**UNITEDSTATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

**FORM 10-K**

 

**ý****                                                                                ****ANNUAL REPORT PURSUANTTO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 (FEE REQUIRED)**

 

**For fiscalyear ended December 31, 2003**

 

**OR**

 

**TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934(NO FEE REQUIRED)**

 

**For the transition period from          to         .**

 

**Commission File Number:  0-22743**

 

**VISTA MEDICAL TECHNOLOGIES, INC.**

(Exact name of Registrant as specified in its charter)

 

| **DELAWARE**                                                    |   | **94-3184035**                        |
|-----------------------------------------------------------------|--------|---------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |   | (I.R.S. Employer  Identification No.) |

 

**2101 Faraday Avenue,Carlsbad, California 92008**

(Address of principal executive offices)

 

**(760) 603-9120**

(Registrant’s telephone number, including area code)

 

Securities registered pursuant to Section12(b) of the Act:  **None**

 

Securities registered pursuant to Section12(g)  of the Act:  **CommonStock, par value $.01 per share**

 

Indicate bycheck mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes  ý  No  o

 

Indicate bycheck mark whether the registrant is an accelerated filer (as defined in Rule12b-2 of the Exchange Act).   Yes  o  No  ý

 

Indicate bycheck mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to the bestof registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or any amendment tothis Form 10-K.  o

 

The aggregatemarket value of the voting stock held by nonaffiliates of the registrant as ofJune 30, 2003 was approximately $9,186,632. For the purposes of this calculation, shares owned by officers,directors and 10% stockholders known to the registrant have been deemed to beowned by affiliates. This determination of affiliate status is not necessarilya conclusive determination for other purposes.

 

The number ofshares outstanding of the registrant’s Common Stock as of March 24, 2004 was5,011,241.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions ofRegistrant’s Proxy Statement for the Annual Meeting of Stockholders scheduledto be held on May 24, 2004, to be filed on or about April 26, 2004 and referredto herein as the “Proxy Statement” are incorporated as provided in Part III.

 

Certainexhibits filed with the Registrant’s prior registration statements and forms10-Q and 10-K are incorporated herein by reference into Part III of thisReport.

 

 

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**VistaMedical Technologies, Inc.Form 10-KFor the Fiscal Year Ended December 31, 2003**

** **

**TABLEOF 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 |
|      | Item 9A   | Controls and Procedures |
|      |      |   |
| 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 |
|      | Item 14.  | Principal Accountant Fees and Services |
|      |      |   |
| Part IV   |      |
|      | Item  15. | Exhibits,  Financial Statement Schedules, and Reports on Form 8-K |
|      |      | Signatures |
|      |      | Index to Consolidated Financial Statements |

 

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PART I

 

Forward Looking Statements

 

From time totime we have made and may continue to make “forward looking statements” withinthe meaning of the federal securities laws. This report on Form 10-K may contain forward-looking statements.  These statements, which represent ourexpectations or beliefs concerning various future events, may contain wordssuch as “expects,” “anticipates,” “intends,” “plans,” “believes,” “estimates,”or other words indicating future results. Actual results may differ materially from results anticipated in suchforward-looking statements.  We assumeno obligation to update any forward-looking statements to reflect events orcircumstances arising after the date of this report.

 

You shouldcarefully review and consider the various disclosures in this report regardingfactors that could cause actual results to differ materially from anticipatedresults, including those factors under the caption “Risks and Uncertainties” atpages 19 through 27 below, and elsewhere in this report.

 

Item 1.BUSINESS

 

OVERVIEW OF OUR BUSINESS

 

We operate two business units. The Obesity Surgical and Medical Management Services business (operatedvia our wholly-owned subsidiary, VOW Solutions, Inc.), based in Carlsbad, CA,provides services to physicians and hospitals involved in the surgicaltreatment of morbid obesity.  Ourservices include management of our original product offering, the LaparoscopicBariatric Surgery Preceptorship, a comprehensive introduction to starting aminimally invasive gastric bypass surgical program.  We now offer, in addition, systems, consulting and programmanagement services which enable the efficient operation of obesity surgeryprograms.  The Visualization Technologybusiness, based in Westborough, MA, develops, manufactures and markets productsthat provide information to physicians performing minimally invasive generalsurgical, cardiac surgical and other selected endoscopic and interventionalprocedures.  Our technology productscombine a head mounted display with video cameras to provide surgeons withcritical visual information during complex minimally invasive procedures, andalso incorporate the benefit of viewing complementary information in avoice-controlled, picture-in-picture format, to facilitate real-time decisionmaking during surgery.  TheVisualization Technology business also manufactures compact, high-resolutionendoscopic cameras for original equipment manufacturer customers and strategicpartners.  On December 22, 2003 wesigned an agreement to sell the Visualization Technology business to VikingSystems, Inc., (see pages 9 and10 for a description of the terms of thetransaction), subject to the approval of our stockholders.

 

**Backgroundto Obesity Surgery and Medical Management Services (VOW Solutions, Inc.)**

 

The vision of our VOW Solutions business isto enable healthcare providers and organizations in the ongoing evolution ofthe highest standards of treatment and services to optimize the quality of lifefor morbidly obese patients.  Ourmission is to deliver the leading management portfolio of services and productsfor the clinical and business development of continually successful obesitysurgery programs.

 

We believethat our VOW products and services can be instrumental in the implementationand/or optimization of a hospital’s successful bariatric surgery program.  The obesity epidemic is not over; in fact,the rate of increase of severely obese Americans is accelerating.  Obesity-related comorbidities cost theUnited States healthcare system $102 billion annually.  Laparoscopic gastric bypass surgery safelyand effectively treats morbidly obese patients by allowing them to eliminate96% of their comorbidities and average an 80% loss of excess body weight, withinone year of surgery.  VOW Solutions’complement of bariatric management and consulting services positions a hospitalto enter the field of bariatric surgery, as well as to optimize the operationand efficiency of an existing program for future growth.

 

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**Backgroundto Visualization Technology Products**

 

***Minimallyinvasive surgery***

 

Thedevelopment and subsequent widespread adoption of minimally invasive surgicalprocedures have revolutionized many surgical fields, including general surgery,orthopedics, gynecology and urology. Minimally invasive surgical procedures are performed throughstrategically placed ports or mini-incisions as opposed to using largeincisions 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, 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.

 

***Minimallyinvasive microsurgery***

 

Minimallyinvasive microsurgery is an extension of minimally invasive surgery, characterizedby greater complexity and precision. Minimally invasive microsurgical procedures have been made possibleprimarily by recent advances in medical technology.  These procedures are usually performed in very confined areas ofthe body, involve critical parts of the body, and often require dissection,reconstruction and removal of body parts. As a result of the inherent complexity involved in these procedures, webelieve that for surgeons to adopt the procedures, they must have access tospecialized instruments and technology, including technology which will providethem with better visualization of the procedure being performed.  Examples of minimally invasive microsurgeryare emerging in general surgery and cardiac surgery, as well as in the fields ofgynecology and urology.

 

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

 

*Conventional treatments.*

 

Minimally invasive procedures are wellaccepted in general surgery, gynecology and urology.  For less complex procedures such as gallbladder removal or tuballigation, minimally invasive endoscopic techniques have become the standard ofcare, being used in approximately 90% of cases.  For more complex procedures, however, the penetration rate ofminimally invasive techniques has been considerably lower, principally becausethe instruments available make performance of the procedure difficult anduncomfortable.

 

*Minimally invasive microsurgery*.

 

Complex minimally invasive procedures ingeneral surgery, gynecology and urology have evolved relatively slowly over thepast few years, slowing considerably from 1995.  According to the journal *InVivo*, “Though the benefits of MIS(Minimally Invasive Surgery) – shorter recovery times and less pain and traumafor the patient, lower costs and less time lost from work for employers — arewidely applicable across a range of procedures, realizing those benefits beyondgallbladder removal proved tricky. Worse, for more complex procedures, MIS actually proved problematic forsurgeons, notwithstanding its other benefits — longer procedure times, moredifficult manipulation of instruments, more torturous ergonomics.”

 

*The Vista Medical solution*.

 

We believe that the general technologyrequired to drive renewed growth in complex minimally invasive procedures forgeneral surgery is now being undertaken by many companies in fieldscomplementary to ours, for example, in surgical robotics, electrosurgery andsurgical instrument design.  We believethat our advanced visualization and information technology will contribute tothis renewed growth by providing the surgeon with enhanced depth perceptionwhen performing complicated, physically intricate tasks, and will provide thesurgeon with the ability to view additional information in a voice-controlled,picture-in-picture format, to facilitate real-time decision making during aprocedure.  We believe that conventional2-D visualization systems compromise the ability of a surgeon to maneuver,especially in complex reconstructive surgery, and that our natural 3-D picturewill provide the surgeon with an advantage in these cases.

 

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**Our Business Strategy**

 

Our business strategy is to become the leading pure play disease statemanagement company focused on the treatment of morbid obesity.  We will become pure-play when we havecompleted the sale of the Visualization Technology business, which is pendingshareholder approval.

 

When wefounded our company in 1993 it was primarily to develop advanced visualizationtechnologies for complex minimally invasive surgical procedures and it wasthrough the application of this technology in laparoscopic gastric bypasssurgery that we subsequently developed our portfolio of consulting products andservices for the initiation, operation and management of Obesity Surgery Programs.  Since early 2003, our VisualizationTechnology business, located in Westborough, Massachusetts, and our ObesitySurgery and Medical Management Services business unit (now incorporated in awholly owned subsidiary VOW Solutions, Inc.), located in Carlsbad, California,have functioned as individual business units. We intend to become a niche health care services pure play, focused onthe disease state management of chronic or morbid obesity.  The business structure of the company, afterthe planned divestiture of the Visualization Technology business, will be asfollows:

 

 

**Business Overview**

 

We have been a key participant in the rapid development of thebariatric surgery market over the past three years. Bariatrics is the medicalscience of weight reduction and nutrition; bariatric surgery, a sub-specialtyof general surgery, is focused on surgical weight reduction solutions for theseverely, or morbidly, obese.  Since2000, our company has played a key role in the development of some 80 bariatricsurgical centers, based in hospitals across the United States, which providestate-of-art treatment, specifically the minimally invasive gastric bypass rouxen-y procedure, to morbidly obese patients. We have provided this customer base with feasibility analysis,customized projections, implementation support, clinical training, marketingand general consulting services.  Demandfrom hospitals and surgeons wishing to start or expand bariatric surgicalprograms, is driven by surging patient demand for a viable, long-term solutionto the problem of chronic morbid obesity (defined as at least 100 pounds aboveideal body weight).  Patient demand,fortified by the very public success in weight loss of several celebrities, hasdriven the number of gastric bypass procedures from 60,000 in 2001 to 103,000in 2003, with 250,000 projected for 2005. By 2005 there will be approximately 1 million post-surgical gastricbypass patients.  Obesity is nowformally a disease state, classified as an epidemic by the Centers for DiseaseControl and described, in company with its frequent co-morbidity, Type IIDiabetes, as “the epidemic disease of the 21st Century.”  And the data keep getting worse:  In October 2003, the Archives of InternalMedicine published an article showing that the number of extremely obeseAmericans (those more than 100 pounds above ideal body weight – the primecandidates for surgical intervention) has quadrupled since the mid-1980s,accelerating at twice the rate of “ordinary” obesity.

 

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We believe that, to meet the demand for the present form of obesitysurgery, and to offer patients the choice of many new therapies which areeither recently introduced or in development, requires a rapid expansion ofhigh quality surgical programs and related patient medical and wellnessservices.  This comprehensive approachis not the present organizational norm and we believe, based on both marketunderstanding and research, that there is an opportunity to leverage Vista’spresent expertise, market position and relationships, into a turnkey programmanagement solution (the VOW Centers.) This represents a natural extension of our current business model intothe direct management of the infrastructure of obesity surgical care via anational network of company-owned clinical programs, established initially inpartnership with hospitals, surgeons and physicians, and, in due course, withinsurance companies, managed care and employers.

 

**Market Opportunity**

 

Obesity is defined as an excessively high amount of body fat or adiposetissue in relation to lean body mass. Weight standards are most often determined by the Body Mass Index (BMI),a measure expressing the ratio of weight-to-height.  Individuals with a BMI of 25 to 29.9 are considered overweight; aBMI of 30 or more is considered obese, and 40 or more is very severely, ormorbidly, obese.  The Centers forDisease Control and Prevention (CDC) speak of “an epidemic of obesity” in the UnitedStates, with prevalence increasing to 24% of the adult population in 2003, from12% in 1991.  The increase in obesitycuts across all ages, racial and ethnic groups, and both genders.  Obesity, which studies show is associatedwith an increased risk of diabetes, as well as other serious co-morbidities, isa major cause of mortality.  It isestimated that 600,000 US adults die each year from causes related toobesity.  The Surgeon-General, in a Callto Action, estimates that the economic cost of obesity in the United States wasabout $117 billion in 2000.  A recentRand Corp. study found that the health care costs linked to obesity are nowgreater than those related to smoking or alcohol abuse and “is like aging 20years” when measured by the onset of chronic medical problems.  The fact that obesity is a major healthproblem, and is increasing at an alarming rate has been well publicized in themedia.  Also, the IRS, in a recentruling, declared that obesity is a disease in its own right and that the costof physician-directed weight loss programs may be included as a deductiblemedical expense.  Given that medicalexpenses may be deducted only to the extent that they exceed 7.5% of adjustedgross income, and that less than 5% of taxpayers deduct medical expenses, theruling is probably significant more as an indicator of governmental concernover obesity than as a financial incentive to individuals.  As a further example of this, the federalagency in charge of Medicaid and Medicare is conducting a review to determinewhether it should consider obesity as a disease.  However, the principle that obesity itself is a disease, and notmerely a symptom or precursor of a disease, is still a contentious issue, andsuch a classification is resisted by private insurers.

 

Among other issues which attract attention in terms of marketawareness, perhaps the one with the most serious implications for the future isthe rate of growth of obesity in the young, which manifests itself as anacceleration of the incidence of diabetes and other serious health conditions,such as early onset of heart disease. Also, obesity is becoming recognizedoutside the United States as a looming problem; for example, the rate of growthof obesity in Germany and the United Kingdom is the same as the U.S.  The problem is not yet epidemic, becauseeach country’s starting point was lower than the U.S., but the trend is clearand inexorable.  The World HealthOrganization has coined the term “globesity” to highlight the problem.

 

For the morbidly obese, the most significant factor is that virtuallyevery weight loss remedy, apart from weight loss surgery, has been proven to beineffective on a consistent basis over time. The plain fact is that once a person is morbidly obese, reversing thetrend, with an adequate and permanent result, has been nearly impossible inmost cases.  It is this reality whichthat accounts for the growth trajectory of gastric bypass surgery, as it is theonly option with a long-term, proven track record of success.  And, it is the refinement of the procedureover recent years, most notably the patient benefits of a minimally invasiveapproach, which are helping to convince increasing numbers of the morbidlyobese that it is the only valid option. The surgical community has also embraced bariatric surgery, which itoriginally questioned as a legitimate procedure.  The discipline is now endorsed by the National Institute ofHealth Consensus Conference and the American Society of Bariatric Surgery(ASBS) is recognized by the American College of Surgeons.  The outcome is that modern bariatricsurgery, while not risk-free, has a complication rate similar to other majorabdominal operations, and, of course, offers patients dramatic and sustainedweight loss.

 

In summary, approximately 60 million American adults are clinicallyobese, and of these as many as 13-16 million are potential candidates for asurgical weight-loss procedure.  Thatis, according to the National Institutes of Health (NIH) guideline, they have aBMI of 40 or above, (5-6 million) or a BMI of 35 or above, with seriouscomplicating conditions such as diabetes, hypertension, cardiopulmonaryproblems, asthma, sleep apnea, or arthritis and joint problems (8-10 million).

 

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**Our Strategy**

 

Our goal over the next five years (2004-2008) is to become a leadingprovider of consulting and management services to bariatric surgical programsthus becoming a national leader in the provision of state-of-the-art care tothe morbidly obese patient seeking a surgical solution to effectively lose, andmaintain the loss of, an adequate amount of weight.  We then plan to leverage the market platform that our centersprovide to extend our provision of care to obese patients who are not candidatesfor surgery, and to market our consulting services and back-office systemscapability to other bariatric surgical programs.  We intend to realize these objectives through the execution ofthe following strategies:

 

•                  Fast-track VOWCenter roll-out by offering an outsource formula to hospitals and surgeons thatreduces their risk, minimizes their direct investment in programinfrastructure, and maximizes profitable patient flow.

 

•                  Institutebest-practice surgical protocols as a consistent, uniform standard and maintainrigorous clinical oversight.

 

•                  Develop areputation for patient-friendly organizational efficiency, contributing to anextremely valuable national brand image.

 

•                  Maximize theadministrative efficiencies inherent in the centralizing of key back-officefunctions with standardized operating systems.

 

•                  Continue tobuild our management consulting products and services, both as a profitablesource of increased revenues and as a means of further developing stature inbariatrics, and thereby referrals.

 

•                  Build aconsumer-based business, with nutritional supplements specific forpost-surgical gastric bypass patients.

 

***Fast-track VOWCcenter roll-out by offering hospitals and surgeons a reduced-risk outsourceformula. ***Weplan to offer a fast-track approach to the initial set-up of a top-classbariatric surgical center (or the takeover of management of an existingprogram), with a fully developed operating plan ready for implementation.  Our approach covers everything necessary tomaximizing operations in the shortest possible time; our experience shows thatthe ramp-up time for surgeons and hospitals to initiate operation of a newbariatric surgical program can be as long as six months, and even after thatprogress can be slow because of the organizational complexity of the task.  The VOW concept simplifies and standardizesthe formula, leaving our partner surgeons and hospitals and affiliated surgeonsto do what they do best – operate on and provide in-patient care.  Of course, the start up time for existingprograms is considerably shorter since there are usually patients already inprocess.  We feel that existing programswhich that have managed to attain a modest patient volume (50-150 cases ayear), and which want to grow faster, will be our near-term targets.

 

***Institute best-practicesurgical protocols***.  Our experience with the Laparoscopic Bariatric Surgical (LBS)Preceptorship has permitted us, under the direction of our Clinical Faculty, tooffer the most comprehensive surgical training course in state-of-the-artlaparoscopic gastric bypass surgery which is available anywhere.  This training program will be available tosurgeons who affiliate with VOW; the training process will also includesubsequent proctoring by our faculty during cases.

 

***Maximizing operatingefficiencies***. This is key to leveraging economies of scale, and we will devoteconsiderable resources to the further development of a standardized operatingsystem.  Also, many of the functions ofa bariatric surgical program are common and can be centralized for efficiencyand cost-saving reasons.  We believethat independent programs will need to generate very high patient volumes tojustify the infrastructure necessary to operate efficiently.  For example, we know of existing programswith case volumes in the 750-1000 per year which have between 30 and 50staff.  As many as 75% of theseemployees are performing functions which that would be handled centrally in theVOW model.  We believe that in a veryshort time low volume programs will simply be unable to compete effectivelywith high-volume centrally managed programs.

 

***Develop a brandimage of Efficient Empathy***.  We believe that this element of our strategyis extremely important.

 

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Our patients come from a group that has suffered psychologicallybecause of their illness, often at the hands of the medical profession.  We have learned by our experience to datethat the provision of a sensitive and supportive environment is vital tosuccess.  At the same time, the processtowards surgery must be efficient: There are many steps in the process, and it is easy for patients tobecome lost or discouraged if the system, and the staff dealing with them, ishaphazard in its approach.  Standardizedsystems across all managed programs are designed to shepherd patients throughthe process with Efficient Empathy.

 

***Develop and leverageour consulting business***.  Our consulting business, originally based on provision ofclinical training in laparoscopic gastric bypass surgery, has expanded toinclude management, operational, financial and marketing services.  It is this business that has created ourreputation within bariatrics and has given us a total customer base ofapproximately 80 hospitals (including some 60 LBS Centers).  We are currently developing new and valuableproducts to meet the emerging needs of the maturing developing market.  We expect our consulting business to be afertile source of referrals for VOW partnerships.

 

***Build our consumerbusiness***. Gastric bypass patients have a lifelong need for *specialized* vitamins andnutritional support.  We are alreadymarketing VistaVitamins as a specific solution to the bariatrics-vitamin issueand intend to increase marketing and distribution efforts and extend theproduct line.  With one millionpost-surgical gastric bypass patients by 2005, we estimate that the totalavailable annual market is $500 million.

 

**Our Solution:  VOW Centers (Vista Obesity to WellnessCenters)**

 

The number of physicians who are treating bariatric patients isgrowing, in both the medical and the surgical arena.  For example, it is estimated that there are now between 1,200 to1,500 active bariatric surgeons. However, the expertise essential for high-volume patient acquisition,and the infrastructure required for quality patient care at these levels areoften beyond the scope, or the willingness to invest, of many programs.  Even when bariatric centers are establishedin conjunction with a supportive hospital, the proper staffing, knowledge andtime required to efficiently market, educate, collect a comprehensive medicaland diet history, verify insurance and obtain the necessary authorizations canbe a management challenge, one that many simply cannot handlecost-effectively.  Many of thesefunctions are much more efficiently and effectively handled in a centralizedfashion (where one centralized department handles the work for dozens ofprograms).  A focused team ofprofessionals with centralized support is necessary to properly handle all theunique and multifaceted issues involved in securing and serving large numbers(400 — 500 cases per year) of bariatric patients.

 

It is for this reason that we have seen increasing interest fromhospitals and physicians in an outsourced management solution which brings togetherthe resources necessary for establishment and/or operation of successfulmedical and surgical bariatric programs. Our plan is to offer ongoing hands-on management support to such medicalproviders by delivering a cost-effective outsourced solution to the provisionof multi-disciplinary medical and surgical care to a high volume of morbidlyobese patients.

 

The VOW Center concept is designed to overcome the traditional barriersexperienced by physicians and hospitals when attempting to put into operationnew, or to maximize existing, niche product lines.  Our approach will free physicians from nearly all administrativefunctions, allowing them to devote all their time and energy to patient careand the operating suite.  Similarly, theVOW Center will assist and/or provide the hospital with the expertise,personnel and core infrastructure needed to operate a fast track, successful,high-volume bariatric center.

 

We plan to enter into a strategic partnership agreement with physiciansand hospitals to establish VOW Centers. To date, we have entered into one strategic partnership agreement.

