**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C.  20549**

 

**FORM 10-K**

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

 

**Forfiscal year ended December 31, 2002**

 

**OR**

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

 

**For thetransition period from              to              .**

 

**CommissionFile Number:  0-22743**

 

| **VISTA MEDICAL TECHNOLOGIES, INC.**                             |
|------------------------------------------------------------------|
| (Exact name of  Registrant as specified in its charter)          |
|                                                             |   |   |
| **DELAWARE**                                                     |   | **94-3184035** |
| (State or other  jurisdiction of  incorporation or organization) |   | (I.R.S. Employer  Identification No.) |
|                                                             |   |   |
| **2101  Faraday Avenue,  Carlsbad, California 92008**            |
| (Address of principal  executive offices)                        |
|                                                             |   |   |
| **(760)  603-9120**                                              |
| (Registrant’s telephone  number, including area code)       |

 

Securitiesregistered pursuant to Section 12(b) of the Act:  **None**

 

Securitiesregistered pursuant to Section 12(g)  ofthe Act:  **Common Stock, par value $.01 per share**

 

Indicate by checkmark whether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.  Yes  ý  No  o

 

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

 

Indicate by checkmark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-Kis not contained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment to this Form10-K.  o

 

The aggregatemarket value of the voting stock held by nonaffiliates of the registrant as ofJanuary 31, 2003 was approximately $4,344,000. For the purposes of this calculation, shares owned by officers,directors and 10% stockholders known to the registrant have been deemed to beowned by affiliates. This determination of affiliate status is not necessarilya conclusive determination for other purposes.

 

The number ofshares outstanding of the registrant’s Common Stock as of March 21, 2003 was5,001,749.

 

DOCUMENTS INCORPORATED BYREFERENCE

 

Portions ofRegistrant’s Proxy Statement for the Annual Meeting of Stockholders scheduledto be held on June 4, 2003, to be filed on or about April 28, 2003 and referredto herein as the “Proxy Statement”, are incorporated as provided in Part III.

 

Certain exhibitsfiled with the Registrant’s prior registration statements and forms 10-Q and10-K are incorporated herein by reference into Part III of this Report.

 

 

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**Vista Medical Technologies, Inc.**

**Form 10-K**

**For the Fiscal Year Ended December 31, 2002**

 

**TABLE OF CONTENTS**

 
| Part  I   |      |
|-----------|-----------|
|      | Item  1.  | Business |
|      | Item 2.   | Properties |
|      | Item 3.   | Legal Proceedings |
|      | Item  4.  | Submission  of Matters to a Vote of Security Holders |
|      |      |   |
| Part  II  |      |
|      | Item  5.  | Market  for the Registrant’s Common Equity and Related Stockholder Matters |
|      | Item 6.   | Selected Financial  Data |
|      | Item  7.  | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |
|      | Item  7A. | Quantitative  and Qualitative Disclosures About Market Risk |
|      | Item  8.  | Financial  Statements and Supplementary Data |
|      | Item  9.  | Changes  in and Disagreements with Accountants on Accounting and Financial Disclosure |
|      |      |   |
| Part  III |      |
|      | Item  10. | Directors  and Executive Officers of the Registrant |
|      | Item 11.  | Executive  Compensation |
|      | Item  12. | Security  Ownership of Certain Beneficial Owners and Management |
|      | Item  13. | Certain  Relationships and Related Transactions |
|      | Item  14. | Statement  on Disclosure Controls and Procedures |
|      |      |   |
| 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 timewe have made and may continue to make “forward looking statements” within themeaning of the federal securities laws. This report on Form 10-K may contain forward-looking statements.  These statements, which represent our expectationsor beliefs concerning various future events, may contain words such as “expects,”“anticipates,” “intends,” “plans,” “believes,” “estimates,” or other wordsindicating future results.  Actualresults may differ materially from results anticipated in such forward-lookingstatements.  We assume no obligation toupdate any forward-looking statements to reflect events or circumstancesarising after the date of this report.

 

You shouldcarefully review and consider the various disclosures in this report regardingfactors that could cause actual results to differ materially from anticipatedresults, including those factors under the caption “Risks and Uncertainties” atpages 21 through 29 below, and elsewhere in this report.

 

Item 1.             BUSINESS

 

OVERVIEW OF OUR BUSINESS

 

Over the course ofthe past year, we have defined our business into two separate units.  The Obesity Surgery Management Servicesbusiness, based in Carlsbad, CA, provides services to physicians and hospitalsinvolved in the surgical treatment of morbid obesity.  Our services include management of the Laparoscopic BariatricSurgery Preceptorship, a comprehensive introduction to starting a minimallyinvasive gastric bypass surgical program. Additionally, we offer systems and consulting services which enable theefficient operation of obesity surgery programs.

 

The VisualizationTechnology business, based in Westborough, MA, develops, manufactures andmarkets products that provide information to physicians performing minimallyinvasive general surgical, cardiac surgical and other selected endoscopic andinterventional procedures.  Ourtechnology products combine a head mounted display with video cameras toprovide surgeons with critical visual information during complex minimallyinvasive procedures, and also incorporate the benefit of viewing complementaryinformation in a voice-controlled, picture-in-picture format, to facilitatereal-time decision making during surgery. The Visualization Technology business also manufactures compact, highresolution endoscopic cameras for original equipment manufacturer customers andstrategic partners.   In general terms,endoscopic surgery involves a telescopic viewing device which is inserted intoa small incision in the body and which allows the surgeon an adequate view ofthe internal part of the body being repaired.

 

**Backgroundto Obesity Management Services Products**

 

We believe thatcertain emerging complex minimally invasive procedures may require ancillaryservices which support both the clinical introduction of the procedure and theinfrastructure of the organization which provides them to patients.  We believe that laparoscopic gastric bypasssurgery as a treatment for morbid obesity is a good example of such aprocedure, requiring as it does a high level of surgical skill and acomprehensive program to support the patients both before and after surgery.

 

*The Vista Medical solution*

 

We have developeda range of services to support the introduction of laparoscopic gastric bypasssurgery as a treatment for morbid obesity, including management of clinicaltraining courses, production of patient awareness and marketing materials andsystems analysis.  We believe that thiscomprehensive approach to “surrounding the procedure” is applicable in othercomplex minimally invasive disciplines, based on the model we have developedfor gastric bypass surgery.

 

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**Backgroundto Visualization Technology Products**

 

***Minimally invasive surgery***

 

The developmentand subsequent widespread adoption of minimally invasive surgical procedureshave revolutionized many surgical fields, including general surgery,orthopedics, gynecology and urology. Minimally invasive surgical procedures are performed throughstrategically placed ports or mini-incisions as opposed to using largeincisions to gain surgical access.  Theseprocedures are designed to be as safe and effective as conventionalsurgery.  The goal in using a minimallyinvasive procedure is to substantially reduce trauma, pain and suffering, speedrecovery, shorten the length of hospital stays and decrease many of the costsassociated with patient care.  Aminimally invasive procedure is most advantageous in cases in which significanttrauma would otherwise result from gaining surgical access to an affected organor site through the use of a large incision. This movement toward minimally invasive surgery has been driven byadvances in both device technology and surgical technique, as well as patientdemand.

 

***Minimally invasive microsurgery***

 

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

 

**Applicationof our Technology Products to Different Surgical Procedures**

 

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

 

*Conventional treatments.*

 

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

 

*Minimally invasive microsurgery*.

 

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

 

*The Vista Medical solution*.

 

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

 

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***Cardiac Surgery***

 

*Conventional**t**reatments*

 

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

 

*Minimally invasive cardiac surgery*

 

The application ofminimally invasive techniques to cardiac surgery is regarded as a potentiallyrevolutionary development in modern surgery. Minimally invasive heart bypass and heart valve replacement or repairprocedures avoid the trauma caused by cracking the chest open and promise to significantlydecrease pain and trauma and shorten recovery times.  The minimally invasive approaches may also be performed on eithera beating or arrested heart, giving the surgeon more flexibility to treat apatient’s condition.  While there isstill professional debate on the ultimate form or standard of care andtechniques and practices are still under development, nearly all of thoseinvolved believe that minimally invasive procedures will change the futurepractice of heart surgery, just as laparoscopy has revolutionized generalsurgery.  However, minimally invasiveheart microsurgery requires the surgeon to perform technically challengingprocedures, including working on tiny delicate structures, such as a onemillimeter heart vessel with highly restricted access, through smallincisions.  We believe that one of thecurrent limitations to widespread adoption of minimally invasive heartmicrosurgery is the restricted visibility through the small incisions currentlyused.  While new retractor systems arebeing introduced to open the incision and therefore improve the surgeon’saccess and ability to visualize the anatomy directly, restricted visibility,particularly for more complex cases, remains an issue.  However, the goal of truly minimizing theincision to reduce trauma, can only be achieved effectively with products andtechnology that enhance visualization of the affected area through the smallestaccess.

 

*The Vista Medical solution.*

 

We believe thatour visualization technology which provides the heart surgeon with an intuitiveand ergonomically designed product to solve the inherent vision restrictions ofthe minimally invasive cardiac procedure, will enable the use of minimally invasive microsurgerytechniques with the required level of safety, efficacy and precision.  Our technologies are equally effectivewhether the surgeon elects to use either a beating or arrested heart approach,giving the surgeon increased flexibility in treatment options.  We believe that the enhanced visualizationprovided by our products will enable a significant number of surgeons, whootherwise might be reluctant to perform minimally invasive cardiac surgery, toadopt the procedures, particularly as complementary products are developed toprovide a complete technological solution. There is also continuing evidence of patient interest and demand forthese procedures.

 

**OurBusiness Strategy**

 

Our business strategy is to become the leadingdeveloper and marketer of management services and advanced visualization andinformation systems for selected complex minimally invasive applications ingeneral surgery, cardiac surgery and other surgical specialties.  Key elements of our strategy include:

 

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***Develop applications for our technology which are specificto each surgical or medical specialty which we target.***

 

We approach targetmarket segments by configuring our modular visualization system for thespecific requirements of the surgical specialty and procedure for which ourproduct will be used.  We seek to usededicated clinical evaluation programs, clinical advisory boards, andappropriate strategic distribution partners for the introduction and support ofour products.  Our strategy is tooptimize our fundamental technology platform for each of our target medicalspecialties and to develop partnership and distribution systems both in theUnited States and international markets.

 

***Identify specific high-value procedures to facilitate ourentry into the general surgery market.***

 

Our strategy forentering the general surgery market involves identification of high valueprocedures where our visualization technology uniquely enhances procedureperformance.  The first of these islaparoscopic gastric bypass, a surgical technique which addresses morbid orextreme obesity.  Morbid obesity affectsapproximately 12-15 million adults in the United States.  We have been working closely with surgeonspioneering the approach and in January 2000 launched the Laparoscopic BariatricSurgery (LBS) Program to establish a national network of centers to performminimally invasive gastric bypass surgery. The LBS program is designed to provide participating hospitals with thecomplete information, training and technology necessary to perform thissurgery, and also includes a national patient referral campaign.  We began signing up, training and deliveringequipment to hospitals interested in participating in the program in the firstquarter of 2000.  We have since addedother service products to support this procedure and are developing a full-scalemanagement program under the name Vista Obesity and Wellness (VOW) Institute,which we are introducing to the market in 2003.  When the LBS program and VOW Institute are fully established,they may be useful as a model for subsequent procedures which we are in theprocess of identifying and developing.

 

***Establish advanced visualization technologies as standardpractice in minimally invasive cardiac surgery.***

 

We believe that wehave the only visualization system specifically used for minimally invasive cardiacsurgery.  We are currently working withmembers of our clinical advisory boards, other leading surgeons and a strategicpartner to develop operating protocols which incorporate advanced visualizationtechnologies as standard practice.  Weintend to provide training in these procedures, which include the use of ourvisualization system.

 

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

 

The surgeon’saccess to operative data, on demand, in real time and integrated with theanatomical image, enhances procedure performance.  Our head mounted display, incorporating picture-in-picturecapability and voice control, is designed to give the surgeon this real-timeaccess to critical information integrated with the anatomical images generatedby our camera systems.

 

***Develop original equipment manufacture customers with volumesales potential for endoscopic cameras.***

 

We presently havetwo original equipment manufacture customers for our design of conventional,two dimensional single and three-chip endoscopic cameras.  These products have accounted historicallyfor a substantial amount of our revenues and assist in building relationshipswith prospective partners for our advanced technology.

 

***Enter into strategic relationships which ensure distributionor complement technology resources.***

 

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

 

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**Products:  Obesity Surgery Management Services**

 

Our ObesitySurgery Management Services products are services designed to facilitate theinitiation and ongoing operation of Obesity Surgery programs.  We work with hospitals and bariatricsurgeons in the implementation of these service products.

 

***Laparoscopic Bariatric Surgery (LBS) Preceptorship***

 

The overall goalof the LBS Preceptorship is to fast-track the implementation of minimallyinvasive gastric bypass surgery into the hospital and surgical practice.  The program is a combination of clinicalobservation, hands-on cadaver laboratory, didactic sessions, laboratoryexperience, surgical lecture, marketing materials, on-site programimplementation/planning, and case proctoring. Key challenges face surgeons and hospital administrators assigned thetask of establishing a bariatric surgical program.  Proper training, hospital credentialing, and implementationstrategies are fundamental components required to assure program success.

 

Two versions ofthe LBS Preceptorship are available. One version is geared for the surgeon who has had little experience witheither open or laparoscopic gastric bypass surgery.  The second program is designed for the surgeon with experience inopen bariatric procedures as well as having performed advanced laparoscopicprocedures, but has yet to learn the minimally invasive gastric bypasstechnique.

 

***LBS Preceptorship Modules***

 

The LBSPreceptorship is divided into three separate modules”

 

1.               ProgramImplementation Planning (On-Site)

 

2.               ClinicalPreceptorship (at a Vista Center of Excellence)

 

3.               Case Proctoring(On-Site)

 

**ProgramImplementation Planning (done on-site)**

 

We send anexperienced Bariatric Specialist to the client to address the fundamentalelements of organizing and implementing a bariatric surgical program.  Each department of the hospital that isassociated with the bariatric patient is invited to attend this one-day seminar.

 

Program planningprovides LBS clients with the following critical elements of initiation andoperation of an accredited bariatric surgical program:

 

•                                          Marketing:  Vista marketing materials will be reviewedwith the hospital marketing department and suggestions will be made as how tobest utilize the customized marketing materials. (TV, radio, print.)  Customized recommendations for mediacampaign in local market.  Six monthsinclusion in morbid obesity internet site.

 

•                                          AdministrativePathway:  Each department directlyinvolved with treatment of the bariatric patient will be addressed by the VistaBariatric Specialist to discuss their roles in the care and treatment of theobese surgery patient.  A ‘BariatricSurgery Implementation workbook’ is provided.

 

•                                          ImplementationConsulting:  Consulting time with aprogram management expert, through the formation period of the program.

 

**ClinicalPreceptorship:**

 

The clinicalportion of the LBS Preceptorship is delivered over a three day period.  A participating hospital team, consisting ofthe primary surgeon, first assistant, surgical technician, and nursingcirculator, attends a Vista Center of Excellence for intense clinicalinstruction, under the direction of a Clinical Director.

 

*Principalcomponents of the Clinical Preceptorship*

 

•                  Video lecture series:  ‘A Community Lecture/Informed Consent’,‘Laparoscopic Gastric Bypass Surgery’ (step-by-step procedure with narration),‘Gastric Bypass Surgery Performed via Laparotomy’

 

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(step-by-step procedure with narration)

 

•                  Didacticsessions (for Surgeons):  Lecture seriesprepared by bariatric clinical advisors to cover the subjects such as thefollowing:  bariatric patient selectioncriteria; sleep apnea in the morbidly obese patient and associated co-morbidities;bariatric operations performed via open access technique; bariatric operationsperformed via laparoscopic access technique; laparoscopic gastric bypassoverview of technical points; risks and complications in open and laparoscopicgastric bypass surgery; new advances in information and visualizationtechnology; laparoscopic instrumentation set-up; informed consent; bariatriccoding and costs.

 

•                  Didacticsessions (for clinical support staff): Lectures series prepared by hospital staff on subjects including thefollowing: advancing your diet, Adapting to your new body and lifestyles,Adjusting to your new social environment - lectures given by hospital staff aswell as videos of the lectures for take home; overview of the patients ‘path oftreatment’ (intake to discharge); operating room considerations for nursing andsurgical technicians.

 

•                  Observation oflive surgery cases (open and closed): attendees will watch 6-8 gastric bypass procedures over a 3 day period;OR equipment lists distributed

 

•                  Cadaverlab:  visiting OR team will performlaparoscopic gastric bypass on 3 separate cadaver specimens under supervisionof clinical staff member.

 

•                  Tour ofbariatric surgery floor with review of equipment

 

•                  Video taping ofvisiting surgeons to input into customized marketing materials

 

**On-siteCase Proctoring**

 

In order to becomecredentialed under recent guidelines, the surgeon must submit a minimum of 10cases of open bariatric surgery (if not previously doing open gastric bypass)and a minimum of 15 cases of laparoscopic gastric bypass surgery to becomecredentialed in the minimally invasive technique.  Having a proctor present for the first three cases of eitherapproach is mandatory.  After theProgram Implementation Planning and Clinical Preceptorship is completed, wearrange On-Site Case Proctoring for clients. Depending on the needs of the surgeon and hospital, we facilitate twoseparate proctoring events (one session for the open approach and one session forthe laparoscopic approach), with instruction provided by a member of ourSurgical Advisory Board.

