royalties based on sales.

 

In June 2000, we retroactively waived future paymentof specified royalties by Kaiser provided for in the license agreement withthem.  In return, Kaiser agreed tocancel an order that we had placed for a shipment of head mounted displayunits, without additional cost to us. We have not ordered any additional current generation head mounteddisplay units from Kaiser since that time. We continue to work with Kaiser Electro-Optics (now a subsidiary ofRockwell Collins) on development of the next generation head mounted display.

** **

**LicenseAgreements**

 

We have licensed aspects of our technology from thirdparties.

*** ***

***McKinley Optics, Inc.***

 

In September 1995, Mr. H. McKinley and McKinleyOptics, Inc. granted to us a perpetual, exclusive, worldwide license in themedical field to make, have made, modify, use, lease, market, sell andotherwise distribute certain endoscopes and other medical productsincorporating a stereo objective lens and/or a relay lens configuration.  Under the terms of this license agreement,we are obligated to pay McKinley an annual maintenance royalty, additionalroyalties upon the sale of certain numbers of systems incorporating theMcKinley technology and royalties on net sales of products incorporating theMcKinley technology.  The exclusivelicense granted under this agreement becomes a non-exclusive license, or, undercertain circumstances, the license terminates, in the event we  fail to pay any royalties.  In addition, we have the right to terminatethe agreement with limited notice.

*** ***

***Fuji***

 

In June 1996, Fuji Film Co. and Fuji Photo OpticalCo., Ltd. granted to us a non-exclusive license to certain optical zoomtechnology for use in endoscopes.  Weare obligated to pay royalties on net sales of products in the United Stateswhich incorporate Fuji’s technology.  Wehave not incorporated any of this technology into our products and thus havenot been obligated for any royalties as of the date of this annual report. Fujimay terminate the agreement if we do not cure any violation of the agreementwithin a limited period of time.  Ourfailure to retain rights to these technologies may negatively impact ourbusiness.

*** ***

***Carl******Zeiss***

 

In August 1998, Carl Zeiss granted us non-exclusiverights in the medical field to three issued United States patents and fourpending foreign applications.  We areobligated to pay Zeiss royalties on sales of products incorporating thelicensed technology and to provide technical and applications support, at ourcurrent rates for such services, to parties that previously acquired Zeiss’Endo-Live Stereo Endoscope, now discontinued. Zeiss may terminate the agreement in the event of a material breach byus which is not cured within a limited period of time.

 

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Our failure to retain rights to the Zeiss patents may negatively impactour business.

** **

**Intellectualproperty protection**

 

We rely on a combination of technical leadership,patent, trade secret, copyright and trademark protection and nondisclosureagreements to protect our proprietary rights. As of December 31, 2001, we had exclusive ownership rights to 15 issuedUnited States patents, 9 pending United States patent applications and 4pending foreign applications covering various aspects of our devices andsystems.  Furthermore, as of the samedate, we had exclusive rights in the medical field to five issued United Statespatents, one pending United States patent application, 11 issued foreignpatents and 8 pending foreign applications covering various aspects of ourdevices and systems.  In 1998 weadditionally obtained from Carl Zeiss non-exclusive rights to three issued UnitedStates patents and four pending foreign applications.  We intend to file additional patent applications in thefuture.  The failure of such patents toissue could damage our ability to protect our proprietary information.

 

Our future success will depend, in part, on ourability to continue to develop patentable products, enforce our patents andobtain patent protection for our products both in the United States and inother countries.  The patent positionsof medical device companies, however, are generally uncertain and involvecomplex legal and factual questions.  Weare not certain that patents will issue from any patent applications owned byor licensed to us or that, if patents do issue, the claims allowed will besufficiently broad to protect our technology. In addition, we cannot assure you that any issued patents owned by orlicensed to us will not be challenged, invalidated or circumvented, or that therights granted thereunder will provide us with competitive advantages.

 

The medical device industry has been characterized byextensive litigation regarding patents and other intellectual propertyrights.  Litigation, which would resultin substantial expense, may be necessary to enforce any patents issued orlicensed to us and/or to determine the scope and validity of proprietary rightsof third parties or whether our products, processes or procedures infringe anysuch third-party proprietary rights.  Wemay also have to participate in interference proceedings declared by the UnitedStates Patent and Trademark Office, which could result in substantial expense,to determine the priority of inventions covered by our issued United Statespatents or pending patent applications. Furthermore, we may have to participate at substantial cost inInternational Trade Commission proceedings to enjoin importation of productswhich would compete unfairly with our products.  Any adverse outcome of any patent litigation, includinginterference proceedings, could subject us to significant liabilities to thirdparties, require disputed rights to be licensed from or to third parties orrequire us to cease using the technology in dispute.

 

Patent applications in the United States aremaintained in secrecy until a patent issues, and patent applications in foreigncountries are maintained in secrecy for a period of time after filing.  After such period of time, and usuallybefore the grant of the patent, patent applications in foreign countries arepublished.  While publication ofdiscoveries in the scientific or patent literature tends to lag behind actualdiscoveries and the filing of related patent applications, such publication mayenable our competitors to ascertain the areas of research or development inwhich we are engaged prior to our receipt of patent protection in the UnitedStates or foreign countries relating to such research or development.

 

In general, the development of visualization andinformation systems is intensely competitive. Patents  issued and patentapplications filed relating to medical devices are numerous and current andpotential competitors and other third parties may have filed or in the futuremay file applications for, or may receive or in the future will  receive, patents or obtain additionalproprietary rights relating to products or processes used or proposed to beused by us.  We cannot assure you thatthird parties will not assert infringement claims against us in the future orthat any such assertions will not result in costly litigation or require us toobtain a license to intellectual property rights of such parties.  Any such licenses may not be available onacceptable terms, if at all. Furthermore, parties making such claims may be able to obtain injunctiveor other equitable relief that could effectively block our ability to make, use,sell or otherwise practice our intellectual property (whether or not patentedor described in pending patent applications), or to further develop orcommercialize our products in the United States and abroad and could result inthe award of substantial damages. Defense of any lawsuit or failure to obtain any such license coulddamage our business.

 

We rely on unpatented trade secrets to protect ourproprietary technology, and no assurance can be given that others will notindependently develop or otherwise acquire the same or substantially equivalenttechnologies or otherwise gain access to our proprietary technology or disclosesuch technology or that we can ultimately protect our

 

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rights to such unpatented proprietary technology.  Third parties may obtain patent rights tosuch unpatented trade secrets, which patent rights could be used to assertinfringement claims against us.  We alsorely on confidentiality agreements with our collaborators, employees, advisors,vendors and consultants to protect our proprietary technology.  These agreements may be breached, we may nothave adequate remedies for any breach and our trade secrets may otherwisebecome known or be independently developed by competitors.  In addition, our agreements with employeesand consultants require disclosure of ideas, developments, discoveries orinventions conceived during employment or consulting, as the case may be, andassignment to us of proprietary rights to such matters related to our businessand technology.  The extent to whichefforts by others will result in patents and the effect on us of the issuanceof such patents is unknown.  Failure to obtainor maintain patent and trade secret protection, for any reason, could negativelyimpact our business.

** **

**Regulation**

 

The manufacture and sale of medical devices intendedfor commercial distribution are subject to extensive governmental regulation inthe United States.  Medical devices areregulated in the United States primarily by the FDA and, to a lesser extent, bycertain state agencies.  Generally,medical devices require pre-market clearance or pre-market approval prior tocommercial distribution.  In addition,certain material changes or modifications to, and  changes in intended use of, medical devices also are subject toFDA review and clearance or approval. The FDA regulates the research, testing, manufacture, safety,effectiveness, labeling, storage, record keeping, promotion and distribution ofmedical devices in the United States and the export of unapproved medicaldevices from the United States to other countries.  Non-compliance with applicable requirements can result in failureof the government to grant pre-market clearance or approval for devices,withdrawal or suspension of approval, total or partial suspension ofproduction, fines, injunctions, civil penalties, refunds, recall or seizure ofproducts and criminal prosecution.

*** ***

***Device Classes***

 

In the United States, medical devices are classifiedinto one of three classes, Class I, II or III, on the basis of the controlsdeemed by the FDA to be necessary to reasonably ensure their safety andeffectiveness.  Our products to datehave either been classified as Class I or Class II devices.

 

Class I devices are subject to general controls, suchas establishment registration and product listing, labeling, adulteration andmisbranding provisions and medical device reporting requirements and, unlessexempt, to pre-market notification and adherence to “good manufacturing practice”standards.  Class II devices are subjectto general controls and special controls, such as performance standards,post-market surveillance, patient registries and FDA guidelines.  Generally, Class III devices are those thatmust receive pre-market approval by the FDA to ensure their safety andeffectiveness.  Examples of Class IIIproducts include, life-sustaining, life-supporting and implantable or newdevices which have not been found to be substantially equivalent to legallymarketed devices.  Class III devicesordinarily require clinical testing to ensure safety and effectiveness and FDAclearance prior to marketing and distribution. The FDA also has the authority to require clinical testing of Class Iand Class II devices.  A pre-marketapproval application must be filed if a proposed device is not substantiallyequivalent to a legally marketed predicate device or if it is a Class IIIdevice for which the FDA has called for such application.  A pre-market approval application typicallytakes several years to be approved by the FDA.

*** ***

***Device approval***

 

Generally, before a new device can be introduced intothe market in the United States, the manufacturer or distributor must obtainFDA clearance of a 510(k) notification or submission and approval of apre-market approval application.  If amedical device manufacturer or distributor can establish that a device is“substantially equivalent” to a legally marketed Class I or Class II device, orto a Class III device for which the FDA has not called for a pre-marketapproval, the manufacturer or distributor may market the device upon receipt ofan FDA order determining such a device substantially equivalent to a predicatedevice.  The 510(k) notification mayneed to be supported by appropriate performance, clinical or testing dataestablishing the claim of substantial equivalence.  The FDA requires a rigorous demonstration of substantialequivalence.

 

Following submission of the 510(k) notification, themanufacturer or distributor may not place the device into commercialdistribution until an FDA substantial equivalence order permitting themarketing of a device is received by the person who submitted the 510(k)notification.  At this time, the FDAtypically responds to the submission of a 510(k) notification within 90 to 200days.  An FDA letter may declare thatthe device is

 

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substantially equivalent to a legally marketed device and allow theproposed device to be marketed in the United States.  The FDA, however, may determine that the proposed device is notsubstantially equivalent or require further information, including clinicaldata, to make a determination regarding substantial equivalence.  Such determination or request for additionalinformation will delay market introduction of the product that is the subjectof the 510(k) notification.

*** ***

***Investigational device exemptionapplication***

 

All clinical investigationsinvolving the use of an unapproved or uncleared device on humans to determinethe safety or effectiveness of the device must be conducted in accordance withthe FDA’s investigational device exemption regulations.  If the device presents a “significant risk,”the manufacturer or distributor of the device is required to file aninvestigational device exemption application with the FDA prior to commencinghuman clinical trials.  This applicationmust be supported by data, typically the result of animal and benchtesting.  If the application is approvedby the FDA, human clinical trials may begin at a specific number ofinvestigational sites with a maximum number of patients, as approved by theFDA.  If the device presents a“non-significant risk,” approval by an institutional review board prior tocommencing human clinical trials is required, as well as compliance withlabeling, record keeping, monitoring and other requirements.  However, the FDA can disagree with anon-significant risk device finding.

 

Any products which wemanufacture or distribute are subject to continuing regulation by the FDA, whichincludes record keeping requirements, reporting of adverse experience with theuse of the device, “good manufacturing” requirements and post-marketsurveillance, and may include post-market registry and other actions deemednecessary by the FDA.  A new 510(k),pre-market approval or pre-market approval supplement is also required when amedical device manufacturer makes a change or modification to a legallymarketed device that could significantly affect the safety or effectiveness ofthe device, or where there is a major change or modification in the intendeduse of the device or a new indication for use of the device.  When any change or modification is made to adevice or its intended use, the manufacturer is expected to make the initialdetermination as to whether the change or modification is of a kind that wouldnecessitate the filing of a new 510(k), pre-market approval or pre-marketapproval supplement.

*** ***

***Foreign requirements***

 

Sales of medical deviceproducts outside the United States are subject to foreign regulatoryrequirements that vary from country to country.  The time required to obtain approvals required by foreigncountries may be longer or shorter than that required for FDA clearance, andrequirements for licensing may differ from FDA requirements.  Our failure to comply with regulatoryrequirements would jeopardize our ability to market our products.  The current regulatory environment in Europefor medical devices differs significantly from that in the United States.  Since June 1998, all medical devices sold inthe European Union must bear the CE mark. Devices are now classified by manufacturers according to the risks theyrepresent with a classification system giving Class III as the highest riskdevices and Class I as the lowest.  Oncethe device has been classified, the manufacturer can follow one of a series ofconformity assessment routes, typically through a registered quality system,and demonstrate compliance to a “European Notified Body.”  After that, the CE mark may be applied tothe device. Maintenance of the system is ensured through annual on-site auditsby the notified body and a post-market surveillance system requiring themanufacturer to submit serious complaints to the appropriate governmentalauthority.

 

**Marketing and Sales**

 

We organize our sales and marketing efforts byoptimizing the configuration of our systems for specific applications anddisciplines and distributing them via partners’ sales forces or directly asappropriate.  We believe that this typeof structure provides the commitment and focus necessary to introduce andsupport new advanced technology to distinct market segments.  As we enter additional market segments wewill seek to preserve the distinct focus, although there is a limit to theextent of segmentation possible.  In allcases we follow specific principles in developing our business.

*** ***

***Training***

 

The introduction of new technology requires training for both surgeons andoperating room personnel.  The 

 

 

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model for our training philosophy is our sponsorship of theLaparascopic Bariatric Surgery program, introduced in early 2000.  This comprehensive program is designed toprovide participants with the complete information, training and technologynecessary to perform minimally invasive gastric bypass surgery as a treatmentfor morbid obesity.

 

***Clinical evaluation***

 

All of our product lines are developed with frequentinput from our clinical advisory boards which are discussed under “—ClinicalAdvisory Boards.”  This evaluation phasemay progress into a publication phase with advisors publishing results of theirexperience in leading publications or speaking at major clinical conferences.  We support such research, although we haveno control over the content or timing of any publication or presentation,because impartial education of the general clinical audience is a key componentin establishing procedure and equipment acceptance.  As part of our strategy, we also intend to continue to supportseminars and symposiums and participate in industry trade shows eitherindependently or in conjunction with our strategic partners.

*** ***

***International sales***

 

We have entered into a strategic relationship withRichard Wolf, GmbH, for distribution of our products in general surgery,gynecology, and urology in all international markets, and with Jomed N.V. forcardiac surgery.  For a description ofthese relationships, please see “—Strategic Alliances”.  We will continue to evaluate partnershipopportunities as appropriate for international sales of all of our productlines.

** **

**Competition**

 

The medical devicemarket in which we compete is characterized by intensive development effortsand rapidly advancing technology.  Ourfuture success will depend, in large part, upon our ability to anticipate andkeep pace with advancing technology and competing innovations.  There can be no assurance, however, that wewill be successful in identifying, developing and marketing new products orenhancing our existing products.

 

Althoughseveral companies compete with aspects of our visualization product line,we  believe there is no single companywhich offers a complete and independent 3-D visualization and informationsystem specifically directed at minimally invasive microsurgical applications.  In addition, we are not aware of any othertrue 3-D head-mounted display which has been cleared for marketing in surgicalapplications by the FDA.  We do believethat a number of large companies, some of which have significantly greaterfinancial, manufacturing, marketing, distribution and technical resources andexperience than ours, are focusing on the development of advanced visualizationproducts for minimally invasive microsurgery.  There can be no assurance that we will be successful in competing withany such companies.

** **

**Clinical Advisory Boards**

 

We consult frequentlywith surgeons in the specialties we are addressing.  We have previously established clinical advisory boards made upof leading surgeons, one focused on minimally invasive cardiac surgery, and ageneral advisory board focused on other minimally invasive specialties.  Members of our clinical advisory boardsconsult with us exclusively in the field of visualization, but are free toconsult with other non-competing instrumentation companies and are employedelsewhere on a full-time basis.  Ourclinical advisory boards are intended to act as a clinical reference for us andto provide access to potential training sites for our visualization products.