** **

**VOW ConsultingServices**

**Our Solution:**

Our consulting services are organized as specific “products” whichoffer clients a basic standardized set of deliverables, with severalcustomizable options.  Our primaryconsulting products are as follows:

 

*Blueprint*

 

An expert VOW team conducts a detailed assessment and evaluation of anexisting, or projected, bariatric surgery program and provides recommendationsfor improvement.  A comprehensivewritten report, the “Blueprint,” examines a program’s vision, sensitivity,operational capabilities, business/financial model, marketing potential andinformation management, offering a firm feasibility analysis.  Our proprietary financial model projectsprogram-related revenue, expenses, reimbursement and capitalizationrequirements under current operating conditions.  The

 

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recommendations include marketing strategies derived from the NationalHealth and Nutrition Examination Survey and the United States Census,customized to a bariatric program’s geographic location and patient population.

 

*ImplementationConsulting Service*

Our implementation team spends up to 2 days on-site educating a hospitaland program staff on the five fundamental phases of a successful bariatricsurgery program.  This preparationemphasizes patient introduction, the pre-admission/operative period, theperi-operative period, post-operative recovery and discharge, andpost-discharge care.  Included in theservice are templates, tools and training components integral to the ongoingviability of a program.  These includeinformed consent, sensitivity and in-patient/office training, insuranceauthorization strategies, marketing tools, patient education, diet counseling,physical therapy and exercise plans and support group coaching.  Subsequent to this service, a program’sstaff will be educated in delivering efficient, best-practice care in asensitive environment.

 

*LaparoscopicBariatric Surgery (LBS) Preceptorship*

The LBS Preceptorship allows a hospital team to more quickly implementminimally invasive laparoscopic gastric bypass surgery into a hospital andsurgical practice.  The 3-4 day courseincludes clinical observation, laboratory training, surgical lecture anddidactic training that incorporates cadaver experience.  The Preceptorship includes observation bythe entire OR team (primary surgeon, first assistant, surgical technician andnursing circulator) and is a CME and CEU accredited event.

 

*OptimizationConsulting Service*

VOW’s Optimization Consulting Service concentrates on improving anexisting bariatric surgery program’s efficiency, effectiveness andprofitability.  Recommendations focus onoptimizing the finance, operations and marketing of a bariatric program.  The work-up of a program’s financialperformance will facilitate an institutional ability to resolve issuespertaining to revenue, expense attribution, capital investments and payorenvironment.  Operationalrecommendations target a patient’s migration through the program and improvedefficiency between surgeons and the hospital. The comprehensive marketing assessment analyzes referral patterns,per-patient cost of acquisition and overall effectiveness.

 

*Marketing Materials*

The Bariatric Surgery Marketing Materials help to create and/or enhancea hospital’s identity as a Bariatric Center, lending credibility and fosteringcommunity support.  The media toolsenable a hospital to capitalize on varying marketing venues including publicspeaking, print publications, radio and television.  The package includes a customizable “Decision of a Lifetime”video and television advertisement, a 60-second radio advertisement, a printadvertisement, a patient brochure and a community lecture template onPowerPoint.  The message focuses on theexperience of a diverse group of actual patients, their life-long struggle withobesity, and the satisfaction they have realized through gastric bypasssurgery.

 

**VisualizationTechnology Business**

 

Terms of transaction to sell the Visualization Technology Business

 

We enteredinto an Asset Purchase Agreement with Viking Systems Inc. regarding the sale ofall the assets of the Visualization Technology Business on December 22, 2003,subject to the approval of our stockholders. Viking and its principals are not affiliated with us; and our officers,directors, and, to our knowledge, principal stockholders are not affiliatedwith Viking.  Viking formerly conducteda software business, but those operations were unsuccessful.  Recently, a group of investors purchasedcontrol of Viking, with the approval of Viking’s Board of Directors, andViking’s current business plan, as stated in its public filings with the SEC,is to engage in the medical device market.

 

The mostmaterial terms of the Asset Sale are as follows:

 

•                  Viking willpurchase all assets (and assume most liabilities) related to the VisualizationTechnology business in exchange for a combination of cash, stock, and futureroyalty payments.  Specifically:

 

•                  Viking will payus a minimum of $132,000 of cash at closing; Viking will also pay us in cashthe difference between the Accounts Receivable and Accounts Payable of the

 

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Visualization Technology business at the time of closing.  Total cash payable at closing will notexceed $400,000.  As of February 29,2004, the difference between our Accounts Receivable and Accounts Payable was$204,688.  Nonetheless, we expect thisbalance to be zero or negative at closing, resulting in cash at closing of$132,000.

 

•                  Viking willissue to us shares of its common stock equal to ten percent (10%) of thefully-diluted shares of Vikings stock.

 

•                  We will enterinto a License Agreement with Viking pursuant to which we will exclusivelylicense to Viking all intellectual property and product rights used inoperation of the licensed business.  Inexchange for this license grant, Viking will pay us royalties over the nextfive (5) years based on sales of the licensed products by Viking.  The License Agreement will contain minimumroyalties of $150,000 in year one, $300,000 in each of years two, three andfour, and $375,000 in year five.  Theroyalties payable by Viking are capped at a maximum of $4,500,000 in theaggregate over the five year period.  Wewill retain ownership of all intellectual property and product rights under theLicense Agreement until at least the minimum royalty obligations have beensatisfied, at which point we will transfer ownership to Viking.

 

•                  At closing wewill consign our current inventory of products and parts to Viking and will bereimbursed for the value of that inventory, if and when used, over the courseof the twelve months after closing.  Anyinventory not sold by Viking during this one year period will be transferred toViking,

 

We operatetheVisualization Technology business entirely out of our Westborough,Massachusetts location.  As a result,this entire facility, less a few selected assets of minimal dollar value, willbe transferred to Viking in connection with the Asset Sale.

 

We have agreedto indemnify Viking for any breach of the representations and warranties madeby us in the Asset Purchase Agreement and for any liability not assumed byViking.

 

We intend touse the proceeds from the Asset Sale to fund our Obesity Surgery and MedicalServices business.  We may also use someof the proceeds (other than cash received at closing) to redeem shares of ourSeries A Preferred Stock or to encourage the conversion of such stock tocommons stock.  This transaction issubject to the approval of our stockholders. A proxy concerning this transaction has been filed with the SEC and,when approved by the SEC, will be distributed to our stockholders.

 

**Ourtechnology:**

 

Our technologyprovides a 3-D visualization solution to the inherent vision restrictions anddemands of minimally invasive microsurgery. It provides the surgeon with a clear view of the anatomy with theability to view additional information in a voice-controlled, picture-in-pictureformat, which facilitates real-time decision making during the procedure.  Our technology is based on the followingprinciples which we believe are essential in advancing the techniques ofminimally invasive microsurgery.  Webelieve these principles offer several key advantages over other visualizationapproaches:

 

*3-D View*.  The surgeon’s ability to view the principalimage of the anatomy in 3-D provides the accurate depth perception necessary sothat vital anatomical structures are accurately identified and located.  This improves safety, precision and speed ofthe procedure.  Also, a secondary videoimage is available in picture-in-picture format, when the procedure willbenefit from two different views of the anatomy.

 

*High Resolution Images*.  The availability of a high resolution imagewhich can be electronically managed by the surgeon significantly enhances thesurgeon’s ability to differentiate critical tissues in a confined setting andperform intricate dissection, reconstruction and removal.

* *

*Access*.  The surgeon benefits from technology whichallows for the direct insertion of a camera into the body cavities or organsand provides high quality images that are easy to see and understand.

* *

*Ergonomics*.  Due to the complex and time consuming natureof minimally invasive microsurgery procedures, the surgeon requires anergonomic display system which allows comfortable operating posture and

 

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maximizes hand-eye coordinationwithout strain.

* *

*InformationIntegration*. The surgeon’s access to critical monitoring and diagnostic data, ondemand, in real time and integrated with the anatomical image within thesurgeon’s visual field, enhances procedure performance.

 

***Head mounted display***

 

The headmounted display was originally developed for critical applications in militaryaerospace by Kaiser Aerospace.  Wesubsequently determined that the head mounted display was the optimal solutionto the challenge of displaying information during minimally invasivemicrosurgery.  The fundamentaltechnology and human factors experience incorporated in our surgical headmounted display is the result of substantial investment and development byKaiser Aerospace, originally for military applications.  This human factors knowledge, derived frommany years of analysis of the display characteristics which enable pilotsperforming critical physical tasks to simultaneously absorb and react tocrucial information, is a key element in our head mounted display design.  Kaiser’s original know-how and technicalknowledge have been transferred to us under our development agreement withKaiser Electro-Optics, Inc., a subsidiary of Kaiser Aerospace.  We have performed significant additionaldevelopment work, and have proprietary rights, in the surgical head mounteddisplay design.  Our head mounteddisplay, which we believe is the first specifically designed for surgical use,provides 3-D visualization of small delicate body structures, has thecapability of integrating relevant data and presents the image seen by thesurgeon in the most correct, intuitive and ergonomic way.  Wearing the head mounted display, thesurgeon can also perform surgery “in-line”—meaning with the eyes, hands, instrumentsand subject in-line.  In-line surgerycannot be performed when the surgeon is observing the anatomy on aremotely-positioned video monitor.

 

Our headmounted display is a proprietary, lightweight, high resolution display designedto allow the surgeon to view information on demand, whether such information isgenerated from attached endoscopes, microscopes or monitoring equipment in theoperating room.  Further enhancements tothe head mounted display allow for voice-activated control and informationdisplay from other diagnostic equipment in the hospital or from remotelocations via information networks.  Thevideo display in the head mounted display is fixed in relation to the surgeon’seyes, but his or her head may move into any position necessary forcomfort.  The display design allows thesurgeon to have a constant view of the surgical anatomy required for theprocedure as well as full awareness of the surroundings in the operatingroom.  Our head mounted display isdesigned to provide a true 3-D image by replicating the way the human visualsystem works—left and right acquired images are delivered directly to left andright liquid crystal displays.  It isalso designed so that it can be worn with conventional surgical loupes.

*** ***

***Three-dimensional image acquisition***

 

We believethat three-dimensional visualization capability is critical in minimallyinvasive microsurgery procedures such as cardiac surgery and complex endoscopicprocedures in general surgery, gynecology and urology.  Our technology for stereo visualizationconsists of the following proprietary elements: the optical system, the stereocamera and the stereo processor.  Thefirst 3-D endoscopic optical system we employed was originally developed andpatented by a noted optical designer, Mr. H. McKinley, and is licensedexclusively to us for medical applications. We have also acquired rights to the stereo endoscope technology of CarlZeiss.  Both McKinley and Zeiss systemsare designed to replicate the view that the surgeon would have if theprocedures were being performed open and he or she had direct sight of theanatomy.  We believe that the McKinleyand Zeiss optical systems will provide us with a significant and enduringcompetitive advantage because they provide natural depth perception, and can bepackaged with twin cameras in a very compact design.  The twin cameras acquire the image in a manner analogous to thehuman visual system.

 

Our technologycan package the twin cameras in two ways. In the first method, a stereo micro-camera is attached to the end of aflexible or rigid guide which can then be inserted directly into the bodycavity and organs.  The image isdirectly captured by the camera chips without being transmitted throughmultiple rod lenses as in a conventional design.  The elimination of optical surfaces produces several importantadvantages, including increased image quality, improved contrast, betterreliability and improved ability to sterilize the instrument.  Alternatively, for applications wherestandard endoscopic surgical technique remains preferable, a stereo camera ismounted externally on a stereo endoscope. This second method is the current preferred approach for the proceduresin which

 

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we are primarily involved. Theimage acquired by either approach is then processed for display by controlelectronics which we have developed. The controller also includes image management features which contributesignificantly to procedure performance, such as dual image presentation andpicture-in-picture.

*** ***

***Information management***

 

Medicine is aninformation rich discipline, but the ability of a surgeon to obtain relevantinformation in real-time during a procedure has not been developed to thelevels attained, for example, in military aviation.  The head mounted display is designed to give the surgeonreal-time access on demand to critical information integrated with theanatomical images generated by our camera systems.  In addition to real-time display, the information can be storedor transmitted within the hospital or transmitted to remote locations fortraining, advisory or administrative purposes. The applications software to control this flow of information is a keyelement in our long-term product strategy which positions visualization withinthe context of a total information management system for the surgeon.

** **

**VisualizationTechnology Products**

 

We developproducts based on our core technology and product platform described above,that are customized for the specific general surgical, cardiac surgical andother procedures to which they are directed. Our product lines are as follows:

*** ***

***EndoSite: 3-D visualization and information system for general surgery and othercomplex endoscopic procedures***

 

The mostrecent application of our platform technology is complex procedures in generalsurgery.  Our first public demonstrationof this platform was in October 2002, principally targeted at the emergingprocedure of minimally invasive gastric bypass to control morbid obesity, butalso applicable to many emerging minimally invasive procedures. Our advancedvisualization system is designed to be modular and consists of the followingmajor components:

 
| **Component**                 |   | **Description**                                                                                                                                                                                                                                        |
|-------------------------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                          |   |                                                                                                                                                                                                                                                   |
| Head mounted display/EndoSite |   | 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.                                                                                                                                                                                                  |

 

All necessary510(k) clearances which are required to market the components of theEndoSite have been received.

 

***OEM Endoscopic Cameras***

 

Our endoscopiccameras are the state-of-the-art in two-dimensional endoscopic imaging.  We currently

 

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manufacture compact, highresolution endoscopic cameras for original equipment manufacture customers andstrategic partners.

 

**StrategicAlliances**

 

Our strategyis to leverage our position in both our business units by forming strategicalliances with corporations and research institutions with respect to thedistribution, technology and marketing of some of our products. We have enteredinto strategic partnering arrangements as follows:

*** ***

***EthiconEndo-Surgery, Inc.***

*** ***

***In June 2001, we entered into an agreement with EthiconEndo-Surgery, Inc. (EES) providing that the companies will work together indeveloping the surgical weight reduction market.  This alliance primarily involves sales and marketing support byEES of our Laparascopic Bariatric Surgery (LBS) program and other Vistaproducts and services related to the surgical weight reduction market.  Also, we will receive payments in return forthe Company’s commitment to promote use of EES equipment in certain trainingprograms sponsored by the Company for the benefit of its customers with noobligation by the Company or its customers to purchase***anyEES equipment. This original agreement expiredin November 2003, and a new agreement with EES was entered into for thedevelopment of optimization programs, and is currently in force until December1, 2004.

*** ***

***KaiserElectro-Optics***

 

In July 1995,we entered into a Manufacturing Supply Agreement with Kaiser Electro-Optics, asubsidiary of Kaiser Aerospace.  Thisagreement was then amended in December 1997. In December 1997, we entered into a Technology Strategic Alliance:Memorandum of Understanding with Kaiser Aerospace, which superseded a similaragreement entered into with Kaiser Electro-Optics in July 1995.  The technology strategic alliance providesthat Kaiser Aerospace will cooperate with us in joint development programsrelated to our current generation head mounted display to be negotiated on anarms-length and project-by-project basis for a five-year term.  We will also contract with KaiserElectro-Optics for development and manufacturing services related to the headmounted display, including initial production quantities.  The manufacturing supply agreement withKaiser Electro-Optics provides that they will be our preferred supplier for afive-year period for not less than 75% of our requirements for the opticalsubassembly of the head mounted display, provided that pricing and other termsare competitive and mutually agreed upon. Under the technology strategic alliance with Kaiser Aerospace, theygranted us a right of first refusal to exclusively license independently developednew technology or devices for medical applications.  Reciprocally, in December 1997, we entered into a LicenseAgreement with Kaiser Aerospace under which we exclusively licensed to KaiserAerospace the right to manufacture and distribute industrial and professionalversions of our head mounted display in market segments other than medicine inreturn for an up-front payment and royalties based on sales.

 

In June 2000,we retroactively waived future payment of specified royalties by Kaiserprovided for in the license agreement with them.  In return, Kaiser agreed to cancel an order that we had placedfor a shipment of head mounted display units, without additional cost tous.  In late 2001, we started workingwith Kaiser Electro-Optics (now a subsidiary of Rockwell Collins) ondevelopment of an upgraded head mounted display, which was introduced to themarket in October, 2002.  We continue towork with Kaiser Electro-Optics on the next generation head mounted display,which we have displayed in prototype form at meetings during 2003.

** **

**LicenseAgreements**

 

We havelicensed aspects of our technology from third parties.

*** ***

***McKinley Optics, Inc.***

 

In September1995, Mr. H. McKinley and McKinley Optics, Inc. granted to us a perpetual,exclusive, worldwide license in the medical field to make, have made, modify,use, lease, market, sell and otherwise distribute certain endoscopes and othermedical products incorporating a stereo objective lens and/or a relay lensconfiguration.  Under the terms of thislicense agreement, we are obligated to pay McKinley an annual maintenanceroyalty, additional royalties upon the sale of certain numbers of systemsincorporating the McKinley technology and royalties on net sales of productsincorporating the McKinley technology. The exclusive license granted under this

 

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agreement becomes anon-exclusive license, or, under certain circumstances, the license terminates,in the event we fail to pay any royalties. In addition, we have the right to terminate the agreement with limitednotice.

 

***Fuji***

 

In June 1996,Fuji Film Co. and Fuji Photo Optical Co., Ltd. granted to us a non-exclusivelicense to certain optical zoom technology for use in endoscopes.  We are obligated to pay royalties on netsales of products in the United States which incorporate Fuji’stechnology.  We have not incorporatedany of this technology into our products and thus have not been obligated forany royalties as of the date of this annual report. Fuji may terminate theagreement if we do not cure any violation of the agreement within a limitedperiod of time.  Our failure to retainrights to these technologies may negatively impact our business.

 

***Carl Zeiss***

 

In August1998, Carl Zeiss granted us non-exclusive rights in the medical field to threeissued United States patents and four pending foreign applications.  We are obligated to pay Zeiss royalties onsales of products incorporating the licensed technology and to providetechnical and applications support, at our current rates for such services, toparties that previously acquired Zeiss’ Endo-Live Stereo Endoscope, nowdiscontinued.  Zeiss may terminate theagreement in the event of a material breach by us which is not cured within alimited period of time.  Our failure toretain rights to the Zeiss patents may negatively impact our business.

 

**Intellectualproperty protection**

 

We rely on acombination of technical leadership, patent, trade secret, copyright andtrademark protection and nondisclosure agreements to protect our proprietaryrights.  As of December 31, 2003, we hadexclusive ownership rights to 14 issued United States patents covering variousaspects of our devices and systems. Furthermore, as of the same date, we had exclusive rights in the medicalfield to 6 issued United States patents, 5 issued foreign patents and 3 pendingforeign applications covering various aspects of our devices and systems.  In 1998 we additionally obtained from CarlZeiss non-exclusive rights to three issued United States patents and fourpending foreign applications.  We intendto file additional patent applications in the future.  The failure of such patents to issue could damage our ability toprotect our proprietary information.

 

Our futuresuccess will depend, in part, on our ability to continue to develop patentableproducts, enforce our patents and obtain patent protection for our productsboth in the United States and in other countries.  The patent positions of medical device companies, however, aregenerally uncertain and involve complex legal and factual questions.  We are not certain that patents will issuefrom any patent applications owned by or licensed to us or that, if patents doissue, the claims allowed will be sufficiently broad to protect our technology.  In addition, we cannot assure you that any issuedpatents owned by or licensed to us will not be challenged, invalidated orcircumvented, or that the rights granted thereunder will provide us withcompetitive advantages.

 

The medicaldevice industry has been characterized by extensive litigation regardingpatents and other intellectual property rights.  Litigation, which would result in substantial expense, may benecessary to enforce any patents issued or licensed to us and/or to determinethe scope and validity of proprietary rights of third parties or whether ourproducts, processes or procedures infringe any such third-party proprietaryrights.  We may also have to participatein interference proceedings declared by the United States Patent and TrademarkOffice, which could result in substantial expense, to determine the priority ofinventions covered by our issued United States patents or pending patentapplications.  Furthermore, we may haveto participate at substantial cost in International Trade Commissionproceedings to enjoin importation of products which would compete unfairly withour products.  Any adverse outcome ofany patent litigation, including interference proceedings, could subject us tosignificant liabilities to third parties, require disputed rights to belicensed from or to third parties or require us to cease using the technologyin dispute.

 

Patentapplications in the United States are maintained in secrecy until a patentissues, and patent applications in foreign countries are maintained in secrecyfor a period of time after filing. After such period of time, and usually before the grant of the patent,patent applications in foreign countries are published.  While publication of discoveries in the scientificor patent literature tends to lag behind actual discoveries and the filing ofrelated patent applications, such publication may enable our competitors toascertain the areas of research or development in which we are engaged prior toour receipt of patent protection in the United States or foreign

 

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countries relating to suchresearch or development.

 

In general,the development of visualization and information systems is intenselycompetitive.  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 additional proprietary rights relating to products orprocesses used or proposed to be used by us. We cannot assure you that third parties will not assert infringementclaims against us in the future or that any such assertions will not result incostly litigation or require us to obtain a license to intellectual propertyrights of such parties.  Any suchlicenses may not be available on acceptable terms, if at all.  Furthermore, parties making such claims maybe able to obtain injunctive or other equitable relief that could effectivelyblock our ability to make, use, sell or otherwise practice our intellectualproperty (whether or not patented or described in pending patent applications),or to further develop or commercialize our products in the United States andabroad and could result in the award of substantial damages.  Defense of any lawsuit or failure to obtainany such license could damage our business.

 

We rely onunpatented trade secrets to protect our proprietary technology, and noassurance can be given that others will not independently develop or otherwiseacquire the same or substantially equivalent technologies or otherwise gainaccess to our proprietary technology or disclose such technology or that we canultimately protect our 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 which effortsby others will result in patents and the effect on us of the issuance of suchpatents is unknown.  Failure to obtainor maintain patent and trade secret protection, for any reason, couldnegatively impact our business.

 

**GovernmentalRegulation: Health Care Services**

 

As a participant in the health careservices industry the Company is, and the VOW Centers, if any, will be subjectto extensive and frequently changing regulation under many laws administered bygovernmental entities at the federal, state and local levels.  Althoughthe Company believes it is in compliance in all material respects with suchlaws, rules and regulations, if a determination is made that the Company was inmaterial violation of such laws, rules or regulations, its business, financialposition or results of operations could be materially adversely affected.Furthermore,  the Company’sparticipating surgeons and hospitals are also subject to a wide variety of lawsand regulations that could affect the nature and scope of their relationshipswith us.

