**UNITEDSTATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

**FORM 10-K/A**

**Amendment No. 1**

 

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

 

**For fiscalyear ended December 31, 2003**

 

**OR**

 

**TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF1934 (NO FEE REQUIRED)**

 

**For the transition period from          to         .**

 

**Commission File Number:  0-22743**

 

**VISTAMEDICAL TECHNOLOGIES, INC.**

(Exact name of Registrant as specified in itscharter)

 

| **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 toSection 12(b) of the Act:  **None**

 

Securities registered pursuant toSection 12(g)  of the Act:  **CommonStock, par value $.01 per share**

 

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Actof 1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days. Yes  ý  No  o

 

Indicate by check mark whether the registrant is an accelerated filer(as defined in Rule 12b-2 of the Exchange Act).    Yes  o  No  ý

 

Indicate by check mark if disclosure of delinquent filers pursuant toItem 405 of Regulation S-K is not contained herein, and will not be contained,to the best of registrant’s knowledge, in definitive proxy or informationstatements incorporated by reference in Part III of this Form 10-K or any amendmentto this Form 10-K.  o

 

The aggregate market value of the voting stock held by nonaffiliates ofthe registrant as of June 30, 2003 was approximately $9,186,632.  For the purposes of this calculation, sharesowned by officers, directors and 10% stockholders known to the registrant havebeen deemed to be owned by affiliates. This determination of affiliate statusis not necessarily a conclusive determination for other purposes.

 

The number of shares outstanding of the registrant’s Common Stock as ofJuly 30, 2004 was 10,893,817.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Certain exhibits filed with the Registrant’s prior registrationstatements and forms 10-Q and 10-K are incorporated herein by reference intoPart III of this Report.

 

**EXPLANATORY NOTE**

 

We are filing this Amendment to our Annual Report on Form 10-K for thefiscal year ended December 31, 2003, to set forth information that we hadpreviously incorporated by reference to our Proxy Statement relating to theAnnual Meeting of our stockholders held on May 24, 2004.  Such information is set forth in fullherein.  We also inform the reader thaton April 15, 2004, we completed the sale of our Visualization Technologybusiness as contemplated.

 

 

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**VistaMedical Technologies, Inc.Form 10-K/AFor 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 to time we have made and may continue to make “forwardlooking statements” within the meaning of the federal securities laws.  This report on Form 10-K/A may containforward-looking statements.  Thesestatements, which represent our expectations or beliefs concerning variousfuture events, may contain words such as “expects,” “anticipates,” “intends,”“plans,” “believes,” “estimates,” or other words indicating future results.  Actual results may differ materially fromresults anticipated in such forward-looking statements.  We assume no obligation to update anyforward-looking statements to reflect events or circumstances arising after thedate of this report.

 

You should carefully review and consider the various disclosures inthis report regarding factors that could cause actual results to differmaterially from anticipated results, including those factors under the caption“Risks and Uncertainties” at pages 19 through 27 below, and elsewhere in thisreport.

 

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 visionof our VOW Solutions business is to enable healthcare providers andorganizations in the ongoing evolution of the highest standards of treatmentand services to optimize the quality of life for morbidly obese patients.  Our mission is to deliver the leadingmanagement portfolio of services and products for the clinical and businessdevelopment of continually successful obesity surgery programs.

 

We believe that our VOW products and services can be instrumental inthe implementation and/or optimization of a hospital’s successful bariatricsurgery program.  The obesity epidemicis not over; in fact, the rate of increase of severely obese Americans isaccelerating.  Obesity-relatedcomorbidities cost the United States healthcare system $102 billionannually.  Laparoscopic gastric bypasssurgery safely and effectively treats morbidly obese patients by allowing themto eliminate 96% of their comorbidities and average an 80% loss of excess bodyweight, within one year of surgery.  VOWSolutions’ complement of bariatric management and consulting services positionsa hospital to enter the field of bariatric surgery, as well as to optimize theoperation and efficiency of an existing program for future growth.

 

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**Backgroundto Visualization Technology Products**

 

***Minimallyinvasive surgery***

 

The development and subsequent widespread adoption of minimallyinvasive surgical procedures have revolutionized many surgical fields,including general surgery, orthopedics, gynecology and urology.  Minimally invasive surgical procedures areperformed through strategically placed ports or mini-incisions as opposed tousing large incisions to gain surgical access. These procedures are designed to be as safe and effective asconventional surgery.  The goal in usinga minimally invasive procedure is to substantially reduce trauma, 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***

 

Minimally invasive microsurgery is an extension of minimally invasivesurgery, characterized by greater complexity and precision.  Minimally invasive microsurgical procedureshave been made possible primarily by recent advances in medicaltechnology.  These procedures areusually performed in very confined areas of the body, involve critical parts ofthe body, and often require dissection, reconstruction and removal of bodyparts.  As a result of the inherentcomplexity involved in these procedures, we believe that for surgeons to adoptthe procedures, they must have access to specialized instruments andtechnology, including technology which will provide them with bettervisualization of the procedure being performed.  Examples of minimally invasive microsurgery are emerging ingeneral surgery and cardiac surgery, as well as in the fields of gynecology andurology.

 

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

 

*Conventional treatments.*

 

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

 

*Minimally invasive microsurgery*.

 

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

 

*The Vista Medical solution*.

 

We believe that the generaltechnology required to drive renewed growth in complex minimally invasiveprocedures for general surgery is now being undertaken by many companies infields complementary to ours, for example, in surgical robotics, electrosurgeryand surgical instrument design.  Webelieve that our advanced visualization and information technology will contributeto this 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 we founded our company in 1993 it was primarily to developadvanced visualization technologies for complex minimally invasive surgical proceduresand it was through the application of this technology in laparoscopic gastricbypass surgery that we subsequently developed our portfolio of consultingproducts and services for the initiation, operation and management of ObesitySurgery Programs.  Since early 2003, ourVisualization Technology business, located in Westborough, Massachusetts, andour Obesity Surgery and Medical Management Services business unit (nowincorporated in a wholly owned subsidiary VOW Solutions, Inc.), located inCarlsbad, California, have functioned as individual business units.  We intend to become a niche health careservices pure play, focused on the disease state management of chronic ormorbid obesity.  The business structureof the company, after the planned divestiture of the Visualization Technologybusiness, will be as follows:

 

 

**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 ofInternal Medicine published an article showing that the number ofextremely obese Americans (those more than 100 pounds above ideal body weight –the prime candidates for surgical intervention) has quadrupled since themid-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 theUnited States, with prevalence increasing to 24% of the adult population in2003, from 12% in 1991.  The increase inobesity cuts 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, suchas early onset of heart disease. Also, obesity is becoming recognized outsidethe United States as a looming problem; for example, the rate of growth ofobesity 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 clinically obese,and of these as many as 13-16 million are potential candidates for a surgicalweight-loss procedure.  That is,according to the National Institutes of Health (NIH) guideline, they have a BMIof 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 notcandidates for surgery, and to market our consulting services and back-officesystems capability to other bariatric surgical programs.  We intend to realize these objectivesthrough the execution of the 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.

 

***Institutebest-practice surgical protocols***.  Our experience with the LaparoscopicBariatric Surgical (LBS) Preceptorship has permitted us, under the direction ofour Clinical Faculty, to offer the most comprehensive surgical training coursein state-of-the-art laparoscopic gastric bypass surgery which is availableanywhere.  This training program will beavailable to surgeons who affiliate with VOW; the training process will alsoinclude subsequent 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 effectively withhigh-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 to success.  At the same time, the process towardssurgery must be efficient:  There aremany steps in the process, and it is easy for patients to become lost ordiscouraged if the system, and the staff dealing with them, is haphazard in itsapproach.  Standardized systems acrossall managed programs are designed to shepherd patients through the process withEfficient Empathy.

 

***Develop and leverageour consulting business***.  Our consulting business, originally based on provision ofclinical training in laparoscopic gastric bypass surgery, has expanded to includemanagement, 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 is growing,in both the medical and the surgical arena. For example, it is estimated that there are now between 1,200 to 1,500active bariatric surgeons.  However, theexpertise essential for high-volume patient acquisition, and the infrastructurerequired for quality patient care at these levels are often beyond the scope,or the willingness to invest, of many programs.  Even when bariatric centers are established in conjunction with asupportive hospital, the proper staffing, knowledge and time required to efficientlymarket, educate, collect a comprehensive medical and diet history, verifyinsurance and obtain the necessary authorizations can be a managementchallenge, one that many simply cannot handle cost-effectively.  Many of these functions are much more efficientlyand effectively handled in a centralized fashion (where one centralizeddepartment handles the work for dozens of programs).  A focused team of professionals with centralized support isnecessary to properly handle all the unique and multifaceted issues involved insecuring and serving large numbers (400 — 500 cases per year) of bariatricpatients.

 

It is for this reason that we have seen increasing interest fromhospitals and physicians in an outsourced management solution which bringstogether the resources necessary for establishment and/or operation ofsuccessful medical and surgical bariatric programs.  Our plan is to offer ongoing hands-on management support to suchmedical providers 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 several customizableoptions.  Our primary consultingproducts 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.

 

*Implementation Consulting Service*

Our implementation team spends up to 2 days on-site educating ahospital and program staff on the five fundamental phases of a successfulbariatric surgery program.  Thispreparation emphasizes patient introduction, the pre-admission/operativeperiod, the peri-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.

 

*Laparoscopic Bariatric 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.

 

*Optimization Consulting 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.  Operational recommendationstarget a patient’s migration through the program and improved efficiencybetween surgeons and the hospital.  Thecomprehensive marketing assessment analyzes referral patterns, per-patient costof 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 print advertisement,a patient brochure and a community lecture template on PowerPoint.  The message focuses on the experience of adiverse group of actual patients, their life-long struggle with obesity, andthe satisfaction they have realized through gastric bypass surgery.

 

**Visualization Technology Business**

 

Terms of transaction to sell the Visualization Technology Business

 

We entered into an Asset Purchase Agreement with Viking Systems Inc.regarding the sale of all the assets of the Visualization Technology Businesson December 22, 2003, subject to the approval of our stockholders.  Viking and its principals are not affiliatedwith us; and our officers, directors, and, to our knowledge, principalstockholders are not affiliated with Viking. Viking formerly conducted a software business, but those operations wereunsuccessful.  Recently, a group ofinvestors purchased control of Viking, with the approval of Viking’s Board ofDirectors, and Viking’s current business plan, as stated in its public filingswith the SEC, is to engage in the medical device market.

 

The most material 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 ofFebruary 29, 2004, the difference between our Accounts Receivable andAccounts Payable was $204,688. Nonetheless, we expect this balance 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 next five(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 the aggregateover the five year period.  We willretain 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 operate theVisualization Technology business entirely out of ourWestborough, Massachusetts location.  Asa result, this entire facility, less a few selected assets of minimal dollarvalue, will be transferred to Viking in connection with the Asset Sale.

 

We have agreed to indemnify Viking for any breach of therepresentations and warranties made by us in the Asset Purchase Agreement andfor any liability not assumed by Viking.

 

We intend to use the proceeds from the Asset Sale to fund our ObesitySurgery and Medical Services business. We may also use some of the proceeds (other than cash received atclosing) to redeem shares of our Series A Preferred Stock or to encourage theconversion of such stock to commons stock. This transaction is subject to the approval of our stockholders.  A proxy concerning this transaction has beenfiled with the SEC and, when approved by the SEC, will be distributed to ourstockholders.

 

**Our technology:**

 

Our technology provides a 3-D visualization solution to the inherentvision restrictions and demands of minimally invasive microsurgery.  It provides the surgeon with a clear view ofthe anatomy with the ability to view additional information in avoice-controlled, picture-in-picture format, which facilitates real-timedecision making during the procedure. Our technology is based on the following principles which we believe areessential in advancing the techniques of minimally invasive microsurgery.  We believe these principles offer severalkey advantages over other visualization approaches:

 

*3-D View*. The surgeon’s ability to view the principal image of the anatomy in 3-Dprovides the accurate depth perception necessary so that vital anatomicalstructures are accurately identified and located.  This improves safety, precision and speed of the procedure.  Also, a secondary video image is availablein picture-in-picture format, when the procedure will benefit from twodifferent views of the anatomy.