** **

**Employees**

 

As of February 28, 2002, we had 37 full-timeemployees, none of whom hold advanced degrees. None of our employees is represented by a collective bargainingagreement, nor have we experienced work stoppages.  We believe our relations with our employees are good.

 

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RISKS AND UNCERTAINTIES

 

You should consider the following factors carefully inevaluating an investment in Vista Medical in addition to the other informationin this report.  You are cautioned thatthe statements in this annual report that are not descriptions of historicalfacts may be forward-looking statements that are subject to risks anduncertainties.  Our actual results coulddiffer materially from those currently anticipated due to a number of factors,including those identified in this section and elsewhere in this annualreport.  We undertake no obligation torelease publicly the results of any revisions to these forward-lookingstatements to reflect events or circumstances arising after the date of thisannual report.  The following discussionshould be read in conjunction with our consolidated financial statements andnotes thereto.

** **

**We mayneed additional funds to support our currently proposed operations.  If we are unable to obtain them, we may haveto significantly scale back our operations or forgo opportunities in new marketsegments.**

 

We are working on initiatives to extend our business,most immediately in the surgical obesity****market, by****adding new products andservices. As a result, we may be required to raise additional funds to supportour operations.  In addition, if we areunable to sustain our cash flow under our current business plan, we will berequired to raise additional funds.  Ifwe are unable to raise sufficient funds from an offering of securities orotherwise, we may be unable to continue operations at their current level andmay be unable to pursue this new objective. Moreover, our liquidity and capital requirements will depend upon othernumerous factors, including the following:

 

•              The extent to which our productsgain market acceptance;

** **

**•             **The progress and scope ofproduct evaluations;

 

•              The timing and costs of filingfuture regulatory submissions;

 

•              The timing and costs required toreceive both domestic and international governmental approvals;

 

•              The timing and costs of productintroductions;

 

•              The extent of our ongoing researchand development programs;

 

•              The costs of sponsorship trainingof the physicians to become proficient in the use of our products andprocedures;

 

•              The costs of developing marketingand distribution capabilities.

 

Even if we are successful in raising additional funds,circumstances, including slow rate of market acceptance of our products or ourinability to scale up manufacturing, would accelerate our use of proceeds fromany offering we might do and require us to seek additional funds to support ouroperating requirements.

** **

**Wehave a history of losses and may not become profitable.**

 

Since our formation in July 1993, and as of December31, 2001, we have incurred cumulative net losses of $64.8 million.  We expect to incur losses for at least thenext 12 months.  We may never achieve orsustain profitability in the future. Even if we achieve profitability, we may not be able to sustain it on anongoing basis.

 

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**Weare, to a significant extent, dependent on distribution partners to sell ourproducts.**

 

We only have a small direct sales force and, in thepast, we were primarily dependent on agreements with thirdparties for sales of the majority of products derived from our corethree-dimensional technology.  Two ofour primary distribution agreements were terminated in 2000.  We entered into an arrangement with JomedN.V. in May, 2000 to transition distribution in cardiac surgery and to continuesupporting our cardiac customer base. However, the success of this transition depends upon the concurrentdevelopment of new technology by Jomed N.V. and may not be achieved in a reasonabletimeframe, or at all.  If we are unableto make this transition, we may be unsuccessful in distributing our cardiacsurgery products and may lose revenues.

 

In addition, during 2000, we changed our strategicemphasis for our core three-dimensional technology for applications in generalsurgery, gynecology and urology.  Wecannot assure you that we will be successful in these areas of sales.  Even if we are successful, we cannot assureyou that the revenue achieved in these areas of emphasis will be sufficient tocompensate for any loss of sales revenue from the termination of our previousdistribution agreements for cardiac products. Either of these results could have an adverse affect on our financialcondition and results of operations.

** **

**Ourprofitability is primarily dependent upon the successful development andcommercialization of our products based on our core three-dimensionaltechnology.**

 

Products derived from our core technology - the ORPCfor general surgery and the Series 8000 for minimallyinvasive cardiac surgery are expected to account for the majority of ourrevenues over the next several years. The demand for these products may not be sufficient to allow us toachieve profitable operations.

 

Our development efforts for improvementsto these products may not be successful. In addition, other products under development may not be shown to besafe or effective, capable of being manufactured in commercial quantities atacceptable costs, acquire appropriate regulatory clearances or be successfullymarketed.

** **

**Oursuccess is dependent upon acceptance of a minimally invasive approach tocomplex procedures as a reliable, safe and cost effective alternative toexisting treatments.**

 

Complex minimally invasive procedures are onlyperformed on a very limited basis by a relatively small number of highlyskilled surgeons.  We are unable topredict how quickly, if at all, complex minimally invasive procedures will beadopted by the medical community or, if they are adopted, the number ofprocedures that will be performed.

 

Even if the clinical safety and effectiveness of complex minimally invasive procedures is establishedin general surgery, cardiac and other specialties, surgeons and otherphysicians may choose not to recommend the procedures for any number of otherreasons.  Adoption of these proceduresby doctors will depend, for example, upon our ability to facilitate and sponsortraining of surgeons to perform complex minimally invasive procedures and thewillingness of these surgeons to perform such procedures.  Doctors may also elect not to recommend theminimally invasive procedures based on possible unavailability of acceptablereimbursement from health care payors. Health care payor acceptance may require evidence of the costeffectiveness of minimally invasive procedures as compared to other currentlyavailable treatments.  We believe thatphysician endorsements will be essential for clinical adoption of minimallyinvasive procedures and these endorsements may not be obtained.  Patient acceptance of new procedures willdepend upon doctor recommendations, as well as other factors, including theeffectiveness of, and the rate and severity of complications associated with,the procedure as compared to other treatments.

 

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**Widespreaduse of our products will require sponsoring the training of a large number ofsurgeons, and the time required to institute a training program and to trainsuch surgeons could adversely affect near term market acceptance.**

 

Evaluations of visualization technology, such as ours, which have been conducted to date, have shownthat there is a learning process involved for surgeons and other members of thesurgery team to become proficient with the use of the systems.  Based on the clinical and laboratoryprocedures performed to date, we cannot assure you that visualization andinformation system enhancements incorporated, or to be incorporated, in ourproducts will prove suitable for use by a substantial number of surgeons.  If they prove unsuitable for a large numberof surgeons to use, the potential markets and applications for our productswould be significantly limited.

 

**Thereare significant risks associated with any scale-up of manufacturing which maybe required to meet market demand and become profitable.**

 

We have never established high-volume manufacturingoperations and if we are required to do so to meet market demand or to becomeprofitable, we may not be able to establish or maintain reliable operations atcommercially reasonable costs.  We mayalso require additional manufacturing facilities if production volumesincrease.  Acquisition of newmanufacturing facilities would also likely involve relocation.  Difficulties in scaling up manufacturing ofproducts could result from problems involving:

 

•                                            qualitycontrol and assurance,

 

•                                            componentand service availability,

 

•                                            adequacyof control policies and procedures,

 

•                                            lackof qualified personnel,

 

•                                            compliancewith FDA regulations and the need for further FDA approval of new manufacturingprocesses and facilities and

 

•                                            otherproduction constraints.

 

We have considered and will continue to consider asappropriate, the internal manufacture of sub-assemblies currently provided bythird-party subcontractors, as well as the implementation of new productionprocesses.  Our manufacturing yields orcosts may increase as a result of the transition to in-house production or tonew production processes when such efforts are undertaken.  In addition, costs to comply with FDA goodmanufacturing practices or changes in such practices may exceed ourexpectations.

** **

**Wemay face component shortages and are dependent in some instances on singlesources of supply.**

 

Any significant supply interruption, or inventoryshortage or overage, would negatively impact our ability to manufacture ourproducts.  We use and rely on specificcomponents and services used in our systems for which we have only a singlesource of supply.  The manufacture ofour products in larger commercial quantities will require a substantialincrease in component supplies and will likely necessitate the replacement ofcurrent suppliers or the addition of new suppliers.  The qualification of additional or replacement vendors forspecified components or services is a lengthy process.  In addition, the substitution of replacementvendors may entail re-engineering time and cost and could delay the supply ofour products.

 

We expect to manufacture our products based onforecasted product orders and intend to purchase subassemblies and componentsprior to receipt of purchase orders from customers.  Lead times for ordered materials and components varysignificantly and depend on factors such as the business practices of thespecific supplier, contract terms and general demand for a component at a giventime.  Some components used in ourproducts have long lead times.  As aresult, there is a risk of excess or inadequate inventory if orders do notmatch forecasts.

 

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**Weare subject to significant domestic and international regulation and may not beable to obtain necessary regulatory clearances to sell our products.**

 

Themanufacture and sale of medical devices intended for commercial distributionare subject to extensive governmental regulation.  Our failure to comply with regulatory requirements wouldjeopardize our ability to market our products. Noncompliance with applicable requirements can result in failure of theregulatory agency to grant pre-market clearance or approval for devices,withdrawal or suspension of approval, total or partial suspension ofproduction, fines, injunctions, civil penalties, refunds, recall or seizure ofproducts and criminal prosecution.

 

Medicaldevices are regulated in the United States primarily by the FDA and, to alesser extent, by state agencies.  Salesof medical device products outside the United States are subject to foreignregulatory requirements that vary from country to country.  Generally, medical devices requirepre-market clearance or pre-market approval prior to commercial distribution.  A determination that information availableon the medical device is not sufficient to grant the needed clearance orapproval will delay market introduction of the product.  In addition, material changes ormodifications to, and changes in intended use of, medical devices also aresubject to FDA review and clearance or approval.  The FDA regulates the research, testing, manufacture, safety,effectiveness, labeling, storage, record keeping, promotion and distribution ofmedical devices in the United States and the export of unapproved medicaldevices from the United States to other countries.  The time required to obtain approvals required by foreigncountries may be longer or shorter than that required for FDA clearance, andrequirements for licensing may differ from FDA requirements.  The current regulatory environment in Europefor medical devices differs significantly from that in the United States.

** **

**Weexpect to encounter rapid technological change and significant competition.**

 

Themedical device market in which we compete is characterized by intensivedevelopment efforts and rapidly advancing technology.  Our future success will depend, in large part, upon our abilityto anticipate and keep pace with advancing technology and competinginnovations.  We may not be successfulin identifying, developing and marketing new products or enhancing our existingproducts.

 

Webelieve that a number of large companies, with significantly greater financial,manufacturing, marketing, distribution and technical resources and experiencethan ours, are focusing on the development of visualization products forminimally invasive microsurgery. Several companies are currently developing and marketing visualizationproducts for minimally invasive microsurgery which could be applied to generalsurgery or heart surgery.

 

Technologicaladvances with other therapies such as drugs, interventional procedures orfuture innovations in surgical techniques could make such other therapies moreeffective or lower in cost than minimally invasive microsurgery procedures andcould diminish growth prospects for minimally invasive microsurgery.

** **

**Weexpect fluctuations in our operating results.**

 

Ourresults of operations may vary significantly from quarter to quarter dependingupon numerous factors, including the following:

 

•        timingand results of product evaluations,

 

•        delays associated with the FDA and other regulatoryapproval processes,

 

•        demand for and utilization of our products,

 

•        changes in our pricing policies or those of our competitors,

 

•        changes in third-party payment guidelines,

 

•        the number, timing and significance of product enhancementsand new product announcements by us or our competitors,

 

•        ourability to develop, introduce and market new and enhanced versions of ourproducts on a timely basis,

 

 

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•        customerorder deferrals in anticipation of enhancements or of new product introductionsby us or our competitors,

 

•        productquality problems,

 

•        personnelchanges and

 

•        thelevel of international sales.

** **

**Ourprofitability is directly related to the level of reimbursements for surgicalprocedures using our products.**

 

Our profitability is directly related to the level ofpayments for the surgical procedures in which our products are involved, eitherby Medicare or private insurance companies. We could be adversely affected by changes in payment policies ofgovernment or private health care payors, particularly to the extent any suchchanges affect payment for the procedure in which our products are intended tobe used.  It is a continuing trend inU.S. health care for such payments to be under continual scrutiny and downwardpressure.  We believe that reimbursementin the future will be subject to increased restrictions, both in the UnitedStates and in foreign markets and that the overall escalating cost of medicalproducts and services has led to and will continue to lead to increasedpressures on the health care industry, both foreign and domestic, to reduce thecost of products and services, including products which we offer.

 

We expect that our products typically will be used byhospitals and surgical centers, which bill various third-party payors, such asgovernmental programs and private insurance plans, for the health care servicesprovided to their patients.  Third-partypayors carefully review and increasingly challenge the prices charged formedical products and services or negotiate a flat rate fee in advance.  Payment rates from private companies alsovary depending on the procedure performed, the third-party payor, the insuranceplan and other factors.  Medicarecompensates hospitals at a predetermined fixed amount for the costs associatedwith an in-patient hospitalization based on the patient’s discharge diagnosisand compensates physicians at a pre-determined fixed amount based on theprocedure performed, regardless of the actual costs incurred by the hospital orphysician in furnishing the care and unrelated to the specific devices orsystems used in that procedure. Medicare and other third-party payors are increasingly scrutinizingwhether to cover new products and the level of payment for new procedures.  The flat fee reimbursement trend is causinghospitals to control costs strictly in the context of a managed care system inwhich health care providers contract to provide comprehensive health care for afixed cost per person.  We are unable topredict what changes will be made in the reimbursement methods utilized by suchthird-party payors.

 

If we obtain the necessary foreign regulatoryregistrations or approvals, market acceptance of our products in internationalmarkets would be dependent, in part, upon the acceptance by the prevailinghealth care financing system in each country. Health care financing systems in international markets varysignificantly by country and include both government sponsored health careprograms and private insurance.  Wecannot assure you that these financing systems will endorse the use of ourproducts.

** **

**Wehave limited experience directly marketing our products overseas and may not besuccessful in expanding into international markets without experiencedpartners.**

 

We have limited experience in directly marketing ourproducts overseas.  Changes in overseaseconomic conditions, currency exchange rates, foreign tax laws or tariffs orother trade regulations could negatively impact our business.  The anticipated international nature of ourbusiness is also expected to subject our representatives, agents anddistributors to laws and regulations of the foreign jurisdictions in which theyoperate or in which our products  aresold, including laws regulating manufacture and sale of medical devices.  In addition, the laws of some foreigncountries do not protect our intellectual property rights to the same extent asdo the laws of the United States.

 

21

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**Wemay be subject to product liability claims and have limited insurance coverage.**

 

We face an inherent and significant business risk of exposureto product liability claims in the event that the use of our products resultsin personal injury or death.  Also, inthe event that any of our products proves to be defective, we may be requiredto recall or redesign such products. Our current product liability insurance coverage limit is $10.0 millionper occurrence and in the aggregate. Our coverage limits may not be adequate to protect us from anyliabilities we might incur in connection with the development, manufacture andsale of our products.  In addition,increased product liability coverage may be required if additional products areused in clinical evaluations or successfully commercialized.  Product liability insurance is expensive andin the future may not be available to us on acceptable terms, if at all.  A successful product liability claim orseries of claims brought against us in excess of our insurance coverage or aproduct recall would negatively impact our business.

** **

**Ifwe are unable to protect our intellectual property, we may be unable to preventother companies from using our technology in competitive products.**

 

Our future success will depend, in part, on ourability to continue developing patentable products, enforcing our patents andobtaining patent protection for our products both in the United States and inother countries.  The patent positionsof medical device companies, however, are generally uncertain and involvecomplex legal and factual questions. Patents may never issue from any patent applications owned by or licensedto us.  Even  if patents do issue, the claims allowed may not be sufficientlybroad to protect our technology.  Inaddition, issued patents owned by or licensed to us may be challenged,invalidated or circumvented, or the rights granted thereunder may not provideus with competitive advantages.