 

Laws regulating health careproviders cover a broad array of subjects.  For example, theconfidentiality of patient medical information and the circumstances underwhich such information may be released for inclusion in the Company’s databases,or released by the Company to third parties, are subject to substantialregulation by the federal and state authorities.  These laws andregulations govern both the disclosure and the use of confidential patientmedical information and are evolving rapidly.  The Company has establishedan implementation plan that it believes complies with the existing federal andstate laws and regulations.

 

In addition, provisions of theSocial Security Act prohibit, among other things, paying or offering to pay anyremuneration in exchange for the referral of patients to a person participatingin, or for the order, purchase or recommendation of items or services that aresubject to reimbursement by Medicare, Medicaid and similar other federal orstate health care programs.  Sanctions for violation of these provisionsinclude criminal penalties and civil sanctions, including fines and possibleexclusion from federal and state health care programs.  Most states have also enacted illegalremuneration laws that are similar to the federal laws, but typically apply toreferrals for services reimbursed by all third-party payors, not just federalor state health programs.  These laws are applicable to the Company’sfinancial relationships with, and any marketing or other promotional activitiesinvolving, our participating surgeons and hospitals.

 

Moreover, all states regulate theprovision of health care services, including those to be provided at theCenters, and require participating surgeons and hospitals to be licensed and tocomply with applicable laws and regulations.  It is

 

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also possible that some statescurrently, or in the future may, require licensure or registration of certainof the Company’s operations, and may further regulate how the company doesbusiness.  Finally, various states regulate the operations of anadvertising and referral service for physicians, and may require registrationof such services with a state agency as well as compliance with variousrequirements on how they conduct business and structure their relationshipswith participating providers.

 

The Company is unable to predictthe future course of such federal, state and local regulation orlegislation.  Changes in the regulatoryframework could have a material adverse effect on the Company’s business,financial position or results of operation.

 

**GovernmentalRegulation: Medical Devices**

 

Themanufacture and sale of medical devices intended for commercial distributionare subject to extensive governmental regulation in the United States.  Medical devices are regulated in the UnitedStates primarily by the FDA and, to a lesser extent, by certain stateagencies.  Generally, medical devicesrequire pre-market clearance or pre-market approval prior to commercialdistribution.  In addition, certainmaterial changes or modifications to, and changes in intended use of, medicaldevices also are subject to FDA review and clearance or approval.  The FDA regulates the research, testing,manufacture, safety, effectiveness, labeling, storage, record keeping,promotion and distribution of medical devices in the United States and theexport of unapproved medical devices from the United States to othercountries.  Non-compliance withapplicable requirements can result in failure of the government to grantpre-market clearance or approval for devices, withdrawal or suspension ofapproval, total or partial suspension of production, fines, injunctions, civilpenalties, refunds, recall or seizure of products and criminal prosecution.

 

***Device Classes***

 

In the UnitedStates, medical devices are classified into one of three classes, Class I, IIor III, on the basis of the controls deemed by the FDA to be necessary toreasonably ensure their safety and effectiveness.  Our products to date have either been classified as Class I orClass II devices.

 

Class Idevices are subject to general controls, such as establishment registration andproduct listing, labeling, adulteration and misbranding provisions and medicaldevice reporting requirements and, unless exempt, to pre-market notificationand adherence to “good manufacturing practice” standards.  Class II devices are subject to generalcontrols and special controls, such as performance standards, post-marketsurveillance, patient registries and FDA guidelines.  Generally, Class III devices are those that must receivepre-market approval by the FDA to ensure their safety and effectiveness.  Examples of Class III products include,life-sustaining, life-supporting and implantable or new devices which have notbeen found to be substantially equivalent to legally marketed devices.  Class III devices ordinarily requireclinical testing to ensure safety and effectiveness and FDA clearance prior tomarketing and distribution.  The FDAalso has the authority to require clinical testing of Class I and Class IIdevices.  A pre-market approvalapplication must be filed if a proposed device is not substantially equivalentto a legally marketed predicate device or if it is a Class III device for whichthe FDA has called for such application. A pre-market approval application typically takes several years to beapproved by the FDA.

 

***Device approval***

 

Generally,before a new device can be introduced into the market in the United States, themanufacturer or distributor must obtain FDA clearance of a 510(k) notificationor submission and approval of a pre-market approval application.  If a medical device manufacturer ordistributor can establish that a device is “substantially equivalent” to a legallymarketed Class I or Class II device, or to a Class III device for which the FDAhas not called for a pre-market approval, the manufacturer or distributor maymarket the device upon receipt of an FDA order determining such a devicesubstantially equivalent to a predicate device.  The 510(k) notification may need to be supported by appropriateperformance, clinical or testing data establishing the claim of substantialequivalence.  The FDA requires arigorous demonstration of substantial equivalence.

 

Followingsubmission of the 510(k) notification, the manufacturer or distributor may notplace the device into commercial distribution until an FDA substantialequivalence order permitting the marketing of a device is received by theperson who submitted the 510(k) notification. At this time, the FDA typically responds to the submission of a 510(k)notification within 90 to 200 days.  AnFDA letter may declare that the device is substantially equivalent to a legallymarketed device and allow the proposed device to be marketed in the United

 

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States.  The FDA, however, may determine that theproposed device is not substantially equivalent or require further information,including clinical data, to make a determination regarding substantialequivalence.  Such determination orrequest for additional information will delay market introduction of theproduct that is the subject of the 510(k) notification.

 

***Investigational device exemption application***

 

All clinicalinvestigations involving the use of an unapproved or uncleared device on humansto determine the safety or effectiveness of the device must be conducted inaccordance with the 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 productswhich we manufacture or distribute are subject to continuing regulation by theFDA, which includes record keeping requirements, reporting of adverseexperience with the use of the device, “good manufacturing” requirements andpost-market surveillance, and may include post-market registry and otheractions deemed necessary by the FDA.  Anew 510(k), pre-market approval or pre-market approval supplement is alsorequired when a medical device manufacturer makes a change or modification to alegally marketed device that could significantly affect the safety oreffectiveness of the device, or where there is a major change or modificationin the intended use 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 ofmedical device products outside the United States are subject to foreignregulatory requirements that vary from country to country.  The time required to obtain approvalsrequired by foreign countries may be longer or shorter than that required forFDA clearance, and requirements for licensing may differ from FDArequirements.  Our failure to complywith regulatory requirements 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.

 

**Marketingand Sales**

 

Our VOWSolutions business markets directly to hospitals and surgeons via our in-housesales and marketing departments and in conjunction with the Bariatric AccountManagement force of our strategic partner, Ethicon Endo-Surgery.  Our Visualization Technology businessmarkets Endosite systems directly to hospitals performing bariatric surgery,and other products via our OEM arrangements.

 

***International sales***

 

Our VOWSolutions business currently does not market outside the United States,although we are evaluating opportunities in international markets for futureexpansion.  Our Visualization Technologybusiness markets via our OEM customers in markets throughout the world.  We also have limited internationaldistribution of our Endosite system.

 

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**Competition**

 

Our VOWSolutions business competes in a developing marketplace with a variety ofcompanies, none of which, to our knowledge, has an identical mix of productsand services.  However, there arecompanies which have products and services which compete with some part of ouroffering.  We expect competition toincrease in the obesity surgery market as companies recognize the potential ofthe market.  We believe that we have aunique business model, but there can be no assurance that we can prevent othercompanies from adopting it or that we will be successful in competing with suchcompanies.

 

The medicaldevice market in which the Visualization Technology business competes ischaracterized by intensive development efforts and rapidly advancingtechnology.  Our future success willdepend, in large part, upon our ability to anticipate and keep pace withadvancing technology and competing innovations.  There can be no assurance, however, that we will be successful inidentifying, developing and marketing new products or enhancing our existingproducts.  Although several companiescompete with aspects of our visualization product line, we believe there is nosingle company which offers a complete and independent 3-D visualization andinformation system specifically directed at minimally invasive microsurgicalapplications.  In addition, we are notaware of any other true 3-D head-mounted display which has been cleared formarketing in surgical applications by the FDA. We do believe that a number of large companies, some of which havesignificantly greater financial, manufacturing, marketing, distribution andtechnical resources and experience than ours, are focusing on the developmentof advanced visualization products for minimally invasive microsurgery.  There can be no assurance that we will besuccessful in competing with any such companies.

 

**ClinicalAdvisory Boards**

 

We consultfrequently with surgeons in the specialties we are addressing.  We have previously established clinicaladvisory boards made up of leading surgeons, one focused on minimally invasivecardiac surgery, and a general advisory board focused on other minimallyinvasive specialties.  Members of ourclinical advisory boards consult with us exclusively in the field ofvisualization, but are free to consult with other non-competing instrumentationcompanies and are employed elsewhere on a full-time basis.  Our clinical advisory boards are intended toact as a clinical reference for us and to provide access to potential trainingsites for our visualization products.

 

**Employees**

 

As of February28, 2004, we had 35 full-time employees, of whom two hold an advanceddegree.  None of our employees isrepresented by a collective bargaining agreement, nor have we experienced workstoppages.  We believe our relations withour employees are good.

 

**WebSite Access to SEC Filings**

 

We maintain an Internet website at *www.vistamt.com*.  We make available free of charge on our Internet website ourannual reports on Form 10-K, quarterly reports on Form 10-Q, current reports onForm 8-K, and amendments to those reports filed or furnished pursuant toSection 13(a) or 15(d) of the Exchange Act as soon as reasonably practicableafter we electronically file such material with, or furnish it to, the SEC.

 

**Recent Developments**

 

In February 2004, we raised an additional $588,000 in equity capitalthrough the sale of shares of our common stock.  We sold these shares in a private placement to several accreditedinvestors.  In connection with thesesales, we agreed to register the shares of common stock within 90 days ofclosing of the private placement.

 

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RISKS AND UNCERTAINTIES

 

You shouldconsider the following factors carefully in evaluating an investment in VistaMedical in addition to the other information in this report.  You are cautioned that the statements in thisannual report that are not descriptions of historical facts may beforward-looking statements that are subject to risks and uncertainties.  Our actual results could differ materiallyfrom those currently anticipated due to a number of factors, including thoseidentified in this section and elsewhere in this annual report.  We undertake no obligation to releasepublicly the results of any revisions to these forward-looking statements toreflect events or circumstances arising after the date of this annual report.  The following discussion should be read inconjunction with our consolidated financial statements and notes thereto.

 

**We will requireadditional funding to meet current commitments, continue the development of ourbusiness and maintain our ability to continue as a going concern.  This includes the divestiture, as planned,of the Visualization Technology business.**

 

At December31, 2003, we had cash, cash equivalents and short-term investments of$636,000.  We believe that these cashresources, together with cash from operations and the additional equity raisedin February 2004, will not be sufficient resources to operate our businessbeyond June 2004.  This cash requirementis very serious.  We need additionalfunding to meet current commitments and continue development of ourbusiness.  Our current cash resourceswill only allow us to continue our business at its current levels for ourimmediate needs.  If we do not receiveadditional funding, our ability to continue as a going concern cannot be assured.  We are also dependent on the divestiture ofthe Visualization Technology business to reduce operating costs and providecash.  This divestiture is in processand is scheduled to close in mid-April, subject to the approval of ourstockholders.  There can be no assurancethat this transaction will close on time, or at all.

 

**Failure to divest ourVisualization Technology business will create a serious cash drain on ourcompany.**

 

VOW Solutions is one of our two existing business units.  We plan to divest the other business unit,Visualization Technology, however , if not divested as planned, this unit willbe a cash drain on us and may prevent us from executing our VOW Solutionsbusiness plan as intended.

 

**We are not in compliance with the requirements to maintainthe listing of our common stock on The Nasdaq SmallCap Market and have receivednotification of de-listing, which could negatively affect the liquidity of ourstock and our ability to raise capital.**

 

The quantitative standards for continued listing on the Nasdaq SmallCapMarket requires a company to have stockholders’ equity of at least $2,500,000(or satisfy alternative requirements). Failure to comply with these requirements subjects a company to de-listingproceedings.  We received notification on March 1, 2004 of aNasdaq Staff Determination indicating that we fail to comply with theStockholders’ Equity requirement for continued listing set forth in MarketplaceRule 4310(c)(2)(B), and that our common stock is, therefore, subject todelisting from the Nasdaq SmallCap Market. We have requested a hearing before a Nasdaq Listing Qualifications Panelto review the Staff Determination.  Thisrequest for a hearing has stayed the delisting of the Company’s common stockpending the Panel’s decision.  A hearinghas been scheduled for April 1, 2004, at which we intend to present a plan forregaining compliance with continued listing requirements.  There can be no assurance, however, that thePanel will grant our request for continued listing.

 

**As a company, we donot have direct experience in the ownership and management of health careservice businesses**.

 

As a company we do not have direct experience in the management ofbariatric surgical programs.  We havebeen involved in the development of bariatric surgical programs since 2000, buthave never directly managed these programs. As such, we have only a limited and indirect operating history uponwhich an evaluation of our prospects can be based.  Our prospects therefore, must be considered in light of therisks, expenses and difficulties frequently encountered by companies in theirearly stages of development, particularly when involved in new and rapidlyevolving markets.  To address theserisks, we must, among other things, respond to competitive developments andattract, retain and motivate qualified staff. There can be no assurance that we will be successful in addressing suchrisks or in implementing our business strategy.  There can be no assurance that we will be able to achieve orsustain revenue growth or profitability.

 

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**Roll-out of our VOWCenters depends on our entering into agreements with hospitals and surgeons;the time to conclude these agreements may be extended and thereby delay orprevent the implementation of our strategy.**

 

We plan to set up our VOW Centers in conjunction with hospitals andsurgeons.  There can be no assurancethat negotiations for the establishment of these Centers will not be protractedor impossible to negotiate satisfactorily. Because of our limited experience in negotiating and concluding theseagreements, we cannot accurately predict the time and expense involved, and anyunexpected delays could prevent the execution of our strategic plan.

 

**We may needadditional funding for our future operating plans beyond that currentlycontemplated.  These funds may not beavailable on acceptable terms, if at all.**

 

Any deviation in the timing or projected cash flow of our VOW Centersmay cause us to require additional investment capital.  There can be no assurance that such capitalwill be available to the extent required, or at all.  The amount of additional capital which we may need to raise willdepend on many factors, including:

 

•                  the extent towhich the VOW Centers and other services gain market acceptance,

•                  the speed withwhich we can execute our plan;

•                  the levels ofreimbursement for procedures performed;

•                  the extent ofcompetition.

 

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

 

Since ourformation in July 1993, and as of December 31, 2003, we have incurredcumulative net losses of $68.1 million. We expect to incur losses for the foreseeable future.  We may never achieve or sustainprofitability in the future.  Even if weachieve profitability, we may not be able to sustain it on an ongoing basis.

 

**The terms of our March, 2003, preferred stockfinancing confer senior rights on the holders of Series A Convertible PreferredStock, and these rights may impair the interests of our common stockholders orimpact our results of operations.**

 

We issued1,000,000 shares of our Series A Convertible Preferred Stock (the “Series AShares”) in March, 2003, which were created pursuant to the terms of aCertificate of Designations, for an aggregate of $950,000 in cash.  In connection with this financing, thepurchasers of Series A Shares were granted several significant rights senior tothe rights of holders of our common stock. Among other rights, in the event of a liquidation, dissolution orwinding up of our company (including consolidations, mergers or other sales),holders of Series A Shares will be entitled to receive up to $3.80 per shareheld by them, in preference to any distribution to the holders of commonstock.  Also, pursuant to theCertificate of Designations, we must obtain the consent of the holders of atleast two-thirds of the outstanding Series A Shares in order to undertakecertain actions, including capital expenditures and the issuance ofsecurities.  Additionally, for so longas any Series A Shares remain outstanding after three hundred ninety (390) daysfollowing the initial issuance of any Series A Shares, the holders of Series AShares will be entitled to elect the greater of (i) two members of our Board ofDirectors or (ii) twenty-five percent (25%) of the total members of our Boardof Directors.  As a result, in the eventwe do not achieve the criteria necessary for us to redeem some or all of theSeries A Shares (e.g., a sale of all or a portion of our VisualizationTechnology business), the holders of Series A Shares will have the right tocontrol at least one-fourth of the seats on our Board of Directors.

 

The Series AShares are subject to redemption by us upon certain events.  If we choose to redeem some or all of theSeries A Shares pursuant to the terms of our Certificate of Designations, wewill use cash that would otherwise fund our business operations.  Although we may believe that such aredemption is the best available business option, valuable cash wouldnonetheless be consumed, which would impact our ability to fund operations orgrow our business.

 

The holders of Series A Shares are also entitled to require us toregister their shares.  We may berequired to register their shares on Form S-3 within 30 days after request, andin any event prior to four hundred (400) days following the initial issuance ofSeries A Shares.  This registration willconsume management time and effort as well as some cash resources.  We have not yet registered these shares andmay be subject to monetary penalties.

 

**We need to increasemarket awareness and acceptance of our products and services.**

 

To our company’s knowledge, the comprehensive services offered by ourVOW Solutions business Centers have not

 

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been available to date on anational level.  In order to accomplishour strategic and business plans, we will have to quickly and effectivelyincrease market awareness of our services and convince doctors, hospitals andpatients of the benefits of our services. Among other things, this will require that we:

 

•                  increaseawareness of the availability of our services;

•                  strengthen ourbrand name to combat competition;

•                  continue toupgrade and expand our services; and

•                  increaseawareness of the availability of surgery as a means of treating obesity.

 

We intend to make our services available to doctors and hospitalsnationally, which will compound the difficulty of meeting our objectives.  We cannot assure you that we will be able toaccomplish these objectives.

 

**After establishingVOW Centers, we must continue to prove our value proposition.**

 

In order to successfully negotiate and complete agreements with doctorsand hospitals to establish VOW Centers, we will present them with our projectedrevenues and operational metrics.  Wecannot assure you that our projections will prove accurate or that we will beable to provide the anticipated metrics. Our projections are based on limited input and operational history andfailure to meet such projections will negatively impact our business.

 

**The provision ofhealth care services is subject to considerable regulation by state and federalagencies.**

 

The Centers will need to comply with many laws and regulations, bothstate and federal, which govern the provision of health care services.  If they fail to comply with any such lawsand regulations, then the penalties involved could be serious, time-consumingfor management and expensive. Inexperience in health care services could contribute to an inadvertentbreach of laws or regulations.

 

**We operate in acompetitive market; new technologies, procedures, or pharmaceuticals couldradically change the modality of treatment of morbid obesity and negativelyimpact the economics of our obesity surgery business**.

 

The market for products and services that address obesity iscompetitive and new offerings and technologies are becoming availableregularly.  We are aware of severaldevelopments, primarily involving nerve stimulation or balloon technology,which may come to the market in the next few years.  These devices would be implanted or placed in a relatively simpleendoscopic procedure.  If they prove tobe more effective than gastric bypass surgery in curing morbid obesity, thenthe economic structure of the industry and the Centers could be negativelyimpacted.  Also, many pharmaceuticalcompanies are researching drug therapies for combating obesity.  If they prove successful in finding a moreeffective solution for morbid obesity than gastric bypass surgery, then demandfor surgery is likely to decline substantially.  We cannot guarantee that we will compete successfully against ourcurrent or potential competitors, especially those with significantly greaterfinancial resources or brand name recognition.

 

**If we fail to retainour key personnel and hire, train and retain additional qualified andexperienced employees, we may not be able to compete effectively, or expand ourconsulting business and the number of Centers as planned, both of which couldresult in reduced revenues.**

 

Our future success will depend to a large extent on retaining our coreoperating management team and recruiting sufficient qualified employees tomanage and staff our Centers.  There islikely to be a competitive labor market for such staff and there is no assurancethat we will be able to attract and retain an adequate number of suitableemployees.  If we are unable to do this,then we may not be able to operate and expand our Centers as planned, which mayreduce our revenues.

 

To be successful, we must strengthen awareness of our services throughour marketing efforts and through establishment of additional VOW Centers.  We have a limited marketing and businessdevelopment force through which the efforts will be conducted, and we will relyheavily on each of these individuals. We cannot assure you that we will be able to attract and retainsufficient qualified personnel.

 

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**Our future financialresults will fluctuate significantly.**

 

As a result of our limited operating history, we cannot predict ourfuture revenues or operating results. We do, however, expect our future revenues and operating results tofluctuate due to a combination of factors, including the potential costs ofestablishing VOW Centers.

 

Our future operating expenses are expected to increase in futureperiods as we intend to establish VOW Centers, expand our sales and marketingoperations, expand our service capabilities and improve our internal operatingand financial systems.  In addition, ouroperating expenses are based on our expectations of future revenues, and arerelatively fixed in the short term.  Wemay be unable to adjust spending quickly enough to offset any unexpectedrevenue shortfall.  If we have ashortfall in revenues in relation to our expenses, or if our expenses increasebefore our revenues do, then our business for a particular period would bematerially adversely affected.

 

Because of all of these factors and the other risks discussed in thissection, we believe that our quarterly and annual revenues, expenses andoperating results likely will vary significantly in the future.

 

**Our liquidity andcapital requirements will be difficult to predict.**

 

Moreover, our liquidity and capital requirements will depend upon othernumerous factors, including the following:

 

•                  The extent towhich our products and services gain market acceptance;

 

•                  Costs associatedwith establishing marketing, and operating our Obesity Surgery and MedicalManagement Services Business and other related programs;

 

•                  The progress andscope of product evaluations;

 

•                  The timing andcosts of filing future regulatory submissions;

 

•                  The timing andcosts required to receive both domestic and international governmentalapprovals;

 

•                  The timing andcosts of product and services introductions;

 

•                  The extent ofour ongoing research and development programs;

 

•                  The costs ofsponsorship training of the physicians to become proficient in the use of ourproducts and procedures;

 

•                  The costs ofdeveloping marketing and distribution capabilities.

 

Even if we are successful in raising additional funds, circumstances,including slow rate of market acceptance of our products or our inability toscale up manufacturing, would accelerate our use of proceeds from any offeringwe might do and require us to seek additional funds to support our operatingrequirements.

 

**Our failure toeffectively manage our growth could have a material adverse effect on ourbusiness.**

 

Growth in our business will place a significant strain on our managementsystems and resources.  We will need tocontinue to improve our operational and financial systems and managerialcontrols and procedures, and we will need to continue to expand, train andmanage our workforce.  We expect thatthe number of our employees will continue to increase for the foreseeablefuture.  We will have to maintain closecoordination among our technical, accounting, finance, marketing and salesdepartments.