 

***Situational Analysis and Program EvaluationBlueprint***

 

We send an expertteam to the client hospital to conduct a detailed assessment and evaluation ofan existing or projected Bariatric Surgical Program and provide recommendationsfor the client’s evaluation in a comprehensive written report.  This customized “Blueprint” covers subjectssuch as: 

 

•                  AdvancedPlanning

We will review and assimilate basic program-relatedfinancial and statistical data submitted to us in advance of our in-sitevisit.  Schedule on-site personnelinterviews and conduct on-site visit, typically two days in duration. Commenceon-site visit with leadership briefing to clarify program vision,sensitivities, timeframes and any special client directives.

 

•                  OperationsAssessment

Evaluate operational elements in place at the Hospitalcurrently that could be arranged to accommodate a hospital-based bariatricsurgery program.  Operational elementsinclude facilities, systems, equipment, and personnel and observations onorganizational readiness.  Identifyadditional elements needed to supplement elements in place.   Assessment of surgeon(s) office functions,hospital operating department and nursing floor, patient acquisition and businessoffice functions, patient support and educational capabilities and continuum ofcare readiness (dietary, exercise psychology and behavioral modification,support group).

 

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•                  RelationalAssessment

Explore relationship options between surgeon practiceand hospital positioning as hospital-based model, practice-based model, andhybrid model.  Division of work amongsurgeon practice, hospital and potential management company.  What are the surgeon(s) support needs?  Identify opportunity to integrate a “medicalmodel” for a broader bariatric service mix.

 

•                  Financial /Managed Care Assessment

Clarify any outstanding issues from review ofHospital-provided financial and statistical overview data and information (from“Advanced Planning” step above). Assessment of bariatric program-related revenue, expenses, andcapitalization requirements under current operating circumstances andincorporating Vista’s program design assumptions.

 

Clarify any outstanding issues from review ofHospital-provided managed care information (from “Advanced Planning” stepabove).  Review of current payor mix,managed care impact and opportunities for prospectively improving bariatricsurgery program reimbursement, as indicated. Identify specific reimbursement strategies and tactics that may beapplicable to Hospital’s payor mix status.

 

•                  MarketAssessment

Clarify and assess patient demographic, local payorenvironment and competitive profile pertinent to a bariatric surgery program inthe Hospital’s local and regional market area. Identify and propose specificmarketing, advertising, and media strategies and associated costs.

 

•                  InformationSystems Assessment

Evaluate information systems support, patient trackingand report writing capabilities as applicable to a bariatric surgery program atthe Hospital.  Identify opportunities tointerface with surgeon(s) office and other external care sites.

 

•                  Exit De-Briefing

At the conclusion of our on-site visit, conduct exitde-briefing with Hospital leadership to summarize observations and clarify anyoutstanding issues that arise during the on-site visit.

 

•                  On-SitePresentation of Findings and Recommendations

Based on the above findings, perform analysis and makedocumented recommendations in the form of a program design “Blueprint”.  Recommend operations, financial andmarketing plan.  Recommend a relationalmodel for the program, particularly the business relationship and division ofwork among surgeon practice, hospital and outsource options.  If applicable, discuss implementation planutilizing Vista’s services in the on-going management of the bariatric surgeryprogram.

 

**VistaObesity and Wellness (VOW) Institute**

 

VOW leverages ourexperience in the recent development of the obesity surgery market.  We plan to establish and administer, inconjunction with participating surgeons and hospitals, a network of bariatricsurgical centers over the next few years. We are planning that VOW Institutes will be organized as a nationalnetwork, and will be managed on the following principles:

 

•                  *National coverage by regional agreements withhospitals and surgeons*:  VOWoffers hospitals the opportunity to implement a comprehensive,disease-specific, quality program, providing profitable health care services toa growing patient population, without significant investment in programinfrastructure, under an arrangement structured for mutual success.  Patients will be screened, and financialresponsibility for services confirmed, on behalf of surgeons, whose primaryresponsibility will be to operate, without the added burden of programmanagement.  Both hospitals and surgeonswill benefit from VOW’s expertise in the administrative management of thecomplex process of patient acquisition, approval for surgery, post-surgicalcare and long-term follow-up.

 

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•                  *Best-practicesurgical protocols*:  OurLaparoscopic Bariatric Surgical (LBS) Preceptorship has already providedcomprehensive training to more than 50 surgical teams in the most advancedminimally invasive techniques of gastric bypass surgery, based upon a provenprotocol, with excellent, published, long-term results.  Our experienced bariatric surgical facultywill train VOW surgeons, and provide continuing and rigorous clinicaloversight.

 

•                  *Patient-friendlyorganizational efficiency*: Managed with efficiency and convenience, but with empathy andsensitivity, VOW centers will offer comprehensive health care services for themorbidly obese, within the context of an organizational process designed tomaximize the delivery of best-practice care at every stage of the patient’sprogress through the system.

 

•                  *Centralizedinfrastructure and uniform systems*: Administrative and marketing services common to all centers will bemanaged on a centralized basis to benefit from economies of scale and topromote a consistent brand image.  Anational Call Center will respond to and track prospective patients, assistdoctors and patients in insurance approval processing, and handle generaladministrative functions and marketing. The network operating system for all Centers will be the Vista BariatricInformation System (VBIS), Vista/Care’s proprietary real-time ASP-basedsoftware system.

 

The VOW Instituteconcept is being introduced to the market in 2003 and we have not yet signedany agreements with participating hospitals and surgeons.

 

**Products:Visualization Technology**

 

Our technologyprovides a 3-D visualization solution to the inherent vision restrictions anddemands of minimally invasive microsurgery. Our technology provides the surgeon with a clear view of the anatomywith the ability to view additional information in a voice-controlled,picture-in-picture format, which facilitates real-time decision making during theprocedure.  Our technology is based onthe following principles which we believe are essential in advancing thetechniques of minimally invasive microsurgery. We believe these principles offer several key advantages over othervisualization approaches:

 

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

 

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

 

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

 

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

 

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***Head mounted display***

 

The head mounteddisplay device was originally developed for critical applications in militaryaerospace by Kaiser Aerospace.  Wesubsequently determined that the head mounted display was the optimal solutionto the challenge of displaying information during minimally invasivemicrosurgery.  The fundamentaltechnology and human factors experience incorporated in our surgical headmounted display is the result of substantial investment and development byKaiser Aerospace, originally for military applications.  This human factors knowledge, derived frommany years of analysis of the display characteristics which enable pilotsperforming critical physical tasks to simultaneously absorb and react tocrucial information, is a key element in our head mounted display design.  Kaiser’s original know-how and technicalknowledge have been transferred to us under our development agreement withKaiser Electro-Optics, Inc., a subsidiary of Kaiser Aerospace.  We have performed significant additionaldevelopment work, and have proprietary rights, in the surgical head mounteddisplay design.  Our head mounteddisplay, which we believe is the first specifically designed for surgical use,provides 3-D visualization of small delicate body structures, has thecapability of integrating relevant data and presents the image seen by thesurgeon in the most correct, intuitive and ergonomic way.  Wearing the head mounted display, thesurgeon can also perform surgery “in-line”—meaning with the eyes, hands,instruments and subject in-line.  In-linesurgery cannot be performed when the surgeon is observing the anatomy on aremotely-positioned video monitor.

 

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

 

***Three-dimensional image acquisition***

 

We believe thatthree-dimensional visualization capability is critical in minimally invasive microsurgeryprocedures such as cardiac surgery and complex endoscopic procedures in generalsurgery, gynecology and urology.  Ourtechnology for stereo visualization consists of the following proprietaryelements: the optical system, the stereo camera and the stereo processor.  The first 3-D endoscopic optical system weemployed was originally developed and patented by a noted optical designer,Mr. H. McKinley, and is licensed exclusively to us for medical applications.  We have also acquired rights to the stereoendoscope technology of Carl Zeiss. Both McKinley and Zeiss systems are designed to replicate the view thatthe surgeon would have if the procedures were being performed open and he orshe had direct sight of the anatomy.  Webelieve that the McKinley and Zeiss optical systems will provide us with asignificant and enduring competitive advantage because they provide naturaldepth perception, and can be packaged with twin cameras in a very compactdesign.  The twin cameras acquire theimage in a manner analogous to the human visual system.

 

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

 

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significantly toprocedure performance, such as dual image presentation and picture-in-picture.

 

***Information management***

 

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

 

The data integrationcapability of our products has been enhanced through a perpetual, exclusivelicense from GDE which has added high speed image-based information processingand networking software to our technology platform. We believe that ourtechnology will demonstrate that real-time access to relevant information,along with enhanced visualization, is a critical requirement of performingminimally invasive microsurgery and other surgical procedures. We anticipateincorporating appropriate elements of this software package into futureproducts.

 

**ProductLines**

 

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

 

***EndoSite:  3-Dvisualization and information system for general surgery and other complexendoscopic procedures***

 

The most recentapplication of our platform technology is complex procedures in generalsurgery.  Our first public demonstrationof this platform was in October 2002, principally targeted at the emergingprocedure of minimally invasive gastric bypass to control morbid obesity, butalso applicable to many emerging minimally invasive procedures. Our advanced visualizationsystem is designed to be modular and consists of the following majorcomponents:

 
| **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.                                                                                                                                                                                                 |

 

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

 

***OEM Endoscopic Cameras***

 

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

 

**StrategicAlliances**

 

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

 

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

 

In June 2001, we entered into an agreementwith Ethicon Endo-Surgery, Inc. (EES) providing that the companies will worktogether in developing the surgical weight reduction market.  This alliance primarily involves sales andmarketing support by EES of our Laparascopic Bariatric Surgery (LBS) programand other Vista products and services related to the surgical weight reductionmarket.  Also, we will receive paymentsin return for the Company’s commitment to promote use of EES equipment incertain training programs sponsored by the Company for the benefit of itscustomers with no obligation by the Company or its customers to purchase anyEES equipment.   The agreement alsoprovides that the companies will evaluate other complex minimally invasivesurgical procedures which may benefit from the type of combined training andtechnology involved in the LBS program and gives EES the right of firstnegotiation to acquire certain technology from us, which right has beendeclined by EES.  The agreement with EESis renewable annually, and was renewed for the period commencing in 2002.

 

***Jomed***

 

In May 2000, weentered into an exclusive distribution agreement and a cooperative technologyagreement with Jomed International. Under the exclusive distribution agreement, Jomed became the exclusivedistributor of our Series 8000 product in cardiac and related interventionalradiology markets.  In connection withthis agreement, Jomed agreed not to market or sell any product directlycompetitive with our products in these fields. Jomed agreed to pay us a fixed amount for each product ordered, as wellas royalties based on gross profits of units sold.  We agreed to supply products to Jomed at a price that is at leastas favorable as that charged to other customers.  Each year during the term of the distribution agreement, we willagree upon a marketing plan with Jomed and will be allowed to terminate Jomed’sexclusive rights if they, by negligence, fail to implement the marketing plansin any material respect.  In this event,Jomed would then retain non-exclusive rights to distribute our product for aperiod of time.  The distributionagreement is to remain in effect until December 31, 2004 and is automaticallyrenewable for additional one-year periods if Jomed has met at least 70% of itsprojected sales for the previous year. The distribution agreement may be terminated for material breach byeither party or if either party ceased to do business or seeks protection underany bankruptcy proceeding.  Jomedapplied for bankruptcy protection in the Netherlands in January, 2003.  We have not yet elected to terminate theagreement pending clarification of Jomed’s ongoing status. During 2002, wederived 9% of our revenue from sales to Jomed.

 

Under the terms ofthe cooperative technology agreement with Jomed, we agreed to cooperate withJomed on developing enhancements for our Series 8000 product to optimize itsutilization as the standard visualization platform for the placement of Jomed’sSOLEM GraftConnectorTM.  This agreementwill terminate when the exclusive distribution agreement terminates or ifJomed’s exclusive rights under that agreement terminate.

 

***Kaiser Aerospace***

 

In July 1995, weentered into a Manufacturing Supply Agreement with Kaiser Electro-Optics, asubsidiary of Kaiser Aerospace.  Thisagreement was then amended in December 1997. In December 1997, we entered into a Technology Strategic Alliance:Memorandum of Understanding with Kaiser Aerospace, which superseded a similaragreement entered into with Kaiser Electro-Optics in July 1995.  The technology strategic alliance providesthat

 

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Kaiser Aerospace willcooperate with us in joint development programs related to our current generationhead mounted display to be negotiated on an arms-length and project-by-projectbasis for a five-year term.  We willalso contract with Kaiser Electro-Optics for development and manufacturingservices related to the head mounted display, including initial productionquantities.  The manufacturing supplyagreement with Kaiser Electro-Optics provides that they will be our preferredsupplier for a five-year period for not less than 75% of our requirements forthe optical subassembly of the head mounted display, provided that pricing andother terms are competitive and mutually agreed upon.  Under the technology strategic alliance with Kaiser Aerospace,they granted us a right of first refusal to exclusively license independentlydeveloped new technology or devices for medical applications.  Reciprocally, in December 1997, we enteredinto a License Agreement with Kaiser Aerospace under which we exclusivelylicensed to Kaiser Aerospace the right to manufacture and distribute industrialand professional versions of our head mounted display in market segments otherthan medicine in return for an up-front payment and royalties based on sales.

 

In June 2000, weretroactively waived future payment of specified royalties by Kaiser providedfor in the license agreement with them. In return, Kaiser agreed to cancel an order that we had placed for ashipment of head mounted display units, without additional cost to us.  In late 2001, we started working with KaiserElectro-Optics (now a subsidiary of Rockwell Collins) on development of thenext generation head mounted display, which was introduced to the market inOctober, 2002.

 

**LicenseAgreements**

 

We have licensedaspects 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 to make, have made, modify, use, lease,market, sell and otherwise distribute certain endoscopes and other medicalproducts incorporating a stereo objective lens and/or a relay lensconfiguration.  Under the terms of thislicense agreement, we are obligated to pay McKinley an annual maintenanceroyalty, additional royalties upon the sale of certain numbers of systems incorporatingthe McKinley technology and royalties on net sales of products incorporatingthe McKinley technology.  The exclusivelicense granted under this agreement becomes a non-exclusive license, or, undercertain circumstances, the license terminates, in the event we  fail to pay any royalties.  In addition, we have the right to terminatethe agreement with limited notice.

 

***Fuji***

 

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

 

***Carl Zeiss***

 

In August 1998,Carl Zeiss granted us non-exclusive rights in the medical field to three issuedUnited States patents and four pending foreign applications.  We are obligated to pay Zeiss royalties onsales of products incorporating the licensed technology and to providetechnical and applications support, at our current rates for such services, toparties that previously acquired Zeiss’ Endo-Live Stereo Endoscope, nowdiscontinued.  Zeiss may terminate theagreement in the event of a material breach by us which is not cured within a limitedperiod of time.  Our failure to retainrights to the Zeiss patents may negatively impact our business.

 

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**Intellectualproperty protection**

 

We rely on acombination of technical leadership, patent, trade secret, copyright andtrademark protection and nondisclosure agreements to protect our proprietaryrights.  As of December 31, 2002, we hadexclusive ownership rights to 17 issued United States patents, 1 pending UnitedStates patent applications and 2 pending foreign applications covering variousaspects of our devices and systems. Furthermore, as of the same date, we had exclusive rights in the medicalfield to 6 issued United States patents, 5 issued foreign patents and 4 pendingforeign applications covering various aspects of our devices and systems.  In 1998 we additionally obtained from CarlZeiss non-exclusive rights to three issued United States patents and fourpending foreign applications.  We intendto file additional patent applications in the future.  The failure of such patents to issue could damage our ability toprotect our proprietary information.

 

Our future successwill depend, in part, on our ability to continue to develop patentableproducts, enforce our patents and obtain patent protection for our productsboth in the United States and in other countries.  The patent positions of medical device companies, however, aregenerally uncertain and involve complex legal and factual questions.  We are not certain that patents will issue fromany patent applications owned by or licensed to us or that, if patents doissue, the claims allowed will be sufficiently broad to protect ourtechnology.  In addition, we cannotassure you that any issued patents owned by or licensed to us will not be challenged,invalidated or circumvented, or that the rights granted thereunder will provideus with competitive advantages.

 

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

 

Patentapplications in the United States are maintained in secrecy until a patentissues, and patent applications in foreign countries are maintained in secrecyfor a period of time after filing. After such period of time, and usually before the grant of the patent,patent applications in foreign countries are published.  While publication of discoveries in thescientific or patent literature tends to lag behind actual discoveries and thefiling of related patent applications, such publication may enable ourcompetitors to ascertain the areas of research or development in which we areengaged prior to our receipt of patent protection in the United States orforeign countries relating to such research or development.

 

In general, thedevelopment of visualization and information systems is intenselycompetitive.  Patents  issued and patent applications filedrelating to medical devices are numerous and current and potential competitorsand other third parties may have filed or in the future may file applicationsfor, or may receive or in the future will receive, patents or obtain additional proprietary rights relating toproducts or processes used or proposed to be used by us.  We cannot assure you that third parties willnot assert infringement claims against us in the future or that any suchassertions will not result in costly litigation or require us to obtain alicense to intellectual property rights of such parties.  Any such licenses may not be available onacceptable terms, if at all.  Furthermore,parties making such claims may be able to obtain injunctive or other equitablerelief that could effectively block our ability to make, use, sell or otherwisepractice our intellectual property (whether or not patented or described inpending patent applications), or to further develop or commercialize ourproducts in the United States and abroad and could result in the award ofsubstantial damages.  Defense of anylawsuit or failure to obtain any such license could damage our business.