 

The medical device industry has been characterized byextensive litigation regarding patents and other intellectual propertyrights.  Litigation, which would resultin substantial expense, may be necessary to enforce any patents issued orlicensed to us and/or to determine the scope and validity of proprietary rightsof third parties or whether our products, processes or procedures infringe anysuch third-party proprietary rights.  Wemay also have to participate in interference proceedings declared by the UnitedStates Patent and Trademark Office, which could result in substantial expense,to determine the priority of inventions covered by our issued United Statespatents or pending patent applications. Furthermore, we may have to participate at substantial cost inInternational Trade Commission proceedings to enjoin importation of productswhich would compete unfairly with our products.  Any adverse outcome of any patent litigation, includinginterference proceedings, could subject us to significant liabilities to thirdparties, require disputed rights to be licensed from or to third parties orrequire us to cease using the technology in dispute.  Any such licenses may not be available on acceptable terms, if atall.  Furthermore, parties making suchclaims may be able to obtain injunctive or other equitable relief that couldeffectively block our ability to make, use, sell or otherwise practice ourintellectual property, whether or not patented or described in pending patentapplications, or to further develop or commercialize our products in the UnitedStates and abroad and could result in the award of substantial damages.  Defense of any lawsuit or failure to obtainany such license could damage our business.

 

In addition to patents,we rely on unpatented tradesecrets to protect our proprietary technology. Others may independently develop or otherwise acquire the same orsubstantially equivalent technologies or otherwise gain access to ourproprietary technology or disclose this technology.  It is difficult to protect rights to unpatented proprietarytechnology.  Third parties may obtainpatent rights to these unpatented trade secrets, which patent rights could beused to assert infringement claims against us. We also rely on confidentiality agreements with our collaborators,employees, advisors, vendors and consultants to protect our proprietarytechnology.  These agreements may bebreached, we may not have adequate remedies for any breach and our tradesecrets may otherwise become known or be independently developed bycompetitors.  In addition, ouragreements with employees and consultants require disclosure of ideas,developments, discoveries or inventions conceived during employment orconsulting, as the case may be, and assignment to us of proprietary rights tosuch matters related to our business and technology.  The extent to which efforts by others will result in patents andthe effect on us of the issuance of such patents is unknown.

 

22

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**Wehave licensed some aspects of our products from third parties and may lose therights to these essential aspects under the agreements which govern thoserelationships.**

 

We have licensed some aspects of our technology fromthird parties.  The rights under thegoverning agreements may be terminated if we breach our obligations or in othercircumstances.  Our failure to retainrights to these licensed rights could negatively impact our business.  For additional information concerning theagreements which govern these relationships, please see “Business—StrategicAlliances” and “Business - Licenses.”

** **

**Ifwe are not able to attract and retain key technical and senior managementpersonnel and doctors to participate in our advisory boards, it may adverselyaffect our ability to obtain financing or develop our products.**

 

Our future business andoperating results depend in significant part upon the continued contributionsof our key technical and senior management personnel, many of whom would bedifficult to replace and some of whom perform important functions beyond thosesuggested by their job titles or descriptions. Our business and future operating results also depend in significant partupon our ability to attract and retain qualified management, manufacturing,technical, marketing and sales and support personnel for our operations.  Competition for such personnel is intense,and we may not be successful in attracting or retaining such personnel.

 

Members of our clinicaladvisory boards consult with us exclusively in the field of visualization, butare free to consult with other non-competing instrumentation companies and areemployed elsewhere on a full-time basis. As a result, they only spend a limited amount of time on our business.  Although we have entered into consultingagreements, including confidentiality provisions with each of the members ofour clinical advisory boards, the consulting and confidentiality agreementsbetween us and each of the members of our clinical advisory boards may beterminated or breached.

** **

**Ourstock price could continue to be volatile and your investment in our commonstock could suffer a decline in value, adversely affecting our ability to raiseadditional capital.**

 

The market prices and trading volumes for securitiesof emerging companies, like ours, have historically been highly volatile andhave experienced significant fluctuations unrelated to the operatingperformance.  The market price of ourcommon stock has historically been highly volatile and may be significantlyaffected by factors such as:

 

•        actual or anticipated fluctuations inour operating results,

 

•        changes infinancial estimates by securities analysts,

 

•        announcementsof technological innovations,

 

•        new productsor new contracts by us or our competitors,

 

•        regulatoryannouncements,

 

•        developmentswith respect to patents or proprietary rights,

 

•        conditionsand trends in the medical device and other technology industries,

 

•        adoption of new accounting standardsaffecting the medical device industry, and

 

•        general marketconditions.

 

In addition, the stockmarket has from time to time experienced significant price and volumefluctuations that have particularly affected the market prices for shares ofearly stage companies.  These broadmarket fluctuations may adversely affect the market price of our commonstock.  In the past, following periodsof volatility in the market price of a particular company’s securities,securities class action litigation has often been brought against thatcompany.  Such litigation, if broughtagainst us, could result in substantial costs and a diversion of management’sattention and resources.

 

23

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**Ouruse of hazardous materials may result in unexpected and substantial claimsagainst us for which we do not have sufficient financial resources.**

 

Our research and developmentactivities may involve the controlled use of hazardous materials andchemicals.  The risk of accidentalcontamination or injury from these materials cannot be completelyeliminated.  In the event of such anaccident, we could be held liable for any resultant damages, and any suchliability could exceed our resources. We may incur substantial cost to comply with environmental regulations.

** **

**Wedo not anticipate paying any dividends and any gains from your investment inour stock will have to come from increases in the price of such stock.**

 

We currently intend toretain any future earnings for use in our business and do not anticipate payingany cash dividends in the foreseeable future.

** **

**Ourcharter documents may prevent us from participating in transactions that couldbe beneficial to you.**

 

Our charter documentscontain provisions that may make it more difficult or discourage a change incontrol.  This may adversely affect themarket price of our common stock.

 

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Item 2.       PROPERTIES

 

Our facilities consistof approximately 6,500 square feet of office space located in Carlsbad,California, in which our executive offices, plus some marketing and sales staffare located.  The lease for our Carlsbadfacility expires in January 2003.  Inaddition, we maintain a facility of approximately 27,939 square feet inWestborough, Massachusetts in which our development, engineering, manufacturingoperations and customer service personnel are located.  We currently sublease approximately 10,119square feet of this space to one party and only occupy 17,820 square feet forour operations. The lease under which we have acquired the right to occupy theWestborough facilities expires in October 2002.    We believe that suitable additional space will be available tous, when needed, on commercially reasonable terms.

 

Item 3.        LEGAL PROCEEDINGS

 

From time to time, we may be involved in litigationrelating to claims arising out of our operations in the normal course ofbusiness.  As of the date of this AnnualReport, we are not a party to any legal proceedings.

 

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Item 4.        SUBMISSION OF MATTERS TO A VOTE OFSECURITY HOLDERS

 

None.

 

PART II

 

Item 5.        MARKET FOR REGISTRANT’S COMMON EQUITYAND RELATED STOCKHOLDER MATTERS

 

(a)               Market Price of and Dividends onthe Registrant’s Common Equity.

 

Our Common Stockis traded on the over-the-counter market and prices are quoted on the NasdaqSmall Cap Market under the symbol “VMTI.” The following table sets forth the high and low sale prices for theCommon Stock on the Nasdaq Small Cap Market from January 1, 2000 throughDecember 31, 2001.

 
| **Quarter**      |   | **High** |   | **Low** |
|------------------|--------|----------|--------|---------|
|             |   |     |   |    |
| 1st Quarter 2000 |   | 11.52    |   | 2.52    |
|             |   |     |   |    |
| 2nd Quarter 2000 |   | 5.52     |   | 2.52    |
|             |   |     |   |    |
| 3rd Quarter 2000 |   | 8.00     |   | 3.76    |
|             |   |     |   |    |
| 4th Quarter 2000 |   | 6.00     |   | 0.76    |
|             |   |     |   |    |
| 1st Quarter 2001 |   | 6.00     |   | 1.875   |
|             |   |     |   |    |
| 2nd Quarter 2001 |   | 5.00     |   | 2.76    |
|             |   |     |   |    |
| 3rd Quarter 2001 |   | 4.00     |   | 1.55    |
|             |   |     |   |    |
| 4th Quarter 2001 |   | 4.30     |   | 1.70    |

 

On March 22, 2002 the last reported sale price of theCommon Stock was $4.00.  As of March 22,2002, there were approximately 92****holders of record of the Common Stock.

 

We have never declared or paid any cash dividends on our capitalstock.  We currently do not intend topay any cash dividends in the foreseeable future and intend to retain ourearnings, if any, for the operation of our business.

 

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Item 6.        SELECTED FINANCIAL DATA

 

SELECTED FINANCIAL DATA

 

The selected financial data set forth below should beread in conjunction with “Management’s Discussion and Analysis of FinancialCondition and Results of Operations” and our financial statements and notesthereto appearing elsewhere in this Form 10-K.

 
|                                                          |      | **YEARS ENDED DECEMBER 31,**                       |      |
|---------------------------------------------------------------|-----------|----------------------------------------------------|-----------|
| **STATEMENT OF OPERATIONS DATA:**                             |      | **1997**                                           |      | **1998** |   | **1999** |   | **2000** |   | **2001** |   |
|                                                          |      | **(DOLLARS IN THOUSANDS, EXCEPT PER  SHARE DATA)** |      |
| Sales                                                         |      | $                                                  | 4,141     |   | $ | 6,572 |   | $ | 5,516 |   | $ | 6,539 |   | $ | 9,326 |   |
|                                                          |      |                                               |      |   |   |   |   |   |   |   |   |
| Cost and expenses:                                            |      |                                               |      |   |   |   |   |   |   |   |   |
|                                                          |      |                                               |      |   |   |   |   |   |   |   |   |
| Cost of sales                                                 |      | 4,559                                              |      | 6,119 |   | 7,521 |   | 5,947 |   | 6,405 |   |
|                                                          |      |                                               |      |   |   |   |   |   |   |   |   |
| Research and development                                      |      | 6,875                                              |      | 5,480 |   | 3,229 |   | 1,736 |   | 1,945 |   |
|                                                          |      |                                               |      |   |   |   |   |   |   |   |   |
| Sales and marketing                                           |      | 5,011                                              |      | 5,953 |   | 2,890 |   | 1,158 |   | 2,237 |   |
|                                                          |      |                                               |      |   |   |   |   |   |   |   |   |
| General and administrative                                    |      | 5,499                                              |      | 5,039 |   | 2,178 |   | 1,925 |   | 2,031 |   |
|                                                          |      |                                               |      |   |   |   |   |   |   |   |   |
| Restructuring expense                                         |      | —                                             |      | 940 |   | 690 |   | (400 | ) | — |   |
|                                                          |      |                                               |      |   |   |   |   |   |   |   |   |
| Total costs and expenses                                      |      | 21,944                                             |      | 23,531 |   | 16,508 |   | 10,366 |   | 12,618 |   |
|                                                          |      |                                               |      |   |   |   |   |   |   |   |   |
| Loss from operations                                          |      | (17,803                                            | )         | (16,959 | ) | (10,992 | ) | (3,827 | ) | (3,292 | ) |
|                                                          |      |                                               |      |   |   |   |   |   |   |   |   |
| Interest income                                               |      | 926                                                |      | 900 |   | 218 |   | 213 |   | 70 |   |
|                                                          |      |                                               |      |   |   |   |   |   |   |   |   |
| Other gains/(losses)                                          |      | —                                             |      | (662 | ) | 51 |   | — |   |   |   |
|                                                          |      |                                               |      |   |   |   |   |   |   |   |   |
| Net loss                                                      |      | $                                                  | (16,877   | ) | $ | (16,721 | ) | $ | (10,723 | ) | $ | (3,614 | ) | $ | (3,222 | ) |
|                                                          |      |                                               |      |   |   |   |   |   |   |   |   |
| Basic and diluted net loss per share (1)                      |      | $                                                  | (10.03    | ) | $ | (5.02 | ) | $ | (3.16 | ) | $ | (0.80 | ) | $ | (0.66 | ) |
|                                                          |      |                                               |      |   |   |   |   |   |   |   |   |
| Shares used in computing basic and diluted loss per share (1) |      |                                               |      |   |   |   |   |   |   |   |   |
|                                                          | 1,682,750 |                                               | 3,328,000 |   | 3,398,000 |   | 4,495,000 |   | 4,906,197 |   |

 
|                                              |   | **YEARS ENDED DECEMBER 31,** |   |
|---------------------------------------------------|--------|------------------------------|--------|
| **BALANCE SHEET DATA:**                           |   | **1997**                     |   | **1998** |   | **1999** |   | **2000** |   | **2001** | ** ** |
|                                              |   | **IN THOUSANDS**             |   |
| Cash, cash equivalents and short-term investments |   | $                            | 24,113 |   | $ | 8,803 |   |   | $ | 1,658 |   |   | $ | 2,934 |   |   | $ | 1,317 |   |
|                                              |   |                         |   |   |   |   |   |   |   |   |   |
| Working capital                                   |   | 25,977                       |   | 12,128 |   | 2,972 |   | 5,113 |   | 2,696 |   |
|                                              |   |                         |   |   |   |   |   |   |   |   |   |
| Total assets                                      |   | 32,130                       |   | 16,605 |   | 7,367 |   | 7,155 |   | 4,823 |   |
|                                              |   |                         |   |   |   |   |   |   |   |   |   |
| Total debt                                        |   | —                       |   | — |   | — |   | — |   | — |   |
|                                              |   |                         |   |   |   |   |   |   |   |   |   |
| Accumulated deficit                               |   | (30,498                      | )      | (47,218 | ) | (57,941 | ) | (61,555 | ) | (64,777 | ) |
|                                              |   |                         |   |   |   |   |   |   |   |   |   |
| Total stockholder’s equity                   |   | 29,866                       |   | 14,666 |   | 4,584 |   | 6,151 |   | 3,091 |   |
|                                                   |        |                              |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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Item 7.        MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

This annual report may contain predictions, estimatesand other forward-looking statements that involve a number of risks anduncertainties, including those discussed earlier at “risks anduncertainties.”  While this outlookrepresents our current judgment on the future direction of our business, suchrisks and uncertainties could cause actual results to differ materially fromany future performance suggested below. We undertake no obligation to release publicly the results of anyrevisions to these forward-looking statements to reflect events orcircumstances arising after the date of this annual report.  The following discussion should be read inconjunction with our consolidated financial statements and the notes thereto.

** **

**Overviewof our Business**

 

We develop, manufacture and market products thatprovide information to doctors performing minimally invasive general surgical,cardiac surgical and other selected microsurgical procedures.  We also develop and sponsor training andsupport programs for medical personnel which enhance the adoption of proceduresincorporating use of our visualization technology.  Our products combine a head mounted display with video cameras toprovide surgeons with critical visual information during these microsurgicalprocedures, combined with the ability to view new additional information in avoice-controlled, picture-in-picture format, to facilitate real-time decisionmaking during surgery.  Our productlines include the ORPC Advanced Visualization and Information System forgeneral surgery and other complex endoscopic procedures and the Series 8000Advanced Visualization and Information System, for use in cardiac surgery.  In general terms, endoscopic surgeryinvolves a telescopic viewing device which is inserted into a small incision inthe body and which allows the surgeon an adequate view of the internal part ofthe body being repaired.

 

At December 31, 2001, we had  34 employees.  We expectstaffing to increase modestly in the near term to approximately 40 employeesand stabilize at or near that level for the balance of our fiscal year2002.  Our expectation is based on thefact that significant development work on our core platform technology is nowcomplete and on strategic decisions to partner rather than develop anindependent distribution capability.

** **

**CriticalAccounting Policies**

 

Revenue Recognition

 

Revenue generated from LBS program sales are recognized upon shipmentof equipment and marketing materials and completion of the related trainingcomponent, provided that a purchase order has been received, there are nouncertainties regarding customer acceptance, the sales price is fixed anddeterminable and collectibility is deemed probable.  Sales of all other products are similarly recognized uponshipment provided that a purchase order has been received, there are nouncertainties regarding customer acceptance, the sales price is fixed anddeterminable and collectibility is deemed probable.