 

**We depend on ourintellectual property for the establishment and operation of our VOW Centers.**

 

We rely on a combination of trade secrets, know-how and confidentialityrestrictions for the establishment and operation of our VOW Centers.  We have expended significant effortsdevising the types of products and services we will offer and the manner inwhich these will be delivered.  Ourability to maintain the secrecy and confidentiality of our trade secrets andinternal knowledge are crucial to the success of our business.  Any failure to do so may negatively impactour prospects.

 

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**If we dispose of our Visualization Technologybusiness, our future success will depend solely on our ability to establish andgrow our obesity surgery management business.**

 

If thesale of our Visualization Technology business is approved by our stockholdersour future success as a company will depend on our ability to execute on theestablishment and growth of our Obesity Surgery Management Servicesbusiness.  As a company, we have limitedexperience in the provision of surgical services.  We will also be required to build this business from a relativelysmall base, finding partners and surgeons willing to participate.  We cannot assure you that we will be able tobuild a successful services business in the long term.

 

**Wehave been, to a significant extent, dependent on distribution partners to sellour Visualization Technology products.**

 

We only have a small direct sales force and, in thepast, we were primarily dependent on agreements with third parties for sales ofthe majority of products derived from our core three-dimensionaltechnology.  Two of our primarydistribution agreements were terminated in 2000 and the arrangement with JomedN.V. to manage distribution in cardiac surgery and to continue supporting ourcardiac customer base was terminated in 2003. We now depend primarily on our direct sales force to sell our 3Dproducts.

 

**Widespread use of ourvisualization products will require sponsoring the training of a large numberof surgeons, and the time required to institute a training program and to trainsuch surgeons could adversely affect near term market acceptance.**

** **

Evaluations ofvisualization technology, such as ours, which have been conducted to date, haveshown that there is a learning process involved for surgeons and other membersof the surgery 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.

 

**There are significantrisks associated with any scale-up of manufacturing which may be required tomeet market demand and become profitable.**

** **

We have neverestablished high-volume manufacturing operations and if we are required to doso to meet market demand or to become profitable, we may not be able toestablish or maintain reliable operations at commercially reasonablecosts.  We may also require additionalmanufacturing facilities if production volumes increase.  Acquisition of new manufacturing facilitieswould also likely involve relocation. Difficulties in scaling up manufacturing of products could result fromproblems 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 haveconsidered and will continue to consider as appropriate, the internalmanufacture of sub-assemblies currently provided by third-party subcontractors,as well as the implementation of new production processes.  Our manufacturing yields or costs mayincrease as a result of the transition to in-house production or to newproduction 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.**

 

Anysignificant supply interruption, or inventory shortage or overage, wouldnegatively impact our ability to manufacture our products.  We use and rely on specific components andservices used in our systems for which we have only a single source ofsupply.  The manufacture of our productsin larger commercial quantities will require a substantial increase incomponent supplies and will likely necessitate the replacement of current suppliersor the addition of new suppliers.  Thequalification of additional or replacement vendors for specified components orservices is a lengthy process.  Inaddition, the substitution of replacement vendors may entail re-engineeringtime and cost and could delay the supply of our products.

 

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We expect tomanufacture our products based on forecasted product orders and intend topurchase subassemblies and components prior to receipt of purchase orders fromcustomers.  Lead times for ordered materialsand components vary significantly and depend on factors such as the businesspractices of the specific supplier, contract terms and general demand for acomponent at a given time.  Somecomponents used in our products have long lead times.  As a result, there is a risk of excess or inadequate inventory iforders do not match forecasts.

 

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

 

The manufactureand sale of medical devices intended for commercial distribution are subject toextensive governmental regulation.  Ourfailure to comply with regulatory requirements would jeopardize our ability tomarket our products.  Noncompliance withapplicable requirements can result in failure of the regulatory agency to grantpre-market clearance or approval for devices, withdrawal or suspension ofapproval, total or partial suspension of production, fines, injunctions, civilpenalties, refunds, recall or seizure of products 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 commercialdistribution.  A determination thatinformation available on the medical device is not sufficient to grant the neededclearance or approval 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.

 

**Ourprofitability in our visualization technology business is directly related tothe level of reimbursements for surgical procedures using our products.**

 

Ourprofitability is directly related to the level of payments for the surgicalprocedures in which our products are involved, either by Medicare or privateinsurance companies.  We could beadversely affected by changes in payment policies of government or privatehealth care payors, particularly to the extent any such changes affect paymentfor the procedure in which our products are intended to be used.  It is a continuing trend in U.S. health carefor such payments to be under continual scrutiny and downward pressure.  We believe that reimbursement in the futurewill be subject to increased restrictions, both in the United States and inforeign markets and that the overall escalating cost of medical products andservices has led to and will continue to lead to increased pressures on thehealth care industry, both foreign and domestic, to reduce the cost of productsand services, including products which we offer.

 

We expect thatour products typically will be used by hospitals and surgical centers, whichbill various third-party payors, such as governmental programs and privateinsurance plans, for the health care services provided to their patients.  Third-party payors carefully review andincreasingly challenge the prices charged for medical products and services ornegotiate a flat rate fee in advance. Payment rates from private companies also vary depending on theprocedure performed, the third-party payor, the insurance plan and otherfactors.  Medicare compensates hospitalsat a predetermined fixed amount for the costs associated with an in-patient hospitalizationbased on the patient’s discharge diagnosis and compensates physicians at apre-determined fixed amount based on the procedure performed, regardless of theactual costs incurred by the hospital or physician in furnishing the care andunrelated to the specific devices or systems used in that procedure.  Medicare and other third-party payors areincreasingly scrutinizing whether to cover new products and the level ofpayment for new procedures.  The flatfee reimbursement trend is causing hospitals to control costs strictly in thecontext of a managed care system in which health care providers contract toprovide comprehensive health care for a fixed cost per person.  We are unable to predict what changes willbe made in the reimbursement methods utilized by such third-party payors.

 

If we obtainthe necessary foreign regulatory registrations or approvals, market acceptanceof our products in international markets would be dependent, in part, upon theacceptance by the prevailing health care financing system in each country.  Health care financing systems ininternational markets vary significantly by country and

 

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include both governmentsponsored health care programs and private insurance.  We cannot assure you that these financing systems will endorsethe use of our products.

 

**We have limitedexperience directly marketing our products overseas and may not be successfulin expanding into international markets without experienced partners.**

** **

We havelimited experience in directly marketing our products overseas.  Changes in overseas economic conditions,currency exchange rates, foreign tax laws or tariffs or other trade regulationscould negatively impact our business. The anticipated international nature of our business is also expected tosubject our representatives, agents and distributors to laws and regulations ofthe foreign jurisdictions in which they operate 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.

 

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

 

We face aninherent and significant business risk of exposure to product liability claimsin the event that the use of our products results in personal injury ordeath.  Also, in the event that any ofour products proves to be defective, we may be required to recall or redesignsuch products.  Our current productliability insurance coverage limit is $10.0 million per occurrence and in theaggregate.  Our coverage limits may notbe adequate to protect us from any liabilities we might incur in connection withthe development, manufacture and sale of our products.  In addition, increased product liabilitycoverage may be required if additional products are used in clinicalevaluations or successfully commercialized. Product liability insurance is expensive and in the future may not beavailable to us on acceptable terms, if at all.  A successful product liability claim or series of claims broughtagainst us in excess of our insurance coverage or a product recall would negativelyimpact 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 futuresuccess will depend, in part, on our ability to continue developing patentableproducts, enforcing our patents and obtaining patent protection for ourproducts both in the United States and in other countries.  The patent positions of medical devicecompanies, however, are generally uncertain and involve complex legal andfactual questions.  Patents may neverissue from any patent applications owned by or licensed to us.  Even if patents do issue, the claims allowedmay not be sufficiently broad to protect our technology.  In addition, issued patents owned by orlicensed to us may be challenged, invalidated or circumvented, or the rightsgranted thereunder may not provide us with competitive advantages.

 

The medicaldevice industry has been characterized by extensive litigation regardingpatents and other intellectual property rights.  Litigation, which would result in substantial expense, may benecessary to enforce any patents issued or licensed to us and/or to determinethe scope and validity of proprietary rights of third parties or whether ourproducts, processes or procedures infringe any such third-party proprietaryrights.  We may also have to participatein interference proceedings declared by the United States Patent and TrademarkOffice, which could result in substantial expense, to determine the priority ofinventions covered by our issued United States patents or pending patentapplications.  Furthermore, we may haveto participate at substantial cost in International Trade Commissionproceedings to enjoin importation of products which would compete unfairly withour products.  Any adverse outcome ofany patent litigation, including interference proceedings, could subject us tosignificant liabilities to third parties, require disputed rights to belicensed from or to third parties or require us to cease using the technologyin dispute.  Any such licenses may notbe available on acceptable 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 notpatented or 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.

 

In addition topatents,we rely on unpatented trade secrets to protect our proprietarytechnology.  Others may independentlydevelop or otherwise acquire the same or substantially equivalent technologiesor otherwise gain access to our proprietary technology or disclose thistechnology.  It is difficult to protectrights to unpatented proprietary technology. Third parties may obtain patent rights to these unpatented tradesecrets, which patent rights could be used to assert infringement claimsagainst us.  We also rely onconfidentiality agreements with our collaborators, employees, advisors, vendorsand consultants to protect our proprietary technology.  These agreements may be breached, we may nothave adequate remedies for any breach and our trade secrets may

 

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otherwise become known or beindependently developed by competitors. In addition, our agreements with employees and consultants requiredisclosure of ideas, developments, discoveries or inventions conceived duringemployment or consulting, as the case may be, and assignment to us ofproprietary rights to such matters related to our business and technology.  The extent to which efforts by others willresult in patents and the effect on us of the issuance of such patents isunknown.

 

**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 havelicensed some aspects of our technology from third parties.  The rights under the governing agreementsmay be terminated if we breach our obligations or in other circumstances.  Our failure to retain rights to theselicensed rights could negatively impact our business.  For additional information concerning the agreements which governthese relationships, please see “Business—Strategic Alliances” and “Business —Licenses.”

 

**Ifwe are not able to attract and retain key management and technical personneland doctors to participate in our advisory boards, it may adversely affect ourability to obtain financing or develop our products.**

 

Our futurebusiness and operating results depend in significant part upon the continuedcontributions of our key management and technical personnel, many of whom wouldbe difficult to replace and some of whom perform important functions beyondthose suggested by their job titles or descriptions.  Our business and future operating results also depend insignificant part upon our ability to attract and retain qualified management,manufacturing, technical, marketing and sales and support personnel for ouroperations.  Competition for suchpersonnel is intense, and we may not be successful in attracting or retainingsuch personnel.

 

Members of ourclinical advisory boards consult with us exclusively but are free to consultwith other non-competing companies and are employed elsewhere on a full-timebasis.  As a result, they only spend alimited amount of time on our business. Although we have entered into consulting agreements, includingconfidentiality provisions with each of the members of our clinical advisoryboards, the consulting and confidentiality agreements between us and each ofthe members of our clinical advisory boards may be terminated or breached.

 

**Our stock price couldcontinue to be volatile and your investment in our common stock could suffer adecline in value, adversely affecting our ability to raise additional capital.**

 

The marketprices and trading volumes for securities of emerging companies, like ours,have historically been highly volatile and have experienced significantfluctuations unrelated to the operating performance.  The market price of our common stock has historically been highlyvolatile and may be significantly affected by factors such as:

 

•                                          actualor anticipated fluctuations in our operating results,

 

•                                          ourability to remain listed on Nasdaq,

 

•                                          changesin financial estimates by securities analysts,

 

•                                          announcementsof technological innovations,

 

•                                          newproducts or 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,

 

•                                          adoptionof new accounting standards affecting the medical device industry, and

 

•                                          generalmarket conditions.

 

In addition,the stock market 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.

 

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**There is a limitedmarket for our common stock and therefore investors may not be able toliquidate their investment in the foreseeable future, if at all.**

** **

There is a limited market for our common stock even though it ispublicly quoted, and the market is not expected to increase significantly inthe foreseeable future.  The units andthe common stock into which those units are convertible will constituterestricted securities under U.S. federal and applicable state securities laws.  As such, they may not be transferred, soldor otherwise disposed of in the United States, except as permitted under U.S.federal and state securities laws pursuant to a registration or an exemptionfrom registration.  Investors should beprepared to hold our common stock for an indefinite period.  An investment in our company is highlyspeculative, and an investor should be able to withstand a total loss of theinvestment.

 

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

 

Our researchand development activities in the Visualization Technology business may involvethe controlled use of hazardous materials and chemicals.  The risk of accidental contamination orinjury from these materials cannot be completely eliminated.  In the event of such an accident, we couldbe held liable for any resultant damages, and any such liability could exceedour resources.  We may incur substantialcost 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 currentlyintend to retain any future earnings for use in our business and do notanticipate paying any cash dividends in the foreseeable future.

 

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

 

Our charterdocuments contain provisions that may make it more difficult or discourage achange in control.  This may adverselyaffect the market price of our common stock.

 

Item 2.PROPERTIES

 

Our facilitiesconsist of approximately 5,000 square feet of subleased office space located inCarlsbad, California, in which our executive offices, plus the staff of our VOWSolutions Business is located.  Inaddition, we maintain a facility of approximately 17,850 square feet inWestborough, Massachusetts in which the development, engineering, manufacturingoperations and customer service personnel of our Visualization TechnologyBusiness are located.  The lease underwhich we have acquired the right to occupy the Westborough facilities expiresin October 2004.  The sublease of theCarlsbad premises expires in January 2005 and was executed with a relatedparty.  We believe that suitable additionalspace will be available to us, when needed, on commercially reasonable terms.

 

Item 3. LEGALPROCEEDINGS

 

From time totime, we may be involved in litigation relating to claims arising out of ouroperations in the normal course of business. As of the date of this Annual Report, we are not a party to any legalproceedings.

 

Item 4.SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

None.

 

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PART II

 

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

 

(a)                                  Market Price of andDividends on the Registrant’s Common Equity.

 

Our CommonStock is traded on the over-the-counter market and prices are quoted on theNasdaq SmallCap Market under the symbol “VMTI.”  The following table sets forth the high and low sale prices forour Common Stock on the Nasdaq SmallCap Market from January 1, 2002 throughDecember 31, 2003.

 
| **Quarter**      |   | **High** |   | **Low** |   |
|------------------|--------|----------|--------|---------|--------|
|             |   |     |   |    |   |
| 1st Quarter 2002 |   | $        | 4.59   |    | $      | 2.47 |   |
|             |   |     |   |    |   |
| 2nd Quarter 2002 |   | $        | 4.15   |    | $      | 3.65 |   |
|             |   |     |   |    |   |
| 3rd Quarter 2002 |   | $        | 4.20   |    | $      | 2.70 |   |
|             |   |     |   |    |   |
| 4th Quarter 2002 |   | $        | 3.90   |    | $      | 2.52 |   |
|             |   |     |   |    |   |
| 1st Quarter 2003 |   | $        | 2.57   |    | $      | 1.34 |   |
|             |   |     |   |    |   |
| 2nd Quarter 2003 |   | $        | 4.18   |    | $      | 0.77 |   |
|             |   |     |   |    |   |
| 3rd Quarter 2003 |   | $        | 3.30   |    | $      | 1.71 |   |
|             |   |     |   |    |   |
| 4th Quarter 2003 |   | $        | 3.20   |    | $      | 1.07 |   |

 

On March 11,2004 the last reported sale price of our Common Stock was $1.66.  As of March 11, 2004, there wereapproximately 101****holders of record of our Common Stock.

 

We have never declared or paid any cash dividends on our capital stock.  We currently do not intend to pay any cashdividends in the foreseeable future and intend to retain our earnings, if any,for the operation of our business.

 

The informationcalled for by Item 5 with respect to securities authorized for issuance underequity compensation plans is incorporated herein by reference to the materialin our Proxy Statement related to the Annual Meeting of Stockholders to be heldon May 24, 2004.

 

28

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Item 6.SELECTED FINANCIAL DATA

 

SELECTED FINANCIAL DATA

 

The selectedfinancial data set forth below should be read in conjunction with “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” andour financial statements and notes thereto appearing elsewhere in this Form10-K.

 
|                                                       |   | **YEARS ENDED DECEMBER 31,**                        |       |
|------------------------------------------------------------|--------|-----------------------------------------------------|------------|
| **STATEMENT OF OPERATIONS DATA:**                          |   | **1999**                                            |       | **2000** |   | **2001** |   | **2002** |   | **2003** |   |
|                                                       |   | **(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)** | ** ** |
|                                                       |   |                                                |       |   |   |   |   |   |   |   |   |
| Sales                                                      |   | $                                                   | 5,516      |   | $ | 6,539 |   | $ | 9,326 |   | $ | 11,106 |   | $ | 8,709 |   |
|                                                       |   |                                                |       |   |   |   |   |   |   |   |   |
| Cost and expenses:                                         |   |                                                |       |   |   |   |   |   |   |   |   |
|                                                       |   |                                                |       |   |   |   |   |   |   |   |   |
| Cost of  revenues                                     |   | 7,521                                               |       | 5,947 |   | 6,405 |   | 5,989 |   | 5,185 |   |
|                                                       |   |                                                |       |   |   |   |   |   |   |   |   |
| Research and development                                   |   | 3,229                                               |       | 1,736 |   | 1,945 |   | 1,709 |   | 1,178 |   |
|                                                       |   |                                                |       |   |   |   |   |   |   |   |   |
| Sales and marketing                                        |   | 2,890                                               |       | 1,158 |   | 2,237 |   | 2,690 |   | 2,548 |   |
|                                                       |   |                                                |       |   |   |   |   |   |   |   |   |
| General and administrative                                 |   | 2,178                                               |       | 1,925 |   | 2,031 |   | 1,882 |   | 1,879 |   |
|                                                       |   |                                                |       |   |   |   |   |   |   |   |   |
| Restructuring expense                                      |   | 690                                                 |       | (400 | ) | — |   | — |   | — |   |
|                                                       |   |                                                |       |   |   |   |   |   |   |   |   |
| Total costs and expenses                                   |   | 16,508                                              |       | 10,366 |   | 12,618 |   | 12,270 |   | 10,790 |   |
|                                                       |   |                                                |       |   |   |   |   |   |   |   |   |
| Loss from operations                                       |   | (10,992                                             | )          | (3,827 | ) | (3,292 | ) | (1,164 | ) | (2,081 | ) |
|                                                       |   |                                                |       |   |   |   |   |   |   |   |   |
| Interest income                                            |   | 218                                                 |       | 213 |   | 70 |   | 17 |   | 32 |   |
|                                                       |   |                                                |       |   |   |   |   |   |   |   |   |
| Other gains/(losses)                                       |   | 51                                                  |       | — |   | — |   | — |   | — |   |
|                                                       |   |                                                |       |   |   |   |   |   |   |   |   |
| Net loss                                                   |   | $                                                   | (10,723    | ) | $ | (3,614 | ) | $ | (3,222 | ) | $ | (1,147 | ) | $ | (2,049 | ) |
| Less accretion of dividends on  referred stock             |   | —                                              |       | — |   | — |   | — |   | (118 | ) |
|                                                       |   |                                                |       |   |   |   |   |   |   |   |   |
| Net loss applicable to common  stockholders                |   | $                                                   | (10,723    | ) | $ | (3,614 | ) | $ | (3,222 | ) | $ | (1,147 | ) | $ | (2,167 | ) |
|                                                       |   |                                                |       |   |   |   |   |   |   |   |   |
| Basic and diluted net loss per  share                      |   | $                                                   | (3.16      | ) | $ | (0.80 | ) | $ | (0.66 | ) | $ | (0.23 | ) | $ | (0.43 | ) |
|                                                       |   |                                                |       |   |   |   |   |   |   |   |   |
| Shares used in computing basic  and diluted loss per share |   | 3,398,000                                           |       | 4,495,000 |   | 4,906,000 |   | 4,969,000 |   | 5,004,126 |   |

 
|                                               |   | **DECEMBER 31,**   | ** ** |
|----------------------------------------------------|--------|--------------------|------------|
| **BALANCE SHEET DATA:**                            |   | **1999**           | ** ** | **2000** | ** ** | **2001** | ** ** | **2002** | ** ** | **2003** | ** ** |
|                                               |   | **(IN THOUSANDS)** | ** ** |
|                                               |   |               |       |   |   |   |   |   |   |   |   |
|                                               |   |               |       |   |   |   |   |   |   |   |   |
| Cash, cash equivalents and  short-term investments |   | $                  | 1,658      |   | $ | 2,934 |   | $ | 1,317 |   | $ | 829 |   | $ | 636 |   |
|                                               |   |               |       |   |   |   |   |   |   |   |   |
| Working capital                                    |   | 2,972              |       | 5,113 |   | 2,696 |   | 2,007 |   | 1,085 |   |
|                                               |   |               |       |   |   |   |   |   |   |   |   |
| Total assets                                       |   | 7,367              |       | 7,155 |   | 4,823 |   | 4,182 |   | 2,991 |   |
|                                               |   |               |       |   |   |   |   |   |   |   |   |
| Long-tern debt                                     |   | —             |       | — |   | — |   | 7 |   | 19 |   |
|                                               |   |               |       |   |   |   |   |   |   |   |   |
| Accumulated deficit                                |   | (57,941            | )          | (61,555 | ) | (64,777 | ) | (65,925 | ) | (68,092 | ) |
|                                               |   |               |       |   |   |   |   |   |   |   |   |
| Total stockholders’ equity                    |   | 4,584              |       | 6,151 |   | 3,091 |   | 2,081 |   | 1,108 |   |
|                                                    |        |                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

29

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

 

This annualreport may contain predictions, estimates and other forward-looking statementsthat involve a number of risks and uncertainties, including those discussedearlier at “risks and uncertainties.” While this outlook represents our current judgment on the future directionof our business, such risks and uncertainties could cause actual results todiffer materially from any future performance suggested below.  We undertake no obligation to releasepublicly the results of any revisions to these forward-looking statements toreflect events or circumstances arising after the date of this annualreport.  The following discussion shouldbe read in conjunction with our consolidated financial statements and the notesthereto.