 

We rely onunpatented trade secrets to protect our proprietary technology, and noassurance can be given that others will not independently develop or otherwiseacquire the same or substantially equivalent technologies or otherwise gainaccess to our proprietary technology or disclose such technology or that we canultimately protect our rights to such unpatented proprietary technology.  Third parties may obtain patent rights tosuch unpatented trade secrets, which patent rights could be used to assertinfringement claims against us.  We alsorely on confidentiality

 

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agreements with ourcollaborators, employees, advisors, vendors and consultants to protect ourproprietary 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 care providerscover a broad array of subjects.  For example, the confidentiality ofpatient medical information and the circumstances under which such informationmay be released for inclusion in the Company’s databases, or released by theCompany to third parties, are subject to substantial regulation by the federaland state authorities.  These laws and regulations govern both thedisclosure and the use of confidential patient medical information and areevolving rapidly.  The Company has established an implementation plan thatit believes complies with the existing federal and state 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 to referralsfor services reimbursed by all third-party payors, not just federal or statehealth programs.  These laws are applicable to the Company’s financialrelationships 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 also possible thatsome states currently, or in the future may, require licensure or registrationof certain of the Company’s operations, and may further regulate how thecompany does business.  Finally, various states regulate the operations ofan advertising and referral service for physicians, and may requireregistration of such services with a state agency as well as compliance withvarious requirements on how they conduct business and structure theirrelationships with participating providers.

 

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

 

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**GovernmentalRegulation: Medical Devices**

 

The manufactureand sale of medical devices intended for commercial distribution are subject toextensive governmental regulation in the United States.  Medical devices are regulated in the UnitedStates primarily by the FDA and, to a lesser extent, by certain stateagencies.  Generally, medical devicesrequire pre-market clearance or pre-market approval prior to commercialdistribution.  In addition, certain materialchanges or modifications to, and changes in intended use of, medical devices also are subject to FDAreview and clearance or approval.  TheFDA regulates the research, testing, manufacture, safety, effectiveness,labeling, storage, record keeping, promotion and distribution of medicaldevices in the United States and the export of unapproved medical devices fromthe United States to other countries. Non-compliance with applicable requirements can result in failure of thegovernment to grant pre-market clearance or approval for devices, withdrawal orsuspension of approval, total or partial suspension of production, fines,injunctions, civil penalties, refunds, recall or seizure of products andcriminal prosecution.

 

***Device Classes***

 

In the United States,medical devices are classified into one of three classes, Class I, II or III,on the basis of the controls deemed by the FDA to be necessary to reasonablyensure their safety and effectiveness. Our products to date have either been classified as Class I or Class IIdevices.

 

Class I devicesare subject to general controls, such as establishment registration and productlisting, labeling, adulteration and misbranding provisions and medical devicereporting requirements and, unless exempt, to pre-market notification andadherence to “good manufacturing practice” standards.  Class II devices are subject to general controls and specialcontrols, such as performance standards, post-market surveillance, patient registriesand FDA guidelines.  Generally, ClassIII devices are those that must receive pre-market approval by the FDA toensure their safety and effectiveness. Examples of Class III products include, life-sustaining, life-supportingand implantable or new devices which have not been found to be substantiallyequivalent to legally marketed devices. Class III devices ordinarily require clinical testing to ensure safetyand effectiveness and FDA clearance prior to marketing and distribution.  The FDA also has the authority to requireclinical testing of Class I and Class II devices.  A pre-market approval application must be filed if a proposeddevice is not substantially equivalent to a legally marketed predicate deviceor if it is a Class III device for which the FDA has called for suchapplication.  A pre-market approvalapplication typically takes several years to be approved by the FDA.

 

***Device approval***

 

Generally, beforea new device can be introduced into the market in the United States, themanufacturer or distributor must obtain FDA clearance of a 510(k) notificationor submission and approval of a pre-market approval application.  If a medical device manufacturer ordistributor can establish that a device is “substantially equivalent” to alegally marketed Class I or Class II device, or to a Class III device for whichthe FDA has not called for a pre-market approval, the manufacturer ordistributor may market the device upon receipt of an FDA order determining sucha 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.

 

Followingsubmission of the 510(k) notification, the manufacturer or distributor may notplace the device into commercial distribution until an FDA substantialequivalence order permitting the marketing of a device is received by theperson who submitted the 510(k) notification. At this time, the FDA typically responds to the submission of a 510(k)notification within 90 to 200 days.  AnFDA letter may declare that the device is substantially equivalent to a legallymarketed device and allow the proposed device to be marketed in the UnitedStates.  The FDA, however, may determinethat the proposed device is not substantially equivalent or require furtherinformation, 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 exemptionapplication***

 

All clinicalinvestigations involving the use of an unapproved or uncleared device on humansto determine the safety or effectiveness of the device must be conducted inaccordance with the FDA’s investigational device exemption regulations.  If the device presents a “significant risk,”the manufacturer or distributor of the device is

 

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required to file aninvestigational device exemption application with the FDA prior to commencinghuman clinical trials.  This applicationmust be supported by data, typically the result of animal and bench testing.  If the application is approved by the FDA,human clinical trials may begin at a specific number of investigational siteswith a maximum number of patients, as approved by the FDA.  If the device presents a “non-significantrisk,” approval by an institutional review board prior to commencing humanclinical trials is required, as well as compliance with labeling, recordkeeping, monitoring and other requirements. However, the FDA can disagree with a non-significant risk devicefinding.

 

Any products whichwe manufacture or distribute are subject to continuing regulation by the FDA,which includes record keeping requirements, reporting of adverse experiencewith the use of the device, “good manufacturing” requirements and post-marketsurveillance, and may include post-market registry and other actions deemednecessary by the FDA.  A new 510(k),pre-market approval or pre-market approval supplement is also required when amedical device manufacturer makes a change or modification to a legally marketeddevice that could significantly affect the safety or effectiveness of thedevice, or where there is a major change or modification in the intended use ofthe device or a new indication for use of the device.  When any change or modification is made to a device or itsintended use, the manufacturer is expected to make the initial determination asto whether the change or modification is of a kind that would necessitate thefiling of a new 510(k), pre-market approval or pre-market approval supplement.

 

***Foreign requirements***

 

Sales of medicaldevice products outside the United States are subject to foreign regulatoryrequirements that vary from country to country.  The time required to obtain approvals required by foreigncountries may be longer or shorter than that required for FDA clearance, andrequirements for licensing may differ from FDA requirements.  Our failure to comply with regulatoryrequirements would jeopardize our ability to market our products.  The current regulatory environment in Europefor medical devices differs significantly from that in the United States.  Since June 1998, all medical devices sold inthe European Union must bear the CE mark. Devices are now classified by manufacturers according to the risks theyrepresent with a classification system giving Class III as the highest riskdevices and Class I as the lowest.  Oncethe device has been classified, the manufacturer can follow one of a series ofconformity assessment routes, typically through a registered quality system, 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**

 

We organize oursales and marketing efforts by optimizing the configuration of our systems forspecific applications and disciplines and distributing them via partners’ salesforces or directly as appropriate.  Webelieve that this type of structure provides the commitment and focus necessaryto introduce and support new advanced technology to distinct marketsegments.  As we enter additional marketsegments we will seek to preserve the distinct focus, although there is a limitto the extent of segmentation possible. In all cases we follow specific principles in developing our business.

 

***Training***

 

The introductionof new technology requires training for both surgeons and operating roompersonnel.  The model for our trainingphilosophy is our sponsorship of the Laparoscopic Bariatric Surgery program,introduced in early 2000.  Thiscomprehensive program is designed to provide participants with the completeinformation, training and technology necessary to perform minimally invasivegastric bypass surgery as a treatment for morbid obesity.

 

***Clinical evaluation***

 

All of our productlines are developed with frequent input from our clinical advisory boards whichare discussed under “Clinical Advisory Boards.”  This evaluation phase may progress into a publication phase withadvisors publishing results of their experience in leading publications orspeaking at major clinical conferences. We support such research, although we have no control over the contentor timing of any publication or presentation, because impartial education ofthe general clinical audience is a key component in establishing procedure and

 

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equipmentacceptance.  As part of our strategy, wealso intend to continue to support seminars and symposiums and participate inindustry trade shows either independently or in conjunction with our strategicpartners.

 

***International sales***

 

We entered into astrategic relationship with Richard Wolf, GmbH, for distribution of ourproducts in general surgery, gynecology, and urology in all internationalmarkets.  Although the formal agreementhas now lapsed, we maintain close relations with Richard Wolf in developingmarkets for advanced visualization technology. We also entered into a strategicrelationship with Jomed N.V. for cardiac surgery, although Jomed applied forbankruptcy protection in the Netherlands in January, 2003.  For a description of these relationships,please see “Strategic Alliances”.  Wewill continue to evaluate partnership opportunities as appropriate forinternational sales of all of our product lines.

 

**Competition**

 

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

 

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

 

**ClinicalAdvisory Boards**

 

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

 

**Employees**

 

As of February 28,2003, we had 35 full-time employees, of whom one holds an advanced degree.  None of our employees is represented by acollective bargaining agreement, nor have we experienced work stoppages.  We believe our relations with our employeesare good.

 

**Web Site Access to SEC Filings**

 

We maintain anInternet website 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 soon asreasonably practicable after we electronically file such material with, orfurnish it to, the SEC.

 

**RecentDevelopments**

 

In March 2003, weraised an additional $950,000 in equity capital through the sale of sharesof our preferred stock.  These shares of preferred stock areconvertible into shares of our common stock.  We sold these shares ina private placement to two accredited investors.  In connection withthese sales, we agreed to register (under certain circumstances) the shares ofcommon stock issuable upon conversion of the preferred stock.

 

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RISKS AND UNCERTAINTIES

 

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

 

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

 

At December 31,2002, we had cash, cash equivalents and short-term investments of$829,000.  Additionally, in March 2003,we raised an additional $950,000 through a private placement of preferredstock.  We believe that these cashresources, together with cash from operations will be sufficient resources forthe next twelve months.

 

We are working oninitiatives to extend our business, most immediately in the surgical obesity****market,by****addingnew products and services. For our business to be successful, we believe wemust establish and grow our Obesity Surgery Management Services business.  As a result, we may be required to raiseadditional funds to support our planned operations.  In addition, if we are unable to sustain our cash flow under ourcurrent business plan, we will be required to raise additional funds.  If we are unable to raise sufficient fundsfrom an offering of securities or otherwise, we may be unable to continueoperations at their current level and may be unable to pursue our newobjectives.  Moreover, our liquidity andcapital requirements will depend upon other numerous factors, including thefollowing:

 

**•**                                          Theextent to which our products and services gain market acceptance;

 

•                                          Costsassociated with establishing marketing, and operating our Obesity SurgeryManagement Services Business and other related programs;

 

**•****                                         **Theprogress and scope of product evaluations;

 

**•**                                          Thetiming and costs of filing future regulatory submissions;

 

**•**                                          Thetiming and costs required to receive both domestic and internationalgovernmental approvals;

 

**•**                                          Thetiming and costs of product and services introductions;

 

**•**                                          Theextent of our ongoing research and development programs;

 

**•**                                          Thecosts of sponsorship training of the physicians to become proficient in the useof our products and procedures;

 

•                                          Thecosts of developing marketing and distribution capabilities.

 

Even if we aresuccessful in raising additional funds, circumstances, including slow rate ofmarket acceptance of our products or our inability to scale up manufacturing,would accelerate our use of proceeds from any offering we might do and requireus to seek additional funds to support our operating requirements.

 

**Ourfailure to maintain compliance with the continued listing requirements of theNasdaq SmallCap Market may result in the de-listing of our common stock.**

 

We have recently satisfied the requirements for continued listing ofour common stock on the Nasdaq SmallCap Market outlined for us by the NasdaqListing Qualifications Panel on February 21, 2003.  We accomplished this by

 

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raising additional equity capital such that we achieved a shareholders’equity balance of at least $2,800,000. The Nasdaq SmallCap Market has notified us that our exception to thecontinued listing requirements shall be extended until March 31, 2003.  Although we expect to maintain the minimumrequired shareholder’s’ equity balance, we have very little cushion to protectagainst an unexpected decline.  Ourfailure to maintain the minimum required shareholders’ equity balance couldcause our common stock to be de-listed from the Nasdaq SmallCap Market.  We cannot assure you that we will be able toremain in compliance.

 

**If wedispose of some or all of our visualization technology business, our futuresuccess will depend on our ability to establish and grow our obesity surgerymanagement business.**

 

Together with our investment advisors, we arecurrently considering strategic options with respect to our visualizationtechnology business.  In the event wedetermine to sell all or a portion of that business, our future success as acompany will increasingly 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 the ground up, findingpartners and surgeons willing to participate. We cannot assure you that we will be able to build a successful servicesbusiness.

 

**We havea history of losses and may not become profitable.**

 

Since ourformation in July 1993, and as of December 31, 2002, we have incurredcumulative net losses of $65.9 million. We expect to incur losses for at least the next 9 months.  We may never achieve or sustainprofitability in the future.  Even if weachieve profitability, we may not be able to sustain it on an ongoing basis.

 

**As acompany, we do not have experience in the ownership and management of healthcare service businesses**.

 

As a company we donot have extensive experience in providing management services and have nodirect experience in the management of bariatric surgical programs.  We have been involved in the development ofbariatric surgical programs since 2000, but have never directly managed theseprograms.  As such, we have only alimited and indirect operating history upon which an evaluation of ourprospects in this business sector can be based.  Our prospects therefore, must be considered in light of therisks, expenses and difficulties frequently encountered by companies in theirearly stages of development, particularly when involved in new and rapidlyevolving markets.  To address theserisks, we must, among other things, respond to competitive developments andattract, retain and motivate qualified staff. There can be no assurance that we will be successful in addressing suchrisks or in implementing our business strategy.  There can be no assurance that we will be able to achieve orsustain revenue growth or profitability.

 

**Successof the Vista Obesity and Wellness Institutes depends on our entering intoagreements with hospitals and surgeons; the time to conclude these agreementsmay be extended and thereby delay or prevent the implementation of ourstrategy.**

 

We plan to set upour VOW Institutes in conjunction with hospitals and surgeons.  There can be no assurance that negotiationsfor the establishment of these Institutes will not be protracted or impossibleto negotiate satisfactorily.  Because ofour limited experience in negotiating and concluding these agreements, wecannot accurately predict the time and expense involved, and any unexpecteddelays could prevent the execution of our strategic plan.

 

**Weexpect to need additional funding if we are to fully develop the VOW Instituteconcept.**

 

Any deviation inthe timing or projected cash flow of our Obesity Surgery Strategy may cause usto require additional investment capital. There can be no assurance that such capital will be available to theextent required, or at all.  The amountof additional capital which we may need to raise will depend on many factors,including:

 

•                  the extent towhich the Institutes and other services gain market acceptance,

•                  the speed withwhich we can execute our plan;

•                  the levels ofreimbursement for procedures performed;

•                  the extent ofcompetition.

 

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**We willincur significant expenses as we attempt to establish and grow our obesity surgerymanagement services business**.

 

Establishing ournew services business will be expensive and time-consuming.  Significant management time and energy willbe diverted from our existing visualization technology business as we attemptto establish relationships and partnerships with surgeons and entities willingto participate in the establishment of our obesity surgery centers.  These centers will also be financiallycostly to establish and operate.  If wedo not generate sufficient surgical procedures through these centers, the feeswe receive for the services we provide may be insufficient to sustain thebusiness.

 

**Afterestablishing a VOW Institute, we must continue to prove our value proposition.**

 

In order tosuccessfully negotiate and complete agreements with doctors and hospitals toestablish a VOW Institute, we will present them with our projected revenues andoperational metrics.  We cannot assureyou that our projections will prove accurate or that we will be able to providethe anticipated metrics.  Ourprojections are based on limited input and operational history and failure tomeet such projections will negatively impact our business.

 

**Weoperate in a competitive market; new technologies, procedures, orpharmaceuticals could radically change the modality of treatment of morbidobesity and negatively impact our management services business and theprojected VOW Institutes**.

 

The market forproducts and services that address obesity is competitive and new offerings andtechnologies are becoming available regularly. We are aware of several developments, primarily involving nervestimulation or balloon technology, which may come to the market in the next fewyears.  These devices would be implantedor placed in a relatively simple endoscopic procedure.  If they prove to be more effective thangastric bypass surgery in curing morbid obesity, then the economic structure ofthe business could be negatively impacted. Also, many pharmaceutical companies are researching drug therapies forcombating obesity.  If they provesuccessful in finding a more effective solution for morbid obesity than gastricbypass surgery, then demand for surgery is likely to decline substantially.

 

We cannotguarantee that we will compete successfully against our current or potentialcompetitors, especially those with significantly greater financial resources orbrand name recognition.

 

**If wefail to retain our key personnel and hire, train and retain additionalqualified and experienced employees, we may not be able to compete effectively.**

 

Our future successwill depend to a large extent on retaining our core operating management teamand recruiting sufficient qualified employees to manage and staff our servicesbusinesses.  There is likely to be a competitivelabor market for such staff and there is no assurance that we will be able toattract and retain an adequate number of suitable employees.