 

*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 which allows for the directinsertion of a camera into the body cavities or organs and provides highquality images that are easy to see and understand.

 

*Ergonomics*. Due to the complex and time consuming nature of minimally invasivemicrosurgery procedures, the surgeon requires an ergonomic display system whichallows comfortable operating posture and

 

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maximizes hand-eye coordination without strain.

 

*Information Integration*.  The surgeon’s access to critical monitoringand diagnostic data, on demand, in real time and integrated with the anatomicalimage within the surgeon’s visual field, enhances procedure performance.

 

***Headmounted display***

 

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

 

Our head mounted display is a proprietary, lightweight, high resolutiondisplay designed to allow the surgeon to view information on demand, whethersuch information is generated from attached endoscopes, microscopes ormonitoring equipment in the operating room. Further enhancements to the head mounted display allow forvoice-activated control and information display from other diagnostic equipmentin the hospital or from remote locations via information networks.  The video display in the head mounteddisplay is fixed in relation to the surgeon’s eyes, but his or her head maymove into any position necessary for comfort. The display design allows the surgeon to have a constant view of thesurgical anatomy required for the procedure as well as full awareness of thesurroundings in the operating room.  Ourhead mounted display is designed to provide a true 3-D image by replicating theway the human visual system works—left and right acquired images are delivereddirectly to left and right liquid crystal displays.  It is also designed so that it can be worn with conventionalsurgical loupes.

 

***Three-dimensional image acquisition***

 

We believe that three-dimensional visualization capability is criticalin minimally invasive microsurgery procedures such as cardiac surgery andcomplex endoscopic procedures 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 technology can package the twin cameras in two ways.  In the first method, a stereo micro-camerais attached to the end of a flexible or rigid guide which can then be inserteddirectly into the body cavity and organs. The image is directly captured by the camera chips without beingtransmitted through multiple rod lenses as in a conventional design.  The elimination of optical surfaces producesseveral important advantages, including increased image quality, improvedcontrast, better reliability and improved ability to sterilize theinstrument.  Alternatively, forapplications where standard endoscopic surgical technique remains preferable, astereo camera is mounted externally on a stereo endoscope.  This second method is the current preferredapproach for the procedures in which

 

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we are primarily involved. The image acquired by either approach isthen processed for display by control electronics which we have developed.  The controller also includes imagemanagement features which contribute significantly to procedure performance,such as dual image presentation and picture-in-picture.

 

***Information management***

 

Medicine is an information rich discipline, but the ability of asurgeon to obtain relevant information in real-time during a procedure has notbeen developed to the levels attained, for example, in military aviation.  The head mounted display is designed to givethe surgeon real-time access on demand to critical information integrated withthe anatomical images generated by our camera systems.  In addition to real-time display, theinformation can be stored or transmitted within the hospital or transmitted toremote locations for training, advisory or administrative purposes.  The applications software to control thisflow of information is a key element in our long-term product strategy whichpositions visualization within the context of a total information managementsystem for the surgeon.

 

**VisualizationTechnology Products**

 

We develop products based on our core technology and product platformdescribed above, that are customized for the specific general surgical, cardiacsurgical and other 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 most recent application of our platform technology is complex proceduresin general surgery.  Our first publicdemonstration of this platform was in October 2002, principally targetedat the emerging procedure of minimally invasive gastric bypass to controlmorbid obesity, but also applicable to many emerging minimally invasiveprocedures. Our advanced visualization system is designed to be modular andconsists of the following major 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 necessary 510(k) clearances which are required to market thecomponents of the EndoSite have been received.

 

***OEM Endoscopic Cameras***

 

Our endoscopic cameras are the state-of-the-art in two-dimensionalendoscopic imaging.  We currently

 

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manufacture compact, high resolution endoscopic cameras for originalequipment manufacture customers and strategic partners.

 

**StrategicAlliances**

 

Our strategy is to leverage our position in both our business units byforming strategic alliances with corporations and research institutions withrespect to the distribution, technology and marketing of some of our products.We have entered into 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 untilDecember 1, 2004.

 

***KaiserElectro-Optics***

 

In July 1995, we entered into a Manufacturing Supply Agreementwith Kaiser Electro-Optics, a subsidiary of Kaiser Aerospace.  This agreement was then amended inDecember 1997.  InDecember 1997, we entered into a Technology Strategic Alliance: Memorandumof Understanding with Kaiser Aerospace, which superseded a similar agreemententered 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 independentlydeveloped new technology or devices for medical applications.  Reciprocally, in December 1997, weentered into a License Agreement with Kaiser Aerospace under which weexclusively licensed to Kaiser Aerospace the right to manufacture anddistribute industrial and professional versions of our head mounted display inmarket segments other than medicine in return for an up-front payment androyalties based on sales.

 

In June 2000, we retroactively waived future payment of specifiedroyalties by Kaiser provided for in the license agreement with them.  In return, Kaiser agreed to cancel an orderthat we had placed for a shipment of head mounted display units, withoutadditional cost to us.  In late 2001, westarted working with Kaiser Electro-Optics (now a subsidiary of RockwellCollins) on development of an upgraded head mounted display, which wasintroduced to the market in October, 2002. We continue to work with Kaiser Electro-Optics on the next generationhead mounted display, which we have displayed in prototype form at meetingsduring 2003.

 

**LicenseAgreements**

 

We have licensed aspects of our technology from third parties.

 

***McKinley Optics, Inc.***

 

In September 1995, Mr. H. McKinley and McKinley Optics, Inc.granted to us a perpetual, exclusive, worldwide license in the medical field tomake, have made, modify, use, lease, market, sell and otherwise distributecertain endoscopes and other medical products incorporating a stereo objectivelens and/or a relay lens configuration. Under the terms of this license agreement, we are obligated to payMcKinley an annual maintenance royalty, additional royalties upon the sale ofcertain numbers of systems incorporating the McKinley technology and royaltieson net sales of products incorporating the McKinley technology.  The exclusive license granted under this

 

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agreement becomes a non-exclusive license, or, under certaincircumstances, the license terminates, in the event we fail to pay anyroyalties.  In addition, we have theright to terminate the agreement with limited notice.

 

***Fuji***

 

In June 1996, Fuji Film Co. and Fuji Photo Optical Co., Ltd.granted to us a non-exclusive license to certain optical zoom technology foruse in endoscopes.  We are obligated topay royalties on net sales of products in the United States which incorporateFuji’s technology.  We have notincorporated any of this technology into our products and thus have not beenobligated for any royalties as of the date of this annual report. Fuji mayterminate the agreement if we do not cure any violation of the agreement withina limited period of time.  Our failureto retain rights to these technologies may negatively impact our business.

 

***Carl Zeiss***

 

In August 1998, Carl Zeiss granted us non-exclusive rights in themedical field to three issued United States patents and four pending foreignapplications.  We are obligated to payZeiss royalties on sales of products incorporating the licensed technology andto provide technical and applications support, at our current rates for suchservices, to parties that previously acquired Zeiss’ Endo-Live StereoEndoscope, now discontinued.  Zeiss mayterminate the agreement in the event of a material breach by us which is notcured within a limited period of time. Our failure to retain rights to the Zeiss patents may negatively impactour business.

 

**Intellectualproperty protection**

 

We rely on a combination of technical leadership, patent, trade secret,copyright and trademark protection and nondisclosure agreements to protect ourproprietary rights.  As ofDecember 31, 2003, we had exclusive ownership rights to 14 issued UnitedStates patents covering various aspects of our devices and systems.  Furthermore, as of the same date, we hadexclusive rights in the medical field to 6 issued United States patents, 5issued foreign patents and 3 pending foreign applications covering variousaspects of our devices and systems.  In1998 we additionally obtained from Carl Zeiss non-exclusive rights to threeissued United States patents and four pending foreign applications.  We intend to file additional patentapplications in the future.  The failureof such patents to issue could damage our ability to protect our proprietaryinformation.

 

Our future success will depend, in part, on our ability to continue todevelop patentable products, enforce our patents and obtain patent protectionfor our products 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.  We are not certainthat patents will issue from any patent applications owned by or licensed to usor that, if patents do issue, the claims allowed will be sufficiently broad toprotect our technology.  In addition, wecannot assure you that any issued patents owned by or licensed to us will notbe challenged, invalidated or circumvented, or that the rights grantedthereunder will provide us with competitive advantages.

 

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

 

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

 

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countries relating to such research or development.

 

In general, the development of visualization and information systems isintensely competitive.  Patents issuedand patent applications filed relating to medical devices are numerous andcurrent and potential competitors and other third parties may have filed or inthe future may file applications for, or may receive or in the future willreceive, patents or obtain additional proprietary rights relating to productsor processes used or proposed to be used by us.  We cannot assure you that third parties will not assertinfringement claims against us in the future or that any such assertions willnot result in costly litigation or require us to obtain a license tointellectual property rights of such parties. Any such licenses may not be available on acceptable terms, if atall.  Furthermore, parties making suchclaims may be able to obtain injunctive or other equitable relief that couldeffectively block our ability to make, use, sell or otherwise practice ourintellectual property (whether or not patented or described in pending patentapplications), or to further develop or commercialize our products in theUnited States and abroad and could result in the award of substantial damages.  Defense of any lawsuit or failure to obtainany such license could damage our business.

 

We rely on unpatented trade secrets to protect our proprietarytechnology, and no assurance can be given that others will not independentlydevelop or otherwise acquire the same or substantially equivalent technologiesor otherwise gain access to our proprietary technology or disclose suchtechnology or that we can ultimately protect our rights to such unpatentedproprietary technology.  Third partiesmay obtain patent rights to such unpatented trade secrets, which patent rightscould be used to assert infringement claims against us.  We also rely on confidentiality agreementswith our collaborators, employees, advisors, vendors and consultants to protectour proprietary technology.  Theseagreements may be breached, we may not have adequate remedies for any breachand our trade secrets may otherwise become known or be independently developedby competitors.  In addition, ouragreements with employees and consultants require disclosure of ideas,developments, discoveries or inventions conceived during employment orconsulting, as the case may be, and assignment to us of proprietary rights tosuch matters related to our business and technology.  The extent to which efforts by others will result in patents andthe effect on us of the issuance of such patents is unknown.  Failure to obtain or maintain patent andtrade secret protection, for any reason, could negatively 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 various requirementson how they conduct business and structure their relationships withparticipating 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**

 

The manufacture and sale of medical devices intended for commercialdistribution are subject to extensive governmental regulation in the UnitedStates.  Medical devices are regulatedin the United States primarily by the FDA and, to a lesser extent, by certainstate agencies.  Generally, medicaldevices require 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 United States, medical devices are classified into one of threeclasses, Class I, II or III, on the basis of the controls deemed by the FDA tobe necessary to reasonably ensure their safety and effectiveness.  Our products to date have either beenclassified as Class I or Class II devices.

 

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

 

***Device approval***

 

Generally, before a new device can be introduced into the market in theUnited States, the manufacturer or distributor must obtain FDA clearance of a510(k) notification or submission and approval of a pre-market approvalapplication.  If a medical devicemanufacturer or distributor can establish that a device is “substantiallyequivalent” to a legally marketed Class I or Class II device, or to a Class IIIdevice for which the FDA has not called for a pre-market approval, themanufacturer or distributor may market the device upon receipt of an FDA orderdetermining such a device substantially equivalent to a predicate device.  The 510(k) notification may need to besupported by appropriate performance, clinical or testing data establishing theclaim of substantial equivalence.  TheFDA requires a rigorous demonstration of substantial equivalence.

 

Following submission of the 510(k) notification, the manufacturer ordistributor may not place the device into commercial distribution until an FDAsubstantial equivalence order permitting the marketing of a device is receivedby the person who submitted the 510(k) notification.  At this time, the FDA typically responds to the submission of a510(k) notification within 90 to 200 days. An FDA letter may declare that the device is substantially equivalent toa legally marketed device and allow the proposed device to be marketed in theUnited

 

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States.  The FDA, however, maydetermine that the proposed device is not substantially equivalent or requirefurther information, including clinical data, to make a determination regardingsubstantial equivalence.  Suchdetermination or request for additional information will delay marketintroduction of the product that is the subject of the 510(k) notification.