 

**Overview of ourBusiness**

 

We operate two business units. The Obesity Surgical and Medical Management Services business (operatedvia our wholly-owned subsidiary, VOW Solutions, Inc.), based in Carlsbad, CA,provides services to physicians and hospitals involved in the surgicaltreatment of morbid obesity.  Ourservices include management of our original product offering, the LaparoscopicBariatric Surgery Preceptorship, a comprehensive introduction to starting aminimally invasive gastric bypass surgical program.  We now offer, in addition, systems, consulting and programmanagement services which enable the efficient operation of obesity surgeryprograms.  The Visualization Technologybusiness, based in Westborough, MA, develops, manufactures and markets productsthat provide information to physicians performing minimally invasive generalsurgical, cardiac surgical and other selected endoscopic and interventionalprocedures.  Our technology productscombine a head mounted display with video cameras to provide surgeons withcritical visual information during complex minimally invasive procedures, andalso incorporate the benefit of viewing complementary information in avoice-controlled, picture-in-picture format, to facilitate real-time decisionmaking during surgery.  TheVisualization Technology business also manufactures compact, high-resolutionendoscopic cameras for original equipment manufacturer customers and strategicpartners.  On December 22, 2003 wesigned an agreement to sell the Visualization Technology business to VikingSystems, Inc., (see pages 9 and 10 for a description of the terms of thetransaction), subject to the approval of our stockholders.

 

At December31, 2003, we had 32 employees.  Weexpect staffing to increase from our Obesity Management Services business,while there would be an elimination of 19 employees from the sale of ourVisualization Technology business in our Westborough facility.  We expect that there will be a steadyincrease in employees during 2004 within the Obesity Management Servicesbusiness which would bring us to approximately 22 employees by the end of 2004.

 

**Critical AccountingPolicies**

 

The discussionand analysis of our financial condition and results of operations are basedupon our consolidated financial statements, which have been prepared inaccordance with accounting principles generally accepted in the UnitedStates.  The presentation of thesefinancial statements requires us to make estimates and judgments that affectthe reported amounts of assets and liabilities, revenues and expenses, andrelated disclosure at the date of our financial statements.  The significant accounting policies which webelieve are most critical in gaining an understanding of our financialstatements include policies and judgments relating to revenue recognition,accounts receivable, inventories and deferred taxes.  Actual results could differ materially from these estimates.  Our significant accounting policies aresummarized in the notes to our consolidated financial statements.  The significant accounting policies which webelieve are the most critical in gaining full understanding and evaluating ourreported financial results include the following:

 

RevenueRecognition

 

The Company recognizes revenue pursuant to Staff Accounting Bulletin(“SAB”) No. 104 “Revenue Recognition”. Accordingly, revenue is recognized when all four of the followingcriteria are met: (i) persuasive evidence of an arrangement exists; (ii)delivery of the product and/or services has occurred; (iii) the selling priceis fixed or determinable and; (iv) collectibility is reasonably assured.  Sales returns are estimated based on thehistorical experience and management’s expectations and are recorded at thetime product revenue is recognized. Shipping and handling costs are included in cost of sales.

 

30

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Within the Obesity SurgeryManagement Services business, the Company’s revenues are derived fromconsulting and training services. Consulting and training services revenue is recognized upon delivery ofrelated marketing materials and completion of the related training component,provided all of the criteria of SAB 104 are met.

 

Within the VisualizationTechnology business, the Company’s revenues are derived from the sale oftechnology products to end users, distributors and original equipmentmanufactures.  Product revenue isrecognized upon shipment, provided all the criteria of SAB 104 are met.

 

The Company receives semiannualpayments as a result of fulfilling certain obligations related to its strategicalliance agreement with Ethicon Endo-Surgery, Inc. (EES).  These payments are recognized as revenue ona straight-line basis over the related contract term, provided that the Companyhas complied with all contractual obligations.

 

Inventory

 

Inventory is accounted for on afirst-in first-out basis and is valued at the lower of cost or market.  The Company regularly evaluates inventoryfor excess quantities or obsolescence and reserves for 100% of inventoryconsidered to be excess or obsolete. This evaluation requires significant judgment and estimates made bymanagement regarding factors such as customer demand, product life cycle andgeneral market conditions.  At December31, 2003 such inventory reserves approximated $1,303,000.  The Company believes it is adequatelyreserved for obsolescence of current inventory.  However, future product introductions and related inventories mayrequire additional reserves based upon changes in market demand or introductionof competing technologies.  In addition,the expected sale of the Visualization Technology business to Viking Systems,Inc. may require that we reassess the adequacy of our inventory reserves underthe terms of the proposed transaction.

 

**Our Results of Operations**

 

**Year ended December 31, 2003 compared withyear ended December 31, 2002**

 

**Revenues**

 

We hadrevenues from product sales and contract revenue of $8,709,000 for the yearended December 31, 2003 and product sales and contract revenue of $11,106,000for the year ended December 31, 2002, representing a decrease of $2,397,000 or22%.  The decrease in revenues during2003 was primarily due to decreased unit sales from our VisualizationTechnology business for our Laparoscopic Bariatric Surgery program.  Of the $2,397,000 decrease in total sales,$1,000,000 is represented by the loss of Jomed sales due to their bankruptcyfiling in January, 2003. We also had a decrease in camera sales of $200,000 toour original equipment manufacturer customers. Finally, we had decreased sales relative to fewer Training Programs fromour Obesity Surgery Management Services business of approximately$1,200,000.  Sales to individualcustomers exceeding 10% or more of revenues in the years ended December 31,were as follows:  during 2003, threecustomers accounted for 20%, 16% and 11% of revenues, respectively, and during2002, one customer accounted for 14% of revenues.

 

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**Costs and expenses**

 
|                       |   | **2002**  |       | **2003**  |   |
|----------------------------|--------|-----------|------------|-----------|--------|
| Cost of revenues           |   | $         | 5,989,000  |      | $      | 5,185,000 |   |
| Research and development   |   | 1,709,000 |       | 1,178,000 |   |
| Sales and marketing        |   | 2,690,000 |       | 2,548,000 |   |
|                       |   |      |       |      |   |
| General and administrative |   | 1,882,000 |       | 1,879,000 |   |
|                       |   |      |       |      |   |
| Total costs and expenses   |   | $         | 12,270,000 |      | $      | 10,790,000 |   |

 

Cost ofrevenues.  Our cost of revenues were$5,185,000 and $5,989,000 for the years ended December 31, 2003 and 2002,respectively.  Our gross margins were40% and 46% for the years ended December 31, 2003 and 2002, respectively.  The decrease in gross margin was primarilydue to decreased unit sales of our higher margin Laparoscopic Bariatric Surgeryprogram.

 

Research anddevelopment expenses.  Our research anddevelopment expenses were $1,178,000 and $1,709,000 for the years endedDecember 31, 2003 and 2002, respectively, representing a decrease of $532,000or 31%.  The decrease in research anddevelopment expenses during 2003 was primarily attributable to near completionof next generation product development. Research and development expenses in 2003 were primarily spent on thenext generation head mounted display and the development of a new Vista Stereo3 Chip camera.  However, should the saleof the Visualization Technology business take place, it is anticipated thatsubstantially all research and development expenses would be eliminated.  Since 2000, the Company’s principaldevelopment efforts have focused on new products and services within thesurgical obesity market.  The Company’sfuture spending on research and development will be focused on furtherexpansion of LBS peripheral products and services and development of the nextgeneration Head Mounted Display.

 

Sales andmarketing expenses.  Our sales andmarketing expenses were $2,548,000 and $2,690,000 for the years ended December31, 2003 and 2002, respectively, representing a decrease of $142,000 or 5%.  Our sales and marketing expenses did notdrop in accordance with our decrease in revenues due to increased expensesrelated to the development of our Obesity Management Services business.  We expect a steady increase in sales andmarketing expenses during 2004 as we ramp up our field activities for theobesity surgery market.

 

General andadministrative expenses.  Our generaland administrative expenses were $1,879,000 and $1,882,000 for the years endedDecember 31, 2002 and 2001, respectively. General and administrative expenses were consistent in 2003 compared to2002.

 

**Other income andlosses**

 

Interestincome. Our net interest income was $32,000 and $17,000 for the years endedDecember 31, 2003 and 2002, respectively. The increase in 2003 was due primarilyto interest recorded on notes receivable from stockholders, partially offset bydecreasing average cash balances and lower interest rates.

 

**Income****Taxes**

 

At December31, 2002, we had federal and state tax net loss carryforwards of approximately$55,588,000 and $30,388,000, respectively. The federal tax loss carryforwardswill begin to expire in 2010. Approximately $15,671,000 of the state tax loss carryforwards expired in2003, and will continue to expire in 2004 unless previously utilized. At December31, 2003, we also had federal and state research tax credit carryforwards ofapproximately $2,248,000 and $902,000, respectively, which will begin to expirein 2010 unless previously utilized. We have provided a full valuation allowanceon the deferred tax assets as realization of such assets is uncertain.

 

32

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**Year ended December 31, 2002 compared withyear ended December 31, 2001**

 

**Revenues**

 

We hadrevenues from product sales and contract revenue of $11,106,000 for the yearended December 31, 2002 and product sales and contract revenue of $9,326,000for the year ended December 31, 2001. The increase in revenues during 2002 was primarily due to increased unitsales from our Laparoscopic Bariatric Surgery program.    Sales to individual customers exceeding10% or more of revenues in the years ended December 31, were as follows:  during 2002, one customer accounted for 14%of revenues, and during 2001, three customers accounted for 22%, 18%  and 10% of revenues, respectively.

 

**Costs and expenses**

 

Cost ofrevenues.  Our cost of revenues were$5,989,000 and $6,405,000 for the years ended December 31, 2002 and 2001,respectively.  Our gross margins were46% and 31% for the years ended December 31, 2002 and 2001, respectively.  The increase in gross margin was primarilydue to increased unit sales of our higher margin Laparoscopic Bariatric Surgeryprogram coupled with associated contract revenue recognition of $1,000,000 froman agreement with Ethicon Endo-Surgery, Inc., with no associated cost ofrevenues.

 

Research anddevelopment expenses.  Our research anddevelopment expenses were $1,709,000 and $1,945,000 for the years endedDecember 31, 2002 and 2001, respectively. The decrease in research and development expenses during 2002 wasprimarily attributable to near completion of next generation productdevelopment.  Since 2000, the Company’sprincipal development efforts have focused on new products and services withinthe surgical obesity market. Approximately $600,000 of the $1,709,000 research and developmentexpenses were spent on the next generation Head Mounted Display which startedshipping in the fourth quarter of 2002. There were no other individually significant research projects.  The Company’s future spending on researchand development will be focused on further expansion of LBS peripheral productsand services and development of the next generation Head Mounted Display.

 

Sales andmarketing expenses.  Our sales andmarketing expenses were $2,690,000 and $2,237,000 for the years ended December31, 2002 and 2001,  respectively.  The increase in sales and marketing expensesduring 2002  reflects a ramp up of fieldactivities for the obesity surgery market.

 

General andadministrative expenses.  Our generaland administrative expenses were $1,882,000 and $2,031,000 for the years endedDecember 31, 2002 and 2001, respectively. The decrease during 2002 was primarily due to lower depreciation andfacility charges.

 

**Other income andlosses**

 

Interestincome. Our net interest income was $17,000 and $70,000 for the years endedDecember 31, 2002 and 2001, respectively. The decrease in 2002 was dueprimarily to decreasing average cash balances and lower interest rates.

 

**Liquidity and CapitalResources**

 

Our principalsources of liquidity have been funds raised from public and private placementsof our capital stock and, to a lesser degree, cash flows generated fromoperations.  At December 31, 2003, wehad cash, cash equivalents and short-term investments of $636,000.  In addition, in February 2004, we raised anadditional $588,000 through a private placement of common stock.

 

Net cash usedin operating activities was approximately $1,250,000, $462,000 and $1,556,000in 2003, 2002 and 2001, respectively. The increase in net cash used in operating activities during 2003compared to 2002 was primarily attributable to increasing net losses.  The decrease in net cash used in operatingactivities during 2002 compared to 2001 was primarily attributable todecreasing net losses partially offset by increased inventory purchases.

 

Net cashprovided from investing activities was approximately $109,000 and $52,000 in2003 and 2002, respectively, and cash used in 2001 for investing activities was$257,000.  The increase in cash providedfrom 

 

33

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investing activities in 2003was primarily attributable to maturities of short-term investments.  The increase in net cash provided byinvesting activities in 2002 compared to 2001 was primarily attributable tomaturities of short-term investments, partially offset by increased purchasesof property and equipment.

 

Cash flowsfrom financing activities were $1,133,000, $66,000 and $25,000 in 2003, 2002and 2001, respectively.  The cash flowsfrom financing activities in 2003 were primarily attributable to proceeds froma private placement of preferred stock for approximately $950,000 and shortterm bank borrowings of $200,000.The cash flows from financing activities in2002 and 2001 were primarily attributable to proceeds from purchase of stock byemployees through our employee stock purchase plan and the exercise of stockoptions.

 

We incurred operating losses in 2001,2002 and 2003, and at December 31, 2003, had an accumulated deficit of $68.1million.  At December 31, 2003, we hadcash and short-term investments of $636,000. In February 2004, we sold $588,000 of common stock in a privateplacement.   In addition, we haveamounts available under a $2.0 million bank line of credit facility, whichexpires in October 2004 and is subject to annual renewals.  We believe that these sources of liquidity,together with anticipated 2004 product revenues and interest income, will notbe sufficient to operate our business beyond June 2004.  These factors raise substantial doubt aboutthe Company’s ability to continue as a going concern.  We are pursuing several alternatives to address this situation,including raising additional funding and the intended sale of the VisualizationTechnology business.  However, there canbe no assurance that the requisite fundings or sale of the VisualizationTechnology business will be consummated in the necessary time frame or on termsacceptable to us.  Should we be unableto raise sufficient funds, we may be required to curtail our operating plansand possibly relinquish rights to portions of our technology or products.  In addition, increases in expenses or delaysin product development may adversely impact our cash position and requirefurther cost reductions.  No assurancecan be given that we will be able to operate profitably on a consistent basis,or at all, in the future.

 

**Borrowing Arrangements**

 

In October2001, we secured a $2,000,000 line of credit Facility (the Facility) with abank for one year with automatic yearly renewals.  The current line of credit agreement expires in October2004.  The Facility is secured byqualified accounts receivable and bears interest at the rate of prime plus 2%(4.5% at December 31, 2003).  Borrowingsunder the Facility are limited to 80% of qualified accounts receivable.  At December 31, 2003, there was $200,000 ofborrowings outstanding , and $730,000 available under the Facility.

 

**ContractualObligations**

 

At December31, 2003, we are obligated under operating leases, principally related to realestate.  Additionally, we are obligatedunder capital leases related to computer hardware.  The following is a schedule of future minimum payments, excludingtaxes and other operating costs, as of December 31, 2003:

 
| **YEAR ENDING DECEMBER 31,**  |   | **Operating  Leases** |    | **Capital  Leases** |   |
|-------------------------------|--------|-----------------------|---------|---------------------|--------|
| 2004                          |   | $                     | 223,125 |                | $      | 30,422 |   |
| 2005                          |   | 18,624                |    | 20,530              |   |
| 2006                          |   | —                |    | 5,572               |   |
|                          |   |                  |    |                |   |
| Total contractual obligations |   | $                     | 265,588 |                | $      | 56,524 |   |

 

**Related PartyTransactions**

 

We have asublease agreement for our California office space.  The sublease agreement has been executed with another company, ofwhich our Chairman of the Board is also a Director.  Total rental payments of $104, 500 were paid to this company in2003.

 

**Off-Balance SheetArrangements**

 

We currentlydo not have any material off-balance sheet arrangements other than theoperating lease commitments 

 

34

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described above..

 

**Inflation**

 

We believethat the effects of inflation generally do not have a material adverse impacton our operations****or financial condition.

 

**New AccountingPronouncements**

 

In January 2003 FASB InterpretationNo. 46, “Consolidation of Variable Interest Entities” was issued. Thisinterpretation requires a company to consolidate variable interest entities(“VIE”) if the enterprise is a primary beneficiary (holds a majority of thevariable interest) of the VIE and the VIE passes specific characteristics. Italso requires additional disclosures for parties involved with VIEs.  In December, 2003, the FASB issued arevision of Interpretation No. 46 (the Revised Interpretation 46). RevisedInterpretation 46 codifies both the proposed modifications and other decisionspreviously issued through certain FASB Staff Positions (FSPs) and supersedesthe original Interpretation No. 46 to include: (1) deferring  the effective date of theInterpretation’s provisions for certain variable interests, (2) providingadditional scope exceptions for certain other variable interests, (3)clarifying the impact of troubled debt restructurings on the requirement toreconsider (a) whether an entity is a VIE or (b) which party is the primarybeneficiary of a VIE, and (4) revising Appendix B of the Interpretation toprovide additional guidance on what constitutes a variable interest.Accordingly, the Company will adopt Revised Interpretation No. 46 effective thefirst quarter 2004 and does not expect the adoption of this interpretation willhave an impact on its consolidated financial position or results of operations.

 

In December 2003, the SEC issued StaffAccounting Bulletin (SAB) No. 104, “Revenue Recognition”, which codifies,revises and rescinds certain sections of SAB No. 101, Revenue Recognition, inorder to make this interpretive guidance consistent with current authoritativeaccounting and auditing guidance and SEC rules and regulations.  The changes noted in SAB No. 104 did nothave a material effect on the Company’s results of operations, financialposition or cash flows.

 

In May 2003, the FASB issued SFAS No.150, “*Accountingfor Certain Financial Instruments with Characteristics of Both Liabilities andEquity*.”  SFAS No. 150establishes standards for how an issuer classifies and measures certainfinancial instruments with characteristics of both liabilities and equity.  Many of these instruments were previouslyclassified as equity.  SFAS No. 150 iseffective for financial instruments entered into or modified after May 31,2003, and otherwise was effective at the beginning of the first interim periodbeginning after June 15, 2003.  Theadoption of this Statement did not have an effect on the Company’s financialstatements.

 

Item 7A.                           QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK

 

At December31, 2003, our investment portfolio included fixed-income securities of $0.1million.  These securities are subjectto interest rate risk and will decline in value if interest ratesincrease.  Due to the short-term natureof our investment portfolio, an immediate 10 percent increase in interest rateswould have no material impact on our financial condition or results ofoperations.

 

We have a$2,000,000 credit facility with a financial institution.  Interest on this facility was prime plus 2%at December 31, 2003.  At December 31,2003, we had $200,000 in advances outstanding under this credit facility.  If we were to draw under this facility,changes in interest rates would affect the interest expense we would pay andcould impact our cash flows and results of operations.  The maturity date of this credit facility isOctober, 2004.

 

We generallyconduct business, including sales to foreign customers, in U.S. dollars and asa result have limited foreign currency exchange rate risk.  The effect of an immediate 10 percent changein foreign exchange rates would not have a material impact on our financialcondition or results of operations.

 

Item 8.                                     FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA

 

Theconsolidated financial statements and supplementary data required by this itemare set forth at the pages indicated in Item 15(a)(1).

 

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

 

Notapplicable.

 

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PART III

 

Item 9A.                                                   CONTROLSAND PROCEDURES

 

Our Chief Executive Officer, Mr. Lyon, andChief Financial Officer, Mr. Gorgol, carried out an evaluation of theeffectiveness of the design and operation of our disclosure controls andprocedures (as defined in the Securities Exchange Act of 1934) as of the end ofthe period covered by this report.  Basedupon that evaluation, Mr. Lyon and Mr. Gorgol concluded that our disclosurecontrols and procedures are effective in causing material information to becollected, communicated and analyzed by our management on a timely basis and toensure that the quality and timeliness of our public disclosures comply withSEC disclosure obligations.

 

There were no significant changes in our internal controls or in otherfactors that could significantly affect these controls after the date of ourmost recent evaluation.

 

Item 10.                                                       DIRECTORSAND EXECUTIVE OFFICERS 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 May 24, 2004,  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 on May24, 2004, 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 May 24, 2004, is incorporatedherein by reference.

 

Item 11.                                                       EXECUTIVECOMPENSATION

 

Theinformation under the headings “Executive Compensation and Other Information,”appearing in our Proxy Statement related to the Annual Meeting of Stockholdersto be held on May 24, 2004, is incorporated herein by reference.

 

Item 12.                                                       SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

 

Theinformation required under this item is incorporated herein by reference to ourProxy Statement related to the Annual Meeting of Stockholders to be held on May24, 2004.

 

Item 13.                                                       CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS

 

Theinformation under the heading “Certain Relationships and Related Transactions,”appearing in our Proxy Statement related to the Annual Meeting of Stockholdersto be held on May 24, 2004, is incorporated herein by reference.

 

Item 14.       PRINCIPAL ACCOUNTANTFEES AND SERVICES

 

Theinformation under the heading “Proposal No. 3 – Ratification of IndependentAuditor”, appearing in our Proxy Statement related to our Annual Meeting ofstockholders to be held on May 24, 2004.

 

36

----

 

PART IV

 

Item 15.                                                       EXHIBITS,FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

 

(a)                                  (1)                                  FinancialStatements

 

The financial statements required by this item are submitted in aseparate 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, 2002 and 2003                                                    |   |
| Consolidated Statements of Operations for  the years ended  December 31, 2001, 2002, and 2003                |   |
| Consolidated Statements of Stockholders’  Equity for the years ended  December 31, 2001, 2002, and 2003 |   |
| Consolidated Statements of Cash Flows for  the years ended  December 31, 2001, 2002, and 2003                |   |
| Notes to Consolidated Financial Statements                                                                   |   |
| Schedule II – Valuation and Qualifying Accounts                                                         |   |

 

(2)                                  FinancialStatement Schedules

 

All schedules for which provision is made in the applicable accountingregulation of the Securities and Exchange Commission are not required under therelated instructions or are inapplicable, and therefore have been omitted,except for Schedule II required under Regulation S-X, Rule 5-04, which isincluded herein following the Financial Statements.