 

**We are,to a significant extent, dependent on distribution partners to sell ourvisualization 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.  We entered into an arrangement with JomedN.V. in May, 2000 to transition distribution in cardiac surgery and to continuesupporting our cardiac customer base. However, the success of this transition depends upon the concurrentdevelopment of new technology by Jomed N.V. and may not be achieved in areasonable timeframe, or at all.  If weare unable to make this transition, we may be unsuccessful in distributing ourcardiac surgery products and may lose revenues. Jomed applied for bankruptcyprotection in the Netherlands in January, 2003.  We have not yet elected to terminate our agreement pendingclarification of Jomed’s ongoing status.

 

In addition,during 2000, we changed our strategic emphasis for our core three-dimensionaltechnology for applications in general surgery, gynecology and urology.  We cannot assure you that we will besuccessful in these areas of sales. Even if we are successful, we cannot assure you that the revenueachieved in these areas of emphasis will be sufficient to compensate for anyloss of sales revenue from the termination of our previous distributionagreements for cardiac products.  Eitherof these results could have an adverse affect on our financial condition andresults of operations.

 

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**Ourprofitability is dependent upon the successful commercialization of ourvisualization technology products and the establishment and growth of ourobesity surgery management services business.**

 

Products derivedfrom our core visualization technology – the Endosite for general surgery andthe Series 8000 for minimally invasive cardiac surgery – are expected toaccount for the majority of our visualization technology revenues over the nextseveral years.  The demand for theseproducts may not be sufficient to allow us to achieve profitableoperations.  Our development efforts forimprovements to these products may not be successful.  In addition, other products under development may not be shown tobe safe or effective, capable of being manufactured in commercial quantities atacceptable costs, acquire appropriate regulatory clearances or be successfullymarketed.  Our obesity surgerymanagement services business is of relatively recent origin and it is difficultto predict its longer term success.

 

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

 

Complex minimallyinvasive procedures are only performed on a very limited basis by a relativelysmall number of highly skilled surgeons. We are unable to predict how quickly, if at all, complex minimallyinvasive procedures will be adopted by the medical community or, if they areadopted, the number of procedures that will be performed.

 

Even if theclinical safety and effectiveness of complex minimally invasive procedures isestablished in general surgery, cardiac and other specialties, surgeons andother physicians may choose not to recommend the procedures for any number ofother reasons.  Adoption of theseprocedures by doctors will depend, for example, upon our ability to facilitateand sponsor training of surgeons to perform complex minimally invasiveprocedures and the willingness of these surgeons to perform such procedures.  Doctors may also elect not to recommend theminimally invasive procedures based on possible unavailability of acceptablereimbursement from health care payors. Health care payor acceptance may require evidence of the costeffectiveness of minimally invasive procedures as compared to other currentlyavailable treatments.  We believe thatphysician endorsements will be essential for clinical adoption of minimallyinvasive procedures and these endorsements may not be obtained.  Patient acceptance of new procedures willdepend upon doctor recommendations, as well as other factors, including theeffectiveness of, and the rate and severity of complications associated with,the procedure as compared to other treatments.

 

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

 

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

 

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

 

We have neverestablished high-volume manufacturing operations and if we are required to doso to meet market demand or to become profitable, we may not be able toestablish or maintain reliable operations at commercially reasonablecosts.  We may also require additionalmanufacturing facilities if production volumes increase.  Acquisition of new manufacturing facilitieswould also likely involve relocation. Difficulties in scaling up manufacturing of products could result fromproblems involving:

 

•                                          qualitycontrol and assurance,

 

•                                          componentand service availability,

 

•                                          adequacyof control policies and procedures,

 

•                                          lackof qualified personnel,

 

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

 

•                                          otherproduction constraints.

 

We have consideredand will continue to consider as appropriate, the internal manufacture ofsub-assemblies currently provided by third-party subcontractors, as well as theimplementation of new production processes. Our manufacturing yields or costs may increase as a result of thetransition to in-house production or to new production processes when suchefforts are undertaken.  In addition,costs to comply with FDA good manufacturing practices or changes in suchpractices may exceed our expectations.

 

**We mayface component shortages and are dependent in some instances on single sourcesof supply.**

 

Any significantsupply interruption, or inventory shortage or overage, would negatively impactour ability to manufacture our products. We use and rely on specific components and services used in our systemsfor which we have only a single source of supply.  The manufacture of our products in larger commercial quantitieswill require a substantial increase in component supplies and will likelynecessitate the replacement of current suppliers or the addition of newsuppliers.  The qualification ofadditional or replacement vendors for specified components or services is alengthy process.  In addition, thesubstitution of replacement vendors may entail re-engineering time and cost andcould delay the supply of our products.

 

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

 

**Theprovision of health care services is subject to considerable regulation by stateand federal agencies.**

 

The Instituteswill need to comply with many laws and regulations, both state and federal,which govern the provision of health care services.  If they fail to comply with any such laws and regulations, thenthe penalties involved could be serious, time-consuming for management andexpensive.  Inexperience in health careservices could contribute to an inadvertent breach of laws or regulations.  (See Governmental Regulation.)

 

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

 

The manufactureand sale of medical devices intended for commercial distribution are subject toextensive governmental regulation.  Ourfailure to comply with regulatory requirements would jeopardize our ability tomarket our products.  Noncompliance withapplicable requirements can result in failure of the regulatory agency to grantpre-market clearance or approval for devices, withdrawal or suspension of approval,total or partial suspension of production, fines, injunctions, civil penalties,refunds, recall or seizure of products and criminal prosecution.

 

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

 

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

 

The medical devicemarket in which we compete is characterized by intensive development effortsand rapidly advancing technology.  Ourfuture success will depend, in large part, upon our ability to anticipate andkeep pace with advancing technology and competing innovations.  We may not be successful in identifying,developing and marketing new products or enhancing our existing products.

 

We believe that anumber of large companies, with significantly greater financial, manufacturing,marketing, distribution and technical resources and experience than ours, arefocusing on the development of visualization products for minimally invasivemicrosurgery.  Several companies are currentlydeveloping and marketing visualization products for minimally invasivemicrosurgery which could be applied to general surgery or heart surgery.

 

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

 

**Weexpect fluctuations in our operating results.**

 

Our results ofoperations may vary significantly from quarter to quarter depending uponnumerous factors, including the following:

 

•                                          timingand results of product evaluations,

 

•                                          delaysassociated with the FDA and other regulatory approval processes,

 

•                                          demandfor and utilization of our products,

 

•                                          changesin our pricing policies or those of our competitors,

 

•                                          changesin third-party payment guidelines,

 

•                                          thenumber, timing and significance of product enhancements and new productannouncements by us or our competitors,

 

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

 

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

 

•                                          productquality problems,

 

•                                          personnelchanges and

 

•                                          thelevel of international sales.

 

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

 

Our profitabilityis directly related to the level of payments for the surgical procedures inwhich our products are involved, either by Medicare or private insurancecompanies.  We could be adverselyaffected by changes in payment policies of government or private health carepayors, particularly to the extent any such changes affect payment for theprocedure 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 ourproducts typically will be used by hospitals and surgical centers, which billvarious third-party payors, such as governmental programs and private insuranceplans, for the health care services provided

 

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to their patients.  Third-party payors carefully review andincreasingly challenge the prices charged for medical products and services ornegotiate a flat rate fee in advance. Payment rates from private companies also vary depending on theprocedure performed, the third-party payor, the insurance plan and otherfactors.  Medicare compensates hospitalsat a predetermined fixed amount for the costs associated with an in-patienthospitalization based on the patient’s discharge diagnosis and compensatesphysicians at a pre-determined fixed amount based on the procedure performed,regardless of the actual costs incurred by the hospital or physician infurnishing the care and unrelated to the specific devices or systems used inthat procedure.  Medicare and otherthird-party payors are increasingly scrutinizing whether to cover new productsand the level of payment for new procedures. The flat fee reimbursement trend is causing hospitals to control costsstrictly in the context of a managed care system in which health care providerscontract to provide comprehensive health care for a fixed cost per person.  We are unable to predict what changes willbe made in the reimbursement methods utilized by such third-party payors.

 

If we obtain thenecessary foreign regulatory registrations or approvals, market acceptance ofour products in international markets would be dependent, in part, upon theacceptance by the prevailing health care financing system in each country.  Health care financing systems ininternational markets vary significantly by country and include both governmentsponsored health care programs and private insurance.  We cannot assure you that these financing systems will endorsethe use of our products.

 

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

 

We have limitedexperience in directly marketing our products overseas.  Changes in overseas economic conditions,currency exchange rates, foreign tax laws or tariffs or other trade regulationscould negatively impact our business. The anticipated international nature of our business is also expected tosubject our representatives, agents and distributors to laws and regulations ofthe foreign jurisdictions in which they operate or in which our products  are sold, including laws regulatingmanufacture and sale of medical devices. In addition, the laws of some foreign countries do not protect ourintellectual property rights to the same extent as do the laws of the UnitedStates.

 

**We maybe subject to product liability claims and have limited insurance coverage.**

 

We face aninherent and significant business risk of exposure to product liability claimsin the event that the use of our products results in personal injury ordeath.  Also, in the event that any ofour products proves to be defective, we may be required to recall or redesignsuch products.  Our current productliability insurance coverage limit is $10.0 million per occurrence and in theaggregate.  Our coverage limits may notbe adequate to protect us from any liabilities we might incur in connectionwith 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.

 

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

 

Our future successwill depend, in part, on our ability to continue developing patentableproducts, enforcing our patents and obtaining patent protection for ourproducts both in the United States and in other countries.  The patent positions of medical devicecompanies, however, are generally uncertain and involve complex legal and factualquestions.  Patents may never issue fromany patent applications owned by or licensed to us.  Even  if patents do issue,the claims allowed may 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 deviceindustry has been characterized by extensive litigation regarding patents andother intellectual property rights. Litigation, which would result in substantial expense, may be necessaryto enforce any patents issued or licensed to us and/or to determine the scopeand validity of proprietary rights of third parties or whether our products,processes or procedures infringe any such third-party proprietary rights.  We may also have to participate ininterference proceedings declared by the United States Patent and TrademarkOffice, which could result in substantial expense, to determine the priority ofinventions covered by our issued United States patents or pending patentapplications.  Furthermore, we may haveto participate at substantial cost in International Trade 

 

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Commission proceedings toenjoin importation of products which would compete unfairly with ourproducts.  Any adverse outcome of anypatent litigation, including interference proceedings, could subject us tosignificant liabilities to third parties, require disputed rights to belicensed from or to third parties or require us to cease using the technologyin dispute.  Any such licenses may notbe available on acceptable terms, if at all. Furthermore, parties making such claims may be able to obtain injunctiveor other equitable relief that could effectively block our ability to make,use, sell or otherwise practice our intellectual property, whether or notpatented or described in pending patent applications, or to further develop orcommercialize our products in the United States and abroad and could result inthe award of substantial damages. Defense of any lawsuit or failure to obtain any such license coulddamage our business.

 

In addition topatents,we rely on unpatented trade secrets to protect our proprietarytechnology.  Others may independentlydevelop or otherwise acquire the same or substantially equivalent technologiesor otherwise gain access to our proprietary technology or disclose thistechnology.  It is difficult to protectrights to unpatented proprietary technology. Third parties may obtain patent rights to these unpatented tradesecrets, which patent rights could be used to assert infringement claimsagainst us.  We also rely onconfidentiality agreements with our collaborators, employees, advisors, vendorsand consultants to protect our proprietary technology.  These agreements may be breached, we may nothave adequate remedies for any breach and our trade secrets may otherwisebecome known or be independently developed by competitors.  In addition, our agreements with employeesand consultants require disclosure of ideas, developments, discoveries orinventions conceived during employment or consulting, as the case may be, andassignment to us of proprietary rights to such matters related to our businessand technology.  The extent to whichefforts by others will result in patents and the effect on us of the issuanceof such patents is unknown.

 

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

 

We have licensedsome aspects of our technology from third parties.  The rights under the governing agreements may be terminated if webreach our obligations or in other circumstances.  Our failure to retain rights to these licensed rights couldnegatively impact our business.  Foradditional information concerning the agreements which govern theserelationships, please see “Business—Strategic Alliances” and “Business –Licenses.”

 

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

 

Our futurebusiness and operating results depend in significant part upon the continuedcontributions of our key technical and senior management personnel, many ofwhom would be difficult to replace and some of whom perform important functionsbeyond 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 ourclinical advisory boards consult with us exclusively in the field ofvisualization, but are free to consult with other non-competing instrumentationcompanies and are employed elsewhere on a full-time basis.  As a result, they only spend a limitedamount of time on our business. Although we have entered into consulting agreements, includingconfidentiality provisions with each of the members of our clinical advisoryboards, the consulting and confidentiality agreements between us and each ofthe members of our clinical advisory boards may be terminated or breached.

 

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

 

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

 

•                                          actualor anticipated fluctuations in our operating results,

 

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•                                          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, thestock market has from time to time experienced significant price and volumefluctuations that have particularly affected the market prices for shares ofearly stage companies.  These broadmarket fluctuations may adversely affect the market price of our common stock.  In the past, following periods of volatilityin the market price of a particular company’s securities, securities classaction litigation has often been brought against that company.  Such litigation, if brought against us,could result in substantial costs and a diversion of management’s attention andresources.

 

**Our useof hazardous materials may result in unexpected and substantial claims againstus for which we do not have sufficient financial resources.**

 

Our research anddevelopment activities may involve the controlled use of hazardous materialsand chemicals.  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.

 

**We donot anticipate paying any dividends and any gains from your investment in ourstock will have to come from increases in the price of such stock.**

 

We currentlyintend to retain any future earnings for use in our business and do notanticipate paying any cash dividends in the foreseeable future.

 

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

 

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

 

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Item 2.             PROPERTIES

 

Our facilitiesconsist of approximately 5,000 square feet of subleased office space located inCarlsbad, California, in which our executive offices, plus the staff of ourObesity Surgery Management Services Business is located.   In addition, we maintain a facility of approximately17,850 square feet in Westborough, Massachusetts in which the development,engineering, manufacturing operations and customer service personnel of ourVisualization Technology Business are located.   The lease under which we have acquired the right to occupy theWestborough facilities expires in October 2004.  We believe that suitable additional space will be available tous, when needed, on commercially reasonable terms.

 

Item 3.             LEGALPROCEEDINGS

 

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

 

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Item 4.             SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS

 

None.

 

PART II

 

Item 5.             MARKET FOR REGISTRANT’S COMMON EQUITY ANDRELATED STOCKHOLDER MATTERS

 

(a)                                  MarketPrice of and Dividends on the Registrant’s Common Equity.

 

Our Common Stockis traded on the over-the-counter market and prices are quoted on the NasdaqSmall Cap Market under the symbol “VMTI.” The following table sets forth the high and low sale prices for theCommon Stock on the Nasdaq Small Cap Market from January 1, 2001 throughDecember 31, 2002.

 
| **Quarter**      |   | **High** |   | **Low** |   |
|------------------|--------|----------|--------|---------|--------|
|             |   |     |   |    |   |
| 1st Quarter 2001 |   | $        | 6.00   |    | $      | 1.875 |   |
|             |   |     |   |    |   |
| 2nd Quarter 2001 |   | $        | 5.00   |    | $      | 2.76 |   |
|             |   |     |   |    |   |
| 3rd Quarter 2001 |   | $        | 4.00   |    | $      | 1.55 |   |
|             |   |     |   |    |   |
| 4th Quarter 2001 |   | $        | 4.30   |    | $      | 1.70 |   |
|             |   |     |   |    |   |
| 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 |   |

 

On March 21, 2003the last reported sale price of the Common Stock was $1.55.  As of March 21, 2003, there wereapproximately 99****holders of record of the Common Stock.

 

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

 

The information called for by Item 5 with respect to securitiesauthorized for issuance under equity compensation plans is incorporated hereinby reference to the material in our Proxy Statement related to the AnnualMeeting of Stockholders to be held on June 4, 2003.