 

***Investigational device exemption application***

 

All clinical investigations involving the use of an unapproved oruncleared device on humans to determine the safety or effectiveness of thedevice must be conducted in accordance with the FDA’s investigational deviceexemption regulations.  If the devicepresents a “significant risk,” the manufacturer or distributor of the device isrequired to file an investigational device exemption application with the FDAprior to commencing human clinical trials. This application must be supported by data, typically the result ofanimal and bench testing.  If theapplication is approved by the FDA, human clinical trials may begin at aspecific number of investigational sites with a maximum number of patients, asapproved by the FDA.  If the devicepresents a “non-significant risk,” approval by an institutional review boardprior to commencing human clinical trials is required, as well as compliancewith labeling, record keeping, monitoring and other requirements.  However, the FDA can disagree with anon-significant risk device finding.

 

Any products which we manufacture or distribute are subject tocontinuing regulation by the FDA, which includes record keeping requirements,reporting of adverse experience with the use of the device, “goodmanufacturing” requirements and post-market surveillance, and may includepost-market registry and other actions deemed necessary by the FDA.  A new 510(k), pre-market approval orpre-market approval supplement is also required when a medical devicemanufacturer makes a change or modification to a legally marketed device thatcould significantly affect the safety or effectiveness of the device, or wherethere is a major change or modification in the intended use of the device or anew indication for use of the device. When any change or modification is made to a device or its intended use,the manufacturer is expected to make the initial determination as to whetherthe change or modification is of a kind that would necessitate the filing of anew 510(k), pre-market approval or pre-market approval supplement.

 

***Foreign requirements***

 

Sales of medical device products outside the United States are subjectto foreign regulatory 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 ourproducts.  The current regulatoryenvironment in Europe for medical devices differs significantly from that inthe United States.  SinceJune 1998, all medical devices sold in the European Union must bear the CEmark.  Devices are now classified bymanufacturers according to the risks they represent with a classificationsystem giving Class III as the highest risk devices and Class I as thelowest.  Once the device has beenclassified, the manufacturer can follow one of a series of conformityassessment routes, typically through a registered quality system, anddemonstrate compliance to a “European Notified Body.”  After that, the CE mark may be applied to the device. Maintenanceof the system is ensured through annual on-site audits by the notified body anda post-market surveillance system requiring the manufacturer to submit seriouscomplaints to the appropriate governmental authority.

 

**Marketingand Sales**

 

Our VOW Solutions business markets directly to hospitals and surgeonsvia our in-house sales and marketing departments and in conjunction with theBariatric Account Management force of our strategic partner, EthiconEndo-Surgery.  Our VisualizationTechnology business markets Endosite systems directly to hospitals performingbariatric surgery, and other products via our OEM arrangements.

 

***International sales***

 

Our VOW Solutions business currently does not market outside the UnitedStates, although we are evaluating opportunities in international markets forfuture expansion.  Our VisualizationTechnology business markets via our OEM customers in markets throughout theworld.  We also have limitedinternational distribution of our Endosite system.

 

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**Competition**

 

Our VOW Solutions business competes in a developing marketplace with avariety of companies, none of which, to our knowledge, has an identical mix ofproducts and services.  However, thereare companies which have products and services which compete with some part ofour offering.  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 medical device market in which the Visualization Technologybusiness competes is characterized by intensive development efforts and rapidlyadvancing technology.  Our futuresuccess will depend, in large part, upon our ability to anticipate and keeppace with advancing technology and competing innovations.  There can be no assurance, however, that wewill be successful in identifying, developing and marketing new products orenhancing our existing products. Although several companies compete with aspects of our visualizationproduct line, we believe there is no single company which offers a complete andindependent 3-D visualization and information system specifically directed atminimally invasive microsurgical applications. In addition, we are not aware of any other true 3-D head-mounted displaywhich has been cleared for marketing in surgical applications by the FDA.  We do believe that a number of largecompanies, some of which have significantly greater financial, manufacturing,marketing, distribution and technical resources and experience than ours, arefocusing on the development of advanced visualization products for minimallyinvasive microsurgery.  There can be noassurance that we will be successful in competing with any such companies.

 

**ClinicalAdvisory Boards**

 

We consult frequently with surgeons in the specialties we areaddressing.  We have previouslyestablished clinical advisory boards made up of leading surgeons, one focusedon minimally invasive cardiac surgery, and a general advisory board focused onother minimally invasive specialties. Members of our clinical advisory boards consult with us exclusively inthe field of visualization, but are free to consult with other non-competinginstrumentation companies 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 February 28, 2004, we had 35 full-time employees, of whomtwo hold an advanced degree.  None ofour employees is represented by a collective bargaining agreement, nor have weexperienced work stoppages.  We believeour relations with our employees are good.

 

**Web SiteAccess to SEC Filings**

 

We maintain an Internetwebsite at *www.vistamt.com*.  We make available free of charge on ourInternet website our annual reports on Form 10-K, quarterly reports on Form10-Q, current reports on Form 8-K, and amendments to those reports filed orfurnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soonas reasonably practicable after we electronically file such material with, orfurnish it to, the SEC.

 

**Recent Developments**

 

In February 2004, we raised an additional $588,000 in equitycapital through the sale of shares of our common stock.  We sold these shares in a private placementto several accredited investors.  Inconnection with these sales, we agreed to register the shares of common stockwithin 90 days of closing of the private placement.

 

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RISKS AND UNCERTAINTIES

 

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

 

**We 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 December 31, 2003, we had cash, cash equivalents and short-terminvestments of $636,000.  We believethat these cash resources, together with cash from operations and theadditional equity raised in February 2004, will not be sufficientresources to operate our business beyond June 2004.  This cash requirement is very serious.  We need additional funding to meet currentcommitments and continue development of our business.  Our current cash resources will only allow us to continue ourbusiness at its current levels for our immediate needs.  If we do not receive additional funding, ourability 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 tomaintain the listing of our common stock on The Nasdaq SmallCap Market and havereceived notification of de-listing, which could negatively affect theliquidity of our stock 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 tode-listing proceedings.  We receivednotification on March 1, 2004 of a Nasdaq Staff Determination indicatingthat we fail to comply with the Stockholders’ Equity requirement for continuedlisting set forth in Marketplace Rule 4310(c)(2)(B), and that our common stockis, therefore, subject to delisting from the Nasdaq SmallCap Market.  We have requested a hearing before a NasdaqListing Qualifications Panel to review the Staff Determination.  This request for a hearing has stayed thedelisting of the Company’s common stock pending the Panel’s decision.  A hearing has been scheduled forApril 1, 2004, at which we intend to present a plan for regainingcompliance with continued listing requirements.  There can be no assurance, however, that the Panel will grant ourrequest 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 the risks,expenses and difficulties frequently encountered by companies in their earlystages of development, particularly when involved in new and rapidly evolvingmarkets.  To address these risks, wemust, among other things, respond to competitive developments and attract,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 our formation in July 1993, and as of December 31,2003, we have incurred cumulative net losses of $68.1 million.  We expect to incur losses for theforeseeable future.  We may neverachieve or sustain profitability in the future.  Even if we achieve profitability, we may not be able to sustainit 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 issued 1,000,000shares of our Series A Convertible Preferred Stock (the “Series A Shares”) inMarch, 2003, which were created pursuant to the terms of a Certificate ofDesignations, for an aggregate of $950,000 in cash.  In connection with this financing, the purchasers of Series AShares were granted several significant rights senior to the rights of holdersof our common stock.  Among otherrights, in the event of a liquidation, dissolution or winding up of our company(including consolidations, mergers or other sales), holders of Series A Shareswill be entitled to receive up to $3.80 per share held by them, in preferenceto any distribution to the holders of common stock.  Also, pursuant to the Certificate of Designations, we must obtainthe consent of the holders of at least two-thirds of the outstanding Series AShares in order to undertake certain actions, including capital expendituresand the issuance of securities. Additionally, for so long as any Series A Shares remain outstandingafter three hundred ninety (390) days following the initial issuance of anySeries A Shares, the holders of Series A Shares will be entitled to elect thegreater of (i) two members of our Board of Directors or (ii) twenty-fivepercent (25%) of the total members of our Board of Directors.  As a result, in the event we do not achievethe criteria necessary for us to redeem some or all of the Series A Shares(e.g., a sale of all or a portion of our Visualization Technology business),the holders of Series A Shares will have the right to control at leastone-fourth of the seats on our Board of Directors.

 

The Series A Shares aresubject to redemption by us upon certain events.  If we choose to redeem some or all of the Series A Sharespursuant to the terms of our Certificate of Designations, we will use cash thatwould otherwise fund our business operations. Although we may believe that such a redemption is the best availablebusiness option, valuable cash would nonetheless be consumed, which would impactour ability to fund operations or grow 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 a national level.  In order to accomplish our strategic and business plans, we willhave to quickly and effectively increase market awareness of our services andconvince doctors, hospitals and patients of the benefits of our services.  Among other things, this will require thatwe:

 

•                  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, whichmay 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 noassurance that we will be able to attract and retain an adequate number ofsuitable employees.  If we are unable todo this, then we may not be able to operate and expand our Centers as planned,which may reduce 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 ourmanagement systems and resources.  Wewill need to continue to improve our operational and financial systems andmanagerial controls and procedures, and we will need to continue to expand,train and manage our workforce.  Weexpect that the number of our employees will continue to increase for theforeseeable future.  We will have tomaintain close coordination among our technical, accounting, finance, marketingand sales departments.

 

**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 the sale of ourVisualization Technology business is approved by our stockholders our futuresuccess as a company will depend on our ability to execute on the establishmentand growth of our Obesity Surgery Management Services business.  As a company, we have limited experience inthe provision of surgical services.  Wewill also be required to build this business from a relatively small base,finding partners and surgeons willing to participate.  We cannot assure you that we will be able to build a successfulservices business in the long term.

 

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

 

We only have a smalldirect sales force and, in the past, we were primarily dependent on agreementswith third parties for sales of the majority of products derived from our corethree-dimensional technology.  Two ofour primary distribution agreements were terminated in 2000 and the arrangementwith Jomed N.V. to manage distribution in cardiac surgery and to continuesupporting our cardiac customer base was terminated in 2003.  We now depend primarily on our direct salesforce to sell our 3D products.

 

**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 of visualization technology, such as ours, which have beenconducted to date, have shown that there is a learning process involved forsurgeons and other members of the surgery team to become proficient with theuse of the systems.  Based on theclinical and laboratory procedures performed to date, we cannot assure you thatvisualization and information system enhancements incorporated, or to beincorporated, in our products will prove suitable for use by a substantialnumber of surgeons.  If they proveunsuitable for a large number of surgeons to use, the potential markets andapplications for our products would 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 never established high-volume manufacturing operations and ifwe are required to do so to meet market demand or to become profitable, we maynot be able to establish or maintain reliable operations at commerciallyreasonable costs.  We may also requireadditional manufacturing 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 have considered 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.**

 

Any significant supply interruption, or inventory shortage or overage,would negatively 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 currentsuppliers or the addition of new suppliers. The qualification of additional or replacement vendors for specifiedcomponents or services is a lengthy process. In addition, the substitution of replacement vendors may entailre-engineering time and cost and could delay the supply of our products.

 

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We expect to manufacture our products based on forecasted productorders and intend to purchase subassemblies and components prior to receipt ofpurchase orders from customers.  Leadtimes for ordered materials and components vary significantly and depend onfactors such as the business practices of the specific supplier, contract termsand general demand for a component at a given time.  Some components used in our products have long lead times.  As a result, there is a risk of excess orinadequate inventory if orders 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 manufacture and sale of medical devices intended for commercialdistribution are subject to extensive governmental regulation.  Our failure to comply with regulatoryrequirements would jeopardize our ability to market our products.  Noncompliance with applicable requirementscan result in failure of the regulatory agency to grant pre-market clearance orapproval for devices, withdrawal or suspension of approval, total or partialsuspension of production, fines, injunctions, civil penalties, refunds, recallor seizure of products and criminal prosecution.