 

(b)                                 Wefiled or furnished three reports on Form 8-K during our fourth quarter endedDecember 31, 2003. Information regarding the items reported on is as follows:

 
| **Date Filed or  Furnished** |   | **Item No.** |   | **Description**                                                                                                                                                                               |
|------------------------------|--------|--------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| November 5, 2003             |   | 12           |   | On November 5,  2003, we announced our financial results for the three months ended September  30, 2003 (Consolidated Financial Statements for this period were furnished  with this report). |
| December 23,  2003           |   | 5            |   | On December 23,  2003, we announced an agreement to sell our Visualization Technology business  to Viking Systems, Inc.                                                                       |

 

(c)                                  Exhibits

 
| **NUMBER  EXHIBIT** |   | **DESCRIPTION**                                                                                                                                                         |
|---------------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                |   |                                                                                                                                                                    |
| 3.1(1)              |   | Second Restated Certificate of Incorporation                                                                                                                            |
| 3.4(2)              |   | Restated Bylaws.                                                                                                                                                        |
| 3.2(14)             |   | Certificate of Amendment of Second Restated Certificate of  Incorporation                                                                                               |
| 3.3(15)             |   | Certificate of Designations of Series A Convertible Preferred Stock                                                                                                     |
| 4.1(2)              |   | Form of certificate for common stock.                                                                                                                                   |
| 4.2(15)             |   | Registration Rights Agreement datd March 3, 2003, with the  parties listed on Exhibit A therto.                                                               |
| 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.                   |
| 10.5(b)(15)         |   | Preferred Stock Purchase Agreement dated March 3, 2003, with the  parties listed on Schedule A therto.                                                                  |
| 10.6*(2)            |   | Consulting Agreement with Harry R. McKinley, dated September  15, 1995, as amended.                                                                                |

 

37

----

 
| 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.                                                                                                                                               |

 

38

----

 
| 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.            |
| 10.59**    |   | Asset Purchase Agreement with Viking Systems, Inc. dated as of  December 22, 2003.                               |
| 23.1**     |   | Consent of Ernst & Young LLP, Independent Auditors.                                                          |
| 24.1**     |   | Power of Attorney (included on signature page).                                                                  |
| 27.1**     |   | Financial Data Schedule (included on page F-23)                                                                  |
|       |   |                                                                                                             |
| 31.1**     |   | Certification of Principal Executive Officer pursuant to Section 302  of the Sarbanes-Oxley Act of 2002.         |
| 31.2**     |   | Certification of Principal Financial Officer pursuant to Section 302  of the Sarbanes-Oxley Act of 2002.         |
| 32.1**     |   | Certification pursuant to 18 U.S.C. 1350, as adapted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002. |

 

----

(1)                                                                    Incorporatedby reference to our Form 10-K/A, filed on September 10, 1998.

 

(2)                                                                    Incorporatedby reference to our Registration Statement on Form S-1, as amended, filed onJuly 2, 1997.

 

(3)                                                                    Incorporatedby reference to our Form 10-Q, filed on November 13, 1997.

 

(4)                                                                    Incorporatedby reference to our Form 10-K, filed on March 30, 1998.

 

(5)                                                                    Incorporatedby reference to our Form 10-Q, filed on August 12, 1998.

 

(6)                                                                    Incorporatedby reference to our Form 10-Q, filed on November 13, 1998.

 

(7)                                                                    Incorporatedby reference to our Form 10-K, filed on March 29, 1999.

 

(8)                                                                    Incorporatedby reference to our Form 10-Q, filed on August 13, 1999.

 

(9)                                                                    Incorporatedby reference to our Registration Statement on Form S-1 filed on September 7,1999.

 

(10)                                                              Incorporatedby reference to our Form 10-K, filed on March 29, 2000.

 

(11)                                                              Incorporatedby reference to our Form 10-Q, filed May 12, 2000.

 

(12)                                                              Incorporatedby reference to our Form 10-Q filed April 2, 2001.

 

(13)                                                              Incorporatedby reference to our Form 10-Q, filed August 3, 2001.

 

(14)                                                              Incorporatedby reference to our Form 10-Q, filed November 14, 2001.

 

(15)                                                              Incorporatedby reference to our Form 10-K, filed March 31, 2003.

 

*                                         Certainconfidential portions of this exhibit were omitted by means of redacting aportion of the text (the “Mark”).  Thisexhibit has been filed separately with the Secretary of the Securities andExchange Commission without the Mark pursuant to our application requestingconfidential treatment under Rule 406 under the Securities Act.

 

**                                  Filed herewith

 

SUPPLEMENTAL INFORMATION

 

Copies of theRegistrant’s Proxy Statement for the Annual Meeting of Stockholders to be heldMay24, 2004 and copies of the form of proxy to be used for such Annual Meetingwill be furnished to the Commission prior to the time they are distributed tothe Stockholders.

 

39

----

 

SIGNATURES

 

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

 

 
|   |                       |   |   |   |   | VISTA MEDICAL TECHNOLOGIES, INC. |
|--------|----------------------------|--------|--------|--------|--------|----------------------------------|
|   |                       |   |   |   |   |                             |   |
|   |                       |   |   |   |   |                             |   |
|   | Date:  March 30, 2004 |   |   |   | By:    | /s/ John R. Lyon                 |   |
|   |                       |   |   |   |   |                             | John R. Lyon |
|   |                       |   |   |   |   |                             | President and Chief Executive Officer |

 

 

POWER OF ATTORNEY

 

Know all menby these presents, that each person whose signature appears below constitutesand appoints John R. Lyon or Stephen A. Gorgol, his or her attorney-in-fact,with power of substitution in any and all capacities, to sign any amendments tothis Annual Report on Form 10-K, and to file the same with exhibits thereto,and other documents in connection therewith, with the Securities and ExchangeCommission, hereby ratifying and confirming all that the attorney-in-fact orhis or her substitute or substitutes may do or cause to be done by virtuehereof.

 

Pursuant tothe requirements of the Securities Exchange Act of 1934, this Report has beensigned below by the following persons on behalf of the Registrant in thecapacities and on the dates indicated.

 
| **SIGNATURE**                  |   | **TITLE**                                                             |                               | **DATE** |           |
|--------------------------------|--------|-----------------------------------------------------------------------|------------------------------------|----------|----------------|
|                           |   |                                                                  |                               |     |           |
| /s/  John R. Lyon         |   |                                                                  | President, Chief Executive         |     | March 30, 2004 |   |
| (John R. Lyon)                 |   | Officer and Director (Principal  Executive Officer)                   |                               |     |           |
|                           |   |                                                                  |                               |     |           |
| /s/ Stephen A. Gorgol          |   |                                                                  | Vice President of Finance and      |     | March 30, 2004 |   |
| (Stephen A. Gorgol)            |   | Chief Financial Officer (Principal  Financial and Accounting Officer) |                               |     |           |
|                           |   |                                                                  |                               |     |           |
|  /s/  James C. Blair |   |                                                                  | Chairman of the Board and Director |     | March 30, 2004 |   |
| (James C. Blair)               |   |                                                                  |                               |     |           |
|                           |   |                                                                  |                               |     |           |
| /s/  George B. DeHuff     |   |                                                                  | Director                           |     | March 30, 2004 |   |
| (George B. DeHuff)             |   |                                                                  |                               |     |           |
|                           |   |                                                                  |                               |     |           |
| /s/  Scott Pancoast       |   |                                                                  | Director                           |     | March 30, 2004 |   |
| (Scott Pancoast)               |   |                                                                  |                               |     |           |
|                           |   |                                                                  |                               |     |           |
| /s/  Michael Owens        |   |                                                                  | Director                           |     | March 30, 2004 |   |
| (Michael Owens)                |   |                                                                  |                               |     |           |
|                           |   |                                                                  |                               |     |           |
| /s/  Larry M. Osterink    |   |                                                                  | Director                           |     | March 30, 2004 |   |
| (Larry M. Osterink)            |   |                                                                  |                               |     |           |

 

40

----

Vista Medical Technologies, Inc.

 

Index to Consolidated Financial Statements

 
| Report of Ernst & Young LLP, Independent Auditors                                                             |   |
|-------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                              |   |
| CONSOLIDATED FINANCIAL STATEMENTS                                                                                 |   |
|                                                                                                              |   |
| Consolidated Balance Sheets at December 31, 2002 and 2003                                                    |   |
| Consolidated Statements of Operations for  the years ended  December 31, 2001, 2002, and 2003                |   |
| Consolidated Statements of Stockholders’  Equity for the years ended  December 31, 2001, 2002, and 2003 |   |
| Consolidated Statements of Cash Flows for  the years ended  December 31, 2001, 2002, and 2003                |   |
| Notes to Consolidated Financial Statements                                                                        |   |
|                                                                                                              |   |
| Schedule II  Valuation  and Qualifying Accounts                                                         |   |

 

----

 

Report of  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, 2002 and 2003 and therelated consolidated statements of operations, stockholders’ equity, and cashflows for each of the three years in the period ended December 31, 2003.  Our audit also included the financial statementschedule listed in the index at Item 15(a).  These financial statements are the responsibility of theCompany’s management. Our responsibility is to express an opinion on thesefinancial 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, 2002 and 2003, and theconsolidated results of its operations and its cash flows for each of the threeyears in the period ended December 31, 2003, in conformity with accountingprinciples generally accepted in the United States.  Also, in our opinion, the related financial statement schedule,when considered in relation to the basic financial statements taken as a whole,presents fairly in all material respects the information set forth therein.

 

As discussed in Note 1 to the financial statements, Vista MedicalTechnologies, Inc. continues to experience losses from operations and hasaccumulated losses totaling $68.1 million through December 31, 2003.  At December 31, 2003, the Company hadcash, cash equivalents and short-term investments of $636,000.  The Company will require additionalfinancing to fund its operations through January 2005. These factors raisesubstantial doubt about the Company’s ability to continue as a going concern.  Management’s plan as to this matter isdescribed in Note 1. The 2003 financial statements do not include anyadjustments to reflect the possible future effects on the recoverability andclassification of assets or the amounts and classification of liabilities thatmay result from the outcome of this uncertainty.

 
|                  |   |   |   |   |   |   | /s/ Ernst & Young LLP |   |
|-----------------------|--------|--------|--------|--------|--------|--------|---------------------------|--------|
|                  |   |   |   |   |   |   |                      |   |
| Boston, Massachusetts |   |   |   |   |   |   |                      |   |
| March 2, 2004    |   |   |   |   |   |   |                      |   |

 

F-1

----

 

Vista Medical Technologies, Inc.

 

Consolidated Balance Sheets

 
|                                                                                                                                            |   | **DECEMBER 31,** |      |
|-------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------|-----------|
|                                                                                                                                            |   | **2002**              |      | **2003** |   |
| ASSETS                                                                                                                                          |   |                  |      |   |   |
| Current  assets:                                                                                                                                |   |                  |      |   |   |
| Cash and cash  equivalents                                                                                                                      |   | $                     | 457,052   |   | $ | 448,943 |   |
| Short-term  investments                                                                                                                         |   | 372,320               |      | 187,209 |   |
| Accounts  receivable, net                                                                                                                       |   | 1,670,480             |      | 979,877 |   |
| Inventories,  net                                                                                                                               |   | 1,493,278             |      | 1,159,207 |   |
| Other current  assets                                                                                                                           |   | 108,536               |      | 174,466 |   |
| Total current  assets                                                                                                                           |   | 4,101,666             |      | 2,949,702 |   |
| Property and  equipment, net                                                                                                                    |   | 77,431                |      | 41,459 |   |
| Patents and  other assets, net                                                                                                                  |   | 3,061                 |      | 0 |   |
| Total Assets                                                                                                                                    |   | $                     | 4,182,158 |   | $ | 2,991,161 |   |
|                                                                                                                                            |   |                  |      |   |   |
| LIABILITIES  AND STOCKHOLDERS’ EQUITY                                                                                                      |   |                  |      |   |   |
| Current  liabilities:                                                                                                                           |   |                  |      |   |   |
| Accounts  payable                                                                                                                               |   | $                     | 936,706   |   | $ | 702,838 |   |
| Current  portion of capital leases                                                                                                              |   | 12,474                |      | 23,984 |   |
| Short term  bank borrowings                                                                                                                     |   | 0                     |      | 200,000 |   |
| Accrued  compensation                                                                                                                           |   | 262,225               |      | 235,993 |   |
| Deferred  revenue                                                                                                                               |   | 499,167               |      | 480,000 |   |
| Accrued  liabilities                                                                                                                            |   | 383,848               |      | 221,558 |   |
| Total current  liabilities                                                                                                                      |   | 2,094,420             |      | 1,864,373 |   |
|                                                                                                                                            |   |                  |      |   |   |
| Total long  term portion of capital leases                                                                                                      |   | 6,781                 |      | 18,624 |   |
|                                                                                                                                            |   |                  |      |   |   |
| TOTAL  LIABILITIES                                                                                                                              |   | 2,101,201             |      | 1,882,997 |   |
|                                                                                                                                            |   |                  |      |   |   |
| Stockholders’  equity:                                                                                                                     |   |                  |      |   |   |
| Preferred  stock, $.01 par value:                                                                                                               |   |                  |      |   |   |
| Authorized  shares – 5,000,000 Issued and outstanding shares – none in 2002, and  1,000,000 in 2003 (Liquidation Value of $3,800,000) |   | 0                     |      | 1,068,686 |   |
|                                                                                                                                            |   |                  |      |   |   |
| Common stock,  $.01 par value:                                                                                                                  |   |                  |      |   |   |
| Authorized  shares – 35,000,000 Issued and outstanding shares – 5,001,749 in 2002 and  5,007,918 in 2003                              |   | 50,018                |      | 50,079 |   |
| Additional  paid-in capital                                                                                                                     |   | 68,079,861            |      | 68,111,244 |   |
| Notes  receivable from stockholders                                                                                                             |   | (78,375               | )         | 0 |   |
| Deferred  compensation                                                                                                                          |   | (45,947               | )         | (29,856 | ) |
| Accumulated  deficit                                                                                                                            |   | (65,924,600           | )         | (68,091,989 | ) |
|                                                                                                                                            |   |                  |      |   |   |
| Total  stockholders’ equity                                                                                                                |   | 2,080,957             |      | 1,108,164 |   |
|                                                                                                                                            |   |                  |      |   |   |
| Total  liabilities and stockholders’ equity                                                                                                |   | $                     | 4,182,158 |   | $ | 2,991,161 |   |

 

SEE ACCOMPANYING NOTES

 

F-2

----

 

Vista Medical Technologies, Inc.

 

Consolidated Statements of Operations

 
|                                                           |   | **YEARS ENDED DECEMBER 31,** |       |
|----------------------------------------------------------------|--------|-----------------------------------|------------|
|                                                           |   | **2001**                          |       | **2002** |   | **2003** |   |
|                                                           |   |                              |       |   |   |   |   |
| Revenues                                                       |   | $                                 | 9,326,490  |   | $ | 11,106,130 |   | $ | 8,709,208 |   |
|                                                           |   |                              |       |   |   |   |   |
| Cost and  expenses:                                            |   |                              |       |   |   |   |   |
|                                                           |   |                              |       |   |   |   |   |
| Cost of  revenues                                              |   | 6,405,340                         |       | 5,988,881 |   | 5,184,838 |   |
|                                                           |   |                              |       |   |   |   |   |
| Research and  development                                      |   | 1,945,433                         |       | 1,709,534 |   | 1,177,656 |   |
|                                                           |   |                              |       |   |   |   |   |
| Sales and  marketing                                           |   | 2,237,108                         |       | 2,690,032 |   | 2,548,391 |   |
|                                                           |   |                              |       |   |   |   |   |
| General and  administrative                                    |   | 2,030,917                         |       | 1,882,260 |   | 1,879,416 |   |
|                                                           |   |                              |       |   |   |   |   |
| Total costs  and expenses                                      |   | 12,618,798                        |       | 12,270,707 |   | 10,790,301 |   |
|                                                           |   |                              |       |   |   |   |   |
| Loss from  operations                                          |   | (3,292,308                        | )          | (1,164,577 | ) | (2,081,093 | ) |
|                                                           |   |                              |       |   |   |   |   |
| Other income,  net                                             |   | 69,879                            |       | 17,426 |   | 32,390 |   |
|                                                           |   |                              |       |   |   |   |   |
| Net loss                                                       |   | $                                 | (3,222,429 | ) | $ | (1,147,151 | ) | $ | (2,048,703 | ) |
|                                                           |   |                              |       |   |   |   |   |
| Less-  Accretion of dividends on preferred stock               |   | —                            |       | — |   | (118,684 | ) |
| Net loss  applicable to common stockholders                    |   | $                                 | (3,222,429 | ) | $ | (1,147,151 | ) | $ | (2,167,387 | ) |
|                                                           |   |                              |       |   |   |   |   |
| Basic and  diluted net loss per share                          |   | $                                 | (0.66      | ) | $ | (0.23 | ) | $ | (0.43 | ) |
|                                                           |   |                              |       |   |   |   |   |
| Shares used in  computing basic and diluted net loss per share |   | 4,906,197                         |       | 4,968,519 |   | 5,004,126 |   |

 

SEE ACCOMPANYING NOTES

 

F-3

----

 

Vista Medical Technologies, Inc.

 

ConsolidatedStatements of Stockholders’ Equity

 
|                                                         |   | **PREFERRED  STOCK** |   | **COMMON  STOCK** |         | **ADDITIONAL  PAID IN  CAPITAL** |      | **NOTES  RECEIVABLE  FROM  STOCKHOLDERS** |   | **DEFERRED  COMPENSATION** |   | **ACCUMULATED  DEFICIT** |       | **TOTAL** |    |
|--------------------------------------------------------------|--------|----------------------|--------|-------------------|--------------|----------------------------------|-----------|-------------------------------------------|--------|----------------------------|--------|--------------------------|------------|-----------|---------|
|                                                         |   |                 |
|                                                         |   | **SHARES**           |   | **AMOUNT**        |         | **SHARES**                       |      | **AMOUNT**                                |
|                                                         |   |                 |   |              |         |                             |      |                                      |   |                       |   |                     |       |      |    |   |   |   |   |
| Balance at December 31, 2000                            |   |                 |   |              |         | 4,897,342                        |      | $                                         | 48,973 |                       | $      | 68,003,535               |       | $         | (78,375 | ) | $ | (267,951 | ) | $ | (61,555,020 | ) | $ | 6,151,162 |   |
|                                                         |   |                 |   |              |         |                             |      |                                      |   |                       |   |                     |       |      |    |   |   |   |   |
| 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    | )       |   |   | (137,322 | ) |
| Net loss                                                     |   |                 |   |              |         |                             |      |                                      |   |                       |   |                     |       |      |    | (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 |   |
|                                                         |   |                 |   |              |         |                             |      |                                      |   |                       |   |                     |       |      |    |   |   |   |   |
| Exercise of stock options and warrants for cash              |   |                 |   |              |         | 64,808                           |      | 649                                       |   | 34,982                     |   |                     |       |      |    |   |   | 35,631 |   |
| Issuance of stock under employee stock purchase  plan        |   |                 |   |              |         | 23,910                           |      | 239                                       |   | 34,792                     |   |                     |       |      |    |   |   | 35,031 |   |
| Deferred compensation- issuance of options to  consultants   |   |                 |   |              |         |                             |      |                                      |   | 36,000                     |   |                     |       | (36,000   | )       |   |   | –– |   |
| Amortization of deferred compensation                        |   |                 |   |              |         |                             |      |                                      |   |                       |   |                     |       | 66,358    |    |   |   | 66,358 |   |
| Net loss                                                     |   |                 |   |              |         |                             |      |                                      |   |                       |   |                     |       |      |    | (1,147,151 | ) | (1,147,151 | ) |
|                                                         |   |                 |   |              |         |                             |      |                                      |   |                       |   |                     |       |      |    |   |   |   |   |
| Balance at December 31, 2002                            |   | ––         |   | $                 | –– |                             | 5,001,749 |                                      | $      | 50,018                     |   | $                        | 68,079,861 |      | $       | (78,375 | ) | $ | (45,947 | ) | $ | (65,924,600 | ) | $ | 2,080,957 |   |
|                                                         |   |                 |   |              |         |                             |      |                                      |   |                       |   |                     |       |      |    |   |   |   |   |
| Exercise of stock options for cash                           |   |                 |   |              |         | 1,333                            |      | 13                                        |   | 1,986                      |   |                     |       |      |    |   |   | 1,999 |   |
| Issuance of stock under employee stock purchase  plan        |   |                 |   |              |         | 4,836                            |      | 48                                        |   | 6,397                      |   |                     |       |      |    |   |   | 6,445 |   |
| Deferred compensation - issuance of options to  consultants  |   |                 |   |              |         |                             |      |                                      |   | 23,000                     |   |                     |       | (23,000   | )       |   |   | –– |   |
| Amortization of deferred compensation                        |   |                 |   |              |         |                             |      |                                      |   |                       |   |                     |       | 39,091    |    |   |   | 39,091 |   |
| Issuance of stock – Series A preferred stock  financing |   | 1,000,000            |   | 950,000           |         |                             |      |                                      |   |                       |   |                     |       |      |    |   |   | 950,000 |   |
| Forgiveness of notes receivable                              |   |                 |   |              |         |                             |      |                                      |   |                       |   | 78,375                   |       |      |    |   |   | 78,375 |   |
| Accretion of Preferred Stock dividends                       |   |                 |   | 118,686           |         |                             |      |                                      |   |                       |   |                     |       |      |    | (118,686 | ) | –– |   |
| Net loss                                                     |   |                 |   |              |         |                             |      |                                      |   |                       |   |                     |       |      |    | (2,048,703 | ) | (2,048,703 | ) |
|                                                         |   |                 |   |              |         |                             |      |                                      |   |                       |   |                     |       |      |    |   |   |   |   |
| Balance at December 31, 2003                            |   | 1,000,000            |   | $                 | 1,068,686    |                             | 5,007,918 |                                      | $      | 50,079                     |   | $                        | 68,111,244 |      | $       | –– |   | $ | (29,856 | ) | $ | (68,091,989 | ) | $ | 1,108,164 |   |

 

F-4

----

 

Vista Medical Technologies, Inc.