 

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Item 6.                     SELECTEDFINANCIAL DATA

 

SELECTED FINANCIAL DATA

 

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

 
|                                                      |   | **YEARS ENDED DECEMBER 31,**                        |    |
|-----------------------------------------------------------|--------|-----------------------------------------------------|---------|
| **STATEMENT OF OPERATIONS DATA:**                         |   | **1998**                                            |    | **1999** |   | **2000** |   | **2001** |   | **2002** |   |
|                                                      |   | **(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)** |    |
|                                                      |   |                                                |    |   |   |   |   |   |   |   |   |
| Sales                                                     |   | $                                                   | 6,572   |   | $ | 5,516 |   | $ | 6,539 |   | $ | 9,326 |   | $ | 11,106 |   |
|                                                      |   |                                                |    |   |   |   |   |   |   |   |   |
| Cost and expenses:                                        |   |                                                |    |   |   |   |   |   |   |   |   |
|                                                      |   |                                                |    |   |   |   |   |   |   |   |   |
| Cost of sales                                             |   | 6,119                                               |    | 7,521 |   | 5,947 |   | 6,405 |   | 5,989 |   |
|                                                      |   |                                                |    |   |   |   |   |   |   |   |   |
| Research and development                                  |   | 5,480                                               |    | 3,229 |   | 1,736 |   | 1,945 |   | 1,709 |   |
|                                                      |   |                                                |    |   |   |   |   |   |   |   |   |
| Sales and marketing                                       |   | 5,953                                               |    | 2,890 |   | 1,158 |   | 2,237 |   | 2,690 |   |
|                                                      |   |                                                |    |   |   |   |   |   |   |   |   |
| General and administrative                                |   | 5,039                                               |    | 2,178 |   | 1,925 |   | 2,031 |   | 1,882 |   |
|                                                      |   |                                                |    |   |   |   |   |   |   |   |   |
| Restructuring expense                                     |   | 940                                                 |    | 690 |   | (400 | ) | — |   | — |   |
|                                                      |   |                                                |    |   |   |   |   |   |   |   |   |
| Total costs and expenses                                  |   | 23,531                                              |    | 16,508 |   | 10,366 |   | 12,618 |   | 12,270 |   |
|                                                      |   |                                                |    |   |   |   |   |   |   |   |   |
| Loss from operations                                      |   | (16,959                                             | )       | (10,992 | ) | (3,827 | ) | (3,292 | ) | (1,164 | ) |
|                                                      |   |                                                |    |   |   |   |   |   |   |   |   |
| Interest income                                           |   | 900                                                 |    | 218 |   | 213 |   | 70 |   | 17 |   |
|                                                      |   |                                                |    |   |   |   |   |   |   |   |   |
| Other gains/(losses)                                      |   | (662                                                | )       | 51 |   | — |   | — |   | — |   |
|                                                      |   |                                                |    |   |   |   |   |   |   |   |   |
| Net loss                                                  |   | $                                                   | (16,721 | ) | $ | (10,723 | ) | $ | (3,614 | ) | $ | (3,222 | ) | $ | (1,147 | ) |
|                                                      |   |                                                |    |   |   |   |   |   |   |   |   |
| Basic and diluted net loss per share                      |   | $                                                   | (5.02   | ) | $ | (3.16 | ) | $ | (0.80 | ) | $ | (0.66 | ) | $ | (0.23 | ) |
|                                                      |   |                                                |    |   |   |   |   |   |   |   |   |
| Shares used in computing basic and diluted loss per share |   | 3,328,000                                           |    | 3,398,000 |   | 4,495,000 |   | 4,906,000 |   | 4,969,000 |   |

 
|                                              |   | **DECEMBER 31,**   |   |
|---------------------------------------------------|--------|--------------------|--------|
| **BALANCE SHEET DATA:**                           |   | **1998**           |   | **1998** |   | **2000** |   | **2001** |   | **2002** |   |
|                                              |   | **(IN THOUSANDS)** |   |
|                                              |   |               |   |   |   |   |   |   |   |   |   |
| Cash, cash equivalents and short-term investments |   | $                  | 8,803  |   | $ | 1,658 |   | $ | 2,934 |   | $ | 1,317 |   | $ | 829 |   |
|                                              |   |               |   |   |   |   |   |   |   |   |   |
| Working capital                                   |   | 12,128             |   | 2,972 |   | 5,113 |   | 2,696 |   | 2,000 |   |
|                                              |   |               |   |   |   |   |   |   |   |   |   |
| Total assets                                      |   | 16,605             |   | 7,367 |   | 7,155 |   | 4,823 |   | 4,182 |   |
|                                              |   |               |   |   |   |   |   |   |   |   |   |
| Accumulated deficit                               |   | (47,218            | )      | (57,941 | ) | (61,555 | ) | (64,777 | ) | (65,925 | ) |
|                                              |   |               |   |   |   |   |   |   |   |   |   |
| Total stockholders’ equity                   |   | 14,666             |   | 4,584 |   | 6,151 |   | 3,091 |   | 2,081 |   |
|                                                   |        |                    |        |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

31

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Item 7.                     MANAGEMENT’S DISCUSSION ANDANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

This annual reportmay contain predictions, estimates and other forward-looking statements thatinvolve a number of risks and uncertainties, including those discussed earlierat “risks and uncertainties.”  While thisoutlook represents our current judgment on the future direction of ourbusiness, such risks and uncertainties could cause actual results to differmaterially from any future performance suggested below.  We undertake no obligation to releasepublicly the results of any revisions to these forward-looking statements toreflect events or circumstances arising after the date of this annualreport.  The following discussion shouldbe read in conjunction with our consolidated financial statements and the notesthereto.

 

**Overviewof our Business**

 

Our ObesitySurgery Management Services Business provides services to surgeons andhospitals which support the introduction of laparoscopic gastric bypass surgeryas a treatment for morbid obesity including management of clinical trainingcourses, production of patient awareness and marketing materials and systemsanalysis.  We believe that thiscomprehensive approach to “surrounding the procedure” is applicable in othercomplex minimally invasive disciplines, based on the model we have developedfor gastric bypass surgery. We develop, manufacture and market products thatprovide information to doctors performing minimally invasive general surgical,cardiac surgical and other selected microsurgical procedures.   Our products combine a head mounted displaywith video cameras to provide surgeons with critical visual information duringthese microsurgical procedures, combined with the ability to view newadditional information in a voice-controlled, picture-in-picture format, tofacilitate real-time decision making during surgery.  Our product line include the EndoSite Advanced Visualization andInformation System for general surgery and other complex endoscopic procedures.  In general terms, endoscopic surgeryinvolves a telescopic viewing device which is inserted into a small incision inthe body and which allows the surgeon an adequate view of the internal part ofthe body being repaired.

 

At December 31,2002, we had 35 employees.  We expectstaffing to increase in the near term to approximately 45 employees andstabilize at or near that level for the balance of our fiscal year 2003.  The increase in staffing will come from theobesity management services section of our business. We expect staffing toremain constant in our Westborough facility based on the fact that significantdevelopment work on our core platform technology is now complete and ourstrategic decisions to partner rather than develop an independent distributioncapability.

 

**CriticalAccounting Policies**

 

RevenueRecognition

 

Revenue generated fromLaparoscopic Bariatric Surgical (LBS) Preceptorship program sales is recognized(i) with regard to equipment sales, upon shipment of equipment and marketingmaterials and (ii) with regard to training services, upon completion of therelated training component, provided that a purchase order has been received,there are no uncertainties regarding customer acceptance, the sales price isfixed or determinable and collectibility is deemed probable.  Sales of all other products are similarlyrecognized upon shipment provided that a purchase order has been received,there are no uncertainties regarding customer acceptance, the sales price isfixed or determinable and collectibility is deemed probable.

 

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

 

Inventory

 

Inventory is accountedfor on a first-in first-out basis and is valued at the lower of cost ormarket.  The Company regularly evaluatesinventory for obsolescence and reserves for 100% of inventory considered to beobsolete.  At December 31, 2002 suchinventory reserves approximated $1,045,000. The Company believes it is adequately reserved for obsolescence ofcurrent inventory.  However, futureproduct introductions and related inventories may require additional reservesbased upon changes in market demand or introduction of competing technologies.

 

32

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**OurResults of Operations**

 

**Yearended December 31, 2002 compared with year ended December 31, 2001**

 

**Revenues**

 

We had revenuesfrom product sales and contract revenue of $11,106,000 for the year endedDecember 31, 2002 and product sales and contract revenue of $9,326,000 for theyear ended December 31, 2001.  Theincrease in revenues during 2002 was primarily due to increased unit sales fromour Laparoscopic Bariatric Surgery program. Sales to individual customers exceeding 10% or more of revenues in theyears ended December 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.

 

**Costs and expenses**

 

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

 

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

 

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

 

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

 

**Other income and losses**

 

Interest income.Our net interest income was $17,000 and $70,000 for the years ended December31, 2002 and 2001, respectively. The decrease in 2002 was due primarily todecreasing average cash balances and lower interest rates.

 

**Taxes**

 

At December 31,2002, we had federal and state tax net loss carryforwards of approximately$53,415,000 and $44,140,000, respectively. The federal tax loss carryforwardswill begin to expire in 2010. Approximately $1,080,000 of the state tax loss carryforwards expired in2002, and will continue to expire in 2003 unless previously utilized. AtDecember 31, 2002, we also had federal and state research tax creditcarryforwards of approximately $2,133,000 and $536,000, respectively, whichwill begin to expire in 2010 unless previously utilized. We have provided afull valuation allowance on the deferred tax assets as realization of suchassets is uncertain.

 

33

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

 

**Revenues**

 

We had revenuesfrom product sales and contract revenue of $9,326,000 for the year endedDecember 31, 2001 and product sales revenue of $6,539,000 for the year endedDecember 31, 2000.  The increase inrevenues during 2001 was primarily due to increased unit sales from ourLaparoscopic Bariatric Surgery program coupled with contract revenuerecognition of $583,000 from our Supply and Promotion Agreement with EthiconEndo-Surgery, Inc.   Sales to individualcustomers exceeding 10% or more of revenues in the years ended December 31,were as follows: during 1999 three customers accounted for 45%, 28% and 16% ofrevenues, respectively, during 2000, two customers accounted for 51% and 23% ofrevenues, respectively, and during 2001, three customers accounted for 22%, 18%and 10% of revenues respectively.

 

**Costs and expenses**

 

Cost ofrevenues.  Our cost of revenues were$6,405,000 and $5,947,000 for the years ended December 31, 2001 and 2000, respectively.  Our gross margins were 31% and 9% for theyears ended December 31, 2001 and 2000, respectively.  The increase in gross margin was primarily due to increased unitsales of our higher margin Laparoscopic Bariatric Surgery Program coupled withcontract revenue recognition of $583,000 from an agreement with EthiconEndo-Surgery, Inc., with no cost of revenues.

 

Research anddevelopment expenses.  Our research anddevelopment expenses were $1,945,000 and $1,736,000 for the years endedDecember 31, 2001 and 2000, respectively. The increase in research and development expenses during 2001 wasprimarily attributable to next generation product development.  Since 2000, the Company’s principaldevelopment efforts have focused on new products and services within thesurgical obesity market.  Approximately$1,000,000 of the $1,945,000 research and development expenses were spent onthe next generation Head Mounted Display which is expected to be available forsale by the fourth quarter of 2002. There were no other individually significant research projects.  The Company’s future spending on researchand development will be focused on further expansion of LBS peripheral productsand services and development of the next generation Head Mounted Display.

 

Sales andmarketing expenses.  Our sales andmarketing expenses were $2,237,000 and $1,158,000 for the years ended December31, 2001 and 2000,  respectively.  The increase in sales and marketing expensesduring 2001  reflects a ramp up of fieldactivities for the obesity surgery market. The 2000 sales and marketing expense of $1,158,000 is net of a one-time$806,000 sales expense reversal in connection with the termination of ourdistribution agreement with Medtronic.

 

General andadministrative expenses.  Our generaland administrative expenses were $2,031,000 and $1,925,000 for the years endedDecember 31, 2001 and 2000, respectively. The increase during 2001 was primarily due to higher professional andlegal fees.

 

Restructuringexpenses.  We recorded no restructuringcharges for the year ended December 31, 2001 and we reported credits of$400,000 for the year ended December 31, 2000. The partial recovery reported in2000 represents the subletting of approximately one half of the facility spacefor which a $690,000 restructuring charge had been incurred in 1999.

 

**Other income and losses**

 

Interest income.Our net interest income was $70,000 and $213,000 for the years ended December31, 2001 and 2000, respectively. The decrease in 2001 was due primarily todecreasing average cash balances.

 

**Liquidityand Capital Resources**

 

Our principalsources of liquidity have been funds raised from public and private placementsof our capital stock and, to a lesser degree, cash flows generated fromoperations.  At December 31, 2002, wehad cash, cash equivalents and short-term investments of $829,000.  In addition, in March 2003, we raised anadditional $950,000 through a private placement of preferred stock.

 

Net cash used inoperating activities was approximately $443,000, $1,556,000 and $3,388,000 in2002, 2001 and 2000, respectively.  Thedecrease in net cash used in operating activities during 2002 compared to 2001

 

34

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was primarilyattributable to decreasing net losses partially offset by increased inventorypurchases.  The decrease in net cashused in operating activities during 2001 compared to 2000 was primarilyattributable to decreasing net losses and the receipt of $500,000 of paymentsunder an agreement with Ethicon Endo-Surgery.

 

Net cash providedfrom investing activities was approximately $29,000 in 2002, and cash used forinvesting activities was $257,000 and $210,000 in 2001 and 2000,respectively.  The increase in cashprovided from investing activities in 2002 was primarily attributable tomaturities of short-term investments, partially offset by increased purchasesof property and equipment.  The increasein net cash used for investing activities in 2001 compared to 2000 wasprimarily attributable to increasing purchases of short-term investmentspartially offset by decreasing purchases of property and equipment.

 

Cash flows fromfinancing activities were $71,000, $25,000 and $4,819,000 in 2002, 2001 and2000, respectively.  The cash flows fromfinancing activities in 2002 and 2001 were primarily attributable to proceedsfrom purchase of stock by employees through our employee stock purchase planand the exercise of stock options.   Thecash flows from financing activities in 2000 were primarily attributable to thesale of stock to three of our stockholders with net proceeds of approximately$4,591,000, along with purchases of stock by employees through our employeestock purchase plan.

 

We incurredoperating losses in 2000, 2001 and 2002, and at December 31, 2002, had anaccumulated deficit of $65.9 million. At December 31, 2002, we had cash and short-term investments of$829,000.  In March 2003, we sold$950,000 of preferred stock in a private placement to two accreditedinvestors.  In addition, we have amountsavailable under a $2.0 million bank line of credit facility, which expires inOctober 2003 and is subject to annual renewals.  We believe that these sources of liquidity, together withanticipated 2003 product revenues and interest income, will be sufficient tomeet our anticipated capital requirements through January 2004.  However, certain circumstances, includingslow rate of market acceptance of our products or inability to scale upmanufacturing, would accelerate use of these funds and require us to seek additionalfunds to support operating requirements.  There can be no assurance that the requisite fundings will beconsummated in the necessary time frame or on terms acceptable to us.  Should we be unable to raise sufficientfunds, we may be required to curtail its operating plans and possiblyrelinquish rights to portions of our technology or products.  In addition, increases in expenses or delaysin product development may adversely impact our cash position and requirefurther cost reductions.  No assurancecan be given that we will be able to operate profitably on a consistent basis,or at all, in the future.

 

Item 7A.    QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK

 

At December 31,2002, our investment portfolio included fixed-income securities of $0.4million.  These securities are subjectto interest rate risk and will decline in value if interest ratesincrease.  Due to the short-term natureof our investment portfolio, an immediate 10 percent increase in interest rateswould have no material impact on our financial condition or results ofoperations.

 

We have a$2,000,000 credit facility with a financial institution.  Interest on this facility was prime plus 2%at December 31, 2002.  At December 31,2002, we had no advances outstanding under this credit facility.  If we were to draw under this facility,changes in interest rates would affect the interest expense we would pay andcould impact our cash flows and results of operations.

 

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

 

Item 8.       FINANCIAL STATEMENTS AND SUPPLEMENTARYDATA

 

The consolidatedfinancial statements and supplementary data required by this item are set forthat the pages indicated in Item 15(a)(1).

 

35

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

 

Not applicable.

 

PART III

 

Item 10.                  DIRECTORS AND EXECUTIVEOFFICERS OF THE REGISTRANT

 

(a)           Identification of Directors.  The information under the caption “Proposal1 - Election of Directors,” appearing in our Proxy Statement related to theAnnual Meeting of Stockholders to be held on June 4, 2003,  is incorporated herein by reference.

 

(b)           Identification of ExecutiveOfficers.  The information under theheadings “Executive Officers and Key Employees,” appearing in our ProxyStatement related to the Annual Meeting of Stockholders to be held on June 4,2003, is incorporated herein by reference.

 

(c)           Compliance with Section 16(a) of theExchange Act.  The information under thecaption “Compliance with Section 16(a) of the Securities Exchange Act of 1934,”appearing in our Proxy Statement related to the Annual Meeting of Stockholdersto be held on June 4, 2003, is incorporated herein by reference.

 

Item 11.                  EXECUTIVECOMPENSATION

 

The informationunder the headings “Executive Compensation and Other Information,” appearing inour Proxy Statement related to the Annual Meeting of Stockholders to be held onJune 4, 2003, is incorporated herein by reference.

 

Item 12.                  SECURITY OWNERSHIP OF CERTAINBENEFICIAL OWNERS AND MANAGEMENT

 

The informationrequired under this item is incorporated herein by reference to our ProxyStatement related to the Annual Meeting of Stockholders to be held on June 4,2003.

 

Item 13.                  CERTAIN RELATIONSHIPS ANDRELATED TRANSACTIONS

 

The informationunder the heading “Certain Relationships and Related Transactions,” appearingin our Proxy Statement related to the Annual Meeting of Stockholders to be heldon June 4, 2003, is incorporated herein by reference.

 

Item 14.     STATEMENTON DISCLOSURE CONTROLS AND PROCEDURES

 

**(a)     Evaluationof Controls and Procedures**

 

Within 90 days before the filingof this report, our Chief Executive Officer, Mr. Lyon, and Chief FinancialOfficer, Mr. Gorgol, carried out an evaluation of the effectiveness of thedesign and operation of our disclosure controls and procedures. Based upon thatevaluation, Mr. Lyon and Mr. Gorgol concluded that our disclosure controls andprocedures are effective in causing material information to be collected,communicated and analyzed by management of the Company on a timely basis and toensure that the quality and timeliness of the Company’s public disclosurescomply with its SEC disclosure obligations.

 

**(b)****               Changes in internal controls**

 

There were no significant changes in our internalcontrols or in other factors that could significantly affect these controlsafter the date of our most recent evaluation.