 

The Company receives semiannual payments as a result of fulfillingcertain obligations related to its strategic alliance agreement with EthiconEndo-Surgery, Inc. (EES).  Thesepayments are recognized as revenue on a straight-line basis over the relatedcontract term, provided that the Company has complied with all contractualobligations.

 

Inventory

 

Inventory is accounted for on a first-in first-out basis and is valuedat the lower of cost or market.  TheCompany regularly evaluates inventory for obsolescence and reserves for 100% ofinventory considered to be obsolete.  AtDecember 31, 2001 such inventory reserves approximated $1,500,000.  The Company believes it is adequately reservedfor obsolescence of current inventory. However, future product introductions and related inventories mayrequire additional reserves based upon changes in market demand or introductionof competing technologies.

 

 

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**OurResults of Operations**

** **

**Yearended December 31, 2001 compared with year ended December 31, 2000**

** **

**Revenues**

 

We had revenues from product sales and contractrevenue of $9,326,000 for the year ended December 31, 2001 and product salesrevenue of $6,539,000 for the year ended December 31, 2000.  The increase in revenues during 2001 wasprimarily due to increased unit sales from our Laparoscopic Bariatric Surgeryprogram coupled with contract revenue recognition of $583,000 from our Supplyand Promotion Agreement with Ethicon Endo-Surgery, Inc.   Sales to individual customers exceeding 10%or more of revenues in the years ended December 31, were as follows: during1999 three customers accounted for 45%, 28% and 16% of revenues, respectively,during 2000, two customers accounted for 51% and 23% of revenues, respectively,and during 2001, three customers accounted for 22%, 18% and 10% of revenuesrespectively.

** **

**Costs and expenses**

 

Cost of revenues. Our cost of revenues were $6,405,000 and $5,947,000 for the years endedDecember 31, 2001 and 2000, respectively. Our gross margins were 31% and 9% for the years ended December 31, 2001and 2000, respectively.  The increase ingross margin was primarily due to increased unit sales of our higher marginLaparascopic Bariatric Surgery Program coupled with contract revenue recognitionof $583,000 from an agreement with Ethicon Endo-Surgery, Inc., with no cost ofrevenues.

 

Research and development expenses.  Our research and development expenses were$1,945,000 and $1,736,000 for the years ended December 31, 2001 and 2000,respectively.  The increase in researchand development expenses during 2001 was primarily attributable to nextgeneration product development.  Since2000, the Company’s principal development efforts have focused on new productsand services within the surgical obesity market.  Approximately $1,000,000 of the $1,945,000 research anddevelopment expenses were spent on the next generation Head Mounted Displaywhich is expected to be available for sale by the fourth quarter of 2002.  There were no other individually significantresearch projects.  The Company’s futurespending on research and development will be focused on further expansion ofLBS peripheral products and services and development of the next generationHead Mounted Display.

 

Sales and marketing expenses.  Our sales and marketing expenses were$2,237,000 and $1,158,000 for the years ended December 31, 2001 and 2000,  respectively.  The increase in sales and marketing expenses during 2001  reflects a ramp up of field activities forthe obesity surgery market.  The 2000sales and marketing expense of $1,158,000 is net of a one-time $806,000 salesexpense reversal in connection with the termination of our distributionagreement with Medtronic.

 

General and administrative expenses.  Our general and administrative expenses were$2,031,000 and $1,925,000 for the years ended December 31, 2001 and 2000,respectively.  The increase during 2001was primarily due to higher professional and legal fees.

 

Restructuring expenses.  We recorded no restructuring charges for the year ended December31, 2001 and we reported credits of $400,000 for the year ended December 31,2000. The partial recovery reported in 2000 represents the subletting ofapproximately one half of the facility space for which a $690,000 restructuringcharge had been incurred in 1999.

** **

**Other income and losses**

 

Interest income. Our net interest income was $70,000and $213,000 for the years ended December 31, 2001 and 2000, respectively. Thedecrease in 2001 was due primarily to decreasing average cash balances.

 

Other gains and losses.  We had no other gains or losses for the year ended December 31,2001 and 2000, respectively.

** **

**Taxes**

 

At December 31, 2001, we had federal and state tax netoperating loss carryforwards of approximately $52,311,000 and $47,541,000,respectively.  The federal tax losscarryforwards will begin to expire in 2010. Approximately $921,000 of the state tax loss carryforwards expired in2001, and will continue to expire in 2002 unless previously utilized.  At December 31, 2001, we also had federaland state research tax credit carryforwards of

 

29

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approximately $2,108,000 and $809,000, respectively, which will beginto expire in 2010 unless previously utilized. We have provided a full valuation allowance on the deferred tax assetsas realization of such assets is uncertain.

** **

**Yearended December 31, 2000 compared with year ended December 31, 1999**

** **

**Revenues**

 

We had revenues from product sales of $6,539,000 and$5,516,000 for the years ended December 31, 2000 and 1999, respectively.  The increase in revenues during 2000 wasprimarily due to revenues generated from our Laparascopic Bariatric SurgeryProgram, which became an area of focus in 2000.  Sales to individual customers exceeding 10% or more of revenuesin the years ended December 31, were as follows: during 1998 three customersaccounted for 34%, 25% and 13% of revenues, respectively, during 1999, threecustomers accounted for 45%, 28% and 16% of revenues, respectively, and during2000, two customers accounted for 51% and 23% of revenues, respectively.

** **

**Costs and expenses**

 

Cost of revenues. Our cost of revenues were $5,947,000and $7,520,000 for the years ended December 31, 2000 and 1999, respectively.The decrease in cost of sales during 2000 was primarily due to a reduction inmanufacturing overhead expenses during 2000 compared to 1999.

 

Research and development expenses.  Our research and development expenses were$1,736,000 and $3,229,000 for the years ended December 31, 2000 and 1999,respectively.  The decrease in researchand development expenses during 2000 was primarily attributable to decreases instaffing and related supply and occupancy costs and a decrease in contractservices related to development efforts.

 

Sales and marketing expenses.  Our sales and marketing expenses were$1,158,000 and $2,890,000 for the years ended December 31, 2000 and 1999,respectively. The decrease in sales and marketing expenses during 2000 reflectsa reduction in staffing and related expenses as a result of an internalrestructuring and a one-time $806,000 sales expense reversal in connection withthe termination of our distribution agreement with Medtronic.

 

General and administrative expenses.  Our general and administrative expenses were$1,925,000 and $2,178,000 for the years ended December 31, 2000 and 1999,respectively.  The decrease during 2000was primarily due to a reduction in staffing and related expenses and areduction in deferred compensation expense.

 

Restructuring expenses.  We recorded credits for restructuring charges of $400,000 andcharges of $690,000 for the years ended December 31, 2000 and 1999,respectively.  Restructuring creditsduring 2000 are primarily attributable to us subleasing the second floor spaceof our facility in Westborough, Massachusetts. The expenses in 1999 relate to our decision to close part of ourfacilities in Westborough, after a significant reduction in our workforceduring the third quarter of 1999 and represented the value of continuing leaseobligations, prior to arranging subleases.

** **

**Other income and losses**

 

Interest income. Our net interest income was $213,000 and $218,000 for the years endedDecember 31, 2000 and 1999, respectively. The decrease in 2000 was due primarily to decreasing average cashbalances.

 

Other gains and losses.  We had no other gains or losses for the year ended December 31,2000 and other gains of $51,000 for the year ended December 31, 1999.  The gains during 1999 relate to proceedsobtained from a sale of securities in connection with an earlier licenseagreement signed in 1996 with Imagyn Medical Technologies, Inc. (formerlyUrohealth Systems, Inc.).

 

**Liquidity****and CapitalResources**

 

Net cash used in operating activities wasapproximately $1,556,000, $3,388,000 and $7,157,000 in 2001, 2000 and 1999,respectively.  The decrease in net cashused in operating activities during 2001 compared to 2000 was primarilyattributable to decreasing net losses and the receipt of $500,000 of paymentsunder an agreement with Ethicon Endo-Surgery. The decrease in net cash used in operating activities during 2000compared to 1999 was

 

30

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primarily attributable to decreasing net losses and lower inventorypurchases.

 

Net cash used in investing activities wasapproximately $257,000 and $210,000 in 2001 and 2000, respectively, and netcash provided by investing activities was approximately $809,000 in 1999.  The increase in net cash used for investingactivities in 2001 compared to 2000 was primarily attributable to increasingbalances of short-term investments partially offset by decreasing purchases ofproperty and equipment.  The decrease innet cash provided by investing activities in 2000 compared to 1999 wasprimarily attributable to declining balances of short-term investments reachingmaturity partially offset by decreasing purchases of property and equipment.

 

Cash flows from financing activities were $25,000,$4,819,000 and $91,000 in 2001, 2000 and 1999, respectively.  The cash flows from financing activities in2001 were primarily attributable to proceeds from the purchase of stock byemployees through our employee stock purchase plan and the exercise of stockoptions.  The cash flows from financingactivities during the 2000 period were primarily attributable to the sale ofstock to three of our stockholders with net proceeds of approximately$4,591,000, along with an increase in purchases of stock by employees throughour employee stock purchase plan, partially offset by a lower level of stockoption exercises. The cash flows from financing activities in 1999 wereprimarily attributable to proceeds from the purchase of stock by employeesthrough our employee stock purchase plan and the exercise of stock options.

 

During fiscal 2000 and 2001, the Company incurredsignificant operating losses, however, in June 2001, the Company entered into aSupply and Promotion Agreement with Ethicon Endo-Surgery, Inc. (EES) which willprovide a significant source of revenue in fiscal 2002.    We are also working on initiatives toextend our business, most immediately in the surgical obesity market, by addingnew products and services which could provide new sources of revenue in fiscal2002.  We have also obtained significantpurchase commitments from current and new customers that could have the effectof increasing our planned OEM sales for fiscal 2002.  In October 2001, we also obtained an additional financing sourcethrough a $2,000,000 bank line of credit facility.

 

We believe that our existing cash resources, line ofcredit facility and cash from operations will meet working capital and researchand development requirements over the next twelve months.  However, management has outlined a number ofaction steps that may be taken if operating results are worse than planned toensure that we have adequate sources of cash to meet our working capitalneeds.  During the second half of 2001,we received approval from our Board of Directors to implement this action planin fiscal 2002 if necessary to sustain operations.  The key elements of the plan are as follows:

 

•       Furtherreduce operating expenses by eliminating certain expenditures that are notessential to achieving critical business objectives (e.g., discretionaryspending, further development efforts);

 

•       Eliminateplanned expansion into new services and production of new products;

 

•       Deferral ofthe development phase of the next generation Head Mounted Display

 

•       Borrow againstthe company’s $2,000,000 credit facility;

 

Unanticipated decreases in operating revenues,increases in expenses or delays in product development may adversely impact theCompany’s cash position and require further cost reductions.  No assurance can be given that the Companywill be able to operate profitably on a consistent basis in the future.

 

Item 7A.                 QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK

 

At December 31, 2001, our investment portfolioincluded fixed-income securities of $0.8 million.  These securities are subject to interest rate risk and willdecline in value if interest rates increase. Due to the short-term nature of our investment portfolio, an immediate10 percent increase in interest rates would have no material impact on ourfinancial condition or results of operations.

 

We have a $2,000,000 credit facility with a financialinstitution.  Interest on this facilitywas prime plus 2% at December 31, 2001. At December 31, 2001, we had no advances outstanding under this creditfacility.  If we were to draw under thisfacility, changes in interest rates would affect the interest expense we wouldpay and could impact our cash flows and results of operations.

 

31

----

 

We generally conduct business, including sales toforeign customers, in U.S. dollars and as a result have limited foreigncurrency exchange rate risk.  The effectof an immediate 10 percent change in foreign exchange rates would not have amaterial impact on our financial condition or results of operations.

 

Item 8.                    FINANCIAL STATEMENTS AND SUPPLEMENTARYDATA

 

The consolidated financial statements andsupplementary data required by this item are set forth at the pages indicatedin 14(a)(1).

 

Item 9.                                                             CHANGESIN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

 

Not applicable.

PART III

 

Item 10.                  DIRECTORS AND EXECUTIVEOFFICERS OF THE REGISTRANT

 

(a)     Identificationof Directors.  The information under thecaption “Proposal 1 - Election of Directors,” appearing in our Proxy Statementrelated to the Annual Meeting of Stockholders to be held on June 5, 2002,  is incorporated herein by reference.

 

(b)     Identificationof Executive Officers.  The informationunder the headings “Executive Officers and Key Employees,” appearing in ourProxy Statement related to the Annual Meeting of Stockholders to be held onJune 5, 2002, is incorporated herein by reference.

 

(c)     Compliancewith Section 16(a) of the Exchange Act. The information under the caption “Compliance with Section 16(a) of theSecurities Exchange Act of 1934,” appearing in our Proxy Statement related tothe Annual Meeting of Stockholders to be held on June 5, 2002, is incorporatedherein by reference.

 

Item 11.                  EXECUTIVE COMPENSATION

 

The information under the headings “ExecutiveCompensation and Other Information,” appearing in our Proxy Statement relatedto the Annual Meeting of Stockholders to be held on June 5, 2002, isincorporated herein by reference.

 

Item 12.                  SECURITY OWNERSHIP OF CERTAINBENEFICIAL OWNERS AND MANAGEMENT

 

The information under the headings “Ownership ofSecurities,” appearing in our Proxy Statement related to the Annual Meeting ofStockholders to be held on June 5, 2002, is incorporated herein by reference.

 

Item 13.                  CERTAIN RELATIONSHIPS ANDRELATED TRANSACTIONS

 

The information under the heading “CertainRelationships and Related Transactions,” appearing in our Proxy Statementrelated to the Annual Meeting of Stockholders to be held on June 5, 2002, isincorporated herein by reference.

 

32

----

 

PART IV

 

Item 14.                  EXHIBITS, FINANCIAL STATEMENTSCHEDULES, AND REPORTS ON FORM 8-K

 

(a)                 (1)      Financial Statements

 

The financial statements required by this item aresubmitted in a separate section beginning on Page F-1 of this report.

 
| Report  of Ernst & Young, LLP Independent Auditors                                                       |
|--------------------------------------------------------------------------------------------------------------|
|                                                                                                         |
| CONSOLIDATED FINANCIAL STATEMENTS                                                                            |
|                                                                                                         |
| Consolidated Balance  Sheets at December 31, 2000 and 2001                                                   |
| Consolidated  Statements of Operations for the years ended December 31, 1999, 2000, and  2001                |
|                                                                                                         |
| Consolidated  Statements of Stockholders’ Equity for the years ended December 31, 1999, 2000,  and 2001 |
|                                                                                                         |
| Consolidated  Statements of Cash Flows for the years ended December 31, 1999, 2000, and  2001                |
|                                                                                                         |
| Notes to  Consolidated Financial Statements                                                                  |

 

(2)     FinancialStatement Schedules

 

All schedules for whichprovision is made in the applicable accounting regulation of the Securities andExchange Commission are not required under the related instructions or areinapplicable, and therefore   have beenomitted except for Schedule II required under Regulation S-X, Rule 5-04. whichis included herein following the Financial Statements.

 

(b)      No reports on Form 8-Khave been filed during the last quarter of the period covered by this report.