 

Medical devices are regulated in the United States primarily by the FDAand, to a lesser extent, by state agencies. Sales of medical device products outside the United States are subjectto foreign regulatory requirements that vary from country to country.  Generally, medical devices requirepre-market clearance or pre-market approval prior to commercialdistribution.  A determination that informationavailable on the medical device is not sufficient to grant the needed clearanceor 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.**

 

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

 

If we obtain the necessary foreign regulatory registrations orapprovals, market acceptance of our products in international markets would bedependent, in part, upon the acceptance by the prevailing health care financingsystem in each country.  Health carefinancing systems in international markets vary significantly by country and

 

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include both government sponsored health care programs and privateinsurance.  We cannot assure you thatthese financing systems will endorse the 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 have limited experience in directly marketing our productsoverseas.  Changes in overseas economicconditions, currency exchange rates, foreign tax laws or tariffs or other traderegulations could negatively impact our business.  The anticipated international nature of our business is alsoexpected to subject our representatives, agents and distributors to laws andregulations of the foreign jurisdictions in which they operate or in which ourproducts are sold, including laws regulating manufacture and sale of medicaldevices.  In addition, the laws of someforeign countries do not protect our intellectual property rights to the sameextent as do the laws of the United States.

 

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

 

We face an inherent and significant business risk of exposure toproduct liability claims in the event that the use of our products results inpersonal injury or death.  Also, in theevent that any of our products proves to be defective, we may be required to recallor redesign such products.  Our currentproduct liability insurance coverage limit is $10.0 million per occurrence andin the aggregate.  Our coverage limitsmay not be adequate to protect us from any liabilities we might incur inconnection with the 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 wouldnegatively impact our business.

 

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

 

Our future success will depend, in part, on our ability to continuedeveloping patentable products, enforcing our patents and obtaining patentprotection for our products both in the United States and in othercountries.  The patent positions ofmedical device companies, however, are generally uncertain and involve complexlegal and factual questions.  Patentsmay never issue 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 medical device industry has been characterized by extensivelitigation regarding patents and other intellectual property rights.  Litigation, which would result insubstantial expense, may be necessary to enforce any patents issued or licensedto us and/or to determine the scope and validity of proprietary rights of thirdparties or whether our products, processes or procedures infringe any suchthird-party proprietary rights.  We mayalso have to participate in interference proceedings declared by the UnitedStates Patent and Trademark Office, which could result in substantial expense,to determine the priority of inventions covered by our issued United States patentsor pending patent applications. Furthermore, we may have to participate at substantial cost inInternational Trade Commission proceedings to enjoin importation of productswhich would compete unfairly with our products.  Any adverse outcome of any patent litigation, includinginterference proceedings, could subject us to significant liabilities to thirdparties, require disputed rights to be licensed from or to third parties orrequire us to cease using the technology in dispute.  Any such licenses may not be available on acceptable terms, if atall.  Furthermore, parties making suchclaims may be able to obtain injunctive or other equitable relief that couldeffectively block our ability to make, use, sell or otherwise practice ourintellectual property, whether or not patented or described in pending patentapplications, or to further develop or commercialize our products in the UnitedStates and abroad and could result in the award of substantial damages.  Defense of any lawsuit or failure to obtainany such license could damage our business.

 

In addition to patents,we rely on unpatented trade secrets to protectour proprietary technology.  Others mayindependently develop or otherwise acquire the same or substantially equivalenttechnologies or otherwise gain access to our proprietary technology or disclosethis technology.  It is difficult toprotect rights 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 be independently developed bycompetitors.  In addition, ouragreements with employees and consultants require disclosure of ideas,developments, discoveries or inventions conceived during employment orconsulting, as the case may be, and assignment to us of proprietary rights tosuch matters related to our business and technology.  The extent to which efforts by others will result in patents andthe effect on us of the issuance of such patents is unknown.

 

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

 

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

 

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

 

Our future business and operating results depend in significant partupon the continued contributions of our key management and technical personnel,many of whom would be difficult to replace and some of whom perform importantfunctions beyond those suggested by their job titles or descriptions.  Our business and future operating resultsalso depend in significant part upon our ability to attract and retainqualified management, manufacturing, technical, marketing and sales and supportpersonnel for our operations. Competition for such personnel is intense, and we may not be successfulin attracting or retaining such personnel.

 

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

 

**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 market prices and trading volumes for securities of emergingcompanies, like ours, have historically been highly volatile and haveexperienced significant fluctuations unrelated to the operatingperformance.  The market price of ourcommon stock has historically been highly volatile and may be significantlyaffected by factors such as:

 

•                                          actual oranticipated fluctuations in our operating results,

 

•                                          our abilityto 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 experiencedsignificant price and volume fluctuations that have particularly affected themarket prices for shares of early stage companies.  These broad market fluctuations may adversely affect the marketprice of our common stock.  In the past,following periods of volatility in the market price of a particular company’ssecurities, securities class action litigation has often been brought againstthat company.  Such litigation, ifbrought against us, could result in substantial costs and a diversion ofmanagement’s attention and resources.

 

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**There is a limited market for our common stock andtherefore investors may not be able to liquidate their investment in theforeseeable 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 research and development activities in the Visualization Technologybusiness may involve the controlled use of hazardous materials andchemicals.  The risk of accidentalcontamination or injury from these materials cannot be completelyeliminated.  In the event of such anaccident, we could be held liable for any resultant damages, and any suchliability could exceed our resources. We may incur substantial cost to comply with environmental regulations.

 

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

 

We currently intend to retain any future earnings for use in ourbusiness and do not anticipate paying any cash dividends in the foreseeablefuture.

 

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

 

Our charter documents contain provisions that may make it moredifficult or discourage a change in control. This may adversely affect the market price of our common stock.

 

Item 2.PROPERTIES

 

Our facilities consist of approximately 5,000 square feet of subleasedoffice space located in Carlsbad, California, in which our executive offices,plus the staff of our VOW Solutions Business is located.  In addition, we maintain a facility ofapproximately 17,850 square feet in Westborough, Massachusetts in which thedevelopment, engineering, manufacturing operations and customer servicepersonnel of our Visualization Technology Business are located.  The lease under which we have acquired theright to occupy the Westborough facilities expires in October 2004.  The sublease of the Carlsbad premisesexpires in January 2005 and was executed with a related party.  We believe that suitable additional spacewill be available to us, when needed, on commercially reasonable terms.

 

Item 3. LEGALPROCEEDINGS

 

From time to time, we may be involved in litigation relating to claimsarising out of our operations in the normal course of business.  There are no material legal proceedingspending against us.  We have beennotified that a party intends to include us as a party to a medical malpracticelawsuit in Florida, but we have not yet been formally included or served, andwe are contesting the issue.

 

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 EQUITY AND RELATED STOCKHOLDERMATTERS

 

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

 

Our Common Stock is traded on the over-the-counter market and pricesare quoted on the Nasdaq SmallCap Market under the symbol “VMTI.”  The following table sets forth the high andlow sale prices for our Common Stock on the Nasdaq SmallCap Market fromJanuary 1, 2002 through December 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 August 5, 2004 the last reported sale price of our Common Stockwas $2.31.  As of July 30, 2004,there were approximately 190 holders of record of our Common Stock.

 

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

 

(b)                                 Equity CompensationPlan Information

 

The following table contains aggregatedinformation regarding our equity compensation plans as of December 31,2003.

 
| **Plan Category(1)**                                        |   | **Number of  securities to be  issued upon exercise of  outstanding options,  warrants and rights (#)** |   | **Weighted  average exercise  price of outstanding  options, warrants and  rights ($)/sh.** |   | **Number of  securities  remaining available for  future issuance under  equity compensation plans  (excluding securities  reflected in column (a)) (#)** |    |
|-------------------------------------------------------------|--------|---------------------------------------------------------------------------------------------------------|--------|---------------------------------------------------------------------------------------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------|---------|
|                                                        |   | **(a)**                                                                                                 |   | **(b)**                                                                                     |   | **(c)**                                                                                                                                                        |    |
| Equity compensation plans approved by  security holders(1)  |   | 839,078                                                                                                 |   | $                                                                                           | 3.62   |                                                                                                                                                           | 146,537 |   |
| Equity compensation plans not approved by  security holders |   | None                                                                                                    |   | None                                                                                        |   | None                                                                                                                                                           |    |
| Total                                                       |   | 839,078                                                                                                 |   | $                                                                                           | 3.62   |                                                                                                                                                           | 146,537 |   |

 

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(1)                                  Equitycompensation plans approved by our security holders include our 1997 StockOption/Stock Issuance Plan and our 1997 Employee Stock Purchase Plan.

 

28

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Item 6.SELECTED FINANCIAL DATA

 

SELECTED FINANCIAL DATA

 

The selected financial data set forth below should be read inconjunction with “Management’s Discussion and Analysis of Financial Conditionand Results of Operations” and our financial statements and notes theretoappearing elsewhere in this Form 10-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 annual report may contain predictions, estimates and otherforward-looking statements that involve a number of risks and uncertainties,including those discussed earlier at “risks and uncertainties.”  While this outlook represents our current judgmenton the future direction of our business, such risks and uncertainties couldcause actual results to differ materially from any future performance suggestedbelow.  We undertake no obligation torelease publicly the results of any revisions to these forward-lookingstatements to reflect events or circumstances arising after the date of thisannual report.  The following discussionshould be read in conjunction with our consolidated financial statements andthe notes thereto.

 

**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 surgical treatmentof morbid obesity.  Our services includemanagement of our original product offering, the Laparoscopic Bariatric SurgeryPreceptorship, a comprehensive introduction to starting a minimally invasivegastric bypass surgical program.  We nowoffer, in addition, systems, consulting and program management services whichenable the efficient operation of obesity surgery programs.  The Visualization Technology business, basedin Westborough, MA, develops, manufactures and markets products that provideinformation to physicians performing minimally invasive general surgical,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.  The VisualizationTechnology business also manufactures compact, high-resolution endoscopiccameras 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 December 31, 2003, we had 32 employees.  We expect staffing to increase from ourObesity Management Services business, while there would be an elimination of 19employees from the sale of our Visualization Technology business in ourWestborough facility.  We expect thatthere will be a steady increase in employees during 2004 within the ObesityManagement Services business which would bring us to approximately 22 employeesby the end of 2004.

 

**Critical AccountingPolicies**

 

The discussion and analysis of our financial condition and results ofoperations are based upon our consolidated financial statements, which havebeen prepared in accordance with accounting principles generally accepted inthe United States.  The presentation ofthese financial statements requires us to make estimates and judgments thataffect the reported amounts of assets and liabilities, revenues and expenses,and related 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:

 

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.

 

30

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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.

 

Inventory

 

Inventory is accounted for on a first-in first-out basis and is valuedat the lower of cost or market.  TheCompany regularly evaluates inventory for excess quantities or obsolescence andreserves for 100% of inventory considered to be excess or obsolete.  This evaluation requires significantjudgment and estimates made by management regarding factors such as customerdemand, product life cycle and general market conditions.  At December 31, 2003 such inventoryreserves approximated $1,303,000.  TheCompany believes it is adequately reserved for obsolescence of currentinventory.  However, future productintroductions and related inventories may require additional reserves basedupon changes in market demand or introduction of competing technologies.  In addition, the expected sale of theVisualization Technology business to Viking Systems, Inc. may require that wereassess the adequacy of our inventory reserves under the terms of the proposedtransaction.