 

36

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PART IV

 

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

 

(a)           (1)           Financial Statements

 

The financialstatements required by this item are submitted in a separate section beginningon Page F-1 of this report.

 
|   | Report of Ernst &  Young, LLP Independent Auditors |
|--------|--------------------------------------------------------|
|   |                                                   |   |
|   | CONSOLIDATED FINANCIAL STATEMENTS                      |
|   |                                                   |   |   |
|   |                                                   |   | Consolidated Balance Sheets  at December 31, 2001 and 2002 |
|   |                                                   |   | Consolidated  Statements of Operations for the years ended  December 31, 2000, 2001, and 2002 |
|   |                                                   |   | Consolidated  Statements of Stockholders’ Equity for the years ended  December 31, 2000, 2001, and 2002 |
|   |                                                   |   | Consolidated  Statements of Cash Flows for the years ended  December 31, 2000, 2001, and 2002 |
|   |                                                   |   | Notes to  Consolidated Financial Statements |
|   |                                                   |   |   |
|   |                                                   |   | Schedule II – Valuation and Qualifying  Accounts |
|        |                                                        |  |  |  |

 

(2)           FinancialStatement Schedules

 

All schedules for which provision is made in theapplicable accounting regulation of the Securities and Exchange Commission arenot required under the related instructions or are inapplicable, andtherefore   have been omitted, exceptfor Schedule II required under Regulation S-X, Rule 5-04, which is includedherein following the Financial Statements.

 

(b)           No reports on Form8-K have been filed during the last quarter of the period covered by thisreport.

 

37

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(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**               |   | Certificate of Designations of Series A Convertible  Preferred Stock                                                                                                                                                                          |
| 4.1(2)              |   | Form of certificate for common stock.                                                                                                                                                                                                         |
| 4.2**               |   | 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.                                                                                              |
| 10.59**             |   | 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.                                                                                                                                                           |
| 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.                                                            |

 

38

----

 
| 10.38(5)   |   | Amended and Restated Sales Agreement with Medtronic,  Inc., dated June 26, 1998 (with certain confidential portions omitted).                                         |
|------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.39(6)   |   | Vista Medical Technologies, Inc., Industrial Real  Estate Lease with Ocean Point Tech Centre dated July 7, 1998.                                                      |
| 10.40(7)   |   | Amendment Number One to License Agreement with  Imagyn Medical Technologies, Inc., dated October 2, 1998.                                                             |
| 10.41(7)   |   | Employment Agreement with John Lyon dated December  28, 1998.                                                                                                         |
| 10.42(7)   |   | Employment Agreement with Koichiro Hori dated  December 28, 1998.                                                                                                     |
| 10.43(7)   |   | Employment Agreement with Allen Newman dated  December 28, 1998.                                                                                                      |
| 10.44(7)   |   | Employment Agreement with Robert De Vaere dated  December 28, 1998.                                                                                                   |
| 10.45(7)   |   | Fifth Amendment to Lease dated April 30, 1999.                                                                                                                        |
| 10.46(7)   |   | Sofamor Danek letter Amendment dated April 1999.                                                                                                                      |
| 10.47(9)   |   | Agreement with John Lyon dated July 20, 1999.                                                                                                                         |
| 10.48(9)   |   | Agreement with Koichiro Hori dated July 20, 1999.                                                                                                                     |
| 10.49(9)   |   | Agreement with Allen Newman dated July 20, 1999.                                                                                                                      |
| 10.50(9)   |   | Agreement with Robert De Vaere dated July 20, 1999.                                                                                                                   |
| 10.51*(10) |   | Sales Agreement with Richard Wolf, GmbH, dated  December 22, 1999.                                                                                                    |
| 10.52(11)  |   | Termination Agreement with Medtronic, Inc., dated  March 27, 2000.                                                                                                    |
| 10.53(11)  |   | Transition Agreement with Medtronic,Inc., dated  March 27, 2000.                                                                                                      |
| 10.54(11)  |   | Common Stock purchase Agreement with John Kennedy,  dated as of August 2, 2000.                                                                                       |
| 10.55(12)  |   | Amendment Two to Industrial Real Estate Lease with  Ocean Pacific Tech Centre, dated January 30, 2001.                                                                |
| 10.56(12)  |   | Exclusive Distribution Agreement with Jomed  International, dated as of May 19, 2000.                                                                                 |
| 10.57(12)  |   | Cooperative Technology Agreement with Jomed  International, dated as of May 19, 2000.                                                                                 |
| 10.58*(13) |   | Exclusive Supply and Promotion Agreement with  Ethicon Endo-Surgery, Inc., dated as of June 22, 2001.                                                                 |
| 23.1       |   | Consent of Ernst & Young LLP, Independent  Auditors.                                                                                                              |
| 24.1       |   | Power of Attorney.                                                                                                                                                    |
| 27.1       |   | Financial Data Schedule                                                                                                                                               |
| 99.1**     |   | Certification of Chief Executive Officer pursuant to  18 U.S.C. Section 1350, as adopted pursuant To Section 906 of the  Sarbanes-Oxley Act of 2002 (filed herewith). |
| 99.2**     |   | Certification of Chief Financial Officer pursuant to  18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002 (filed herewith). |

 

----

| (1)    |   | Incorporated by reference to our Form 10-K/A, filed  on September 10, 1998.                              |
|--------|--------|----------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                     |
| (2)    |   | Incorporated by reference to our Registration  Statement on Form S-1, as amended, filed on July 2, 1997. |
|   |   |                                                                                                     |
| (3)    |   | Incorporated by reference to our Form 10-Q, filed on  November 13, 1997.                                 |
|   |   |                                                                                                     |
| (4)    |   | Incorporated by reference to our Form 10-K, filed on  March 30, 1998.                                    |
|   |   |                                                                                                     |
| (5)    |   | Incorporated by reference to our Form 10-Q, filed on  August 12, 1998.                                   |
|   |   |                                                                                                     |
| (6)    |   | Incorporated by reference to our Form 10-Q, filed on  November 13, 1998.                                 |
|   |   |                                                                                                     |
| (7)    |   | Incorporated by reference to our Form 10-K, filed on  March 29, 1999.                                    |
|   |   |                                                                                                     |
| (8)    |   | Incorporated by reference to our Form 10-Q, filed on  August 13, 1999.                                   |
|   |   |                                                                                                     |
| (9)    |   | Incorporated by reference to our Registration  Statement on Form S-1 filed on September 7, 1999.         |
|   |   |                                                                                                     |
| (10)   |   | Incorporated by reference to our Form 10-K, filed on  March 29, 2000.                                    |
|   |   |                                                                                                     |
| (11)   |   | Incorporated by reference to our Form 10-Q, filed  May 12, 2000.                                         |

 

39

----

 
| (12)   |   | Incorporated by reference to our Form 10-Q filed  April 2, 2001.      |
|--------|--------|-----------------------------------------------------------------------|
|   |   |                                                                  |
| (13)   |   | Incorporated by reference to our Form 10-Q, filed  August 3, 2001.    |
|   |   |                                                                  |
| (14)   |   | Incorporated by reference to our Form 10-Q, filed  November 14, 2001. |

 

*                                         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 and ExchangeCommission without the Mark pursuant to our application requesting confidentialtreatment under Rule 406 under the Securities Act.

 

**                                  Filedherewith

 

40

----

 

SUPPLEMENTALINFORMATION

 

Copies of theRegistrant’s Proxy Statement for the Annual Meeting of Stockholders to be heldJune 4, 2003 and copies of the form of proxy to be used for such Annual Meetingwere furnished to the Commission prior to the time they were distributed to theStockholders.

 

41

----

 

SIGNATURES

 

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

 

 
|   | VISTA MEDICAL TECHNOLOGIES, INC. |
|--------|----------------------------------|
|   |                             |
|   |                             |   |
|   | Date:  March  29, 2003      | By: | /s/ John R. Lyon |   |
|   |                             | John R. Lyon |
|   |                             | President and Chief Executive Officer |
|        |                                  |  |  |  |

 

 

POWER OF ATTORNEY

 

Know all men bythese presents, that each person whose signature appears below constitutes andappoints John R. Lyon or Stephen A. Gorgol, his or her attorney-in-fact, withpower of substitution in any and all capacities, to sign any amendments to thisAnnual Report on Form 10-K, and to file the same with exhibits thereto, and otherdocuments in connection therewith, with the Securities and Exchange Commission,hereby ratifying and confirming all that the attorney-in-fact or his or hersubstitute or substitutes may do or cause to be done by virtue hereof.

 

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

 
| **SIGNATURE**                  |   | **TITLE**                                                                                             |   | **DATE**       |
|--------------------------------|--------|-------------------------------------------------------------------------------------------------------|--------|----------------|
|                           |   |                                                                                                  |   |           |
| /s/  John R.  Lyon        |   | President, Chief  Executive  Officer and Director (Principal  Executive Officer)                      |   | March 29, 2003 |
| (John R. Lyon)                 |   |                                                                                                  |   |
|                           |   |                                                                                                  |   |           |
| /s/ Stephen A. Gorgol          |   | Vice President of  Finance and  Chief Financial Officer (Principal  Financial and Accounting Officer) |   | March 29, 2003 |
| (Stephen A.  Gorgol)           |   |                                                                                                  |   |
|                           |   |                                                                                                  |   |           |
| /s/  James C.  Blair      |   | Chairman of the Board and Director                                                                    |   | March 29, 2003 |
| (James C. Blair)               |   |                                                                                                  |   |           |
|                           |   |                                                                                                  |   |           |
| /s/  George  B. DeHuff    |   | Director                                                                                              |   | March 29, 2003 |
| (George B.  DeHuff)            |   |                                                                                                  |   |           |
|                           |   |                                                                                                  |   |           |
| /s/  Nicholas  B. Binkley |   | Director                                                                                              |   | March 29, 2003 |
| (Nicholas B.  Binkley)         |   |                                                                                                  |   |           |
|                           |   |                                                                                                  |   |           |
| /s/  Daniel  J. Holland   |   | Director                                                                                              |   | March 29, 2003 |
| (Daniel J.  Holland)           |   |                                                                                                  |   |           |
|                           |   |                                                                                                  |   |           |
| /s/  Larry M.  Osterink   |   | Director                                                                                              |   | March 29, 2003 |
| Larry M.  Osterink)            |   |                                                                                                  |   |           |

 

42

----

 

**CERTIFICATIONS**

 

I, John R. Lyon, certify that:

 

1.          I have reviewed this annual report on Form 10-Kof Vista Medical Technologies, Inc.

 

2.          Based on my knowledge, this annual report doesnot contain any untrue statement of a material fact or omit to state a materialfact necessary to make the statements made, in light of the circumstances underwhich such statements were made, not misleading with respect to the periodcovered by this annual report;

 

3.          Based on my knowledge, the financial statements,and other financial information included in this annual report, fairly presentin all material respects the financial condition, results of operations andcash flows of the registrant as of, and for, the periods presented in thisannual report;

 

4.          The registrant’s other certifying officer and I areresponsible for establishing and maintaining disclosure controls and procedures(as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant andhave:

 

a.           designed such disclosure controls and proceduresto ensure that material information relating to the registrant, including itsconsolidated subsidiaries, is made known to us by others within those entities,particularly during the period in which this annual report is being prepared;

 

b.          evaluated the effectiveness of the registrant’sdisclosure controls and procedures as of a date within 90 days prior to thefiling date of this annual report (the “Evaluation Date”); and

 

c.           presented in this annual report our conclusionsabout the effectiveness of the disclosure controls and procedures based on ourevaluation as of the Evaluation Date;

 

5.          The registrant’s other certifying officer and Ihave disclosed, based on our most recent evaluation, to the registrant’sauditors and the audit committee of registrant’s board of directors (or personsperforming the equivalent functions):

 

a.           all significant deficiencies in the design oroperation of internal controls which could adversely affect the registrant’sability to record, process, summarize and report financial data and haveidentified for the registrant’s auditors any material weaknesses in internalcontrols; and

 

b.          any fraud, whether or not material, that involvesmanagement or other employees who have a significant role in the registrant’sinternal controls; and

 

6.          The registrant’s other certifying officer and Ihave indicated in this annual report whether there were significant changes ininternal controls or in other factors that could significantly affect internalcontrols subsequent to the date of our most recent evaluation, including any correctiveactions with regard to significant deficiencies and material weaknesses.

 
| Date: March 29, 2003 |   | /s/   John R.  Lyon     |
|----------------------|--------|----------------------------------------|
|                 |   | John R. Lyon                           |
|                 |   | President and Chief Executive  Officer |

 

I, Stephen A. Gorgol, certify that:

 

1.          I have reviewed this annual report on Form 10-Kof Vista Medical Technologies, Inc.

 

2.          Based on my knowledge, this annual report doesnot contain any untrue statement of a material fact or omit to state a materialfact necessary to make the statements made, in light of the circumstances underwhich such statements were made, not misleading with respect to the periodcovered by this annual report;

 

3.          Based on my knowledge, the financial statements,and other financial information included in this annual report, fairly presentin all material respects the financial condition, results of operations andcash flows of the registrant as of, and for, the periods presented in thisannual report;

 

43

----

 

4.          The registrant’s other certifying officer and Iare responsible for establishing and maintaining disclosure controls andprocedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for theregistrant and have:

 

a.           designed such disclosure controls and proceduresto ensure that material information relating to the registrant, including itsconsolidated subsidiaries, is made known to us by others within those entities,particularly during the period in which this annual report is being prepared;

 

b.          evaluated the effectiveness of the registrant’s disclosurecontrols and procedures as of a date within 90 days prior to the filing date ofthis annual report (the “Evaluation Date”); and

 

c.           presented in this annual report our conclusionsabout the effectiveness of the disclosure controls and procedures based on ourevaluation as of the Evaluation Date;

 

5.          The registrant’s other certifying officer and Ihave disclosed, based on our most recent evaluation, to the registrant’sauditors and the audit committee of registrant’s board of directors (or personsperforming the equivalent functions):

 

a.           all significant deficiencies in the design oroperation of internal controls which could adversely affect the registrant’sability to record, process, summarize and report financial data and haveidentified for the registrant’s auditors any material weaknesses in internalcontrols; and

 

b.          any fraud, whether or not material, that involvesmanagement or other employees who have a significant role in the registrant’sinternal controls; and

 

6.          The registrant’s other certifying officers and Ihave indicated in this annual report whether there were significant changes ininternal controls or in other factors that could significantly affect internalcontrols subsequent to the date of our most recent evaluation, including anycorrective actions with regard to significant deficiencies and materialweaknesses.

 
| Date: March 29, 2003 |   | /s/   Stephen  A. Gorgol |
|----------------------|--------|-----------------------------------------|
|                 |   | Stephen A. Gorgol                       |
|                 |   | Chief Financial Officer                 |

 

44

----

 

Vista Medical Technologies,Inc.

 

Index to ConsolidatedFinancial Statements

 
|   | Report of Ernst &  Young LLP, Independent Auditors |
|--------|--------------------------------------------------------|
|   |                                                   |   |
|   | CONSOLIDATED FINANCIAL STATEMENTS                      |
|   |                                                   |   |
|   |                                                   | Consolidated Balance Sheets  at December 31, 2001 and 2002 |
|   |                                                   | Consolidated  Statements of Operations for the years ended  December 31, 2000, 2001, and 2002 |
|   |                                                   | Consolidated  Statements of Stockholders’ Equity for the years ended  December 31, 2000, 2001, and 2002 |
|   |                                                   | Consolidated  Statements of Cash Flows for the years ended  December 31, 2000, 2001, and 2002 |
|   |                                                   | Notes to  Consolidated Financial Statements |
|   |                                                   |   |
|   |                                                   | Schedule II – Valuation and Qualifying  Accounts |
|        |                                                        |  |  |

 

45

----

 

Report of Independent Auditors

 

The Board of Directors and Stockholders

Vista Medical Technologies, Inc.

 

We have audited theaccompanying consolidated balance sheets of Vista Medical Technologies, Inc. asof December 31, 2001 and 2002 and the related consolidated statements ofoperations, stockholders’ equity, and cash flows for each of the three years inthe period ended December 31, 2002. Our audits also included the financialstatement schedules listed in the index at Item 15(a).  These financial statements and schedules arethe responsibility of the Company’s management. Our responsibility is to expressan opinion on these financial statements based on our audits.

 

We conducted our auditsin accordance with auditing standards generally accepted in the United States.Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements.  An audit also includes assessing theaccounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation. We believethat our audits provide a reasonable basis for our opinion.

 

In our opinion, thefinancial statements referred to above present fairly, in all materialrespects, the consolidated financial position of Vista Medical Technologies,Inc. at December 31, 2001 and 2002, and the consolidated results of itsoperations and its cash flows for each of the three years in the period endedDecember 31, 2002, in conformity with accounting principles generally acceptedin the United States.  Also, in ouropinion, the related financial statement schedules, when considered in relationto the basic financial statements taken as a whole, present fairly in allmaterial respects the information set forth therein.

 

 
|                                                                           | /s/ Ernst & Young LLP |   |
|--------------------------------------------------------------------------------|---------------------------|--------|
|                                                                           |                      |
|                                                                           |                      |
| Boston, Massachusetts                                                          |                      |
| January 27,  2003, except for   Note 10, as to which the date is March 3, 2003 |                      |

 

 

F-2

----

 

Vista MedicalTechnologies, Inc.