 

33

----

 

(c)           Exhibits

 
| **NUMBER  EXHIBIT** |   | **DESCRIPTION**                                                                                                                                                                                                                               |
|---------------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.2(1)              |   | Second Restated Certificate of Incorporation                                                                                                                                                                                                  |
| 3.2(2)              |   | Restated Bylaws.                                                                                                                                                                                                                              |
| 4.1(2)              |   | Form of certificate for common stock.                                                                                                                                                                                                         |
| 10.1(2)             |   | Series A-1 Preferred Stock Purchase Agreement with  the purchasers listed on Schedule A thereto, dated July 27, 1995.                                                                                                                         |
| 10.2*(2)            |   | Manufacturing Supply Agreement with Kaiser  Electro-Optics, Inc., dated July 19, 1995.                                                                                                                                                        |
| 10.3(2)             |   | Amended and Restated Investors’ Rights Agreement  with the stockholders listed on Schedule A thereto, dated November 27, 1996.                                                                                                           |
| 10.4(2)             |   | Amendment to the Amended and Restated Investors’ Rights  Agreement with Heartport and the stockholders listed on Exhibit A thereto,  dated February 22, 1997.                                                                            |
| 10.5(2)             |   | Letter Agreement regarding Investment  Representations and Registration Rights between us and Urohealth Systems,  Inc., dated December 13, 1996.                                                                                              |
| 10.6*(2)            |   | Consulting Agreement with Harry R. McKinley, dated  September 15, 1995, as amended.                                                                                                                                                           |
| 10.7(2)             |   | Form of Professional Services Agreement.                                                                                                                                                                                                      |
| 10.8(2)             |   | Form of Non-Disclosure Agreement for Proprietary or  Business Confidential Information.                                                                                                                                                       |
| 10.9(2)             |   | Non-Competition, Non-Disclosure and Patent and  Inventions Assignment Agreement among Harry R. McKinley, McKinley Optics,  Inc. and AST, dated December 18, 1991.                                                                             |
| 10.10*(2)           |   | License and Development Agreement among Harry R.  McKinley, McKinley Optics, Inc. and AST, dated December 18, 1991, as amended  on June 28, 1994.                                                                                             |
| 10.11*(2)           |   | License Agreement with Allen Newman, dated September  2, 1994, as amended December 13, 1996.                                                                                                                                                  |
| 10.12*(2)           |   | Agreement to Amend License and Development Agreement  with Harry R. McKinley and McKinley Optics, Inc., dated September 15, 1995.                                                                                                             |
| 10.13*(2)           |   | License Agreement with Kaiser Aerospace, dated July  19, 1995.                                                                                                                                                                                |
| 10.14*(2)           |   | Technology Strategic Alliance: Memorandum of  Understanding with Kaiser Electro Optics, Inc., dated July 19, 1995.                                                                                                                            |
| 10.15*(2)           |   | Non-Exclusive License Agreement with Fuji Photo Film  Co., Ltd. and Fuji Photo Film Optical Co., Ltd., dated June 25, 1996.                                                                                                                   |
| 10.16(2)            |   | Lease dated April 14, 1994, as amended by a certain  First Amendment to Lease dated March 29, 1996 and a Second Amendment to Lease  dated October 22, 1996 with Robert F. Tambone, as Trustee of MAT Realty  Trust, u/d/t dated June 4, 1986. |
| 10.17(2)            |   | Standby Letter of Credit from Silicon Valley Bank,  dated August 9, 1996.                                                                                                                                                                     |
| 10.18(2)            |   | 1995 Stock Option Plan.                                                                                                                                                                                                                       |
| 10.19(2)            |   | 1995 Stock Option Plan Form of Notice of Grant.                                                                                                                                                                                               |
| 10.20(2)            |   | 1995 Stock Option Plan Form of Stock Option  Agreement.                                                                                                                                                                                       |
| 10.21(2)            |   | 1995 Stock Option Plan Form of Stock Purchase  Agreement.                                                                                                                                                                                     |
| 10.22(2)            |   | 1997 Stock Option/Stock Issuance Plan, as amended.                                                                                                                                                                                            |
| 10.23(2)            |   | 1997 Stock Option/Stock Issuance Plan Form of Notice  of Grant.                                                                                                                                                                               |
| 10.24(2)            |   | 1997 Stock Option/Stock Issuance Plan Form of Stock  Option Agreement.                                                                                                                                                                        |
| 10.25(2)            |   | 1997 Stock Option/Stock Issuance Plan Form of Stock  Purchase Agreement.                                                                                                                                                                      |
| 10.26(2)            |   | 1997 Employee Stock Purchase Plan.                                                                                                                                                                                                            |
| 10.27(2)            |   | Form of Indemnification Agreement between us and  each of our directors.                                                                                                                                                                      |
| 10.28(2)            |   | Form of Indemnification Agreement between us and  each of our officers.                                                                                                                                                                       |
| 10.29(2)            |   | Form of Waiver of Registration Rights, dated  February 28, 1997.                                                                                                                                                                              |
| 10.30(2)            |   | 1997 Stock Option/Stock Issuance Plan Form of Stock  Issuance Agreement.                                                                                                                                                                      |
| 10.31(2)            |   | Stock Issuance Agreement dated March 3, 1997 with  those purchasers set forth in Schedule A.                                                                                                                                                  |
| 10.32(4)            |   | Common Stock Purchase Warrant with Silicon Valley  Bank, dated October 23, 1997.                                                                                                                                                              |
| 10.33(4)            |   | Second Amendment to the Amended and Restated  Investor’s Rights Agreement with Silicon Valley Bank and the Stockholders  listed on Exhibit A thereto, dated October 22, 1997.                                                            |
| 10.38(5)            |   | Amended and Restated Sales Agreement with Medtronic,  Inc., dated June 26, 1998 (with certain confidential portions omitted).                                                                                                                 |
| 10.39(6)            |   | Vista Medical Technologies, Inc., Industrial Real  Estate Lease with Ocean Point Tech Centre dated July 7, 1998.                                                                                                                              |
| 10.40(7)            |   | Amendment Number One to License Agreement with Imagyn  Medical Technologies, Inc., dated October 2, 1998.                                                                                                                                     |
| 10.41(7)            |   | Employment Agreement with John Lyon dated December  28, 1998.                                                                                                                                                                                 |
| 10.42(7)            |   | Employment Agreement with Koichiro Hori dated  December 28, 1998.                                                                                                                                                                             |
| 10.43(7)            |   | Employment Agreement with Allen Newman dated  December 28, 1998.                                                                                                                                                                              |
| 10.44(7)            |   | Employment Agreement with Robert De Vaere dated  December 28, 1998.                                                                                                                                                                           |
| 10.45(7)            |   | Fifth Amendment to Lease dated April 30, 1999.                                                                                                                                                                                                |
| 10.46(7)            |   | Sofamor Danek letter Amendment dated April 1999.                                                                                                                                                                                              |
| 10.47(9)            |   | Agreement with John Lyon dated July 20, 1999.                                                                                                                                                                                                 |
| 10.48(9)            |   | Agreement with Koichiro Hori dated July 20, 1999.                                                                                                                                                                                             |
| 10.49(9)            |   | Agreement with Allen Newman dated July 20, 1999.                                                                                                                                                                                              |
| 10.50(9)            |   | Agreement with Robert De Vaere dated July 20, 1999.                                                                                                                                                                                           |
| 10.51*(10)          |   | Sales Agreement with Richard Wolf, GmbH, dated  December 22, 1999.                                                                                                                                                                            |
| 10.52(11)           |   | Termination Agreement with Medtronic, Inc., dated  March 27, 2000.                                                                                                                                                                            |
| 10.53(11)           |   | Transition Agreement with Medtronic,Inc., dated  March 27, 2000.                                                                                                                                                                              |
| 10.54(11)           |   | Common Stock purchase Agreement with John Kennedy,  dated as of August 2, 2000.                                                                                                                                                               |
| 10.55(12)           |   | Amendment Two to Industrial Real Estate Lease with  Ocean Pacific Tech Centre, dated January 30, 2001.                                                                                                                                        |
| 10.56(12)           |   | Exclusive Distribution Agreement with Jomed  International, dated as of May 19, 2000.                                                                                                                                                         |
| 10.57(12)           |   | Cooperative Technology Agreement with Jomed  International, dated as of May 19, 2000.                                                                                                                                                         |
| 10.58*(13)          |   | Exclusive Supply and Promotion Agreement with  Ethicon Endo-Surgery, Inc., dated as of June 22, 2001.                                                                                                                                         |
| 10.58(14)           |   | Certificate of Amendment of Second Restated  Certificate of Incorporation.                                                                                                                                                                    |
| 23.1                |   | Consent of Ernst & Young LLP, Independent  Auditors.                                                                                                                                                                                      |
| 24.1                |   | Power of Attorney.                                                                                                                                                                                                                            |

 

----

(1)               Incorporated by reference to ourForm 10-K/A, filed on September 10, 1998.

 

(2)               Incorporated by reference to ourRegistration Statement on Form S-1, as amended, filed on July 2, 1997.

 

(3)               Incorporated by reference to ourForm 10-Q, filed on November 13, 1997.

 

(4)               Incorporated by reference to ourForm 10-K, filed on March 30, 1998.

 

(5)               Incorporated by reference to ourForm 10-Q, filed on August 12, 1998.

 

(6)               Incorporated by reference to ourForm 10-Q, filed on November 13, 1998.

 

(7)               Incorporated by reference to ourForm 10-K, filed on March 29, 1999.

 

(8)               Incorporated by reference to ourForm 10-Q, filed on August 13, 1999.

 

(9)               Incorporated by reference to ourRegistration Statement on Form S-1 filed on September 7, 1999.

 

(10)             Incorporated by reference to ourForm 10-K, filed on March 29, 2000.

 

(11)             Incorporated by reference to ourForm 10-Q, filed May 12, 2000.

 

(12)             Incorporated by reference to ourForm 10-Q filed April 2, 2001.

 

(13)             Incorporated by reference to ourForm 10-Q, filed August 3, 2001.

 

(14)             Incorporated by reference to ourForm 10-Q, filed November 14, 2001.

 

 

*              Certain confidential portions of this exhibit wereomitted by means of redacting a portion of the text (the “Mark”).  This exhibit has been filed separately withthe Secretary of the Securities and Exchange Commission without the Markpursuant to our application requesting confidential treatment under Rule 406under the Securities Act.

 

34

----

 

SUPPLEMENTAL INFORMATION

 

Copies of the Registrant’s Proxy Statement for theAnnual Meeting of Stockholders to be held June 5, 2002 and copies of the formof proxy to be used for such Annual Meeting were furnished to the Commissionprior to the time they were distributed to the Stockholders.

 

35

----

 

SIGNATURES

 

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

 
|   |                        |   |   | VISTA MEDICAL TECHNOLOGIES, INC. |
|--------|-----------------------------|--------|--------|----------------------------------|
|   |                        |   |   |                             |   |
|   | Date:  March  29, 2002 |   |   | By:                              | /s/ John R. Lyon |
|   |                        |   |   |                             | John R. Lyon |
|   |                        |   |   |                             | President and Chief Executive Officer |

 

 

POWER OF ATTORNEY

 

Know all men by these presents, that each person whosesignature appears below constitutes and appoints John R. Lyon or Stephen A.Gorgol, his or her attorney-in-fact, with power of substitution in any and allcapacities, to sign any amendments to this Annual Report on Form 10-K, and tofile the same with exhibits thereto, and other documents in connectiontherewith, with the Securities and Exchange Commission, hereby ratifying andconfirming all that the attorney-in-fact or his or her substitute orsubstitutes may do or cause to be done by virtue hereof.

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, this Report has been signed below by the followingpersons on behalf of the Registrant in the capacities and on the datesindicated.

 
| **SIGNATURE**                  |   | **TITLE**                                                                                            |   | **DATE**       |
|--------------------------------|--------|------------------------------------------------------------------------------------------------------|--------|----------------|
|                           |   |                                                                                                 |   |           |
| /s/ John R. Lyon               |   |                                                                                                 |   |           |
| (John R. Lyon)                 |   | President, Chief  Executive Officer and Director (Principal Executive Officer)                       |   | March 29, 2002 |
|                           |   |                                                                                                 |   |           |
| /s/ Stephen A. Gorgol          |   |                                                                                                 |   |           |
| (Stephen A. Gorgol)            |   | Vice President  of Finance and Chief Financial Officer (Principal Financial and Accounting  Officer) |   | March 29, 2002 |
|                           |   |                                                                                                 |   |           |
| /s/ James C. Blair             |   |                                                                                                 |   |           |
| (James C. Blair)               |   | Chairman of the Board and Director                                                                   |   | March 29, 2002 |
|                           |   |                                                                                                 |   |           |
| /s/  George  B. DeHuff    |   |                                                                                                 |   |           |
| (George B. DeHuff)             |   | Director                                                                                             |   | March 29, 2002 |
|                           |   |                                                                                                 |   |           |
| /s/  Nicholas  B. Binkley |   |                                                                                                 |   |           |
| (Nicholas B. Binkley)          |   | Director                                                                                             |   | March 29, 2002 |
|                           |   |                                                                                                 |   |           |
| /s/  Daniel  J. Holland   |   |                                                                                                 |   |           |
| (Daniel J. Holland)            |   | Director                                                                                             |   | March 29, 2002 |
|                           |   |                                                                                                 |   |           |
| /s/  Larry M.  Osterink   |   |                                                                                                 |   |           |
| Larry M. Osterink)             |   | Director                                                                                             |   | March 29, 2002 |

 

 

36

----

 

 

Vista MedicalTechnologies, Inc.

 

Index toConsolidated Financial Statements

 
|                                                                                                         |
|--------------------------------------------------------------------------------------------------------------|
| Report  of Ernst & Young LLP, Independent Auditors                                                       |
|                                                                                                         |
| CONSOLIDATED FINANCIAL STATEMENTS                                                                            |
|                                                                                                         |
| Consolidated Balance  Sheets at December 31, 2000 and 2001                                                   |
| Consolidated  Statements of Operations for the years ended December 31, 1999, 2000, and  2001                |
| Consolidated  Statements of Stockholders’ Equity for the years ended December 31, 1999,  2000, and 2001 |
| Consolidated  Statements of Cash Flows for the years ended December 31, 1999, 2000, and  2001                |
| Notes to  Consolidated Financial Statements                                                                  |

 

F-1

----

 

Report of Ernst & Young LLP, Independent Auditors

 

The Board of Directors and Stockholders

Vista Medical Technologies, Inc.

 

We have audited the accompanying consolidated balance sheets of VistaMedical Technologies, Inc. as of December 31, 2000 and 2001 and the relatedconsolidated statements of operations, stockholders’ equity, and cash flows foreach of the three years in the period ended December 31, 2001. Our audits alsoincluded the financial statement schedule listed in the index at Item14(a).  These financial statements andschedule are the responsibility of the Company’s management. Our responsibilityis to express an opinion on these financial statements based on our audits.

 

We conducted our audits in accordance with auditing standards generallyaccepted in the United States. Those standards require that we plan and performthe audit to obtain reasonable assurance about whether the financial statementsare free of material misstatement. An audit includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financialstatements.  An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the financial statements referred to above presentfairly, in all material respects, the consolidated financial position of VistaMedical Technologies, Inc. at December 31, 2000 and 2001, and the consolidatedresults of its operations and its cash flows for each of the three years in theperiod ended December 31, 2001 in conformity with accounting principlesgenerally accepted in the United States. Also, in our opinion, the related financial statement schedules, whenconsidered in relation to the basic financial statements taken as a whole,present fairly in all material respects the information set forth therein.

 
|                  |   |   |   |   |   |   | /s/ Ernst & Young LLP |   |
|-----------------------|--------|--------|--------|--------|--------|--------|---------------------------|--------|
|                  |   |   |   |   |   |   |                      |   |
| Boston, Massachusetts |   |   |   |   |   |   |                      |   |
| February 5, 2002      |   |   |   |   |   |   |                      |   |

 

F-2

----

 

Vista MedicalTechnologies, Inc.