 

**Our Results ofOperations**

 

**Year ended December 31,2003 compared with year ended December 31, 2002**

 

**Revenues**

 

We had revenues from product sales and contract revenue of $8,709,000for the year ended December 31, 2003 and product sales and contractrevenue of $11,106,000 for the year ended December 31, 2002, representinga decrease of $2,397,000 or 22%.  Thedecrease in revenues during 2003 was primarily due to decreased unit sales fromour Visualization Technology business for our Laparoscopic Bariatric Surgeryprogram.  Of the $2,397,000 decrease intotal sales, $1,000,000 is represented by the loss of Jomed sales due to theirbankruptcy filing in January, 2003. We also had a decrease in camera sales of$200,000 to our original equipment manufacturer customers.  Finally, we had decreased sales relative tofewer Training Programs from our Obesity Surgery Management Services businessof approximately $1,200,000.  Sales toindividual customers exceeding 10% or more of revenues in the years endedDecember 31, were as follows: during 2003, three customers accounted for 20%, 16% and 11% of revenues,respectively, and during 2002, one customer accounted for 14% of revenues.

 

31

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**Costsand 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 of revenues.  Our cost ofrevenues were $5,185,000 and $5,989,000 for the years ended December 31,2003 and 2002, respectively.  Our grossmargins were 40% and 46% for the years ended December 31, 2003 and 2002,respectively.  The decrease in grossmargin was primarily due to decreased unit sales of our higher marginLaparoscopic Bariatric Surgery program.

 

Research and development expenses. Our research and development expenses were $1,178,000 and $1,709,000 forthe years ended December 31, 2003 and 2002, respectively, representing adecrease of $532,000 or 31%.  Thedecrease in research and development expenses during 2003 was primarilyattributable to near completion of next generation product development.  Research and development expenses in 2003were primarily spent on the next generation head mounted display and thedevelopment of a new Vista Stereo 3 Chip camera.  However, should the sale of the Visualization Technology businesstake place, it is anticipated that substantially all research and developmentexpenses would be eliminated.  Since2000, the Company’s principal development efforts have focused on new productsand services within the surgical obesity market.  The Company’s future spending on research and development will befocused on further expansion of LBS peripheral products and services anddevelopment of the next generation Head Mounted Display.

 

Sales and marketing expenses. Our sales and marketing expenses were $2,548,000 and $2,690,000 for theyears ended December 31, 2003 and 2002, respectively, representing a decreaseof $142,000 or 5%.  Our sales andmarketing expenses did not drop in accordance with our decrease in revenues dueto increased expenses related to the development of our Obesity ManagementServices business.  We expect a steadyincrease in sales and marketing expenses during 2004 as we ramp up our fieldactivities for the obesity surgery market.

 

General and administrative expenses. Our general and administrative expenses were $1,879,000 and $1,882,000for the years ended December 31, 2002 and 2001, respectively.  General and administrative expenses wereconsistent in 2003 compared to 2002.

 

**Otherincome and losses**

 

Interest income. Our net interest income was $32,000 and $17,000 forthe years ended December 31, 2003 and 2002, respectively. The increase in2003 was due primarily to interest recorded on notes receivable fromstockholders, partially offset by decreasing average cash balances and lowerinterest rates.

 

**Income****Taxes**

 

At December 31, 2002, we had federal and state tax net losscarryforwards of approximately $55,588,000 and $30,388,000, respectively. Thefederal tax loss carryforwards will begin to expire in 2010.  Approximately $15,671,000 of the state taxloss carryforwards expired in 2003, and will continue to expire in 2004 unlesspreviously utilized. At December 31, 2003, we also had federal and stateresearch tax credit carryforwards of approximately $2,248,000 and $902,000,respectively, which will begin to expire in 2010 unless previously utilized. Wehave provided a full valuation allowance on the deferred tax assets asrealization of such assets is uncertain.

 

32

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**Year endedDecember 31, 2002 compared with year ended December 31, 2001**

 

**Revenues**

 

We had revenues from product sales and contract revenue of $11,106,000for the year ended December 31, 2002 and product sales and contractrevenue of $9,326,000 for the year ended December 31, 2001.  The increase in revenues during 2002 was primarilydue to increased unit sales from our Laparoscopic Bariatric Surgeryprogram.    Sales to individualcustomers exceeding 10% or more of revenues in the years endedDecember 31, were as follows: during 2002, one customer accounted for 14% of revenues, and during2001, three customers accounted for 22%, 18% and 10% of revenues, respectively.

 

**Costsand expenses**

 

Cost of revenues.  Our cost ofrevenues were $5,989,000 and $6,405,000 for the years ended December 31,2002 and 2001, respectively.  Our grossmargins were 46% and 31% for the years ended December 31, 2002 and 2001,respectively.  The increase in grossmargin was primarily due to increased unit sales of our higher marginLaparoscopic Bariatric Surgery program coupled with associated contract revenuerecognition of $1,000,000 from an agreement with Ethicon Endo-Surgery, Inc.,with no associated cost of revenues.

 

Research and development expenses. Our research and development expenses were $1,709,000 and $1,945,000 forthe years ended December 31, 2002 and 2001, respectively.  The decrease in research and developmentexpenses during 2002 was primarily attributable to near completion of nextgeneration product development.  Since2000, the Company’s principal development efforts have focused on new productsand services within the 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 and marketing expenses. Our sales and marketing expenses were $2,690,000 and $2,237,000 for theyears ended December 31, 2002 and 2001, respectively.  The increase insales and marketing expenses during 2002 reflects a ramp up of field activities for the obesity surgery market.

 

General and administrative expenses. Our general and administrative expenses were $1,882,000 and $2,031,000for the years ended December 31, 2002 and 2001, respectively.  The decrease during 2002 was primarily dueto lower depreciation and facility charges.

 

**Otherincome and losses**

 

Interest income. Our net interest income was $17,000 and $70,000 forthe years ended December 31, 2002 and 2001, respectively. The decrease in2002 was due primarily to decreasing average cash balances and lower interestrates.

 

**Liquidityand Capital Resources**

 

Our principal sources of liquidity have been funds raised from publicand private placements of our capital stock and, to a lesser degree, cash flowsgenerated from operations.  AtDecember 31, 2003, we had cash, cash equivalents and short-terminvestments of $636,000.  In addition,in February 2004, we raised an additional $588,000 through a privateplacement of common stock.

 

Net cash used in operating activities was approximately $1,250,000,$462,000 and $1,556,000 in 2003, 2002 and 2001, respectively.  The increase in net cash used in operatingactivities during 2003 compared to 2002 was primarily attributable toincreasing net losses.  The decrease innet cash used in operating activities during 2002 compared to 2001 wasprimarily attributable to decreasing net losses partially offset by increasedinventory purchases.

 

Net cash provided from investing activities was approximately $109,000and $52,000 in 2003 and 2002, respectively, and cash used in 2001 for investingactivities was $257,000.  The increasein cash provided from 

 

33

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investing activities in 2003 was primarily attributable to maturitiesof short-term investments.  The increasein net cash provided by investing activities in 2002 compared to 2001 wasprimarily attributable to maturities of short-term investments, partiallyoffset by increased purchases of property and equipment.

 

Cash flows from financing activities were $1,133,000, $66,000 and$25,000 in 2003, 2002 and 2001, respectively. The cash flows from financing activities in 2003 were primarilyattributable to proceeds from a private placement of preferred stock forapproximately $950,000 and short term bank borrowings of $200,000.The cashflows from financing activities in 2002 and 2001 were primarily attributable toproceeds from purchase of stock by employees through our employee stockpurchase plan and the exercise of stock options.

 

We incurred operatinglosses in 2001, 2002 and 2003, and at December 31, 2003, had an accumulateddeficit of $68.1 million.  AtDecember 31, 2003, we had cash and short-term investments of$636,000.  In February 2004, wesold $588,000 of common stock in a private placement.   In addition, we have amounts available under a $2.0 million bankline of credit facility, which expires in October 2004 and is subject toannual renewals.  We believe that thesesources of liquidity, together with anticipated 2004 product revenues andinterest income, will not be sufficient to operate our business beyondJune 2004.  These factors raisesubstantial doubt about the Company’s ability to continue as a goingconcern.  We are 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 sale of the Visualization Technology business will beconsummated in the necessary time frame or on terms acceptable to us.  Should we be unable to raise sufficient funds,we may be required to curtail our operating plans and possibly relinquishrights to portions of our technology or products.  In addition, increases in expenses or delays in productdevelopment may adversely impact our cash position and require further costreductions.  No assurance can be giventhat we will be able to operate profitably on a consistent basis, or at all, inthe future.

 

**Borrowing Arrangements**

 

In October 2001, we secured a $2,000,000 line of credit Facility(the Facility) with a bank for one year with automatic yearly renewals.  The current line of credit agreement expiresin October 2004.  The Facility issecured by qualified accounts receivable and bears interest at the rate ofprime plus 2% (4.5% at December 31, 2003).  Borrowings under the Facility are limited to 80% of qualifiedaccounts receivable.  AtDecember 31, 2003, there was $200,000 of borrowings outstanding , and$730,000 available under the Facility.

 

**ContractualObligations**

 

At December 31, 2003, we are obligated under operating leases,principally related to real estate. Additionally, we are obligated under capital leases related to computerhardware.  The following is aschedule of future minimum payments, excluding taxes and other operatingcosts, 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 |   |

 

**RelatedParty Transactions**

 

We have a sublease agreement for our California office space.  The sublease agreement has been executedwith another company, of which our Chairman of the Board is also aDirector.  Total rental payments of$104, 500 were paid to this company in 2003.

 

**Off-BalanceSheet Arrangements**

 

We currently do not have any material off-balance sheet arrangementsother than the operating lease commitments 

 

34

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described above..

 

**Inflation**

 

We believe that the effects of inflation generally do not have amaterial adverse impact on our operations****or financial condition.

 

**NewAccounting Pronouncements**

 

In January 2003 FASBInterpretation No. 46, “Consolidation of Variable Interest Entities” wasissued. This interpretation requires a company to consolidate variable interestentities (“VIE”) if the enterprise is a primary beneficiary (holds a majorityof the variable interest) of the VIE and the VIE passes specificcharacteristics. It also requires additional disclosures for parties involvedwith VIEs.  In December, 2003, the FASBissued a revision of Interpretation No. 46 (the Revised Interpretation 46).Revised Interpretation 46 codifies both the proposed modifications and otherdecisions previously issued through certain FASB Staff Positions (FSPs) andsupersedes the original Interpretation No. 46 to include: (1) deferring  the effective date of the Interpretation’s provisionsfor certain variable interests, (2) providing additional scope exceptions forcertain other variable interests, (3) clarifying the impact of troubled debtrestructurings on the requirement to reconsider (a) whether an entity is a VIEor (b) which party is the primary beneficiary of a VIE, and (4) revisingAppendix B of the Interpretation to provide additional guidance on what constitutesa variable interest. Accordingly, the Company will adopt Revised InterpretationNo. 46 effective the first quarter 2004 and does not expect the adoption ofthis interpretation will have an impact on its consolidated financial positionor results of operations.

 

In December 2003,the SEC issued Staff Accounting Bulletin (SAB) No. 104, “Revenue Recognition”,which codifies, revises and rescinds certain sections of SAB No. 101, RevenueRecognition, in order to make this interpretive guidance consistent withcurrent authoritative accounting and auditing guidance and SEC rules andregulations.  The changes noted in SABNo. 104 did not have a material effect on the Company’s results of operations,financial position or cash flows.

 

In May 2003, the FASB issuedSFAS No. 150, “*Accounting for Certain Financial Instruments with Characteristics ofBoth Liabilities and Equity*.” SFAS No. 150 establishes standards for how an issuer classifies andmeasures certain financial instruments with characteristics of both liabilitiesand equity.  Many of these instrumentswere previously classified as equity. SFAS No. 150 is effective for financial instruments entered into ormodified after May 31, 2003, and otherwise was effective at the beginning ofthe first interim period beginning after June 15, 2003.  The adoption of this Statement did not havean effect on the Company’s financial statements.

 

Item 7A.                           QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

At December 31, 2003, our investment portfolio included fixed-incomesecurities of $0.1 million.  Thesesecurities are subject to interest rate risk and will decline in value ifinterest rates increase.  Due to theshort-term nature of our investment portfolio, an immediate 10 percent increasein interest rates would have no material impact on our financial condition orresults of operations.

 

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

 

We generally conduct business, including sales to foreign customers, inU.S. dollars and as a result have limited foreign currency exchange raterisk.  The effect of an immediate 10percent change in foreign exchange rates would not have a material impact onour financial condition or results of operations.