 

Consolidated Balance Sheets

 
|                                                                    |   | **DECEMBER 31,** |      |
|-------------------------------------------------------------------------|--------|------------------|-----------|
|                                                                    |   | **2001**         |      | **2002** |   |
| ASSETS                                                                  |   |             |      |   |   |
| Current assets:                                                         |   |             |      |   |   |
|                                                                    |   |             |      |   |   |
| Cash and cash equivalents                                               |   | $                | 800,547   |   | $ | 457,052 |   |
|                                                                    |   |             |      |   |   |
| Short-term investments                                                  |   | 516,855          |      | 372,320 |   |
|                                                                    |   |             |      |   |   |
| Accounts receivable, net                                                |   | 1,862,028        |      | 1,670,480 |   |
|                                                                    |   |             |      |   |   |
| Inventories, net                                                        |   | 1,094,574        |      | 1,493,278 |   |
|                                                                    |   |             |      |   |   |
| Other current assets                                                    |   | 154,827          |      | 108,536 |   |
|                                                                    |   |             |      |   |   |
| Total current assets                                                    |   | 4,428,831        |      | 4,101,666 |   |
|                                                                    |   |             |      |   |   |
| Property and equipment, net                                             |   | 357,646          |      | 77,431 |   |
|                                                                    |   |             |      |   |   |
| Patents and other assets, net                                           |   | 37,013           |      | 3,061 |   |
|                                                                    |   |             |      |   |   |
| Total Assets                                                            |   | $                | 4,823,490 |   | $ | 4,182,158 |   |
|                                                                    |   |             |      |   |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                               |   |             |      |   |   |
| Current liabilities:                                                    |   |             |      |   |   |
|                                                                    |   |             |      |   |   |
| Accounts payable                                                        |   | $                | 741,003   |   | $ | 955,961 |   |
|                                                                    |   |             |      |   |   |
| Accrued compensation                                                    |   | 203,413          |      | 262,225 |   |
|                                                                    |   |             |      |   |   |
| Deferred revenue                                                        |   | 416,667          |      | 499,167 |   |
|                                                                    |   |             |      |   |   |
| Accrued liabilities                                                     |   | 371,319          |      | 383,848 |   |
|                                                                    |   |             |      |   |   |
| Total current liabilities                                               |   | 1,732,402        |      | 2,101,201 |   |
|                                                                    |   |             |      |   |   |
| Commitments and contingencies                                           |   |             |      |   |   |
|                                                                    |   |             |      |   |   |
| Stockholders’ equity:                                              |   |             |      |   |   |
|                                                                    |   |             |      |   |   |
| Common stock, $.01 par value:                                           |   |             |      |   |   |
|                                                                    |   |             |      |   |   |
| Authorized shares – 35,000,000                                     |   |             |      |   |   |
|                                                                    |   |             |      |   |   |
| Issued and outstanding shares - 4,913,031 in 2001 and 5,001,749 in 2002 |   | 49,130           |      | 50,017 |   |
|                                                                    |   |             |      |   |   |
| Additional paid-in capital                                              |   | 67,974,087       |      | 68,079,862 |   |
|                                                                    |   |             |      |   |   |
| Notes receivable from stockholders                                      |   | (78,375          | )         | (78,375 | ) |
|                                                                    |   |             |      |   |   |
| Deferred compensation                                                   |   | (76,305          | )         | (45,947 | ) |
|                                                                    |   |             |      |   |   |
| Accumulated deficit                                                     |   | (64,777,449      | )         | (65,924,600 | ) |
|                                                                    |   |             |      |   |   |
| Total stockholders’ equity                                         |   | 3,091,088        |      | 2,080,957 |   |
|                                                                    |   |             |      |   |   |
| Total liabilities and stockholders’ equity                         |   | $                | 4,823,490 |   | $ | 4,182,158 |   |

 

SEE ACCOMPANYING NOTES

 

F-3

----

 

Vista MedicalTechnologies, Inc.

 

Consolidated Statementsof Operations

 
|                                                          |   | **YEARS ENDED DECEMBER 31,** |       |
|---------------------------------------------------------------|--------|------------------------------|------------|
|                                                          |   | **2000**                     |       | **2001** |   | **2002** |   |
|                                                          |   |                         |       |   |   |   |   |
| Revenues                                                      |   | $                            | 6,539,213  |   | $ | 9,326,490 |   | $ | 11,106,130 |   |
|                                                          |   |                         |       |   |   |   |   |
| Cost and expenses:                                            |   |                         |       |   |   |   |   |
|                                                          |   |                         |       |   |   |   |   |
| Cost of revenues                                              |   | 5,946,887                    |       | 6,405,340 |   | 5,988,881 |   |
|                                                          |   |                         |       |   |   |   |   |
| Research and development                                      |   | 1,735,617                    |       | 1,945,433 |   | 1,709,534 |   |
|                                                          |   |                         |       |   |   |   |   |
| Sales and marketing                                           |   | 1,158,422                    |       | 2,237,108 |   | 2,690,032 |   |
|                                                          |   |                         |       |   |   |   |   |
| General and administrative                                    |   | 1,925,168                    |       | 2,030,917 |   | 1,882,260 |   |
|                                                          |   |                         |       |   |   |   |   |
| Restructuring                                                 |   | (399,750                     | )          | — |   | — |   |
|                                                          |   |                         |       |   |   |   |   |
| Total costs and expenses                                      |   | 10,366,344                   |       | 12,618,798 |   | 12,270,707 |   |
|                                                          |   |                         |       |   |   |   |   |
| Loss from operations                                          |   | (3,827,131                   | )          | (3,292,308 | ) | (1,164,577 | ) |
|                                                          |   |                         |       |   |   |   |   |
| Interest income                                               |   | 213,245                      |       | 69,879 |   | 17,426 |   |
|                                                          |   |                         |       |   |   |   |   |
| Net loss                                                      |   | $                            | (3,613,886 | ) | $ | (3,222,429 | ) | $ | (1,147,151 | ) |
|                                                          |   |                         |       |   |   |   |   |
| Basic and diluted net loss per share                          |   | $                            | (0.80      | ) | $ | (0.66 | ) | $ | (0.23 | ) |
|                                                          |   |                         |       |   |   |   |   |
| Shares used in computing basic and diluted net loss per share |   | 4,495,522                    |       | 4,906,197 |   | 4,968,519 |   |

 

SEE ACCOMPANYING NOTES

 

F-4

----

 

Vista MedicalTechnologies, Inc.

 

Consolidated Statementsof Stockholders’ Equity

 
|                                                                               |   | **COMMON STOCK** |   | **ADDITIONAL  PAID-IN  CAPITAL** |   | **NOTES  RECEIVABLE  FROM STOCKHOLDERS** |   | **DEFERRED  COMPENSATION** |   | **ACCUMULATED  DEFICIT** |    | **TOTAL**  |   | **COMPREHENSIVE  LOSS** |   |
|------------------------------------------------------------------------------------|--------|------------------|--------|----------------------------------|--------|------------------------------------------|--------|----------------------------|--------|--------------------------|---------|------------|--------|-------------------------|--------|
| **SHARES**                                                                         |   | **AMOUNT**       |
|                                                                               |   |             |   |                             |   |                                     |   |                       |   |                     |    |       |   |                    |   |   |   |
| Balance at December 31, 1999                                                       |   | 3,448,879        |   | $                                | 34,488 |                                     | $      | 63,146,204                 |   | $                        | (78,375 | )          | $      | (576,738                | )      | $ | (57,941,134 | ) | $ | 4,584,445 |   | $ | (10,724,497 | ) |
|                                                                               |   |             |   |                             |   |                                     |   |                       |   |                     |    |       |   |                    |   |   |   |
| Exercise of stock options for cash                                                 |   | 7,153            |   | 72                               |   | 12,231                                   |   |                       |   |                     |    |       |   | 12,303                  |   |   |   |
| Issuance of stock under employee stock purchase  plan                              |   | 22,871           |   | 229                              |   | 45,263                                   |   |                       |   |                     |    |       |   | 45,492                  |   |   |   |
| Issuance of common stock to employee                                               |   | 3,519            |   | 35                               |   | 15,624                                   |   |                       |   |                     |    |       |   | 15,659                  |   |   |   |
| Issuance of common Stock to business partner                                       |   | 1,318            |   | 13                               |   | 7,687                                    |   |                       |   |                     |    |       |   | 7,700                   |   |   |   |
| Issuance of warrant for services                                                   |   |             |   |                             |   | 103,595                                  |   |                       |   |                     |    |       |   | 103,595                 |   |   |   |
| Deferred compensation-issuance of options to  consultants                          |   |             |   |                             |   | 52,870                                   |   |                       |   | (52,870                  | )       |       |   | —                  |   |   |   |
| Amortization of deferred compensation                                              |   |             |   |                             |   |                                     |   |                       |   | 361,657                  |    |       |   | 361,657                 |   |   |   |
| Issuance of common stock in conjunction with a  second offering at $0.85 per share |   | 1,413,602        |   | 14,136                           |   | 4,620,061                                |   |                       |   |                     |    |       |   | 4,634,197               |   |   |   |
| Net loss                                                                           |   |             |   |                             |   |                                     |   |                       |   | —                   |    | (3,613,886 | )      | (3,613,886              | )      | $ | (3,613,886 | ) |
|                                                                               |   |             |   |                             |   |                                     |   |                       |   |                     |    |       |   |                    |   |   |   |
| Balance at December 31, 2000                                                       |   | 4,897,342        |   | $                                | 48,973 |                                     | $      | 68,003,535                 |   | $                        | (78,375 | )          | $      | (267,951                | )      | $ | (61,555,020 | ) | $ | 6,151,162 |   | $ | (3,613,886 | ) |
|                                                                               |   |             |   |                             |   |                                     |   |                       |   |                     |    |       |   |                    |   |   |   |
| Exercise of stock options for cash                                                 |   | 4,325            |   | 43                               |   | 3,438                                    |   |                       |   |                     |    |       |   | 3,481                   |   |   |   |
| Issuance of stock under employee stock purchase  plan                              |   | 11,364           |   | 114                              |   | 21,295                                   |   |                       |   |                     |    |       |   | 21,409                  |   |   |   |
| Forfeitures of non employee stock options                                          |   |             |   |                             |   | (21,387                                  | )      |                       |   | 21,387                   |    |       |   | —                  |   |   |   |
| Deferred compensation-issuance of options to  consultants                          |   |             |   |                             |   | 99,900                                   |   |                       |   | (99,900                  | )       |       |   | —                  |   |   |   |
| Amortization of deferred compensation                                              |   |             |   |                             |   |                                     |   |                       |   | 274,787                  |    |       |   | 274,787                 |   |   |   |
| Recapture of deferred compensation                                                 |   |             |   |                             |   | (132,694                                 | )      |                       |   | (4,628                   | )       |       |   | (137,322                | )      |   |   |
| Net loss                                                                           |   |             |   |                             |   |                                     |   |                       |   |                     |    | (3,222,429 | )      | (3,222,429              | )      | $ | (3,222,429 | ) |
|                                                                               |   |             |   |                             |   |                                     |   |                       |   |                     |    |       |   |                    |   |   |   |
| Balance at December 31, 2001                                                       |   | 4,913,031        |   | $                                | 49,130 |                                     | $      | 67,974,087                 |   | $                        | (78,375 | )          | $      | (76,305                 | )      | $ | (64,777,449 | ) | $ | 3,091,088 |   | $ | (3,222,429 | ) |
|                                                                               |   |             |   |                             |   |                                     |   |                       |   |                     |    |       |   |                    |   |   |   |
| Exercise of stock options and warrant for cash                                     |   | 64,808           |   | 648                              |   | 34,983                                   |   |                       |   |                     |    |       |   | 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              | )      | $ | 1,147,151 | ) |
|                                                                               |   |             |   |                             |   |                                     |   |                       |   |                     |    |       |   |                    |   |   |   |
| Balance at December 31, 2002

                                                |   | 5,001,749        |   | $                                | 50,017 |                                     | $      | 68,079,862                 |   | $                        | (78,375 | )          | $      | (45,947                 | )      | $ | (65,924,600 | ) | $ | 2,080,957 |   | $ | (1,147,151 | ) |

 

SEE ACCOMPANYING NOTES

 

F-5

----

 

Vista MedicalTechnologies, Inc.

 

Consolidated Statements of Cash Flows

 
|                                                                         |   | **YEARS ENDED DECEMBER 31,** |       |
|------------------------------------------------------------------------------|--------|------------------------------|------------|
|                                                                         |   | **2000**                     |       | **2001** |   | **2002** |   |
|                                                                         |   |                         |       |   |   |   |   |
| **OPERATING  ACTIVITIES**                                                    |   |                         |       |   |   |   |   |
|                                                                         |   |                         |       |   |   |   |   |
| Net loss                                                                     |   | $                            | (3,613,886 | ) | $ | (3,222,429 | ) | $ | (1,147,151 | ) |
|                                                                         |   |                         |       |   |   |   |   |
| Adjustments to reconcile net loss to net cash used in operating  activities: |   |                         |       |   |   |   |   |
|                                                                         |   |                         |       |   |   |   |   |
| Depreciation and amortization                                                |   | 729,126                      |       | 728,481 |   | 430,106 |   |
|                                                                         |   |                         |       |   |   |   |   |
| Amortization of deferred compensation                                        |   | 361,657                      |       | 137,462 |   | 66,358 |   |
|                                                                         |   |                         |       |   |   |   |   |
| Changes in operating assets and liabilities:                                 |   |                         |       |   |   |   |   |
|                                                                         |   |                         |       |   |   |   |   |
| Accounts receivable, net                                                     |   | (186,806                     | )          | (498,113 | ) | 191,548 |   |
|                                                                         |   |                         |       |   |   |   |   |
| Inventories, net                                                             |   | 947,874                      |       | 607,094 |   | (398,704 | ) |
|                                                                         |   |                         |       |   |   |   |   |
| Other current assets                                                         |   | 152,529                      |       | (37,959 | ) | 46,291 |   |
|                                                                         |   |                         |       |   |   |   |   |
| Accounts payable                                                             |   | (525,353                     | )          | 280,835 |   | 214,959 |   |
|                                                                         |   |                         |       |   |   |   |   |
| Accrued compensation                                                         |   | (12,822                      | )          | 10,753 |   | 58,812 |   |
|                                                                         |   |                         |       |   |   |   |   |
| Deferred revenue                                                             |   | —                       |       | 416,667 |   | 82,500 |   |
|                                                                         |   |                         |       |   |   |   |   |
| Accrued liabilities                                                          |   | (1,240,754                   | )          | 20,798 |   | 12,529 |   |
|                                                                         |   |                         |       |   |   |   |   |
| Net cash flows used in operating activities                                  |   | (3,388,435                   | )          | (1,556,411 | ) | (442,752 | ) |
|                                                                         |   |                         |       |   |   |   |   |
| **INVESTING  ACTIVITIES**                                                    |   |                         |       |   |   |   |   |
|                                                                         |   |                         |       |   |   |   |   |
| Purchases (maturities) of short-term investments                             |   | (56,035                      | )          | (171,631 | ) | 144,535 |   |
|                                                                         |   |                         |       |   |   |   |   |
| Purchase of property and equipment                                           |   | (154,380                     | )          | (85,307 | ) | (115,940 | ) |
|                                                                         |   |                         |       |   |   |   |   |
| Net cash flows (used in) provided by investing activities                    |   | (210,415                     | )          | (256,938 | ) | 28,595 |   |
|                                                                         |   |                         |       |   |   |   |   |
| **FINANCING  ACTIVITIES**                                                    |   |                         |       |   |   |   |   |
|                                                                         |   |                         |       |   |   |   |   |
| Issuance of common stock, net                                                |   | 4,818,946                    |       | 24,890 |   | 70,662 |   |
|                                                                         |   |                         |       |   |   |   |   |
| Net cash flows provided by financing activities                              |   | 4,818,946                    |       | 24,890 |   | 70,662 |   |
|                                                                         |   |                         |       |   |   |   |   |
| Net increase (decrease) in cash and cash equivalents                         |   | 1,220,096                    |       | (1,788,459 | ) | (343,495 | ) |
|                                                                         |   |                         |       |   |   |   |   |
| Cash and cash equivalents at beginning of year                               |   | 1,368,910                    |       | 2,589,006 |   | 800,547 |   |
|                                                                         |   |                         |       |   |   |   |   |
| Cash and cash equivalents at end of year                                     |   | $                            | 2,589,006  |   | $ | 800,547 |   | $ | 457,052 |   |

 

SEE ACCOMPANYING NOTES

 

F-6

----

 

Vista MedicalTechnologies, Inc.

 

Notes to ConsolidatedFinancial Statements

 

December 31, 2002

 

1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

ORGANIZATION AND BUSINESS ACTIVITY

 

Vista MedicalTechnologies, Inc. (the “Company”) was founded in July 1993 and develops,manufactures and markets proprietary 3-D visualization and information systemsthat enable minimally invasive surgical solutions in  general surgical, cardiac surgical and other selectedmicrosurgical procedures.  VistaMedical’s visualization and information systems bring together head-mounteddisplay technology originally developed for applications in military aerospaceby Kaiser Aerospace and Electronics Corporation and three-dimensional imagingcapability from its acquisition of Oktas, Inc.