 

Consolidated Balance Sheets

 
|                                                                |   | **DECEMBER 31,** |      |
|---------------------------------------------------------------------|--------|------------------|-----------|
|                                                                |   | **2000**         |      | **2001** |   |
| ASSETS                                                              |   |             |      |   |   |
| Current assets:                                                     |   |             |      |   |   |
| Cash and cash equivalents                                           |   | $                | 2,589,006 |   | $ | 800,547 |   |
|                                                                |   |             |      |   |   |
| Short-term investments                                              |   | 345,224          |      | 516,855 |   |
|                                                                |   |             |      |   |   |
| Accounts receivable, net                                            |   | 1,363,915        |      | 1,862,028 |   |
|                                                                |   |             |      |   |   |
| Inventories, net                                                    |   | 1,701,668        |      | 1,094,574 |   |
|                                                                |   |             |      |   |   |
| Other current assets                                                |   | 116,868          |      | 154,827 |   |
|                                                                |   |             |      |   |   |
| Total current assets                                                |   | 6,116,681        |      | 4,428,831 |   |
|                                                                |   |             |      |   |   |
| Property and equipment, net                                         |   | 900,083          |      | 357,646 |   |
|                                                                |   |             |      |   |   |
| Patents and other assets, net                                       |   | 137,747          |      | 37,013 |   |
|                                                                |   |             |      |   |   |
| Total Assets                                                        |   | $                | 7,154,511 |   | $ | 4,823,490 |   |
|                                                                |   |             |      |   |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                           |   |             |      |   |   |
| Current liabilities:                                                |   |             |      |   |   |
|                                                                |   |             |      |   |   |
| Accounts payable                                                    |   | $                | 460,168   |   | $ | 741,003 |   |
|                                                                |   |             |      |   |   |
| Accrued compensation                                                |   | 192,660          |      | 203,413 |   |
|                                                                |   |             |      |   |   |
| Deferred revenue                                                    |   | —           |      | 416,667 |   |
|                                                                |   |             |      |   |   |
| Accrued liabilities                                                 |   | 350,521          |      | 371,319 |   |
|                                                                |   |             |      |   |   |
| Total current liabilities                                           |   | 1,003,349        |      | 1,732,402 |   |
|                                                                |   |             |      |   |   |
| Commitments and contingencies                                       |   |             |      |   |   |
|                                                                |   |             |      |   |   |
| Stockholders” equity:                                          |   |             |      |   |   |
|                                                                |   |             |      |   |   |
| Common stock, $.01 par value:                                       |   |             |      |   |   |
|                                                                |   |             |      |   |   |
| Authorized shares - 8,750,000                                       |   |             |      |   |   |
|                                                                |   |             |      |   |   |
| Issued and outstanding shares - 4,897,342 in 2000 4,913,031 in 2001 |   | 48,973           |      | 49,130 |   |
|                                                                |   |             |      |   |   |
| Additional paid-in capital                                          |   | 68,003,535       |      | 67,974,087 |   |
|                                                                |   |             |      |   |   |
| Notes receivable from stockholders                                  |   | (78,375          | )         | (78,375 | ) |
|                                                                |   |             |      |   |   |
| Deferred compensation                                               |   | (267,951         | )         | (76,305 | ) |
|                                                                |   |             |      |   |   |
| Accumulated deficit                                                 |   | (61,555,020      | )         | (64,777,449 | ) |
|                                                                |   |             |      |   |   |
| Total stockholders’ equity                                     |   | 6,151,162        |      | 3,091,088 |   |
|                                                                |   |             |      |   |   |
| Total liabilities and stockholders’ equity                     |   | $                | 7,154,511 |   | $ | 4,823,490 |   |

 

SEE ACCOMPANYING NOTES

 

F-3

----

 

Vista MedicalTechnologies, Inc.

 

Consolidated Statementsof Operations

 
|                                                         |   | **YEARS ENDED DECEMBER 31,** |        |
|--------------------------------------------------------------|--------|------------------------------|-------------|
|                                                         |   | **1999**                     |        | **2000** |   | **2001** |   |
| Revenues                                                     |   | $                            | 5,516,104   |   | $ | 6,539,213 |   | $ | 9,326,490 |   |
|                                                         |   |                         |        |   |   |   |   |
| Cost and expenses:                                           |   |                         |        |   |   |   |   |
|                                                         |   |                         |        |   |   |   |   |
| Cost of revenues                                             |   | 7,520,480                    |        | 5,946,887 |   | 6,405,340 |   |
|                                                         |   |                         |        |   |   |   |   |
| Research and development                                     |   | 3,229,330                    |        | 1,735,617 |   | 1,945,433 |   |
|                                                         |   |                         |        |   |   |   |   |
| Sales and marketing                                          |   | 2,890,436                    |        | 1,158,422 |   | 2,237,108 |   |
|                                                         |   |                         |        |   |   |   |   |
| General and administrative                                   |   | 2,177,517                    |        | 1,925,168 |   | 2,030,917 |   |
|                                                         |   |                         |        |   |   |   |   |
| Restructuring expense(recovery)                              |   | 690,269                      |        | (399,750 | ) | — |   |
|                                                         |   |                         |        |   |   |   |   |
| Total costs and expenses                                     |   | 16,508,032                   |        | 10,366,344 |   | 12,618,798 |   |
|                                                         |   |                         |        |   |   |   |   |
| Loss from operations                                         |   | (10,991,928                  | )           | (3,827,131 | ) | (3,292,308 | ) |
|                                                         |   |                         |        |   |   |   |   |
| Interest income                                              |   | 218,017                      |        | 213,245 |   | 69,879 |   |
|                                                         |   |                         |        |   |   |   |   |
| Other gains/(losses)                                         |   | 50,625                       |        | — |   | — |   |
|                                                         |   |                         |        |   |   |   |   |
| Net loss                                                     |   | $                            | (10,723,286 | ) | $ | (3,613,886 | ) | $ | (3,222,429 | ) |
|                                                         |   |                         |        |   |   |   |   |
| Basic and diluted net loss per share                         |   | $                            | (3.16       | ) | $ | (0.80 | ) | $ | (0.66 | ) |
|                                                         |   |                         |        |   |   |   |   |
| Shares used in basic and diluted loss per share computations |   | 3,398,582                    |        | 4,495,522 |   | 4,906,197 |   |

 

SEE ACCOMPANYING NOTES

 

F-4

----

 

Vista MedicalTechnologies, Inc.

 

Consolidated Statementsof Stockholders’ Equity

 
|                                                                                                   |             |      |       |   |   |                             |   |                                        |       |                       |    |                        |   |                     |    |        |   |
|--------------------------------------------------------------------------------------------------------|------------------|-----------|------------|--------|--------|----------------------------------|--------|---------------------------------------------|------------|----------------------------|---------|-----------------------------|--------|--------------------------|---------|-------------|--------|
|                                                                                                   |             |      |       |   |   | **ADDITIONAL  PAID-IN  CAPITAL** |   | **NOTES   RECEIVABLE  FROM   STOCKHOLDERS** |       | **DEFERRED  COMPENSATION** |    | **UNREALIZED  GAIN (LOSS)** |   | **ACCUMULATED  DEFICIT** |    | **TOTAL**   |   | **COMPREHEN  SIVE  LOSS** |   |
|                                                                                                   |             |      |       |   |
|                                                                                                   | **COMMON STOCK** |      |
|                                                                                                   | **SHARES**       |      | **AMOUNT** |   |
| Balance at December 31, 1998                                                                           |             | 3,393,024 |       | $      | 33,930 |                             | $      | 62,957,992                                  |       | $                          | (78,375 | )                           | $      | (1,030,420               | )       | $           | 1,211  |   | $ | (47,217,848 | ) | $ | 14,666,490 |   | $ | (16,302,814 | ) |
|                                                                                                   |             |      |       |   |   |                             |   |                                        |       |                       |    |                        |   |                     |    |        |   |   |   |
| Exercise of stock options for cash                                                                     |             | 44,539    |       | 445    |   | 42,422                           |   |                                        |       |                       |    |                        |   |                     |    | 42,867      |   |   |   |
| Issuance of stock under employee stock purchase  plan                                                  |             | 11,316    |       | 113    |   | 47,962                           |   |                                        |       |                       |    |                        |   |                     |    | 48,075      |   |   |   |
| Issuance of warrant in connection with offering                                                        |             |      |       |   |   | 10,828                           |   |                                        |       |                       |    |                        |   |                     |    | 10,828      |   |   |   |
| Deferred compensation- issuance of options to  consultants                                             |             |      |       |   |   | 87,000                           |   |                                        |       | (87,000                    | )       |                        |   |                     |    | —      |   |   |   |
| Amortization of deferred compensation                                                                  |             |      |       |   |   |                             |   |                                        |       | 540,682                    |    |                        |   |                     |    | 540,682     |   |   |   |
| Adjustments to unrealized gain (loss) on investments  resulting from realization of loss on investment |             |      |       |   |   |                             |   |                                        |       | —                     |    | (1,211                      | )      | —                   |    | (1,211      | )      | (1,211 | ) |
| Net loss                                                                                               |             |      |       |   |   |                             |   |                                        |       | —                     |    | —                      |   | (10,723,286              | )       | (10,723,286 | )      | (10,723,286 | ) |
|                                                                                                   |             |      |       |   |   |                             |   |                                        |       |                       |    |                        |   |                     |    |        |   |   |   |
| Balance at December 31, 1999                                                                           |             | 3,448,879 |       | $      | 34,488 |                             | $      | 63,146,204                                  |       | $                          | (78,375 | )                           | $      | (576,738                 | )       | $           | — |   | $ | (57,941,134 | ) | $ | 4,584,445 |   | (10,724,497 | ) |
|                                                                                                   |             |      |       |   |   |                             |   |                                        |       |                       |    |                        |   |                     |    |        |   |   |   |
| Exercise of stock options for cash                                                                     |             | 7,153     |       | 72     |   | 12,231                           |   |                                        |       |                       |    |                        |   |                     |    | 12,303      |   |   |   |
| Issuance of stock under employee stock purchase  plan                                                  |             | 22,871    |       | 229    |   | 45,263                           |   |                                        |       |                       |    |                        |   |                     |    | 45,492      |   |   |   |
| Issuance of warrant for services                                                                       |             |      |       |   |   | 103,595                          |   |                                        |       |                       |    |                        |   |                     |    | 103,595     |   |   |   |
| Deferred compensation- issuance of options to  consultants                                             |             |      |       |   |   | 52,870                           |   |                                        |       |                       | (52,870 | )                           |   |                     |    |        | — |   |   |   |
| Amortization of deferred compensation                                                                  |             |      |       |   |   |                             |   |                                        |       | 361,657                    |    |                        |   |                     |    | 361,657     |   |   |   |
| Issuance of common stock in conjunction with a  second offering at $0.85 per share                     |             | 1,413,602 |       | 14,136 |   | 4,620,061                        |   |                                        |       |                       |    |                        |   |                     |    | 4,634,197   |   |   |   |
| Issuance of common stock to employee                                                                   |             | 3,519     |       | 35     |   | 15,624                           |   |                                        |       |                       |    |                        |   |                     |    | 15,659      |   |   |   |
| Issuance of common stock to business partner                                                           |             | 1,318     |       | 13     |   | 7,687                            |   |                                        |       |                       |    |                        |   |                     |    | 7,700       |   |   |   |
| Net loss                                                                                               |             |      |       |   |   |                             |   |                                        |       |                       |    |                        |   | (3,613,886               | )       | (3,613,886  | )      | (3,613,886 | ) |
|                                                                                                   |             |      |       |   |   |                             |   |                                        |       |                       |    |                        |   |                     |    |        |   |   |   |
| Balance at December 31, 2000                                                                           |             | 4,897,342 |       | $      | 48,973 |                             | $      | 68,003,535                                  |       | $                          | (78,375 | )                           | $      | (267,951                 | )       | $           | — |   | $ | (61,555,020 | ) | $ | 6,151,162 |   | $ | (3,613,886 | ) |
|                                                                                                   |             |      |       |   |   |                             |   |                                        |       |                       |    |                        |   |                     |    |        |   |   |   |
| Exercise of stock options for cash                                                                     |             | 4,325     |       | 43     |   | 3,438                            |   |                                        |       |                       |    |                        |   |                     |    | 3,481       |   |   |   |
| Issuance of stock under employee stock purchase  plan                                                  |             | 11,364    |       | 114    |   | 21,295                           |   |                                        |       |                       |    |                        |   |                     |    | 21,409      |   |   |   |
| Forfeitures of non employee stock options                                                              |             |      |       |   |   | (21,387                          | )      |                                        |       | 21,387                     |    |                        |   |                     |    | —      |   |   |   |
| Deferred compensation- issuance of options to  consultants                                             |             |      |       |   |   | 99,900                           |   |                                        |       | (99,900                    | )       |                        |   |                     |    | —      |   |   |   |
| Amortization of deferred compensation                                                                  |             |      |       |   |   |                             |   |                                        |       | 274,787                    |    |                        |   |                     |    | 274,787     |   |   |   |
| Recapture of deferred compensation                                                                     |             |      |       |   |   | (132,694                         | )      |                                        |       | (4,628                     | )       |                        |   |                     |    | (137,325    | )      |   |   |
| Net loss                                                                                               |             |      |       |   |   |                             |   |                                        |       |                       |    |                        |   | (3,222,429               | )       | (3,222,429  | )      | (3,222,429 | ) |
| Balance at December 31, 2001                                                                           |             | $         | 4,913,031  |   | $      | 49,130                           |   | $                                           | 67,974,087 |                       | $       | (78,375                     | )      | $                        | (76,305 | )           | $      | — |   | $ | (64,777,449 | ) | $ | 3,091,088 |   | $ | (3,222,429 | ) |
|                                                                                                   |             |      |       |   |   |                             |   |                                        |       |                       |    |                        |   |                     |    |        |   |   |   |
|                                                                                                        |                  |           |            |        |        |                                  |        |                                             |            |                            |         |                             |        |                          |         |             |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

SEE ACCOMPANYING NOTES

F-5

----

 

Vista MedicalTechnologies, Inc.

 

Consolidated Statements of Cash Flows

 
|                                                                          |   | **YEARS ENDED DECEMBER 31,** |        |
|-------------------------------------------------------------------------------|--------|------------------------------|-------------|
|                                                                          |   | **1999**                     |        | **2000** |   | **2001** |   |
| **OPERATING  ACTIVITIES**                                                     |   |                         |        |   |   |   |   |
|                                                                          |   |                         |        |   |   |   |   |
| Net loss                                                                      |   | $                            | (10,723,286 | ) | $ | (3,613,886 | ) | $ | (3,222,429 | ) |
|                                                                          |   |                         |        |   |   |   |   |
| Adjustments to reconcile net loss to net cash used for operating  activities: |   |                         |        |   |   |   |   |
|                                                                          |   |                         |        |   |   |   |   |
| Depreciation and amortization                                                 |   | 1,053,674                    |        | 729,126 |   | 728,481 |   |
|                                                                          |   |                         |        |   |   |   |   |
| Amortization of premium on short-term investments                             |   | (301                         | )           | — |   | — |   |
|                                                                          |   |                         |        |   |   |   |   |
| Amortization of deferred compensation                                         |   | 540,682                      |        | 361,657 |   | 137,462 |   |
|                                                                          |   |                         |        |   |   |   |   |
| Amortization of deferred interest expense related to stock warrants           |   | 10,828                       |        | — |   | — |   |
|                                                                          |   |                         |        |   |   |   |   |
| Gain on sale of securities                                                    |   | (50,625                      | )           | — |   | — |   |
|                                                                          |   |                         |        |   |   |   |   |
| Changes in operating assets and liabilities, net of effect of  acquisitions:  |   |                         |        |   |   |   |   |
|                                                                          |   |                         |        |   |   |   |   |
| Accounts receivable                                                           |   | (424,876                     | )           | (186,806 | ) | (498,113 | ) |
|                                                                          |   |                         |        |   |   |   |   |
| Inventories                                                                   |   | 1,704,797                    |        | 947,874 |   | 607,094 |   |
|                                                                          |   |                         |        |   |   |   |   |
| Other current assets                                                          |   | (111,954                     | )           | 152,529 |   | (37,959 | ) |
|                                                                          |   |                         |        |   |   |   |   |
| Accounts payable                                                              |   | 433,080                      |        | (525,353 | ) | 280,835 |   |
|                                                                          |   |                         |        |   |   |   |   |
| Accrued compensation                                                          |   | (95,326                      | )           | (12,822 | ) | 10,753 |   |
|                                                                          |   |                         |        |   |   |   |   |
| Deferred revenue                                                              |   | —                       |        | — |   | 416,667 |   |
|                                                                          |   |                         |        |   |   |   |   |
| Accrued liabilities                                                           |   | 506,266                      |        | (1,240,754 | ) | 20,798 |   |
|                                                                          |   |                         |        |   |   |   |   |
| Net cash flows used for operating activities                                  |   | (7,157,041                   | )           | (3,388,435 | ) | (1,556,411 | ) |
|                                                                          |   |                         |        |   |   |   |   |
| **INVESTING  ACTIVITIES**                                                     |   |                         |        |   |   |   |   |
|                                                                          |   |                         |        |   |   |   |   |
| Purchases of short-term investments                                           |   | (113,299                     | )           | (56,035 | ) | (171,631 | ) |
|                                                                          |   |                         |        |   |   |   |   |
| Maturities of short-term investments                                          |   | 1,000,000                    |        | — |   | — |   |
|                                                                          |   |                         |        |   |   |   |   |
| Sale of equitable securities                                                  |   | 81,535                       |        | — |   | — |   |
|                                                                          |   |                         |        |   |   |   |   |
| Purchase of property and equipment                                            |   | (159,031                     | )           | (154,380 | ) | (85,307 | ) |
|                                                                          |   |                         |        |   |   |   |   |
| Net cash flows (used for) provided by investing activities                    |   | 809,205                      |        | (210,415 | ) | (256,938 | ) |
|                                                                          |   |                         |        |   |   |   |   |
| **FINANCING  ACTIVITIES**                                                     |   |                         |        |   |   |   |   |
|                                                                          |   |                         |        |   |   |   |   |
| Issuance of common stock, net                                                 |   | 90,942                       |        | 4,818,946 |   | 24,890 |   |
|                                                                          |   |                         |        |   |   |   |   |
| Net cash flows provided by financing activities                               |   | 90,942                       |        | 4,818,946 |   | 24,890 |   |
|                                                                          |   |                         |        |   |   |   |   |
| Net increase (decrease) in cash and cash equivalents                          |   | (6,256,894                   | )           | 1,220,096 |   | (1,788,459 | ) |
|                                                                          |   |                         |        |   |   |   |   |
| Cash and cash equivalents at beginning of year                                |   | 7,625,804                    |        | 1,368,910 |   | 2,589,006 |   |
|                                                                          |   |                         |        |   |   |   |   |
| Cash and cash equivalents at end of year                                      |   | $                            | 1,368,910   |   | $ | 2,589,006 |   | $ | 800,547 |   |

 

SEE ACCOMPANYING NOTES

 

F-6

----

 

Vista MedicalTechnologies, Inc.