 

Item 8.                                     FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA

 

The consolidated financial statements and supplementary data requiredby this item are set forth at the pages indicated in Item 15(a)(1).

 

Item 9.                                     CHANGES IN ANDDISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

 

Not applicable.

 

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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. Based upon that evaluation, Mr. Lyon and Mr. Gorgol concluded that ourdisclosure controls and procedures are effective in causing materialinformation to be collected, communicated and analyzed by our management on atimely basis and to ensure that the quality and timeliness of our publicdisclosures comply with SEC 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 name, age and year inwhich the term expires of each member of our Board of Directors is set forthbelow:

 

| **Name**          |   | **Age** |   | **Position** |
|-------------------|--------|---------|--------|--------------|
| James C. Blair    |   | 65      |   | Director     |
| John R. Lyon      |   | 58      |   | Director     |
| Scott R. Pancoast |   | 45      |   | Director     |
| Larry M. Osterink |   | 63      |   | Director     |
| George B. DeHuff  |   | 50      |   | Director     |
| Michael H. Owens  |   | 52      |   | Director     |

 

***JAMES C. BLAIR.***  Dr. Blair has served as Chairman of theBoard and a Director since July 1995. Dr. Blair has been a ManagingMember of Domain Associates, L.L.C., a venture capital management company,since 1985, which manages and advises Domain Partners V, L.P., a shareholder ofthe Company. Dr. Blair is a graduate of Princeton University and holds MSEand Ph.D. degrees from the University of Pennsylvania.

 

***JOHN R. LYON.***  Mr. Lyon co-founded our Company inJuly 1993 and has served as President since July 1993, as ChiefExecutive Officer since December 1996 and as a Director sinceJuly 1995. Prior to co-founding Vista Medical, Mr. Lyon served forthree years with Cooper Companies, as President of the International Divisionwithin Cooper’s Health Care Group from January 1991 throughDecember 1992, and as President of Cooper Surgical, a manufacturer anddistributor of minimally invasive surgical products, from January 1992through January 1993. Mr. Lyon also was employed by Kaiser Aerospacein a business development role from February 1993 until Vista Medical wasfounded in July 1993. Mr. Lyon holds a B.A. from the University ofDurham, United Kingdom.

 

***SCOTT R. PANCOAST.***  Mr. Pancoast was elected a Director inMarch 2003, following the resignation of Nicholas Binkley.Mr. Pancoast has been the Executive Vice President of Western StatesInvestment Group, a privately owned investment firm with a venture-capitalfocus, since 1994. Prior to Western States, he was Senior Vice President and aDirector of National Sanitary Supply, where he founded and managed thecompany’s Midwest Division. Mr. Pancoast was also Chief Financial Officerof National Sanitary Supply from 1986, when it went public, until 1988.Mr. Pancoast holds a B.A. in Economics from the University of Virginia andan MBA from Harvard Business School.

 

***LARRY M. OSTERINK.***  Dr. Osterink has been a Director sinceJuly 1995. Dr. Osterink is President of Arts Attack, a privatecompany supplying art curriculum to the educational market. FromJanuary 1998 to September 2001, he was Executive Vice President ofClinicon Corporation. From 1993 until 1998, Dr. Osterink served asPresident of Medical Optics Inc., a subsidiary of Kaiser Aerospace. From1984 to 1992, Dr. Osterink was President of KaiserElectro-Optics Inc. and from 1979 to 1984 he was General Manager of theIndustrial Laser Division of SpectraPhysics Inc. Dr. Osterinkgraduated from Michigan State University and holds a Ph.D. in ElectricalEngineering from Stanford University.

 

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***GEORGE B. DEHUFF.***  Mr. DeHuff has served as a Directorsince June 2001. Mr DeHuff was appointed President and Chief ExecutiveOfficer of BI Incorporated in May 2001. Prior to BI, Mr. DeHuff wasPresident and Chief Executive Officer of Davita Inc. (formerly Total RenalCare) from 1999. From 1994 to 1999 Mr. DeHuff served in various seniorexecutive capacities with American Medical Response, including President andChief Executive Officer from 1997. From 1991 to 1994 Mr. DeHuff wasPresident and Chief Executive Officer of LifeFleet, Inc. Mr. DeHuffholds an MBA from the University of Michigan-Ann Arbor.

 

***MICHAEL H. OWENS.***  Dr. Owens is a physician executive withover 20 years of executive healthcare, managed care, physician practicemanagement, marketing and strategic planning experience, as well as 15 yearsof clinical practice experience. Prior to joining Vista, Dr. Owens wasPresident of Imhotep Health Systems, Inc., a healthcare and managed careconsulting firm specializing in strategic business and clinical resourceplanning and implementation. His previous experience includes senior managementroles with CIGNA HealthCare, the Watts Health Foundation and the U.S. PublicHealth Service. His professional certifications and memberships include Fellow,American College of Physician Executives; Diplomat, American College ofPhysician Executives; Diplomat, American Board of Quality Assurance andUtilization Review; and, Diplomat, American Board of Internal Medicine. Heearned his MD degree from Yale University School of Medicine, his MPH inHospital Administration from Yale University School of Public Health and his ABdegree Cum Laude with a major in Chemistry from Bowdoin College, Brunswick, ME.Dr. Owens completed his Hospital Administration Residency at MontefioreHospital, in Bronx, NY, and his Internal Medicine Residency at the Universityof Washington in Seattle.

 

There are no family relationships among anyof our directors or executive officers.

 

*Audit Committee.*  The Audit Committee of the Board ofDirectors currently consists of Mr. Pancoast, Mr. DeHuff andDr. Osterink. The Board has determined that all members of the AuditCommittee are independent directors under the rules of the Nasdaq Stock Marketand each of them is able to read and understand fundamental financialstatements. Mr. Pancoast is an audit committee financial expert. Thepurpose of the Audit Committee is to oversee our accounting and financialreporting processes and audits of our financial statements. Theresponsibilities of the Audit Committee include appointing and providing the compensationof the independent accountants to conduct the annual audit of our accounts,reviewing the scope and results of the independent audits, reviewing andevaluating internal accounting policies, and approving all professionalservices to be provided to the Company by its independent accountants. TheBoard of Directors has adopted a formal written charter for the AuditCommittee.

 

We reimburse our directors for all reasonableand necessary travel and other incidental expenses incurred in connection withtheir attendance at meetings of the Board. Under our 1997 Stock Option/IssuancePlan, as amended (the “Plan”), which was adopted in February 1997 andamended in March and May 1997, and again in June 2001, beginningwith the first Annual Meeting following our initial public offering inJuly 1997, each non-employee director who is first elected to the Boardwill automatically receive an option to purchase 3,750 shares of Common Stockfor the first year of the director’s Board term and 1,250 shares of Common Stockfor each additional year remaining on the director’s Board term following theautomatic option grant. Each director who is currently serving on the Boardwill receive an option to purchase 1,250 shares of Common Stock for eachadditional year for which he is elected as a director. Therefore, each of thenominees, if elected, will receive an option to purchase 1,250 shares of CommonStock for each additional year for which he is elected as a director. Theseoptions will have an exercise price equal to 100% of the fair market value ofthe Common Stock on the grant date. The grant of 3,750 shares will becomeexercisable in equal monthly installments over four years of Board servicecompleted by the director following such grant, and the grants of 1,250 shareswill become exercisable at the end of one year of Board service completed bythe director following the date of grant. However, the shares will immediatelyvest in full upon changes in control or ownership or upon the optionee’s deathor disability.

 

Under our 1995 Stock Option Plan (the“Predecessor Plan”), each non-employee director received a fully vested optionto purchase 1,125 shares of Common Stock in December 1996, andMr. Lyon received an option to purchase 2,812 shares of Common Stock. Theoption grant to Mr. Lyon vested over five years from the date of grant.

 

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(b)                                 Identificationof Executive Officers.  Our executiveofficers as of March 31, 2004, are as follows:

 
| **Name**           |   | **Age** |   | **Position**                                                                |
|--------------------|--------|---------|--------|-----------------------------------------------------------------------------|
| John R. Lyon       |   | 58      |   | President, Chief Executive Officer and Director                             |
| John (Jed) Kennedy |   | 46      |   | Executive Vice President and Chief Operating Officer                        |
| Michael Owens      |   | 52      |   | Chief Medical Officer, President of VOW Solutions, Inc., and  Director |
| Stephen Gorgol(1)  |   | 45      |   | Chief Financial Officer, Vice President of Finance and Secretary            |

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(1)           Mr. Gorgol ceased being an employeeof ours as of July 1, 2004. As of that date, our new Chief FinancialOfficer and Secretary is Howard Sampson.

 

***JOHN R. LYON.***  Mr. Lyon co-founded our Company inJuly 1993 and has served as President since July 1993, as ChiefExecutive Officer since December 1996 and as a director sinceJuly 1995. Prior to co-founding Vista Medical, Mr. Lyon served forthree years with Cooper Companies, as President of the International Divisionwithin Cooper’s Health Care Group from January 1991 throughDecember 1992, and as President of Cooper Surgical, a manufacturer anddistributor of minimally invasive surgical products, from January 1992through January 1993. Mr. Lyon also was employed by Kaiser Aerospacein a business development role from February 1993 until Vista Medical wasfounded in July 1993. Mr. Lyon holds a B.A. from the University ofDurham, United Kingdom.

 

***JED KENNEDY.***  Mr. Kennedy joined Vista Medical in January 1997as Vice President of Research and Development, was appointed VicePresident/General Manager of Westborough Operations in January 2000 untilbeing appointed Executive Vice President and Chief Operating Officer inDecember 2000. Prior to joining Vista, Mr. Kennedy held variouspositions in Manufacturing, Quality Engineering and Product Development atSmith & Nephew Endoscopy from 1984 through January 1997. From1996 through January 1997 he was the Group Director of Product Developmentresponsible for managing all Divisional Product Development activities. From1993 through 1996, Mr. Kennedy was Director, Research and Developmentresponsible for the management of four technology product development groups.Prior to 1984, he held various engineering positions at Honeywell’sElectro-Optics and Avionics divisions. Mr. Kennedy received a BSManufacturing Engineering from Boston University in 1979.

 

***STEPHEN A. GORGOL.***  Mr. Gorgol joined Vista Medical inFebruary 1997 and served as Director of Finance and Administration untilDecember 2000 when he was appointed Vice President of Finance and ChiefFinancial Officer. Prior to joining Vista, Mr. Gorgol served as CorporateController of Voicetek Corporation, a telecommunications company, from 1991 throughAugust 1996. Mr. Gorgol received a BS in Accounting from PlymouthState College in 1980.

 

***MICHAEL H. OWENS.***  Dr. Owens joined Vista Medical inSeptember 2003 as President of VOW Solutions Inc. (a wholly ownedsubsidiary of Vista Medical). Dr. Owens is a physician executive with over20 years of executive healthcare, managed care, physician practicemanagement, marketing and strategic planning experience, as well as15 years of clinical practice experience. Prior to joining Vista,Dr. Owens was President of Imhotep Health Systems, Inc., a healthcareand managed care consulting firm specializing in strategic business andclinical resource planning and implementation. His previous experience includessenior management roles with CIGNA HealthCare, the Watts Health Foundation andthe U.S. Public Health Service. His professional certifications and membershipsinclude Fellow, American College of Physician Executives; Diplomat, AmericanCollege of Physician Executives; Diplomat, American Board of Quality Assuranceand Utilization Review; and, Diplomat, American Board of Internal Medicine. Heearned his MD degree from Yale University School of Medicine, his MPH inHospital Administration from Yale University School of Public Health and his ABdegree Cum Laude with a major in Chemistry from Bowdoin College, Brunswick, ME.Dr. Owens completed his Hospital Administration Residency at MontefioreHospital, in Bronx, NY, and his Internal Medicine Residency at the Universityof Washington in Seattle.

 

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(c)                                  Compliancewith Section 16(a) of the Exchange Act.