 

Consolidated Statements of Cash Flows

 
|                                                                         |   | **YEARS ENDED DECEMBER 31,** |       |
|------------------------------------------------------------------------------|--------|-----------------------------------|------------|
|                                                                         |   | **2001**                          |       | **2002** |   | **2003** |   |
|                                                                         |   |                              |       |   |   |   |   |
| **OPERATING  ACTIVITIES**                                                    |   |                              |       |   |   |   |   |
|                                                                         |   |                              |       |   |   |   |   |
| Net loss                                                                     |   | $                                 | (3,222,429 | ) | $ | (1,147,151 | ) | $ | (2,048,703 | ) |
|                                                                         |   |                              |       |   |   |   |   |
| Adjustments to  reconcile net loss to net cash used in operating activities: |   |                              |       |   |   |   |   |
|                                                                         |   |                              |       |   |   |   |   |
| Depreciation  and amortization                                               |   | 728,481                           |       | 430,106 |   | 164,066 |   |
|                                                                         |   |                              |       |   |   |   |   |
| Forgiveness of  notes receivable                                             |   | —                            |       | — |   | 78,375 |   |
|                                                                         |   |                              |       |   |   |   |   |
| Change in  allowance for doubtful accounts                                   |   | (116,418                          | )          | 100,724 |   | 2,743 |   |
|                                                                         |   |                              |       |   |   |   |   |
| Amortization  of deferred compensation                                       |   | 137,462                           |       | 66,358 |   | 39,091 |   |
|                                                                         |   |                              |       |   |   |   |   |
| Changes in  operating assets and liabilities:                                |   |                              |       |   |   |   |   |
|                                                                         |   |                              |       |   |   |   |   |
| Accounts  receivable                                                         |   | (381,695                          | )          | 90,824 |   | 687,860 |   |
|                                                                         |   |                              |       |   |   |   |   |
| Inventories,  net                                                            |   | 607,094                           |       | (398,704 | ) | 334,071 |   |
|                                                                         |   |                              |       |   |   |   |   |
| Other current  assets                                                        |   | (37,959                           | )          | 46,291 |   | (65,930 | ) |
|                                                                         |   |                              |       |   |   |   |   |
| Accounts  payable                                                            |   | 280,835                           |       | 195,704 |   | (233,868 | ) |
|                                                                         |   |                              |       |   |   |   |   |
| Accrued  compensation                                                        |   | 10,753                            |       | 58,812 |   | (26,232 | ) |
|                                                                         |   |                              |       |   |   |   |   |
| Deferred  revenue                                                            |   | 416,667                           |       | 82,500 |   | (19,167 | ) |
|                                                                         |   |                              |       |   |   |   |   |
| Accrued  liabilities                                                         |   | 20,798                            |       | 12,529 |   | (162,290 | ) |
|                                                                         |   |                              |       |   |   |   |   |
| Net cash flows  used in operating activities                                 |   | (1,556,411                        | )          | (462,007 | ) | (1,249,984 | ) |
|                                                                         |   |                              |       |   |   |   |   |
| **INVESTING  ACTIVITIES**                                                    |   |                              |       |   |   |   |   |
|                                                                         |   |                              |       |   |   |   |   |
| Purchases  (maturities) of short-term investments                            |   | (171,631                          | )          | 144,535 |   | 185,111 |   |
|                                                                         |   |                              |       |   |   |   |   |
| Purchase of  property and equipment                                          |   | (85,307                           | )          | (92,426 | ) | (75,860 | ) |
|                                                                         |   |                              |       |   |   |   |   |
| Net cash flows  (used in) provided by investing activities                   |   | (256,938                          | )          | 52,109 |   | 109,251 |   |
|                                                                         |   |                              |       |   |   |   |   |
| **FINANCING  ACTIVITIES**                                                    |   |                              |       |   |   |   |   |
|                                                                         |   |                              |       |   |   |   |   |
| Issuance of  common stock, net                                               |   | 24,890                            |       | 70,662 |   | 8,444 |   |
| Issuance of  Series A preferred stock                                        |   | —                            |       | — |   | 950,000 |   |
| Short term  bank borrowings                                                  |   | —                            |       | — |   | 200,000 |   |
| Payments on  capital leases                                                  |   | —                            |       | (4,259 | ) | (25,820 | ) |
|                                                                         |   |                              |       |   |   |   |   |
| Net cash flows  provided by financing activities                             |   | 24,890                            |       | 66,403 |   | 1,132,624 |   |
|                                                                         |   |                              |       |   |   |   |   |
| Net decrease  in cash and cash equivalents                                   |   | (1,788,459                        | )          | (343,495 | ) | (8,109 | ) |
|                                                                         |   |                              |       |   |   |   |   |
| Cash and cash  equivalents at beginning of year                              |   | 2,589,006                         |       | 800,547 |   | 457,052 |   |
|                                                                         |   |                              |       |   |   |   |   |
| Cash and cash  equivalents at end of year                                    |   | $                                 | 800,547    |   | $ | 457,052 |   | $ | 448,943 |   |
|                                                                         |   |                              |       |   |   |   |   |
| Non-cash  transactions:                                                      |   |                              |       |   |   |   |   |
| Acquisition of  equipment through capital leases                             |   | $                                 | —     |   | $ | 23,514 |   | $ | 49,173 |   |
| Accretion of  cumulative dividends on preferred stock                        |   | —                            |       | — |   | $ | 118,684 |   |
| Supplementary  cash flow information:                                        |   |                              |       |   |   |   |   |
| Interest paid                                                                |   | $                                 | 0          |   | $ | 0 |   | $ | 4,992 |   |

 

SEE ACCOMPANYING NOTES

 

F-5

----

 

Vista Medical Technologies, Inc.

 

Notes to Consolidated Financial Statements

December 31, 2003

 

1. ORGANIZATION ANDSUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

ORGANIZATION AND BUSINESS ACTIVITY

 

Over the course of the past year, the Company has defined its businessinto two separate units.  The ObesitySurgery Management Services business, based in Carlsbad, CA, provides servicesto physicians and hospitals involved in the surgical treatment of morbidobesity.  The Company’s services includemanagement of the Laparoscopic Bariatric Surgery Preceptorship, a comprehensiveintroduction to starting a minimally invasive gastric bypass surgicalprogram.  Additionally, the Companyoffers systems and consulting services which enable the efficient operation ofobesity surgery programs.

 

The Visualization Technology business, based in Westborough, MA,develops, manufactures and markets products that provide information tophysicians performing minimally invasive general surgical, cardiac surgical andother selected endoscopic and interventional procedures.  The Company’s technology products combine ahead mounted display with video cameras to provide surgeons with criticalvisual information during complex minimally invasive procedures, and alsoincorporate the benefit of viewing complementary information in avoice-controlled, picture-in-picture format, to facilitate real-time decisionmaking during surgery.  TheVisualization Technology business also manufactures compact, high resolutionendoscopic cameras for original equipment manufacturer customers and strategicpartners.

 

Subject to shareholder approval, on December 22, 2003, the Companyentered into an Asset Purchase Agreement with Viking Systems, Inc. (Viking)regarding the sale of all the assets of the Visualization Technology business,as more fully discussed in Note 11 to the financial statements.

 

The Company incurred operating losses in 2001, 2002 and 2003, and atDecember 31, 2003, had an accumulated deficit of $68.1 million.  At December 31, 2003, the Company hadcash, cash equivalents and short-term investments of $636,000.  In February 2004, the Company sold$588,000 of common stock in a private placement to several investors.   In addition, the Company has amountsavailable under a $2.0 million bank line of credit facility, which expires inOctober 2004 and is subject to annual renewals.  The Company believes that these sources of liquidity, togetherwith anticipated 2004 product revenues and interest income, will not besufficient to meet its anticipated capital requirements throughJanuary 2005.  These factors raisesubstantial doubt about the Company’s ability to continue as a goingconcern.  Management is pursuing severalalternatives to address this situation, including raising additional fundingand the intended sale of the Visualization Technology business.  However, there can be no assurance that therequisite fundings or the sale of the Visualization Technology business will beconsummated in the necessary time frame or on terms acceptable to the Company.  Should the Company be unable to raisesufficient funds, the Company may be required to curtail its operating plansand possibly relinquish rights to portions of the Company’s technology orproducts.  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 given that the Company will be able tooperate profitably on a consistent basis, or at all, in the future.

 

The accompanying consolidated financial statements have been preparedon a going concern basis, which contemplates the realization of assets and thesatisfaction of liabilities in the normal course of business.  The financial statements do not include andadjustments relating to the recoverability and classification of assets or theamounts and classification of liabilities that might be necessary should theCompany be unable to continue as a going concern.

 

PRINCIPLES OFCONSOLIDATION

 

The consolidated financial statements include the accounts of theCompany and its wholly-owned subsidiary. Significant intercompany accounts andtransactions have been eliminated.

 

RECLASSIFICATIONS

 

Certain account balances for the prior years have been reclassified toconform to the current year financial statement presentation.

 

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.

 

F-6

----

 

 

REVENUE RECOGNITION

 

The Company recognizes revenue pursuant to Staff Accounting Bulletin(“SAB”) No. 104 “Revenue Recognition”. Accordingly, revenue is recognized when all four of the followingcriteria are met: (i) persuasive evidence of an arrangement exists; (ii)delivery of the product and/or services has occurred; (iii) the selling priceis fixed or determinable and; (iv) collectibility is reasonably assured.  Sales returns are estimated based on thehistorical experience and management’s expectations and are recorded at thetime product revenue is recognized. Shipping and handling costs are included in cost of sales.

 

Within the Obesity Surgery Management Services business, the Company’srevenues are derived from consulting and training services.  Consulting and training services revenue isrecognized upon delivery of related marketing materials and completion of therelated training component, provided all of the criteria of SAB 104 are met.

 

Within the Visualization Technology business, the Company’s revenuesare derived from the sale of technology products to end users, distributors andoriginal equipment manufactures. Product revenue is recognized upon shipment, provided all the criteriaof SAB 104 are met.

 

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 anacceptable level.

 

The Company accounts for its investments in accordance with Statement ofFinancial Accounting Standards (SFAS) No. 115, “Accounting for CertainInvestments in Debt and Equity Securities”, and has classified its cashequivalents and short-term investments as available-for-sale in accordance withthat standard.  Available-for-salesecurities are carried at fair value, with unrealized gains and losses, net oftax, reported in a separate component of stockholders’ equity. AtDecember 31, 2003 and 2002, the cost of cash equivalents and short-terminvestments was equivalent to fair value and the Company had no unrealizedgains or losses.

 

As of December 31, 2002 and 2003, the Company’s cash, cashequivalents and short-term investments consisted of:

 
|                    |   | **2002** |    | **2003** |   |
|-------------------------|--------|----------|---------|----------|--------|
| Cash                    |   | $        | 24,905  |     | $      | 319,790  |   |
| Money market funds      |   | 432,147  |    | 129,153  |   |
| Certificates of deposit |   | 372,320  |    | 187,209  |   |
|                    |   | $        | 829,372 |     | $      | 636,152 |   |

 

 

All of the Company’s certificates of deposit held at December 31,2003, mature in 2004.

 

F-7

----

 

CONCENTRATION OF CREDIT RISK AND SIGNIFICANT CUSTOMERS

 

The Company provides credit, in the normal course of business, tocommercial entities that meet specified credit

requirements. The Company’s principal customers consist of originalequipment manufacturers and distribution partners. The Company provides forlosses from uncollectible accounts and such losses have historically notexceeded management’s expectations. As of December 31, 2003, fourcustomers comprised $275,000, $250,000, $173,000 and $116,000 or 28 %, 26%, 18%and 12%, respectively, of the outstanding trade receivables.  As of December 31, 2002, four customerscomprised $525,000, $223,000, $199,000 and $188,000 or 29 %, 13%, 11% and 10%,respectively, of the outstanding trade receivables.

 

Sales to individual customers exceeding 10% or more of revenues in theyears ended December 31, were as follows:during 2001, Richard Wolf, GmbH,Aesculap AG and Jomed accounted for 22%, 18% and 10% of revenues, respectively;during 2002, Aesculap AG accounted for 14% of revenues, and during 2003,Richard Wolf GmbH, Aesculap AG and Ethicon Endo-Surgery accounted for 20%, 16%and 10% of revenues, respectively.

 

FAIR VALUE OF FINANCIAL INSTRUMENTS

 

The carrying amounts of the Company’s financial instruments, whichinclude cash and cash equivalents, short-term investments, accounts receivable,accounts payable, capital leases and short-term bank borrowings, approximatetheir fair values at December 31, 2002 and 2003, due to the short-termnature of these financial instruments.

 

INVENTORIES

 

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

 

F-8

----

 

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 two to five years.  Marketing demonstration equipment isamortized over its estimated useful life of one year.  Depreciation expense for the years ended 2001, 2002 and 2003 wasapproximately $574,000, $396,000 and $161,000, respectively.

 

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.  Amortization expense for the years ended2001, 2002, and 2003 was approximately $154,000, $34,000 and $3,000,respectively.

 

IMPAIRMENT OF LONG-LIVED ASSETS

 

The Company evaluates its long-lived assets for impairment inaccordance with SFAS No. 144, *Accounting for the Disposal or Impairment ofLong-Lived Assets*.  TheCompany records impairment losses on long-lived assets used in operations whenindicators of impairment are present and the undiscounted cash flows estimatedto be generated by those assets are less than the carrying value of the assets.There have not been any impairments of long-lived assets to date.

 

RESEARCH AND DEVELOPMENT

 

Research and development costs are expensed in the period incurred.

 

INCOME TAXES

 

The Company uses the asset and liability accounting method wherebydeferred tax assets and liabilities are recognized based on temporarydifferences between the financial statements and tax bases of assets andliabilities using current statutory tax rates. A valuation allowance againstnet deferred tax assets is recorded if, based on the available evidence, it ismore likely than not that some or all of the deferred tax assets will not berealized. Management evaluates on a quarterly basis the ability to recover thedeferred tax assets and the level of the valuation allowance.

 

COMPREHENSIVE INCOME / (LOSS)

 

Comprehensive income / (loss) is comprised of net loss and othercomprehensive income/ (loss). Other comprehensive income/(loss) includescertain changes in equity that are excluded from net loss. For the years endedDecember 31, 2001, 2002 and 2003, the Company had no items ofcomprehensive income (loss) other than its net loss.

 

SAVINGS PLANS

 

The Company has a 401(k) plan for U.S. employees, which includeretirement income features consisting of employee tax deferred contributions.Contributions under all plans are invested in professionally managedportfolios.  No Company contributionswere made in 2001, 2002 and 2003.

 

NET LOSS PER SHARE

 

Basic net loss per share is calculated based on the weighted averagenumber of common shares outstanding during the period. Diluted net loss pershare incorporates the dilutive effect of common stock equivalents, includingstock options, warrants and other convertible securities.  Common stock equivalents have been excludedfrom the

 

F-9

----

 

calculation of weighted average number of diluted common shares, astheir effect would be antidilutive for all

periods presented.  Common stockequivalents excluded from the calculation of diluted weighted average shareswere 564,130, 689,328 and 806,286 as of December 31, 2001, 2002 and 2003,respectively.

 

STOCK-BASED COMPENSATION

 

The Company applies the principles of Accounting Principles BoardOpinion No. 25, “*Accounting for Stock Issuedto Employees*,” and related interpretations in accounting for itsemployee stock option compensation plans. Under APB No. 25, compensationexpense is measured as the difference, if any, between the option exerciseprice and the fair value of the Company’s common stock at the date ofgrant.  The Company has historically grantedoptions to employees and directors at exercise prices equal to the fair valueof the Company’s common stock. Accordingly, no compensation expense has beenrecognized for its employee stock-based compensation plans.

 

SFAS No. 123, “*Accounting forStock-Based Compensation*,” establishes a fair value based approachfor valuing stock options.  The Companyfollows the disclosure-only alternative afforded by SFAS No. 123.  Had compensation costs for stock optionsissued to employees and directors been determined based on the estimated fairvalue at the grant dates as calculated in accordance with SFAS No. 123, theCompany’s reported net loss and basic and diluted net loss per common share forthe years ended December 31, 2001, 2002 and 2003 would have been adjustedto the pro forma amounts indicated below:

 
|                                                    |   | **For the  years ended December  31,**                            |   |
|---------------------------------------------------------|--------|-------------------------------------------------------------------|--------|
|                                                    |   | **2001**                                                          |   | **2002** |   | **2003** |   |
|                                                    |   | **(In thousands,  except per share amounts)** |   |
| Net loss:                                               |   |                                                              |   |   |   |   |   |
| As reported                                             |   | $                                                                 | (3,222 | ) | $ | (1,147 | ) | $ | (2,049 | ) |
| Stock based compensation expense included  in net loss  |   | 137                                                               |   | 66 |   | 39 |   |
| Pro forma compensation expense using fair  value method |   | (426                                                              | )      | (344 | ) | (262 | ) |
| Pro forma SFAS No. 123 net loss                         |   | $                                                                 | (3,511 | ) | $ | (1,425 | ) | $ | (2,272 | ) |
|                                                    |   |                                                              |   |   |   |   |   |
| Basic and diluted net loss per share:                   |   |                                                              |   |   |   |   |   |
| As reported                                             |   | $                                                                 | (0.66  | ) | $ | (0.23 | ) | $ | (0.43 | ) |
| Pro forma                                               |   | $                                                                 | (0.72  | ) | $ | (0.29 | ) | $ | (0.48 | ) |

 

The average estimated fair value of options granted during fiscal years2001, 2002 and 2003, was $3.36, $3.47, and $1.09, respectively, and wasestimated using the Black-Scholes option-pricing model using the following weighted-averageassumptions:

 
|                    |   | **2001**       |   | **2002**       |   | **2003**        |   |
|-------------------------|--------|----------------|--------|----------------|--------|-----------------|--------|
| Dividend Yield          |   | None           |   | None           |   | None            |   |
| Volatility              |   | 231%           |   | 106%           |   | 124%            |   |
| Risk-free interest rate |   | 3.9%–6.0% |   | 2.6%–6.5% |   | 1.0%–2.29% |   |
| Expected life (years)   |   | 5              |   | 5              |   | 3               |   |

 

The Black-Scholes option-pricing model was developed for use inestimating the fair value of traded options that have no vesting restrictionsand are fully transferable. In addition, option-pricing models require the useof highly subjective assumptions, including the expected stock price volatility.Because the Company’s employee stock options have characteristics significantlydifferent from those of traded options, and because changes in the subjectiveassumptions can materially affect the fair value estimates, in management’sopinion, the existing models do not necessarily provide a reliable singlemeasure of the fair value of its employee stock-based compensation.

 

F-10

----

 

The Company accounts for stock-based compensation to non-employeesusing the fair value method prescribed by SFAS No. 123.  As a result of stock options issued tonon-employee medical board advisors, the Company recognized $93,000 and $23,000in non-employee deferred compensation during the years ended December 31,2001 and 2003, respectively. The fair value of the non-employee stock optionswas derived from the Black-Scholes option-pricing model using the followingweighted-average assumptions:

 
|                    |   | **2001**        |   | **2003**       |   |
|-------------------------|--------|-----------------|--------|----------------|--------|
| Dividend Yield          |   | None            |   | None           |   |
| Volatility              |   | 231%            |   | 124%           |   |
| Risk-free interest rate |   | 3.05%–3.5% |   | 1.3%–1.3% |   |
| Expected life (years)   |   | 3               |   | 3              |   |

 

NEW ACCOUNTING STANDARDS

 

In January 2003 FASB Interpretation No. 46,“Consolidation of Variable Interest Entities” was issued. This interpretationrequires a company to consolidate variable interest entities (“VIE”) if theenterprise is a primary beneficiary (holds a majority of the variable interest)of the VIE and the VIE passes specific characteristics. It also requiresadditional disclosures for parties involved with VIEs.  In December, 2003, the FASB issued arevision of Interpretation No. 46 (the Revised Interpretation 46). RevisedInterpretation 46 codifies both the proposed modifications and other decisionspreviously issued through certain FASB Staff Positions (FSPs) and supersedes theoriginal Interpretation No. 46 to include: (1) deferringthe effective date of theInterpretation’s provisions for certain variable interests, (2) providingadditional scope exceptions for certain other variable interests, (3)clarifying the impact of troubled debt restructurings on the requirement toreconsider (a) whether an entity is a VIE or (b) which party is the primarybeneficiary of a VIE, and (4) revising Appendix B of the Interpretation toprovide additional guidance on what constitutes a variable interest.Accordingly, the Company will adopt Revised Interpretation No. 46 effective thefirst quarter 2004 and does not expect the adoption of this interpretation willhave an impact on its consolidated financial position or results of operations.

 

In May 2003, the FASB issued SFAS No. 150, “*Accountingfor Certain Financial Instruments with Characteristics of Both Liabilities andEquity*.”  SFAS No. 150establishes standards for how an issuer classifies and measures certainfinancial instruments with characteristics of both liabilities and equity.  Many of these instruments were previouslyclassified as equity.  SFAS No. 150 iseffective for financial instruments entered into or modified after May 31,2003, and otherwise was effective at the beginning of the first interim periodbeginning after June 15, 2003.  Theadoption of this Statement did not have an effect on the Company’s financialstatements.

 

2. BALANCE SHEET COMPONENTS

 

Accounts receivable consist of the following: 

 
|                                  |   | **December 31,** |      |
|---------------------------------------|--------|-----------------------|-----------|
|                                  |   | **2002**              |      | **2003** |   |
| Gross accounts receivable             |   | $                     | 1,787,256 |   | $ | 980,235  |   |
| Less: Allowance for doubtful accounts |   | (116,776              | )         | (358 | ) |
|                                  |   | $                     | 1,670,480 |   | $ | 979,877 |   |

 

F-11

----

 

Inventories consist of the following:

 
|                                             |   | **December 31,** |      |
|--------------------------------------------------|--------|-----------------------|-----------|
|                                             |   | **2002**              |      | **2003** |   |
| Raw materials                                    |   | $                     | 1,243,304 |   | $ | 1,279,958 |   |
| Work in process                                  |   | 375,414               |      | 340,502 |   |
| Finished goods                                   |   | 919,344               |      | 841,317 |   |
|                                             |   | 2,538,062             |      | 2,461,777 |   |
| Less: Reserve for excess and obsolete  inventory |   | (1,044,784            | )         | (1,302,570 | ) |
|                                             |   | $                     | 1,493,278 |   | $ | 1,159,207 |   |

 

F-12

----

 

Property and equipment consists of the following:

 
|                                      |   | **December 31,** |      |
|-------------------------------------------|--------|-----------------------|-----------|
|                                      |   | **2002**              |      | **2003** |   |
| Machinery and equipment                   |   | $                     | 1,009,702 |   | $ | 1,007,497 |   |
| Office computers, furniture and equipment |   | 428,314               |      | 493,070 |   |
| Marketing demonstration equipment         |   | 111,340               |      | 163,444 |   |
| Leasehold improvements                    |   | 27,885                |      | 27,885 |   |
|                                      |   | 1,577,241             |      | 1,691,896 |   |
| Less: Accumulated depreciation            |   | (1,499,810            | )         | (1,650437 | ) |
|                                      |   | $                     | 77,431    |   | $ | 41,459 |   |

 

Accrued liabilities consist of the following: 

 
|                              |   | **December 31,** |         |
|-----------------------------------|--------|-----------------------|--------------|
|                              |   | **2002**              |         | **2003** |   |
| Customer warranty                 |   | $                     | 45,261  |   | $ | 13,261 |   |
| Miscellaneous accrued liabilities |   | 338,587               |         | 208,297 |   |
|                              |   | $                     | 383,848      |   | $ | 221,558 |   |

 

The Company provides for an estimated amount ofproduct warranty expense at the time revenue is recognized. This estimatedamount is determined based on the installed base of units under warranty andbased on historical warranty experience. A rollforward of the customer warranty accrual is as follows:

 
| Balance at December 31, 2002               |   | $       | 45,261 |   |
|-------------------------------------------------|--------|---------|--------|--------|
| Warranty expense                                |   | 17,454  |   |
| Deductions resulting from warranty claims       |   | (29,039 | )      |
| Deductions resulting from a change in  estimate |   | (20,415 | )      |
| Balance at December 31, 2003               |   | $       | 13,261 |   |

 

3. PROMOTION AGREEMENT

 

In June 2001, the Company entered into a Supply and PromotionAgreement with Ethicon Endo-Surgery, Inc. (EES). Under the agreement, theCompany will receive payments in return for the Company’s commitment to promoteuse of EES equipment in certain training programs sponsored by the Company forthe benefit of its customers with no obligation by the Company or its customersto purchase any EES equipment.  Theagreement grants EES with the right of first negotiation to acquire certainCompany technology.  The agreement has afive year term, but may be terminated by EES upon 90 days notice.  This agreement expired inNovember 2003.  A new promotionagreement was executed in December 2003 under which $500,000 will bereceived in 2003 and 2004 for optimization services to be provided, of which$250,000 was included in deferred revenue at December 31, 2003.  No further payments are expected from EESafter this point.  The Companyrecognizes revenue ratably over the

 

F-13

----

 

term of the agreement.  TheCompany recognized $917,000 of revenue in each of the years 2002 and 2003related to the EES agreement.