 

Notes to ConsolidatedFinancial Statements

 

December 31, 2001

 

1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

ORGANIZATION AND BUSINESS ACTIVITY

 

Vista Medical Technologies, Inc. (the “Company”) was founded in July1993 and develops, manufactures and markets proprietary 3-D visualization andinformation systems that enable minimally invasive surgical solutions in  general surgical, cardiac surgical and otherselected microsurgical procedures. Vista Medical’s visualization and information systems bring togetherhead-mounted display technology originally developed for applications inmilitary aerospace by Kaiser Aerospace and Electronics Corporation andthree-dimensional imaging capability from its acquisition of Oktas, Inc.

 

During fiscal 2000 and 2001, the Company incurred significant operatinglosses, however, in June 2001, the Company entered into a Supply and PromotionAgreement with Ethicon Endo-Surgery, Inc. (EES) which will provide asignificant source of revenue in fiscal 2002.    We are also working on initiatives to extend our business, mostimmediately in the surgical obesity market, by adding new products and serviceswhich could provide new sources of revenue in fiscal 2002.  We have also obtained significant purchasecommitments from current and new customers that could have the effect ofincreasing our planned OEM sales for fiscal 2002.  In October 2001, we also obtained an additional financing sourcethrough a $2,000,000 bank line of credit facility.

 

We believe that our existing cash resources, line of credit facilityand cash from operations will meet working capital and research and developmentrequirements over the next twelve months. However, management has outlined a number of action steps that may betaken if operating results are worse than planned to ensure that we haveadequate sources of cash to meet our working capital needs.  During the second half of 2001, we receivedapproval from our Board of Directors to implement this action plan in fiscal2002 if necessary to sustain operations. The key elements of the plan are as follows:

 

•                                          Furtherreduce operating expenses by eliminating certain expenditures that are notessential to achieving critical business objectives (e.g., discretionaryspending, further development efforts);

•                                          Eliminateplanned expansion into new services and production of new products;

•                                          Deferral ofthe development phase of the next generation Head Mounted Display

•                                          Borrowagainst the company’s $2,000,000 credit facility;

 

 

The accompanying financial statements have been prepared assuming thatthe Company will continue as a going concern. The Company believes that its current cash, cash equivalents andshort-term investments of $1.3 million as of December 31, 2001, together withanticipated product revenues and interest income, will be sufficient to meetits anticipated capital requirements through December 2002.  However, certain circumstances, includingslow rate of market acceptance of its products or inability  to scale up manufacturing, would accelerateuse of these funds and require it to seek additional funds to support operatingrequirements.   There can be noassurance that the requisite fundings will be consummated in the necessary timeframe or on terms acceptable to the Company. Should the Company be unable to raise sufficient funds, the Company maybe required to curtail its operating plans and possibly relinquish rights toportions of the Company’s technology or products. In addition, increases inexpenses or delays in product development may adversely impact the Company'scash position and require further cost reductions. No assurance can be giventhat the Company will be able to operate profitably on a consistent basis inthe future.

 

F-7

----

 

Reverse Stock Split

 

On August 17,2001, the Company effected a 1 for 4 reverse stock split of the outstandingshares of common stock.  All commonshare and per share amounts have been restated to reflect the reverse stocksplit.

 

PRINCIPLES OF CONSOLIDATION

 

The consolidated financial statements include the accounts of theCompany and its wholly-owned subsidiary, Oktas, Inc. Significant intercompanyaccounts and transactions have been eliminated.

 

USE OF ESTIMATES

 

The preparation of financial statements in accordance with generallyaccepted accounting principles requires management to make estimates andassumptions that affect the amounts reported in the financial statements anddisclosures made in the accompanying notes to the consolidated financialstatements.  Actual results could differfrom those estimates.

 

REVENUE RECOGNITION

 

The Company recognizes revenue pursuant to Staff Accounting Bulletin(“SAB”) No. 101 “REVENUE RECOGNITION IN FINANCIAL STATEMENTS.”  Accordingly, revenue is recognized when allfour of the following criteria are met: (i) persuasive evidence that an arrangementexists; (ii) delivery of the product and/or services has occurred; (iii) theselling price is fixed or determinable and; (iv) collectibility is reasonablyassured.  Sales returns are estimatedbased on the historical experience and management’s expectations and arerecorded at the time product revenue is recognized.  Shipping and handling costs are included in cost of sales.

 

Revenue generated from LBS program sales are recognized upon shipmentof equipment and marketing materials and completion of the related trainingcomponent, provided that a purchase order has been received, there are nouncertainties regarding customer acceptance, the sales price is fixed anddeterminable and collectibility is deemed probable.  Sales of all other products are similarly recognized uponshipment provided that a purchase order has been received, there are nouncertainties regarding customer acceptance, the sales price is fixed anddeterminable and collectibility is deemed probable.

 

The Company receives semiannual payments as a result of fulfillingcertain obligations related to its strategic alliance agreement with EthiconEndo-Surgery, Inc. (EES).  Thesepayments are recognized as revenue on a straight-line basis over the relatedcontract term, provided that the Company has complied with all contractualobligations.

 

CASH, CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS

 

Cash equivalents and short-term investments consist of money marketfunds, certificates of deposit and commercial

paper. The Company considers all highly liquid investments withmaturities of three months or less when purchased to be cash equivalents. TheCompany evaluates the financial strength of institutions at which significantinvestments are made and believes the related credit risk is limited to an acceptablelevel.

 

The Company has adopted Statement of Financial Accounting Standards No.115, “ACCOUNTING FOR CERTAIN INVESTMENTS IN DEBT AND EQUITY SECURITIES”, andhas classified its cash equivalents and short-term investments asavailable-for-sale in accordance with that standard.  Available-for-sale securities are carried at fair value, withunrealized gains and losses, net of tax, reported in a separate component ofstockholders’ equity. At December 31, 2001, the cost of cash equivalents andshort-term investments was equivalent to fair value and the Company had nounrealized gains or losses.

 

F-8

----

 

As of December 31, 2000 and 2001, the Company’s cash, cash equivalentsand short-term investments were classified as available-for-sale and consistedof:

 
|                     |   | **2000**  |      | **2001** |
|--------------------------|--------|-----------|-----------|----------|
| Cash                     |   | $         | 310,967   |     | $ | 173 |
| Money market  funds      |   | 2,278,039 |      | 801,977  |
| Certificates of  deposit |   | 345,224   |      | 515,252  |
|                     |   | $         | 2,934,230 |     | $ | 1,317,402 |

 

All of the Company’s certificates of deposit mature in 2002.

 

CONCENTRATION OF CREDIT RISK

 

The Company provides credit, in the normal course of business, tocommercial entities that meet specified credit requirements. The Company’sprincipal customers consist of original equipment manufacturers and distributionpartners. The Company provides for losses from uncollectible accounts and suchlosses have historically not exceeded management’s expectations. As of December31, 2001, one customer comprised $500,000, or 26 % of the outstanding tradereceivables.

 

INVENTORIES

 

Inventories are stated at lower of cost (determined on a first-in,first-out basis) or market.

 

F-9

----

 

PROPERTY AND EQUIPMENT

 

Property and equipment is stated at cost. The Company provides fordepreciation on property and equipment using the straight-line method over theestimated useful lives of the assets, generally three to five years.  Marketing demonstration equipment isamortized over a one-year useful life.

 

PATENTS

 

Patents are carried at cost and amortized over five years commencing onthe date the patent is issued. The Company reviews its patents for impairmenton an annual basis or whenever events or changes in circumstances indicate thatthe carrying value of the asset would not be recoverable.

 

IMPAIRMENT OF LONG-LIVED ASSETS

 

The Company records impairment losses on long-lived assets used inoperations when indicators of impairment are present and the undiscounted cashflows estimated to be generated by those assets are less than the carryingvalue of the assets. There have not been any impairments of long-lived assetsto date.

 

RESTRUCTURING EXPENSES

 

The Company recorded credits associated with restructuring expenses of$400,000 during 2000.  The partialrecovery represents the subletting of the second floor of the Company’sfacility in Westborough, Massachusetts. During 1999, the Company recorded a $690,000 restructuring charge.

 

STOCK-BASED COMPENSATION

 

As permitted by Statement of Financial Accounting Standard (“SFAS”) No.123, the Company has elected to follow Accounting Principles Board Opinion(“APB”) No. 25, “ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES”, and relatedInterpretations in accounting for its employee stock options. Under APB 25,when the exercise price of the Company’s employee stock options equals the fairvalue of the underlying stock on the date of grant, no compensation expense isrecognized.

 

Deferred compensation for options granted to non-employees has beendetermined in accordance with SFAS 123 and Emerging Issues Task Force Issue(“EITF”) No. 96-18 as the fair value of the consideration received or the fairvalue of the equity instruments issued, whichever is more reliablymeasured.  Deferred charges for optionsgranted to non-employees are periodically remeasured as the underlying optionsvest.

 

NEW ACCOUNTING STANDARDS

 

In June 1998, the FASB issued SFAS 133, “ACCOUNTING FOR DERIVATIVEINSTRUMENTS AND HEDGING ACTIVITIES,” as amended in June 2000 by SFAS 138,  “ACCOUNTING FOR CERTAIN DERIVATIVEINSTRUMENTS AND CERTAIN HEDGING ACTIVITIES,” which requires companies torecognize all derivatives as either assets or liabilities in the balance sheetand measure such instruments at fair value. As amended by SFAS 137, “ACCOUNTING FOR DERIVATIVE INSTRUMENTS ANDHEDGING ACTIVITIES - DEFERRAL OF THE EFFECTIVE DATE OF FASB STATEMANT NO. 133,”the provisions of SFAS 133 will require adoption no later than the beginning ofthe Company’s fiscal year ending December 31, 2001.  Adoption of SFAS 133, as amended by SFAS 138, is not expected tohave a material impact on the Company’s financial statements.

 

F-10

----

 

In March 2000, the FASB issued FASB interpretation (“FIN”) No. 44,“ACCOUNTING FOR CERTAIN TRANSACTIONS INVOLVING STOCK COMPENSATION, ANINTERPRETATION OF APB OPINION NO. 25.” The interpretation requires that stock options that have been modifiedto effectively reduce the exercise price generally be accounted for asvariable.  The Company adopted theInterpretation prospectively as of July 1, 2000.  The adoption of the interpretation has not had a significantimpact on the Company’s financial statements.

 

In June 2001, the FASB issued SFAS No. 141, “Business Combinations,”and No. 142, “Goodwill and Other Intangible Assets,” effective for fiscal yearsbeginning after December 15, 2001. Under the new rules, goodwill, along with intangible assets deemed tohave indefinite lives, will no longer be amortized but will be subject toannual impairment tests in accordance with the Statements.  Also, business combinations initiated afterJune 30, 2001 must be accounted for using the purchase method ofaccounting.  Adoption of SFAS 141 and142 is not expected to have a material impact on the Company’s financialstatements.

 

2. BALANCE SHEET COMPONENTS

 

Accounts receivable consist of the following:

 
|                       |   | **December  31,** |      |
|----------------------------|--------|-------------------|-----------|
|                       |   | **2000**          |      | **2001** |   |
| Gross accounts  receivable |   | $                 | 1,377,224 |   | $ | 1,878,080 |   |
| Less: reserves             |   | (13,309           | )         | (16,052 | ) |
|                       |   | $                 | 1,363,915 |   | $ | 1,862,028 |   |

 

 

 

Inventories consists of the following:

 
|            |   | **December  31,** |      |
|-----------------|--------|-------------------|-----------|
|            |   | **2000**          |      | **2001** |   |
| Parts           |   | $                 | 2,261,441 |   | $ | 1,587,254 |   |
| Work in process |   | 461,269           |      | 170,815 |   |
| Finished goods  |   | 1,224,706         |      | 858,201 |   |
|            |   | 3,947,416         |      | 2,616,270 |   |
| Less reserves   |   | (2,245,748        | )         | (1,521,696 | ) |
|            |   | $                 | 1,701,668 |   | $ | 1,094,574 |   |

 

 

F-11

----

 

 

Property and equipment consists of the following:

 

 
|                                       |   | **December  31,** |      |
|--------------------------------------------|--------|-------------------|-----------|
|                                       |   | **2000**          |      | **2001** |   |
| Machinery and  equipment                   |   | $                 | 1,570,711 |   | $ | 1,589,759 |   |
| Office  computers, furniture and equipment |   | 1,020,282         |      | 1,052,857 |   |
| Marketing  demonstration equipment         |   | 3,336,314         |      | 3,363,820 |   |
| Leasehold  improvements                    |   | 291,740           |      | 297,918 |   |
|                                       |   | 6,219,047         |      | 6,304,354 |   |
| Less:  accumulated depreciation            |   | (5,318,964        | )         | (5,946,708 | ) |
|                                       |   | $                 | 900,083   |   | $ | 357,646 |   |

 

Patents and other assets consists of the following:

 
|                                 |   | **December  31,** |    |
|--------------------------------------|--------|-------------------|---------|
|                                 |   | **2000**          |    | **2001** |   |
| Patents and  other intangible assets |   | $                 | 229,621 |   | $ | 229,621 |   |
| Prepaid  royalties                   |   | 67,500            |    | — |   |
|                                 |   | 297,121           |    | 229,621 |   |
| Less:  accumulated amortization      |   | (159,374          | )  | (192,608 | ) |
|                                 |   | $                 | 137,747 |   | $ | 37,013 |   |

 

Accrued liabilities consists of the following:

 
|                       |   | **December  31,** |
|----------------------------|--------|-------------------|
|                       |   | **2000**          |   | **2001** |
| Customer  advances         |   | $                 | 4,173 |   | $ | — |
| Customer  warranty         |   | 105,000           |   | 182,504 |
| Miscellaneous  liabilities |   | 241,348           |   | 188,815 |
|                       |   | $                 | 350,521 |   | $ | 371,319 |

 

F-12

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3. PROMOTION AGREEMENT

 

In June 2001, the Company entered into a Supply and Promotion Agreementwith Ethicon Endo-Surgery, Inc. (EES). Under the agreement, the Company willreceive payments in return for the Company’s commitment to promote use of EES equipmentin certain training programs sponsored by the Company for the benefit of itscustomers with no obligation by the Company or its customers to purchase anyEES equipment.  The Company is alsorequired to provide limited compensation to EES sales representatives.  The agreement grants EES with the right offirst negotiation to acquire certain Company technology.  The agreement has a five year term, but maybe terminated by EES upon 90 days notice. The Company will recognize revenue ratably over the term of theagreement.  The Company recognized$583,000 of EES revenue in 2001 and had $417,000 of such revenue deferred atDecember 31, 2001.