 

The members of the Board of Directors, ourexecutive officers and persons who hold more than 10% of our outstanding CommonStock are subject to the reporting requirements of Section 16(a) of theSecurities Exchange Act of 1934 which require them to file reports with respectto their ownership of the Common Stock and their transactions in such CommonStock. Based on a review of the copies of such reports furnished to us, orrepresentations regarding the necessity to file such reports, we haveidentified the following failures to file reports: George DeHuff with 4 latereports and transactions, Stephen Gorgol with 6 late reports and filings, JohnLyon with 2 late reports and filings, Larry Osterink with 4 late filings andreports, Michael Owens with 1 late report and filing and Scott Pancoast with 1late report and filing. We have been informed that all such reports have nowbeen filed and each individual has undertaken a policy of future compliance.

 

**CODE OF ETHICS**

 

We have adopted a code of ethics that appliesto all officers and employees, including its principal executive officer,principal financial officer and controller. This code of ethics is available onour website at *http://www.vistamt.com.*

 

Item 11.                                                       EXECUTIVECOMPENSATION

 

The following table provides summaryinformation concerning the compensation earned by our Chief Executive Officerand each of our three other most highly compensated executive officers, whoearned more than $100,000 for services rendered in all capacities for thefiscal year ended December 31, 2003. No executive officers who would haveotherwise been included in such table on the basis of salary and bonus earnedfor the 2003 fiscal year has been excluded by reason of his or her terminationof employment or change in executive status during that year. The listedindividuals shall be hereinafter referred to as the “Named Executive Officers”in this Proxy Statement.

 

**SUMMARY COMPENSATION TABLE(1)**

 
|                                    |   |      |   |    |    | **Long-Term  Compensation Awards** |   |
|-----------------------------------------|--------|-----------|--------|---------|---------|------------------------------------|--------|
| **Name and Principal Position**         |   | **Year**  |   |    |    |                               |   | **Securities  Underlying  Options/SARS (#)** |   | **All Other  Compensation** |   |
| **Annual  Compensation**                |   |
| **Salary(1)(2)**                        |   | **Bonus** |   |
| John R. Lyon                            |   | 2001      |   | $       | 208,200 |                               | 10,000 |   | — |   | — |   |
| President, Chief Executive Officer and  |   | 2002      |   | 214,446 |    | —                             |   | 35,000 |   | — |   |
| Director                                |   | 2003      |   | 214,446 |    | 45,000                             |   | — |   | — |   |
|                                    |   |      |   |    |    |                               |   |   |   |   |   |
| John (Jed) Kennedy                      |   | 2001      |   | 190,000 |    | 10,000                             |   | — |   | — |   |
| Executive Vice President and Chief      |   | 2002      |   | 195,700 |    | —                             |   | 25,000 |   | — |   |
| Operating Officer                       |   | 2003      |   | 195,700 |    | —                             |   | — |   | — |   |
|                                    |   |      |   |    |    |                               |   |   |   |   |   |
| Stephen A. Gorgol                       |   | 2001      |   | 120,000 |    | 10,000                             |   | 20,000 |   | — |   |
| Chief Financial Officer, Vice President |   | 2002      |   | 138,000 |    | —                             |   | — |   | — |   |
| of Finance and Secretary                |   | 2003      |   | 138,000 |    | —                             |   | 10,000 |   | — |   |
|                                         |        |           |        |         |         |                                    |        |  |  |  |  |  |

 

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(1)                                  Includesamounts deferred pursuant to our 401(k) Plan.

 

(2)                                  InSeptember 2003, Dr. Michael Owens was brought on board as Presidentof VOW Solutions, Inc., and earns over $100,000 per year.

 

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**STOCK OPTIONS AND STOCK APPRECIATION RIGHTS**

 

The following table sets forth informationconcerning stock option grants made to each of the Named Executive Officers forthe 2003 Fiscal Year, and the potential realizable value of those grants (on apre-tax basis) determined in accordance with SEC rules. The information in thistable shows how much the named executive officers may eventually realize infuture dollars under two hypothetical situations: if the price of the commonstock increases 5% or 10% in value per year, compounded over the life of theoptions. These amounts represent assumed rates of appreciation, and are notintended to forecast future appreciation of the common stock.

 

We granted no stock appreciation rights(“SARs”) to Named Executive Officers during 2003.

 

**OPTION GRANTS IN LAST FISCAL YEAR**

 
|                                                       |   |                                                           |   |                              |   |                 |   |                 |       | **Potential  Realizable** |   |
|------------------------------------------------------------|--------|----------------------------------------------------------------|--------|-----------------------------------|--------|----------------------|--------|----------------------|------------|---------------------------|--------|
| **Name**                                                   |   | **Individual  Grants**                                         |   | **Value at  Assumed**             |   |
| **Number of  Securities  Underlying  Options  Granted(3)** |   | **% of Total  Options  Granted to  Employees in  Fiscal Year** |   | **Exercise  Price Per  Share(1)** |   | **Expiration  Date** |   | **Annual Rates  of** |       |
| **Stock  Price**                                           |
| **Appreciation  for**                                      |
| **Option  Term(2)**                                        |
| **5%**                                                     |   | **10%**                                                        |
| John R. Lyon                                               |   | —                                                         |   | —                            |   | —               |   |                 |       |                      |   |   |   |
| John (Jed)Kennedy                                          |   | —                                                         |   | —                            |   |                 |   |                 |       |                      |   |   |   |
| Dr. Michael Owens                                          |   | 60,000                                                         |   | 32                                | %      | $                    | 1.84   |                 | 09/08/2013 |                      | $      | 69,430 |   | $ | 175,949 |   |
| Stephen A. Gorgol                                          |   | —                                                         |   | —                            |   |                 |   |                 |       |                      |   |   |   |
|                                                            |        |                                                                |        |                                   |        |                      |        |                      |            |                           |        |  |  |  |  |  |

 

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(1)                                  Theexercise price per share of options granted represented the fair market valueof the underlying shares of Common Stock on the dates the respective optionswere granted as determined by the Board in accordance with certain provisionsof the 1997 Stock Option/Stock Issuance Plan based on the closing selling priceper share of a share of Common Stock on the date in question as reported by theNasdaq SmallCap Market. The exercise price may be paid in cash or in shares ofCommon Stock valued at fair market value on the exercise date or may be paidwith the proceeds from a same-day sale of the purchased shares. We also haveauthority to finance the optionee’s exercise of the option by loaning suchindividual on a full-recourse basis sufficient funds to cover the exerciseprice for the purchased shares, together with any federal and state withholdingtax liability incurred by the optionee in connection with the option purchase.

 

(2)                                  The5% and 10% assumed annual rates of compounded stock price appreciation aremandated by rules of the Commission. The price used for computing thisappreciation is the exercise price of the options. There is no assuranceprovided to any executive officer or any other holder of our securities thatthe actual stock price appreciation over the 10-year option term will be at theassumed 5% or 10% levels or at any other defined level.

 

(3)                                  Eachof the options granted have a maximum term of ten years measured from theapplicable grant date, subject to earlier termination in the event of theoptionee’s cessation of service with us. Each of the options granted willbecome exercisable in equal monthly installments over the next 36 monthsof service thereafter. However, each of the options will immediately becomeexercisable for all of the option shares in the event we are acquired by amerger or asset sale, unless the options are assumed by the acquiring entity,or in the event there is a hostile change in control or ownership. The grant datefor the options granted to the Executive Officers is September 8, 2003.

 

**OPTION EXERCISES AND HOLDINGS**

 

The following table provides informationconcerning option exercises during 2003 by the Named Executive Officers and thevalue of unexercised options held by each of the Named Executive Officers as ofDecember 31, 2003. No SARs were exercised during 2003 or outstanding as ofDecember 31, 2003.

 

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AGGREGATE OPTION EXERCISES IN LAST FISCALYEAR AND FISCAL YEAR-END OPTION VALUES

 
|               |   | **Shares**        |   |            |   | **Number of  Securities  Underlying Unexercised** |   | **Value of  Unexercised  In-The-Money Options** |   |
|--------------------|--------|-------------------|--------|-----------------|--------|---------------------------------------------------|--------|-------------------------------------------------|--------|
|               |   | **Acquired  on**  |   | **Value**       |   | **Options at  December 31, 2003**            |   | **At  December 31, 2003(3)**               |   |
| **Name**           |   | **Exercise  (#)** |   | **Realized(1)** |   | **Exercisable(2)**                                |   | **Unexercisable**                               |   | **Exercisable(2)** |   | **Unexercisable** |   |
| John R. Lyon       |   | —            |   | —          |   | 96,568                                            |   | 17,431                                          |   | $ | 2,888 |   | $ | 0 |   |
| John (Jed) Kennedy |   | —            |   | —          |   | 43,714                                            |   | 14,286                                          |   | 0 |   | 0 |   |
| Dr. Michael Owens  |   | —            |   | —          |   | 5,000                                             |   | 55,000                                          |   | 0 |   | 0 |   |
| Stephen A. Gorgol  |   | —            |   | —          |   | 30,861                                            |   | 16,639                                          |   | 0 |   | 0 |   |
|                    |        |                   |        |                 |        |                                                   |        |                                                 |        |  |  |  |  |  |  |

 

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(1)                                  “Valuerealized” is calculated on the basis of the fair market value of the CommonStock on the date of exercise minus the exercise price and does not necessarilyindicate that the optionee sold such stock.

 

(2)                                  Theoptions are immediately exercisable; however, any shares purchased uponexercise may be subject to rights of repurchase our part which lapse at varioustimes over the next five years.

 

(3)                                  “Value”is defined as fair market price of the Common Stock at fiscal year-end ($1.19)less exercise price.

 

**STOCK PERFORMANCE GRAPH**

 

The graph depicted below shows a comparisonof our cumulative total stockholder returns, the CRSP Total Return Index forthe Nasdaq Stock Market (U.S. Companies) (the “Nasdaq Stock Market—U.S. Index”)and the Nasdaq Medical Device Manufacturer Index. The graph covers the periodfrom December 31, 1998 to December 31, 2003. The total return for ourCommon Stock and each index assumes that $100 was invested on December 31,1997 and that all dividends were reinvested, although dividends have not beendeclared on our Common Stock. The stockholder return shown on the graph belowis not necessarily indicative of future performance and we will not make orendorse any predictions as to future stockholder returns.

 

**Vista Medical Technologies, Inc.**

**Nasdaq Medical Device Manufacturers Index**

**Nasdaq Stock Market - U.S. Index**

 

 

 

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Item 12.                                                       SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

 

**OWNERSHIP OF SECURITIES**

 

The following table sets forth certaininformation known to us with respect to the beneficial ownership of our CommonStock as of March 31, 2004, by (i) all persons who are beneficialowners of five percent (5%) or more of our Common Stock, (ii) each directorand nominee for director, (iii) the executive officers named in theSummary Compensation Table of the Executive Compensation and RelatedInformation section of this Proxy Statement and (iv) all currentdirectors and executive officers as a group.

 

Except as indicated in the footnotes to thistable, the persons named in the table have sole voting and investment powerwith respect to all shares of Common Stock shown as beneficially owned by them,subject to community property laws, where applicable. Share ownership in eachcase includes shares issuable upon exercise of certain outstanding options asdescribed in the footnotes below. The address for those individuals for whichan address is not otherwise indicated is: 2101 Faraday Avenue, Carlsbad,California 92008.