 

F-14

----

 

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 current line of creditagreement expires in October 2004. The Facility is secured by qualified accounts receivable and bearsinterest at the rate of prime plus 2% (4.5% at December 31, 2003).  Borrowings under the Facility are limited to80% of qualified accounts receivable. At December 31, 2003, there was $200,000 of borrowings outstanding, and $730,000 available under the Facility.

 

5.  COMMITMENTS

 

At December 31, 2003, the Company is obligated under an operatinglease, principally related to real estate. Additionally, the Company is obligated under capital leases related tocomputer hardware.  The following is aschedule of future minimum payments, excluding taxes and other operating costs,as of December 31, 2003:

 
| **YEAR ENDING DECEMBER 31,**         |   | **Operating  Leases** |    | **Capital  Leases** |   |
|-------------------------------------------|--------|-----------------------|---------|---------------------|--------|
| 2004                                      |   | $                     | 223,125 |                | $      | 30,422 |   |
| 2005                                      |   | 18,624                |    | 20,530              |   |
| 2006                                      |   | —                |    | 5,572               |   |
|                                      |   | $                     | 265,588 |                | $      | 56,524 |   |
| Less – Amounts representing interest |   |                  |    | (13,916             | )      |
| Principal capital lease obligation        |   |                  |    | $                   | 42,608 |   |

 

At December 31, 2002 and 2003, the Company had equipment undercapital leases with costs of $23,514 and $72,687, respectively and accumulateddepreciation of $9,502 and $41,163, respectively.

 

Rent expense was $361,000, $406,000 and $349,000 for the years endedDecember 31, 2001, 2002 and 2003, respectively.

 

6. STOCKHOLDERS’ EQUITY

 

COMMON STOCK RESERVED

 

At December 31, 2003, the Company has reserved the followingshares of common stock for future issuance:

 
| Conversion of Series A Convertible  Preferred Stock                 |   | 1,000,000 |   |
|---------------------------------------------------------------------|--------|-----------|--------|
| Exercise of outstanding and unissued stock  options                 |   | 985,865   |   |
| Available for issuance under the 1997  Employee Stock Purchase Plan |   | 62,758    |   |
|                                                                |   |      |   |
|                                                                |   | 2,048,623 |   |

 

F-15

----

 

PREFERRED STOCK

 

On March 3, 2003 the Company sold 1,000,000 shares of newly issuedSeries A Convertible Preferred Stock (Series A Stock) to two accreditedinvestors through a private placement for gross proceeds of $950,000. The sharesare convertible at any time into common shares on a one-for-one basis, subjectto adjustment, accrue annual dividends, payable only if and when declared bythe Company at the rate of $.01425 per share and have a liquidation value of$3,800,000 plus unpaid dividends. Although the shares are redeemable only atthe option of the Company, the Series A Stockholders will be entitled to a cashdividend of 15% per annum if specified redemptions are not effected within oneyear of the occurrence of certain events, including a sale of substantialassets or change of control. Accordingly, the Company recorded accretion of preferred stock dividendsin the amount of $118,864 during 2003. If redeemed, the redemption amount would be at prices of $2.67 to $2.90per share. As long as the Series A Stock is outstanding, the Company willrequire the approval of the Series A Stockholders to undertake various actionsincluding a) sell common shares for less than $2.00 per share, b) revise termsof corporate governance, c) exceed certain capital expenditure limits, or d)expand current stock option plans. The Series A Stockholders will also have theright to elect two directors to the Board of Directors after June 1, 2004.

 

1995 STOCK OPTION PLAN

 

The Company reserved 221,607 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.

 

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 oftermination of employment, to repurchase unvested shares issued under the 1995Plan at the original issue price.  Noadditional shares are available for issuance under the 1995 Plan.

 

F-16

----

 

1997 STOCK OPTION PLAN/ STOCK ISSUANCE PLAN

 

In February 1997, the Company adopted the 1997 Stock OptionPlan/Stock Issuance Plan (the “1997 Plan”). The 1997 Plan incorporates theoutstanding options under the 1995 Plan and no further options will be grantedunder the 1995 Plan.  AtDecember 31, 2003, the Company had a total of 1,092,500 shares authorizedfor issuance under the 1997 Stock Option/Stock Issuance Plan and 179,579options were available for future grant.

 

The following tables summarizes stock option activity under all optionplans:

 
|                              |   | **NUMBER OF  SHARES** |   | **PRICE PER  SHARE** |         | **WEIGHTED  AVERAGE  PRICE PER  SHARE** |        |
|-----------------------------------|--------|-----------------------|--------|----------------------|--------------|-----------------------------------------|-------------|
| Balance at December 31, 2000 |   | 552,910               |   | $                    | .80 -   | $                                       |  57.50 |   | $ | 6.20 |   |
| Granted                           |   | 61,250                |   | $                    | 3.48 -  | $                                       | 5.87        |   | $ | 4.23 |   |
| Exercised                         |   | (4,352                | )      | $                    | .80 -   | $                                       | .80         |   | $ | 0.80 |   |
| Canceled                          |   | (45,678               | )      | $                    | .80 -   | $                                       | 57.50       |   | $ | 12.90 |   |
|                              |   |                  |   |                 |         |                                    |        |
| Balance at December 31, 2001 |   | 564,130               |   | $                    | .80 -   | $                                       | 57.50       |   | $ | 5.50 |   |
| Granted                           |   | 183,700               |   | $                    | 3.12 -  | $                                       | 4.00        |   | $ | 3.76 |   |
| Exercised                         |   | (15,003               | )      | $                    | . 80 -  | $                                       | 2.50        |   | $ | 2 .24 |   |
| Canceled                          |   | (43,499               | )      | $                    | 2.50 -  | $                                       | 45.25       |   | $ | 19.09 |   |
|                              |   |                  |   |                 |         |                                    |        |
| Balance at December 31, 2002 |   | 689,328               |   | $                    | .80 -   | $                                       | 57.50       |   | $ | 4.25 |   |
| Granted                           |   | 185,050               |   | $                    | 89 -    | $                                       | 1.84        |   | $ | 1.56 |   |
| Exercised                         |   | (1,333                | )      | $                    | 1.50 -  | $                                       | 1.50        |   | $ | 1.50 |   |
| Canceled                          |   | (66,759               | )      | $                    | .89 -   | $                                       | 39.50       |   | $ | 5.13 |   |
|                              |   |                  |   |                 |         |                                    |        |
| Balance at December 31, 2003 |   | 806,286               |   | $                    | .80 -   | $                                       | 57.50       |   | $ | 3.56 |   |

 

F-17

----

 
|                         |               | **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 |                           | 468,251    |                                                          | 89     |   | $ | 1.57 |   | 319,955 |   | $ | 1.51 |   |
| $  3.00 -               | $   4.13 |                           | 250,924    |                                                          | 101    |   | $ | 3.64 |   | 175,134 |   | $ | 3.62 |   |
| $  4.62 -               | $   6.12 |                           | 41,111     |                                                          | 88     |   | $ | 4.96 |   | 38,465 |   | $ | 4.97 |   |
| $  9.00 -               | $   9.75 |                           | 21,125     |                                                          | 70     |   | $ | 9.31 |   | 21,450 |   | $ | 9.31 |   |
|                         | $ 20.25            |                           | 10,000     |                                                          | 65     |   | $ | 20.25 |   | 10,500 |   | $ | 20.25 |   |
| $39.50 -                     | $ 45.50            |                           | 13,875     |                                                          | 56     |   | $ | 40.50 |   | 14,125 |   | $ | 40.58 |   |
|                         | $ 57.50            |                           | 1,000      |                                                          | 57     |   | $ | 57.50 |   | 1,000 |   | $ | 57.50 |   |
|                         |               | 806,286                        |       | 63                                                            |   | $ | 3.56 |   | 580,629 |   | $ | 4.05 |   |

 

The weighted average remaining life of the options outstanding atDecember 31, 2002 and 2003 was 66 and 63 months, respectively.

 

WARRANTS

 

In December 2000, the Company issued a warrant to a corporatepartner to purchase 49,805 shares of common stock at an exercise price of $0.01per share.  The warrant is exercisablefor seven years following the date of issuance.  The estimated fair value of the warrant was $104,000, which wasexpensed at the time of issuance.  InMay 2002, this warrant was exercised.

 

F-18

----

 

1997 EMPLOYEE STOCK PURCHASE PLAN

 

In February 1997, the Company adopted the 1997 Employee StockPurchase Plan (the “Purchase Plan”), which permits eligible employees of theCompany to purchase shares of common stock, at semi-annual intervals, throughperiodic payroll deductions.  Payrolldeductions may not exceed 10% of the participant’s base salary, and thepurchase price per share will not be less than 85% of the lower of the fairmarket value of the common stock at either the beginning or the end of thesemi-annual intervals.  The Company hasauthorized and reserved 150,000 shares of common stock for issuance under thePurchase Plan.  There were 11,364,23,910 and 4,836 shares issued under the Purchase Plan in 2001, 2002 and 2003,respectively.   There were 62,758 sharesavailable for issuance at December 31, 2003.

 

NOTES RECEIVABLE FROM STOCKHOLDERS

 

In 1996, $78,375 was advanced to certain employees and a director ofthe Company on a full recourse basis for their exercise of stock options.  Such amounts were classified as notesreceivable from stockholders.  In 2003,the notes were forgiven and recorded as compensation expense.

 

7. INCOME TAXES

 

Significant components ofthe Company’s deferred tax assets as of December 31, 2002 and 2003 areshown below. A valuation allowance has been established to offset the deferredtax assets, as realization of such assets is uncertain.

 
|                                        |   | **December 31,** |       |
|---------------------------------------------|--------|-----------------------|------------|
|                                        |   | **2002**              |       | **2003** |   |
|                                        |   |                  |       |   |   |
| Deferred tax assets:                        |   |                  |       |   |   |
| Net operating loss carryforwards            |   | $                     | 21,515,000 |   | $ | 21,207,000 |   |
| Research and development credits            |   | 2,669,000             |       | 2,843,000 |   |
| Capitalized research and development        |   | 714,000               |       | 665,000 |   |
| Depreciation                                |   | 167,000               |       | 138,000 |   |
| Inventory reserve                           |   | 417,000               |       | 520,000 |   |
| Other                                       |   | 366,000               |       | 285,000 |   |
|                                        |   |                  |       |   |   |
| Total deferred tax assets                   |   | 25,848,000            |       | 25,658,000 |   |
| Valuation allowance for deferred tax assets |   | (25,848,000           | )          | (25,658,000 | ) |
| Net deferred taxes                          |   | $                     | —     |   | $ | — |   |

 

At December 31, 2003, the Company has federal and state tax netoperating loss carryforwards of approximately $55,588,000 and $30,388,000,respectively. The federal tax loss carryforwards will begin to expire in2010.  Approximately $15,671,000 of thestate tax loss carryforwards expired in 2003, and will continue to expire infuture periods unless previously utilized. At December 31, 2003, theCompany also has federal and state research tax credit carryforwards ofapproximately $2,248,000 and $902,000, respectively, which will begin to expirein 2010 unless previously utilized.

 

The difference between the federal and state tax loss carryforwards isprimarily attributable to the expiration of certain state net operating losscarryforwards, which have a shorter life than federal 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.

 

F-19

----

 

8.  SEGMENT AND GEOGRAPHICINFORMATION

 

*Segment Information:*Prior to 2002, the Company operated in one business segment, the VisualizationTechnology business.  Beginning in 2002,the Company reported revenue and certain operating expense information to thechief operating decision maker for its two operating segments, which aredetermined on the type of customer or product. These segments consist of (1)the Obesity Surgery Management Services business and (2) VisualizationTechnology business.

 

The Company’s chief operating decision maker evaluates the performanceof the two segments based on segment revenues and certain segment costs andexpenses, including cost of revenues and research and developmentexpenses.  Other operating expenses,including sales and marketing expenses and general and administrative expenses,are not allocated or evaluated on an individual segment basis, but rather on anenterprise-wide basis.  A summary of theCompany’s profitability by segment and in total for the years ended December 31,2002 and 2003 is as follows:

 
|                                                       |   | **Obesity Surgery  Management** |      | **Visualization  Technology** |   | **Total** |       |
|------------------------------------------------------------|--------|---------------------------------|-----------|-------------------------------|--------|-----------|------------|
| **Year ended  December 31, 2002:**                    |   |                            |      |                          |   |      |       |
| Revenues                                                   |   | $                               | 3,628,590 |                          | $      | 7,477,540 |       | $ | 11,106,130 |   |
| Cost of revenues                                           |   | 904,330                         |      | 5,084,551                     |   | 5,988,881 |       |
| Research and development                                   |   | —                          |      | 1,709,534                     |   | 1,709,534 |       |
| Segment contribution                                       |   | $                               | 2,724,260 |                          | $      | 683,455   |       | $ | 3,407,715 |   |
|                                                       |   |                            |      |                          |   |      |       |
| Reconciliation of segment contribution to  total net loss: |   |                            |      |                          |   |      |       |
| Sales and marketing                                        |   |                            |      |                          |   | 2,690,032 |       |
| General and administrative                                 |   |                            |      |                          |   | 1,882,260 |       |
| Interest income                                            |   |                            |      |                          |   | 17,426    |       |
| Net loss                                                   |   |                            |      |                          |   | $         | (1,147,151 | ) |

 
|                                                       |   | **Obesity  Surgery  Management** |      | **Visualization  Technology** |   | **Total** |       |
|------------------------------------------------------------|--------|----------------------------------|-----------|-------------------------------|--------|-----------|------------|
| **Year ended  December 31, 2003:**                    |   |                             |      |                          |   |      |       |
| Revenues                                                   |   | $                                | 2,489,117 |                          | $      | 6,220,091 |       | $ | 8,709,208 |   |
| Cost of revenues                                           |   | 574,599                          |      | 4,610,239                     |   | 5,184,838 |       |
| Research and development                                   |   | —                           |      | 1,177,656                     |   | 1,177,656 |       |
| Segment contribution                                       |   | $                                | 1,914,518 |                          | $      | 432,196   |       | $ | 2,346,714 |   |
|                                                       |   |                             |      |                          |   |      |       |
| Reconciliation of segment contribution to  total net loss: |   |                             |      |                          |   |      |       |
| Sales and marketing                                        |   |                             |      |                          |   | 2,548,391 |       |
| General and administrative                                 |   |                             |      |                          |   | 1,879,416 |       |
| Interest income                                            |   |                             |      |                          |   | 32,390    |       |
| Net loss                                                   |   |                             |      |                          |   | $         | (2,048,703 | ) |

 

The Company reports assets on a consolidated basis to the chiefoperating decision maker, and all the assets are

located within the United States.

 

*Geographicinformation:* Net sales by major geographical area,determined on the basis of destination of the goods, are as follows:

 

F-20

----

 
|          |   | **2001**  |      | **2002**  |   | **2003**   |   |
|---------------|--------|-----------|-----------|-----------|--------|------------|--------|
| United States |   | $         | 5,015,113 |      | $      | 7,513,804  |   | $ | 5,244,838 |   |
| Europe        |   | 4,311,377 |      | 3,592,326 |   | 3,464,370  |   |
| Total         |   | $         | 9,326,490 |      | $      | 11,106,130 |   | $ | 8,709,208 |   |

 

9. RELATED PARTY TRANSACTION

 

The Company has a sublease agreement for its California officespace.  The sublease agreement has beenexecuted with another company, of which Vista’s Chairman of the Board is also aDirector.  Total rental payments of$104,500 were paid to this company in 2003.

 

10.  SUBSEQUENT EVENT

 

In February 2004, the Company sold 439,000 shares of common stockin a private placement for gross proceeds of $588,000.  Additionally, 219,500 warrants to purchasecommon stock were issued to the investors at an exercise price of $1.97 pershare.

 

On March 4, 2004, the Company received notice from Nasdaq that itdoes not comply with the minimum stockholders’ equity requirement of $2,500,000and that Nasdaq will delist the Company. The Company has filed an appeal which stays the delisting until thehearing on April 1, 2004.

 

11. SALE OF THE VISUALIZATION TECHNOLOGY BUSINESS

 

On December 22, 2003, the Company entered into an Asset PurchaseAgreement with Viking Systems, Inc. (Viking) regarding the sale of all theassets of the Visualization Technology business.  Pursuant to the terms of the Asset Purchase Agreement, Viking willpurchase all assets related to the Visualization Technology business inexchange for a combination of cash, common stock and future royaltypayments.  Specifically, at closing,Viking will pay the Company cash of approximately $132,000 and issue shares of its common stock equal to ten percent(10%) of the fully-diluted common shares of Viking stock.  Additionally, at closing, the Company willenter into a License Agreement with Viking pursuant to which we willexclusively license to Viking all intellectual property and product rights usedin operation of the Visualization Technology business.  In exchange for this license grant, Vikingwill pay the Company royalties over the next five (5) years based on sales ofthe products of the Business by Viking. The License Agreement will contain minimum royalties of $150,000 in yearone, $300,000 in each of years two, three and four, and $375,000 in yearfive.  The royalties payable by Vikingunder the License Agreement are capped at $4,500,000, in the aggregate, overthe five year period.  The Company willretain ownership of all intellectual property and product rights under theLicense Agreement until these royalty obligations have been satisfied, at whichtime the Company will transfer ownership of such intellectual property andproduct rights to Viking.  Lastly, theCompany will consign to Viking at closing its current inventory of products andparts.  Viking will reimburse theCompany the value of that inventory, if and when sold, over the course of thenext year.  The consummation of thistransaction requires the prior approval of the Company’s shareholders, whichwill be solicited in April 2004. Because the sale is contingent upon stockholder approval, the Companyhas not yet met the requirements to classify the Visualization Technologybusiness as a discontinued operation. Therefore, the accompanying financial statements do not reflect anyadjustments or reclassifications as a result of this impending transaction.

 

F-21

----

 

The following is a summary of the results of operations for the yearsended December 31, 2002 and 2003:

 
|                                 |   | **2002**          |      |
|--------------------------------------|--------|-------------------|-----------|
|                                 |   | **March 31** |      | **June 30** |   | **September 30** |   | **December 31** |   |
| Revenues                             |   | $                 | 2,672,909 |   | $ | 2,809,577 |   | $ | 2,868,365 |   | $ | 2,755,279 |   |
| Cost of revenues                     |   | $                 | 1,363,141 |   | $ | 1,507,889 |   | $ | 1,631,155 |   | $ | 1,486,696 |   |
| Net loss                             |   | $                 | (376,075  | ) | $ | (374,532 | ) | $ | (283,372 | ) | $ | (113,173 | ) |
| Basic and diluted net loss per share |   | $                 | (0.08     | ) | $ | (0.08 | ) | $ | (0.06 | ) | $ | (0.02 | ) |

 
|                                 |   | **2003**          | ** ** |
|--------------------------------------|--------|-------------------|------------|
|                                 |   | **March 31** |       | **June 30** |   | **September 30** |   | **December 31** |   |
| Revenues                             |   | $                 | 2,849,585  |   | $ | 2,278,490 |   | $ | 1,680,343 |   | $ | 1,900,790 |   |
| Cost of revenues                     |   | $                 | 1,575,178  |   | $ | 1,295,329 |   | $ | 983,356 |   | $ | 1,330,975 |   |
| Net loss                             |   | $                 | (45,741    | ) | $ | (505,154 | ) | $ | (733,494 | ) | $ | (883,000 | ) |
| Basic and diluted net loss per share |   | $                 | (0.01      | ) | $ | (0.10 | ) | $ | (0.15 | ) | $ | (0.18 | ) |

 

F-22

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SCHEDULE II

 

VISTA MEDICAL TECHNOLOGIES, INC.

 

VALUATION AND QUALIFYING ACCOUNTS

 
| **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, 2001                 |   | $                                    | 2,245,748 |                                | $      | 71,375         |   | $                              | (795,427 | ) | $ | 1,521,696 |   |
| Year ended December 31, 2002                 |   | 1,521,696                            |      | 191,213                             |   | (668,125       | )      | 1,044,784                      |     |
| Year ended December 31, 2003                 |   | 1,044,784                            |      | 281,046                             |   | (23,260        | )      | 1,302,570                      |     |
|                                                   |        |                                      |           |                                     |        |                |        |                                |          |  |  |  |  |

 
| **Allowance for  Doubtful Accounts** |   | **Balance at  Beginning of  Period** |   | **Charged to  Costs and  Expenses** |   | **Deductions** |   | **Balance  at End  of Period** |    |
|--------------------------------------|--------|--------------------------------------|--------|-------------------------------------|--------|----------------|--------|--------------------------------|---------|
|                                 |   |                                 |   |                                |   |           |   |                           |    |
| Year ended December 31, 2001    |   | $                                    | 13,309 |                                | $      | 18,943         |   | $                              | (16,200 | ) | $ | 16,052 |   |
| Year ended December 31, 2002    |   | 16,052                               |   | 102,294                             |   | (1,570         | )      | 116,776                        |    |
| Year ended December 31, 2003    |   | 116,776                              |   | 6,346                               |   | (122,764       | )      | 358                            |    |
|                                      |        |                                      |        |                                     |        |                |        |                                |         |  |  |  |  |

 

F-23

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