 

4. CREDIT AGREEMENT

 

In October 2001, the Company secured a $2,000,000 line of creditfacility (the facility) with a bank for one year with automatic yearlyrenewals.  The facility is secured byqualified accounts receivable and bears interest at the rate of prime plus2%.  Borrowings under the facility arelimited to 80% of qualified accounts receivable.  There were no borrowings outstanding at December 31, 2001.

 

5. MAJOR CUSTOMERS

 

Sales toindividual customers exceeding 10% or more of revenues in the years endedDecember 31, were as follows: during 1999, Richard Wolf, GmbH, Aesculap AG andMedtronic, Inc. accounted for 45%, 28% and 16% of revenues, respectively;during 2000, Richard Wolf, GmbH and Aesculap AG accounted for 51% and 23% ofrevenues, respectively; during 2001, Richard Wolf, GmbH, Aesculap AG and Jomedaccounted for 22%, 18% and 10% of revenues, respectively.

 

6.  COMMITMENTS

 

The Company leases its corporate facilities and certain equipment underoperating leases that expire on various dates through 2003. Annual futureminimum lease payments as of December 31, 2001 are as follows:

 

| **YEAR ENDING DECEMBER 31,** |   |   |
|------------------------------|--------|--------|
| 2002                         |   | $      | 413,000 |
| 2003                         |   | 11,000 |
|                         |   | $      | 424,000 |

 

Rent expense was approximately $523,629, $360,784 and $360,624 for theyears ended December 31, 1999, 2000 and 2001, respectively.  Aggregate future minimum rentals to bereceived under noncancelable subleases as of December 31, 2001 total $113,838.

 

7. STOCKHOLDERS’ EQUITY

 

1995 STOCK OPTION PLAN

 

The Company reserved 503,902 shares of common stock under the 1995Stock Option Plan (the “1995 Plan”) for issuance to eligible employees,officers, directors, advisors and consultants. The 1995 Plan provides for thegrant of incentive and nonstatutory stock options. Terms of the stock optionagreements, including vesting requirements, are determined by the Board ofDirectors, subject to the provisions of the 1995 Plan. Options granted by theCompany generally vest over four to five years and are exercisable from thedate of grant for a period of ten years.

 

F-13

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The exercise price of the incentive stock options must equal at leastthe fair market value of the stock on the date of grant. The exercise price ofnonstatutory stock options must equal at least 85% of the fair market value ofthe stock on the date of grant. The Company has the option, in the event of terminationof employment to repurchase unvested shares issued under the 1995 Plan at theoriginal issue price.

 

The Company recorded $99,900 of deferred compensation for optionsgranted during the year ended December 31, 2001, representing the fair value ofstock options granted to Company consultants and advisors in 2001. Theseoptions vest over two to four years and the Company is recognizing thecompensation expense over the vesting period.

 

F-14

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1997 STOCK OPTION PLAN/ STOCK ISSUANCE PLAN

 

In February 1997, the Company adopted the 1997 Stock Option Plan/StockIssuance Plan (the “1997 Plan”) and reserved 705,000 shares for issuance underthe plan. The 1997 Plan incorporates the outstanding options under the 1995Plan and no further options will be granted under the 1995 Plan.

 

At the Annual Meeting held on June 7, 2001, the stockholders ratifiedan increase of 187,500 shares of common stock to our 1997 Stock Option/StockIssuance Plan.  At December 31, 2001, wehad a total of 892,500 shares reserved for issuance under our 1997 StockOption/Stock Issuance Plan.

 

At December 31,2001, 223,774 options were available for future grant.

 

The following tables summarizes stock option activity under the Plan:

 
|                          |   | **NUMBER OF  SHARES** |    | **PRICE PER  SHARE**       |   | **WEIGHTED   AVERAGE PRICE   PER SHARE** |
|-------------------------------|--------|-----------------------|---------|----------------------------|--------|------------------------------------------|
| Balance at  December 31, 1998 |   | 383,704               |    | $.80 – $57.52         |   | $                                        | 2.85 |
| Granted                       |   | 268,750               |    | $ 1.64 – $  2.52 |   | $                                        | 3.32 |
| Exercised                     |   | (44,539               | )  | $ .80 – $ 9.76        |   | $                                        | .52 |
| Canceled                      |   | (107,932              | )  | $ .80 – $ 45.52       |   | $                                        | 4.59 |
|                          |   |                  |    |                       |   |                                     |   |
| Balance at  December 31, 1999 |   | 499,983               |    | $.80 – $57.52         |   | $                                        | 7.16 |
| Granted                       |   | 89,625                |    | $1.88 – $5 .00        |   | $                                        | 3.92 |
| Exercised                     |   | (7,153                | )  | $.80 – $3.20          |   | $                                        | 1.72 |
| Canceled                      |   | (29,545               | )  | $.80 – $57.52         |   | $                                        | 16.44 |
|                          |   |                  |    |                       |   |                                     |
| Balance at  December 31, 2000 |   | 552,910               |    | $.80 – $57.52         |   | $                                        | 6.20 |
| Granted                       |   | 61,250                |    | $3.48 – $5.87         |   | $                                        | 4.23 |
| Exercised                     |   | (4,352                | )  | $.80 – $.80           |   | $                                        | .80 |
| Canceled                      |   | (45,678               | )  | $.80 – $57.50         |   | $                                        | 12.90 |
|                          |   |                  |    |                       |   |                                     |
| Balance at  December 31, 2001 |   | 564,130               |    | $.80 - $57.50              |   | $                                        | 5.50 |

 

F-15

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|                        |   | **OUTSTANDING  STOCK OPTIONS** |   | **EXERCISABLE  STOCK   OPTIONS**                                 |
|-----------------------------|--------|--------------------------------|--------|------------------------------------------------------------------|
| **RANGE OF EXERCISE PRICE** |   | **SHARES**                     |   | **WEIGHTED-  AVERAGE   REMAINING   CONTRACTUAL   LIFE (MONTHS)** |   | **WEIGHTED-  AVERAGE   EXERCISE   PRICE** |   | **SHARES** |   | **WEIGHTED   AVERAGE   EXERCISE PRICE** |
| $.80 – $2.50           |   | 339,871                        |   | 80                                                               |   | $ | 1.61 |   | 284,684 |   | $ | 1.46 |
| $4.62 – $6.12          |   | 46,736                         |   | 100                                                              |   | $ | 5.03 |   | 29,246 |   | $ | 5.09 |
| $9.00 – $9.75          |   | 26,750                         |   | 82                                                               |   | $ | 9.35 |   | 17,881 |   | $ | 9.36 |
| $16.00 – $20.25        |   | 16,250                         |   | 77                                                               |   | $ | 20.25 |   | 13,250 |   | $ | 20.25 |
| $39.50 – $45.50        |   | 31,812                         |   | 69                                                               |   | $ | 42.08 |   | 28,229 |   | $ | 41.87 |
| $57.50                      |   | 1,000                          |   | 69                                                               |   | $ | 57.50 |   | 1,000 |   | $ | 57.50 |

 

The weighted average fair value of stock options granted during 2000and 2001 was $2.60 and $3.36, respectively. The weighted average remaining lifeof the options at December 31, 2000 and 2001 was 76 and 65 months,respectively.

 

Adjusted pro forma information regarding net income is required by SFAS123, and has been determined as if the Company had accounted for its employeestock options under the fair value method of that Statement. The fair value forthese options was estimated at the date of grant using the minimum value methodfor option pricing for options granted prior to the initial public offering andthe “Black-Scholes” method for option pricing for options granted subsequent tothe initial public offering with the following weighted-average assumptions:risk-free interest rate range of 3.9% to 6.0%; dividend yield of 0%; volatilityof 231% and a weighted average expected life of the option of 2 to 5 years.

 
|                                   |   | **YEARS ENDED  DECEMBER 31,** |        |
|----------------------------------------|--------|-------------------------------|-------------|
|                                   |   | **1999**                      |        | **2000** | ** ** | **2001** | ** ** |
| Adjusted pro  forma net loss           |   | $                             | (10,827,615 | ) | $ | (3,839,136 | ) | $ | (3,510,803 | ) |
| Adjusted pro  forma net loss per share |   | $                             | (3.19       | ) | $ | (0.85 | ) | $ | (0.72 | ) |

 

In December, 2000,the company issued a warrant to a corporate partner to purchase 49,805 sharesof common stock at a price of $0.01 per share. The warrant is exercisable for seven years following the date ofissuance.  The estimated fair value ofthe warrant was $104,000, which was expensed.

 

F-16

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1997 EMPLOYEE STOCK PURCHASE PLAN

 

In February 1997, the Company adopted the 1997 Employee Stock PurchasePlan (the “Purchase Plan”) and reserved 50,000 shares for issuance under theplan.  The Purchase Plan permitseligible employees of the Company to purchase shares of common stock, atsemi-annual intervals, through periodic payroll deductions.  Payroll deductions may not exceed 10% of theparticipant’s base salary, and the purchase price per share will not be lessthan 85% of the lower of the fair market value of the common stock at eitherthe beginning or the end of the semi-annual intervals.

 

In June 2000, theCompany adopted an amendment to the Purchase Plan which increased the number ofshares of common stock authorized for issuance over the term of the PurchasePlan by an additional 50,000 shares.

 

8. INCOME TAXES

 

Deferred income taxes reflect the net tax effects of temporarydifferences between the carrying amounts of assets and liabilities forfinancial reporting purposes and the amounts used for income tax purposes.Significant     components of theCompany’s deferred tax assets as of December 31, 2000 and 2001 are shown below.A valuation allowance has been established to offset the deferred tax assets,as realization of such assets is uncertain.

 
|                                         |   | **December  31,** |       |
|----------------------------------------------|--------|-------------------|------------|
|                                         |   | **2000**          |       | **2001** | ** ** |
| Deferred tax  assets:                        |   |              |       |   |   |
| Net operating  loss carry forwards           |   | $                 | 19,746,000 |   | $ | 20,750,000 |   |
| Research and  development credits            |   | 2,491,000         |       | 2,642,000 |   |
| Capitalized  research and development        |   | 984,000           |       | 678,000 |   |
| Depreciation                                 |   | 84,000            |       | 189,000 |   |
| Inventory  reserve                           |   | 915,000           |       | 613,000 |   |
| Other, net                                   |   | 439,000           |       | 346,000 |   |
|                                         |   |              |       |   |   |
| Total deferred  tax assets                   |   | 24,659,000        |       | 25,218,000 |   |
| Valuation  allowance for deferred tax assets |   | (24,659,000       | )          | (25,218,000 | ) |
| Net deferred  taxes                          |   | $                 | —     |   | $ | — |   |

 

As the Company was part of a consolidated group prior to the change inownership in July 1995, all tax loss and tax credit carryforwards up to thedate of change in ownership have been reported by the previous consolidatedgroup. All tax loss and tax credit carryforwards reflected in the accompanyingfinancial statements reflect activity only for the period beginning July 1995and ending December 31, 2001.

 

At December 31, 2001, the Company has federal and state tax net losscarryforwards of approximately $52,311,000 and $47,541,000, respectively. Thefederal tax loss carryforwards will begin to expire in 2010.  Approximately $921,000 of the state tax losscarryforwards expired in 2001, and will continue to expire in 2002 unless previouslyutilized. At December 31, 2001, the Company also has federal and state researchtax credit carryforwards of approximately $2,108,000 and $809,000,respectively, which will begin to expire in 2010 unless previously utilized.

 

F-17

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The difference between the federal and state tax loss carryforwards isprimarily attributable to the capitalization of research and developmentexpenses for California tax purposes and 55 percent limitation on Californialoss carryforwards.

 

In accordance with Sections 382 and 383 of the Internal Revenue Code, achange in ownership of greater than 50 percent of a corporation within athree-year period will place an annual limitation on the Company’s ability toutilize its existing tax loss and tax credit carryforwards.

 

9. TRANSACTIONS WITH RELATED PARTIES

 

The Company had a technology strategic alliance and a manufacturingsupply agreement with a former Kaiser Aerospace subsidiary (now a subsidiary ofRockwell Collins), a partnership which included senior executives of KaiserAerospace, and was a significant shareholder of the Company for the developmentand manufacturing of certain of the company’s proprietary products. Under theterms of the agreements,  KaiserAerospace provided development and consulting services and a minimum of 75% ofcertain of the Company’s product requirements provided certain competitivecriteria were met.  Payments made toKaiser under these arrangements totaled approximately $793,000, $0 and $0 for theyears ending December 31, 1999, 2000 and 2001, respectively.  In December 1997, the Company entered into alicense agreement with a subsidiary of Kaiser Aerospace whereby Kaiser acquireda license and was required to pay royalties for sale of head mounted displays,derived from Vista’s  developments, innon-medical market segments. All agreements with Kaiser Aerospace have beenterminated and all amounts due or payable have been paid.

 

10. QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)

 

The following is a summary of the results of operations for the yearsended December 31, 2000 and 2001:

 
|                |   | **2000**     |       |
|---------------------|--------|--------------|------------|
|                |   | **March 31** |       | **June 30** |   | **September  30** |   | **December  31** |   |
| Revenue             |   | $            | 1,796,886  |   | $ | 1,521,987 |   | $ | 1,518,717 |   | $ | 1,701,613 |   |
| Cost of revenues    |   | $            | 1,539,846  |   | $ | 1,447,812 |   | $ | 1,396,657 |   | $ | 1,562,571 |   |
| Net loss            |   | $            | (996,966   | ) | $ | (966,303 | ) | $ | (153,713 | ) | $ | (1,496,902 | ) |
| Net loss per  share |   | $            | (0.29      | ) | $ | (0.20 | ) | $ | (0.03 | ) | $ | (0.31 | ) |
|                |   |         |       |   |   |   |   |   |   |
|                |   | **2001**     | ** ** |
|                |   | **March 31** |       | **June 30** | ** ** | **September  30** | ** ** | **December  31** | ** ** |
| Revenue             |   | $            | 1,932,532  |   | $ | 2,072,069 |   | $ | 2,281,486 |   | $ | 3,040,403 |   |
| Cost of Revenues    |   | $            | 1,531,906  |   | $ | 1,731,686 |   | $ | 1,353,226 |   | $ | 1,788,522 |   |
| Net loss            |   | $            | (940,214   | ) | $ | (1,271,695 | ) | $ | (870,755 | ) | $ | (139,765 | ) |
| Net loss per  share |   | $            | (0.19      | ) | $ | (0.26 | ) | $ | (0.18 | ) | $ | (0.03 | ) |

 

F-18

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SCHEDULE II

 

VISTA MEDICALTECHNOLOGIES, INC.

 

VALUATION AND QUALIFYINGACCOUNTS

 
| **Reserve for  Obsolete and  Unusable Inventory** |   | **Balance at    Beginning of   Period** |    | **Charged to  Costs and   Expenses** |   | **Deductions** |   | **Balance  at End  of Period** |
|---------------------------------------------------|--------|-----------------------------------------|---------|--------------------------------------|--------|----------------|--------|--------------------------------|
| Year ended  December 31, 1999                     |   | $                                       | 934,000 |                                 | $      | 1,878,963      |   | $                              | (193,893 | ) | $ | 2,619,070 |
| Year ended  December 31, 2000                     |   | 2,619,070                               |    | 787,821                              |   | (1,161,143     | )      | 2,245,748                      |
| Year ended  December 31, 2001                     |   | 2,245,748                               |    | 71,375                               |   | (795,427       | )      | 1,521,696                      |
|                                                   |        |                                         |         |                                      |        |                |        |                                |  |  |  |  |

 

S-1

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