 

| **Name and Address of Beneficial  Owner**                                     |   | **Number of  Shares** |   | **Percentage  Beneficially Owned(1)** |   |
|-------------------------------------------------------------------------------|--------|-----------------------|--------|---------------------------------------|--------|
| Funds advised by Domain Associates(2)  One Palmer Square  Princeton, NJ 08542 |   | 1,050,525             |   | 17.5                                  | %      |
| SBIC Partners, L.P.(4)  201 Main Street, Suite 2302  Fort Worth, TX 76102     |   | 822,194               |   | 13.7                                  | %      |
| Vectra Partners LLC                                                           |   | 631,579               |   | 10.5                                  | %      |
| James C. Blair(3)                                                             |   | 1,057,921             |   | 17.6                                  | %      |
| Scott R. Pancoast(5)                                                          |   | 635,017               |   | 10.5                                  | %      |
| Daniel J. Holland(6)                                                          |   | 173,999               |   | 2.9                                   | %      |
| John R. Lyon(7)                                                               |   | 161,561               |   | 2.7                                   | %      |
| Dr. Michael Owens(8)                                                          |   | 13,333                |   |                                  | *      |
| John Kennedy(9)                                                               |   | 58,068                |   |                                  | *      |
| Larry Osterink(10)                                                            |   | 42,271                |   |                                  | *      |
| Stephen Gorgol(11)                                                            |   | 43,325                |   |                                  | *      |
| George B. Dehuff(12)                                                          |   | 12,222                |   |                                  | *      |
| All directors and executive officers as a  group (9 persons)(13)         |   | 2,203,757             |   | 36.7                                  | %      |

 

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*                                         Lessthan 1%

 

(1)                                  Percentageof ownership is based on 5,011,251 shares of Common Stock and 1,000,000 sharesof Series A Convertible Preferred Stock outstanding on March 31,2004. Shares of Common Stock subject to stock options which are currentlyexercisable or will become exercisable within 60 days after March 31,2004, are deemed outstanding for computing the percentage of the person orgroup holding such options, but are not deemed outstanding for computing thepercentage of any other person or group.

 

(2)                                  Includes1,030,182 shares beneficially owned by Domain Partners III, L.P., 15,468 sharesbeneficially owned by DP III Associates, L.P. and 4,875 shares beneficiallyowned by Domain Associates L.L.C. Dr. Blair is a managing member of DomainAssociates L.L.C.

 

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(3)                                  Includes7,396 shares issuable upon exercise of options exercisable within 60 daysof March 31, 2004. Also includes 1,030,182 shares beneficially owned byDomain Partners III, L.P., 15,468 shares beneficially owned by DP III Associates,L.P. and 4,875 shares beneficially owned by Domain Associates L.L.C.Dr. Blair is a managing member of Domain Associates L.L.C.

 

(4)                                  Includes1,250 shares beneficially owned by The Binkley Family Trust and 452,523 sharesbeneficially owned by SBIC Partners, L.P., a Texas limited partnership (“SBICPartners”). Also includes 368,421 shares of Series A Convertible PreferredStock acquired in a Preferred Stock financing on March 3, 2003 by SBICPartners, L.P. SBIC Partners is the beneficial owner of all shares of theCompany’s Common Stock registered in its name. Forrest Binkley & BrownL.P., a Texas limited partnership (“FBB”), is the managing general partner ofSBIC Partners, and Forrest Binkley & Brown Venture Co., a Texas corporation(“Venture Co.”), is the sole general partner of FBB. Nicholas Binkley, alimited partner of FBB and an executive officer, director and shareholder ofVenture Co., resigned as one of our directors on February 21, 2003

 

(5)                                  Includes3,438 shares issuable upon exercise of options exercisable within 60 daysof March 31, 2004. Also includes 631,579 shares of Series AConvertible Preferred Stock beneficially owned by Vectra Partners LLC.

 

(6)                                  Includes12,271 shares issuable upon exercise of options exercisable within 60 daysof March 31, 2004. Also includes 161,728 shares beneficially owned by OneLiberty Fund III, L.P. Mr. Holland is a general partner of One LibertyPartners III, L.P., which is a general partner of One Liberty Fund III, L.P.Mr. Holland disclaims beneficial ownership with respect to all shares ofCommon Stock owned by One Liberty Fund III, L.P.

 

(7)                                  Includes102,472 shares issuable upon exercise of options exercisable within60 days of March 31, 2004.

 

(8)                                  Includes13,333 shares issuable upon exercise of options exercisable within 60 daysof March 31, 2004.

 

(9)                                  Includes48,582 shares issuable upon exercise of options exercisable within 60 daysof March 31, 2004.

 

(10)                            Includes12,271 shares issuable upon exercise of options exercisable within 60 daysof March 31, 2004.

 

(11)                            Includes35,514 shares issuable upon exercise of options exercisable within 60 daysof March 31, 2004.

 

(12)                            Includes12,222 shares issuable upon exercise of options exercisable within 60 daysof March 31, 2004.

 

(13)                            Includes247,499 shares issuable upon exercise of options exercisable within60 days of March 31, 2004. See also footnotes 2, 3, 4, 5 and 6.

 

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Item 13.                                                       CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS

 

We have entered into indemnificationagreements with our directors and executive officers. Such agreements requireus, among other things, to indemnify our officers and directors, other than forliabilities arising from willful misconduct of a culpable nature, and toadvance their expenses incurred as a result of any proceedings against them asto which they could be indemnified.

 

Pursuant to an agreement entered into onDecember 28, 1998, we have agreed to continue to pay Mr. Lyon hissalary, and to continue to provide certain health care benefits, for a periodof twelve (12) months in the event of his involuntary terminationfollowing a change in control.

 

Pursuant to an agreement entered into onJanuary 29, 2003, we have agreed to continue to pay Mr. Gorgol andMr. Kennedy their salary, and to continue to provide health care benefits,for a period of (6) months in the event of their involuntary terminationfollowing a change in control. The sale of the Visualization Technologybusiness in April 2004 could result in the envoking of these agreementswith Mr. Gorgol and Mr. Kennedy.

 

Fifty percent of certain unvested sharessubject to options outstanding to our executive officers will immediately vestif we are acquired by a merger or asset sale, unless our repurchase rights withrespect to those shares are transferred to the acquiring entity. The otherfifty percent of these shares vest if the employee is terminated without causewithin two years of the merger or asset sale.

 

All of our officers are employed at will.

 

Our Second Restated Certificate ofIncorporation eliminates, subject to certain exceptions, directors’ personalliability to us or our stockholders for monetary damages for breaches offiduciary duties. The Second Restated Certificate of Incorporation does not,however, eliminate or limit the personal liability of a director for(i) any breach of the director’s duty of loyalty to us or ourstockholders, (ii) acts or omissions not in good faith or which involveintentional misconduct or a knowing violation of law, (iii) unlawfulpayments of dividends or unlawful stock repurchases or redemptions as providedin Section 174 of the Delaware General Corporation Law or (iv) anytransaction from which the director derived an improper personal benefit.

 

Our Restated Bylaws provide that we shallindemnify its directors and executive officers to the fullest extent permittedunder the Delaware General Corporation Law and may indemnify its otherofficers, employees and other agents as set forth in the Delaware GeneralCorporation Law. In addition, we have entered into indemnification agreementswith our directors and officers. The indemnification agreements containprovisions that require us, among other things, to indemnify our directors andexecutive officers against certain liabilities (other than liabilities arisingfrom intentional or knowing and culpable violations of law) that may arise byreason of their status or service as directors or executive officers of ours orother entities to which they provide service at our request and to advanceexpenses they may incur as a result of any proceeding against them as to whichthey could be indemnified. We believe that these provisions and agreements arenecessary to attract and retain qualified directors and officers. We haveobtained an insurance policy covering directors and officers for claims thatsuch directors and officers may otherwise be required to pay or for which weare required to indemnify them, subject to certain exclusions.

 

44

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Item 14.       PRINCIPAL ACCOUNTANTFEES AND SERVICES

 

The Audit Committee has appointedErnst & Young LLP as our independent auditors for the fiscal yearending December 31, 2004.

 

The following table shows the fees paid oraccrued by us for the audit and other services provided by Ernst &Young LLP for fiscal 2003 and 2002.

 

|                  |   | **2003** |    | **2002** |   |
|-----------------------|--------|----------|---------|----------|--------|
| Audit Fees(1)         |   | $        | 96,000  |     | $      | 88,500 |   |
| Audit-Related Fees(2) |   | —   |    | —   |   |
| Tax Fees(3)           |   | 7,500    |    | 6,500    |   |
| All other Fees(4)     |   | 5,500    |    | 6,500    |   |
| Total                 |   | $        | 109,000 |     | $      | 101,200 |   |

 

----

(1)                                  Auditfees represent fees for professional services provided in connection with theaudit of our financial statements and review of our quarterly financialstatement and audit services provided in connection with other statutory orregulatory filings.

 

(2)                                  Audit-relatedfees consisted primarily of accounting consultations, employee benefit planaudits, services related to business acquisitions and divestitures and otherattestation services.

 

(3)                                  Forfiscal 2003 and 2002, respectively, tax fees principally included taxcompliance fees of $7,500 and $6,500, and tax advice and tax planning fees of$0 and $0.

 

(4)                                  Allother fees principally include miscellaneous consulting services.

 

45

----

 

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 two reports on Form 8-K during our fourth quarter endedDecember 31, 2003. Information regarding the items reported on is asfollows:

 
| **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.                                                                                |

 

46

----

 
| 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.                                                                                                                                                                   |

 

47

----

 
| 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(16)  |   | Asset Purchase Agreement with Viking Systems, Inc. dated as of  December 22, 2003.                               |
| 23.1***    |   | Consent of Ernst & Young LLP, Independent Auditors.                                                               |
| 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 onSeptember 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.

 

(16)                                                              Incorporatedby reference to our Form 10-K, filed March 30, 2004.

 

*                                         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

 

***                           Previously filed.

 

SUPPLEMENTAL INFORMATION

 

Copies of the Registrant’s Proxy Statement for the Annual Meeting ofStockholders to be held May24, 2004 and copies of the form of proxy to be usedfor such Annual Meeting will be furnished to the Commission prior to the timethey are distributed to the Stockholders.

 

48

----

 

SIGNATURES

 

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

 

 
|   |                            |   |   |   |   | VISTA MEDICAL TECHNOLOGIES, INC. |
|--------|---------------------------------|--------|--------|--------|--------|----------------------------------|
|   |                            |   |   |   |   |                             |   |
|   |                            |   |   |   |   |                             |   |
|   | Date:  August 6, 2004 |   |   |   | By:    | /s/ John R. Lyon                 |   |
|   |                            |   |   |   |   |                             | John R. Lyon |
|   |                            |   |   |   |   |                             | President and Chief Executive Officer |

 

 

Pursuant to the requirements of the Securities Exchange Act of 1934,this Report has been signed below by the following persons on behalf of theRegistrant in the capacities and on the dates indicated.

 
| **SIGNATURE**          |   | **TITLE**                                                             |                               | **DATE** |                |
|------------------------|--------|-----------------------------------------------------------------------|------------------------------------|----------|---------------------|
|                   |   |                                                                  |                               |     |                |
| /s/  John R. Lyon |   |                                                                  | President, Chief Executive         |     | August 6, 2004 |   |
| (John R. Lyon)         |   | Officer and Director (Principal  Executive Officer)                   |                               |     |                |
|                   |   |                                                                  |                               |     |                |
| /s/ Howard Sampson     |   |                                                                  | Vice President of Finance and      |     | August 6, 2004 |   |
| (Howard Sampson)       |   | Chief Financial Officer (Principal  Financial and Accounting Officer) |                               |     |                |
|                   |   |                                                                  |                               |     |                |
| *                      |   |                                                                  | Chairman of the Board and Director |     | August 6, 2004 |   |
| (James C. Blair)       |   |                                                                  |                               |     |                |
|                   |   |                                                                  |                               |     |                |
| *                      |   |                                                                  | Director                           |     | August 6, 2004 |   |
| (George B. DeHuff)     |   |                                                                  |                               |     |                |
|                   |   |                                                                  |                               |     |                |
| *                      |   |                                                                  | Director                           |     | August 6, 2004 |   |
| (Scott Pancoast)       |   |                                                                  |                               |     |                |
|                   |   |                                                                  |                               |     |                |
| *                      |   |                                                                  | Director                           |     | August 6, 2004 |   |
| (Michael Owens)        |   |                                                                  |                               |     |                |
|                   |   |                                                                  |                               |     |                |
| *                      |   |                                                                  | Director                           |     | August 6, 2004 |   |
| (Larry M. Osterink)    |   |                                                                  |                               |     |                |

 
| *      | By:    | /s/ John R. Lyon |   |
|--------|--------|------------------|--------|
|   |   | John R. Lyon     |
|   |   | Attorney-in-Fact |

 

49

----

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

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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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