 

The Company incurredoperating losses in 2000, 2001 and 2002, and at December 31, 2002, had anaccumulated deficit of $65.9 million. At December 31, 2002, the Company had cash and short-term investments of$829,000.  In March 2003, the Companysold $950,000 of preferred stock in a private placement to two accreditedinvestors (see Note 10).  In addition,the Company has amounts available under a $2.0 million bank line of creditfacility, which expires in October 2003 and is subject to annual renewals.  The Company believes that these sources ofliquidity, together with anticipated 2003 product revenues and interest income,will be sufficient to meet its anticipated capital requirements through January2004.    Therefore, the accompanyingfinancial statements have been prepared assuming that the Company will continueas a going concern.  However, certaincircumstances, including slow rate of market acceptance of its products orinability  to scale up manufacturing,would accelerate use of these funds and require it to seek additional funds tosupport operating requirements.   Therecan be no assurance that the requisite fundings will be consummated in thenecessary 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 in expensesor delays in product development may adversely impact the Company’s cashposition and require further cost reductions. No assurance can be given that the Company will be able to operateprofitably on a consistent basis, or at all, in the future.

 

PRINCIPLES OF CONSOLIDATION

 

The consolidatedfinancial statements include the accounts of the Company and its wholly-ownedsubsidiary. Significant intercompany accounts and transactions have beeneliminated.

 

USE OF ESTIMATES

 

The preparation offinancial statements in accordance with generally accepted accountingprinciples requires management to make estimates and assumptions that affectthe amounts reported in the financial statements and disclosures made in theaccompanying notes to the consolidated financial statements.  Actual results could differ from thoseestimates.

 

REVENUE RECOGNITION

 

The Company recognizesrevenue pursuant to Staff Accounting Bulletin (“SAB”) No. 101 “REVENUERECOGNITION IN FINANCIAL STATEMENTS.” Accordingly, revenue is recognized when all four of the followingcriteria are met: (i) persuasive evidence that 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.

 

F-7

----

 

Revenue generated from LBSprogram sales are recognized upon shipment of equipment and marketing materialsand completion of the related training component, provided that a purchaseorder has been received, there are no uncertainties regarding customeracceptance, the sales price is fixed and determinable and collectibility isdeemed probable.  Sales of all otherproducts are similarly recognized upon shipment provided that a purchase orderhas been received, there are no uncertainties regarding customer acceptance,the sales price is fixed and determinable and collectibility is deemedprobable.

 

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

 

CASH, CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS

 

Cash equivalents andshort-term investments consist of money market funds, certificates of depositand 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 has adoptedStatement of Financial Accounting Standards 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. At December 31,2002, the cost of cash equivalents and short-term investments was equivalent tofair value and the Company had no unrealized gains or losses.

 

As of December 31, 2001and 2002, the Company’s cash, cash equivalents and short-term investmentsconsisted of:

 
|                     |   | **2001** |      | **2002** |   |
|--------------------------|--------|----------|-----------|----------|--------|
| Cash                     |   | $        | (1,430    | )        | $      | 24,905   |   |
|                     |   |     |      |     |   |
| Money market  funds      |   | 801,977  |      | 432,147  |   |
|                     |   |     |      |     |   |
| Certificates of  deposit |   | 516,855  |      | 372,320  |   |
|                     |   |     |      |     |   |
|                     |   | $        | 1,317,402 |     | $      | 829,372 |   |

 

All of the Company’s certificates of deposit held at December 31,2002,  mature in 2003.

 

CONCENTRATION OF CREDIT RISK

 

The Company provides credit, in the normal course of business, tocommercial entities that meet specified credit requirements. The Company’sprincipal customers consist of original equipment manufacturers anddistribution partners. The Company provides for losses from uncollectibleaccounts and such losses have historically not exceeded management’sexpectations. As of December 31, 2002, four customers comprised $525,000,$223,000, $199,000 and $188,000 or 29 %, 13%, 11% and 10%, respectively, of theoutstanding trade receivables.

 

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 isstated at cost. The Company provides for depreciation on property and equipmentusing the straight-line method over the estimated useful lives of the assets,generally two to five years.  Marketingdemonstration equipment is amortized over its estimated useful life of oneyear.

 

PATENTS

 

Patents are carried atcost and amortized over five years commencing on the date the patent is issued.The Company reviews its patents for impairment on an annual basis or wheneverevents or changes in circumstances indicate that the carrying value of theasset would not be recoverable.

 

IMPAIRMENT OF LONG-LIVED ASSETS

 

During 2002, the Companyadopted Statement of Financial Accounting Standards 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 developmentcosts are expensed in the period incurred.

 

INCOME TAXES

 

The Company uses theasset and liability accounting method whereby deferred tax assets andliabilities are recognized based on temporary differences between the financialstatements and tax bases of assets and liabilities using current statutory taxrates. A valuation allowance against net deferred tax assets is recorded if,based on the available evidence, it is more likely than not that some or all ofthe deferred tax assets will not be realized. Management evaluates on aquarterly basis the ability to recover the deferred tax assets and the level ofthe valuation allowance. At such time as it is more likely than not thatdeferred tax assets are realizable, the valuation allowance will beappropriately reduced.

 

COMPREHENSIVEINCOME / (LOSS)

 

Comprehensive income /(loss) is comprised of net loss and other comprehensive income/ (loss). Othercomprehensive income/(loss) includes certain changes in equity that areexcluded from net loss. For the years ended December 31, 2000, 2001 and 2002,the Company had no items of comprehensive income (loss) other than its netloss.

 

RESTRUCTURING EXPENSES

 

During 1999, the Companyrecorded a $690,000 restructuring charge, which represented the anticipatedloss on excess facilities.  The Companyrecorded credits associated with restructuring expenses of $400,000 during2000.  The partial recovery representsthe subletting of a portion of the Company’s facility in Westborough,Massachusetts.  

 

NET LOSS PER SHARE

 

Basic net loss per shareis calculated based on the weighted average number of common shares outstandingduring the period. Diluted net loss per share incorporates the dilutive effectof common stock equivalents, including stock options, warrants and otherconvertible securities.  Common stockequivalents have been excluded from the calculation of weighted average numberof diluted common shares, as their effect would be antidilutive for all

 

F-9

----

 

periods presented.  Common stock equivalents excluded from thecalculation of diluted weighted average shares were 552,910, 564,130 and689,328 as of December 31, 2002, 2001 and 2000, 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 historicallygranted options to employees and directors at exercise prices equal to the fairvalue of the Company’s common stock. Accordingly, no compensation expense hasbeen recognized 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, 2000, 2001 and 2002 would have been adjusted tothe pro forma amounts indicated below:

 
|                                         |   | **For the years ended December 31,**          |   |
|----------------------------------------------|--------|-----------------------------------------------|--------|
|                                         |   | **2000**                                      |   | **2001** |   | **2002** |   |
|                                         |   | **(In thousands,  except per share amounts)** |   |
| Net Loss                                     |   |                                          |   |   |   |   |   |
| As reported                                  |   | $                                             | (3,614 | ) | $ | (3,222 | ) | $ | (1,147 | ) |
| Pro forma SFAS  No. 123 compensation expense |   | (225                                          | )      | (289 | ) | (278 | ) |
| Pro forma net  loss                          |   | $                                             | (3,839 | ) | $ | (3,511 | ) | $ | (1,425 | ) |
|                                         |   |                                          |   |   |   |   |   |
| Basic and  diluted net loss per share        |   |                                          |   |   |   |   |   |
| As reported                                  |   | $                                             | (0.80  | ) | $ | (0.66 | ) | $ | (0.23 | ) |
| Pro forma                                    |   | $                                             | (0.85  | ) | $ | (0.72 | ) | $ | (0.29 | ) |

 

The average estimated fair value of options granted during fiscal years2000, 2001 and 2002, was $2.60, $3.36, and $3.47, respectively, and wasestimated using the Black-Scholes option-pricing model using the followingweighted-average assumptions:

 
|                     |   | **2000**     |   | **2001**     |   | **2002**     |   |
|--------------------------|--------|--------------|--------|--------------|--------|--------------|--------|
| Dividend Yield           |   | None         |   | None         |   | None         |   |
| Volatility               |   | 125          | %      | 231          | %      | 106          | %      |
| Risk-free  interest rate |   | 5.5–6.0 | %      | 3.9–6.0 | %      | 2.6–6.5 | %      |
| Expected life  (years)   |   | 5            |   | 5            |   | 5            |   |

 

The Black-Scholesoption-pricing model was developed for use in estimating the fair value oftraded options that have no vesting restrictions and are fully transferable. Inaddition, option-pricing models require the use of highly subjectiveassumptions, including the expected stock price volatility. Because theCompany’s employee stock options have characteristics significantly differentfrom those of traded options, and because changes in the subjective assumptionscan materially affect the fair value estimates, in management’s opinion, theexisting models do not necessarily provide a reliable single measure of thefair value of its employee stock-based compensation.

 

F-10

----

 

The Company accounts forstock-based compensation to non-employees using the fair value methodprescribed by SFAS No. 123.  As a resultof stock options issued to non-employee medical board advisors, the Companyrecognized $36,000 in non-employee compensation expense during the year endedDecember 31, 2002. The fair value of the non-employee stock options was derivedfrom the Black-Scholes option-pricing model.

 

NEW ACCOUNTING STANDARDS

 

In April 2002, theFASB issued Statement of Financial Accounting Standards No. 145, *Rescission of FASB Statements No. 4, 44, and 64,Amendment of FASB Statement No. 13, and Technical Corrections*(“FAS 145”). Among other matters, FAS 145 rescinds FASB StatementNo. 4, *Reporting Gains and Losses fromExtinguishment of Debt*, which required all gains and losses fromextinguishment of debt be aggregated and, if material, classified as anextraordinary item, net of the related income tax effect. As a result, thecriteria in Accounting Principles Board Opinion 30 will now be used to classifythose gains and losses. The Company adopted FAS 145 as of January 1,2002, and such adoption did not have any impact on the Company’s financialstatements or results or operations.

 

In June 2002, theFASB issued Statement of Financial Accounting Standards No. 146, *Accounting for Costs Associated with Exit or DisposalActivities* (“FAS 146”). FAS 146 requires that a liabilityfor a cost associated with an exit or disposal activity be recognized andmeasured, initially at fair value, only when the liability is incurred;therefore, nullifying Emerging Issues Task Force Issue No. 94-3, *Liability Recognition for Certain EmployeeTermination Benefits and Other Costs to Exit an Activity (including CertainCosts Incurred in a Restructuring)* (“EITF 94-3”) that required aliability for an exit cost to be recognized at the date of an entity’s commitmentto an exit plan. This change in accounting would be expected to result in adelayed recognition of certain types of costs, especially facility closurecosts. The provisions of FAS 146 are effective for exit or disposalactivities that are initiated after December 31, 2002.  The Company will adopt FAS 146 as ofJanuary 1, 2003, and its adoption is not expected to have a materialimpact on the Company’s financial statements or results of operations.

 

In December 2002,the FASB issued Statement of Financial Accounting Standards No. 148, *Accounting for Stock-Based Compensation—Transitionand Disclosure*, (“FAS 148”). FAS 148 amends FAS 123and Accounting Principles Board Opinion No. 28, *Interim Financial Reporting* to present alternative methodsof transition for an entity that voluntarily adopts the fair value based methodof accounting for stock-based employee compensation, and provides modificationsto the disclosure provisions to require prominent disclosure about the effectson reported net income of an entity’s accounting policy decisions with respectto stock-based employee compensation in quarterly and annual financialstatements. At this time, the Company has not voluntarily adopted the fairvalue method of accounting under FAS 123. However, appropriate disclosuresabout the effects on reported net loss of the Company’s accounting policy withrespect to stock-based employee compensation are provided above.

 

In November 2002,the FASB issued Financial Interpretation No. 45, *Guarantor’s Accounting and Disclosure Requirementsfor Guarantees, Including Indirect Guarantees of Indebtedness of Others*,(“FIN 45”). FIN 45 requires a guarantor to disclose (a) the nature of theguarantee, including the approximate term of the guarantee, how the guaranteearose, and the events or circumstances that would require the guarantor toperform under the guarantee; (b) the maximum potential amount of futurepayments under the guarantee; (c) the carrying amount of the liability, ifany, for the guarantor’s obligations under the guarantee; and (d) thenature and extent of any recourse provisions or available collateral that wouldenable the guarantor to recover the amounts paid under the guarantee. FIN 45also clarifies that a guarantor is required to recognize, at the inception of aguarantee, a liability at fair value for the obligations it has undertaken inissuing the guarantee, including its ongoing obligation to stand ready toperform over the term of the guarantee in the event that the specifiedtriggering events or conditions occur. The initial recognition and initialmeasurement provisions of FIN 45 are applicable on a prospective basis toguarantees issued or modified after December 31, 2002. The adoption of FIN45 is not expected to have a material impact on the Company’s financialstatements or results of operations.

 

FIN 45 also addresses thedisclosure requirements regarding product warranties. Instead of disclosing themaximum potential amount of future payments under the product warrantyguarantee, a guarantor is required to disclose its accounting policy andmethodology used in determining its liability for product warranties, as wellas, a

 

F-11

----

 

tabular reconciliation ofthe changes in the guarantor’s product warranty liability for the reportingperiod (see Note 2).

 

At the November 21, 2002meeting, the Emerging Issues Task Force reached a consensus on Issue 00-21, *Accounting for Revenue Arrangements with MultipleDeliverables*, which addresses how to account for arrangements thatmay involve the delivery or performance of multiple products, services, and/orrights to use assets. The final consensus will be applicable to agreementsentered into in fiscal periods beginning after June 15, 2003 with earlyadoption permitted. Additionally, companies will be permitted to apply theconsensus guidance to all existing arrangements as the cumulative effect of achange in accounting principle in accordance with APB Opinion No. 20,Accounting Changes. The Company does not believe the adoption of EITF 00-21will have a material impact on its results of operations or financial position.

 

2. BALANCE SHEET COMPONENTS

 

Accounts receivable consist of the following:

 
|                                   |   | **December  31,** |      |
|----------------------------------------|--------|-------------------|-----------|
|                                   |   | **2001**          |      | **2002** |   |
| Gross accounts  receivable             |   | $                 | 1,878,080 |   | $ | 1,787,256 |   |
| Less: Allowance  for doubtful accounts |   | (16,052           | )         | (116,776 | ) |
|                                   |   | $                 | 1,862,028 |   | $ | 1,670,480 |   |

 

Inventories consists of the following:

 
|            |   | **December  31,** |      |
|-----------------|--------|-------------------|-----------|
|            |   | **2001**          |      | **2002** |   |
| Parts           |   | $                 | 1,587,254 |   | $ | 1,243,304 |   |
| Work in process |   | 170,815           |      | 375,414 |   |
| Finished goods  |   | 858,201           |      | 919,344 |   |
|            |   | 2,616,270         |      | 2,538,062 |   |
| Less: Reserves  |   | (1,521,696        | )         | (1,044,784 | ) |
|            |   | $                 | 1,094,574 |   | $ | 1,493,278 |   |

 

F-12

----

 

Property and equipment consists of the following:

 
|                                       |   | **December  31,** |      |
|--------------------------------------------|--------|-------------------|-----------|
|                                       |   | **2001**          |      | **2002** |   |
|                                       |   |              |      |   |   |
| Machinery and  equipment                   |   | $                 | 1,589,759 |   | $ | 1,629,035 |   |
| Office  computers, furniture and equipment |   | 1,052,857         |      | 1,125,846 |   |
| Marketing  demonstration equipment         |   | 3,363,820         |      | 3,363,820 |   |
| Leasehold  improvements                    |   | 297,918           |      | 301,595 |   |
|                                       |   | 6,304,354         |      | 6,420,296 |   |
| Less:  Accumulated depreciation            |   | (5,946,708        | )         | (6,342,865 | ) |
|                                       |   | $                 | 357,646   |   | $ | 77,431 |   |

 

Patents and other assets consists of the following:

 
|                                 |   | **December  31,** |    |
|--------------------------------------|--------|-------------------|---------|
|                                 |   | **2001**          |    | **2002** |   |
|                                 |   |              |    |   |   |
| Patents and  other intangible assets |   | $                 | 229,621 |   | $ | 229,621 |   |
| Less:  Accumulated amortization      |   | (192,608          | )       | (226,560 | ) |
|                                 |   | $                 | 37,013  |   | $ | 3,061 |   |

 

Accrued liabilities consists of the following:

 
|                       |   | **December  31,** |    |
|----------------------------|--------|-------------------|---------|
|                       |   | **2001**          |    | **2002** |   |
|                       |   |              |    |   |   |
| Customer  warranty         |   | $                 | 182,504 |   | $ | 45,261 |   |
| Miscellaneous  liabilities |   | 188,815           |    | 338,587 |   |
|                       |   | $                 | 371,319 |   | $ | 383,848 |   |

 

The Company provides foran estimated amount of product warranty at the time revenue is recognized. Thisestimated amount is provided by product and based on historical warrantyexperience.  A rollforward of the customerwarranty accrual is as follows:

 
| Balance at  December 31, 2001 |   | $        | 182,504 |   |
|-------------------------------|--------|----------|---------|--------|
|                          |   |     |    |
| Warranty expense              |   | 84,424   |    |
|                          |   |     |    |
| Deductions and  other         |   | (221,667 | )       |
|                          |   |     |    |
| Balance at  December 31, 2002 |   | $        | 45,261  |   |

 

F-13

----

 

3. PROMOTION AGREEMENT

 

In June 2001, the Companyentered into a Supply and Promotion Agreement with Ethicon Endo-Surgery, Inc.(EES). Under the agreement, the Company will receive payments in return for theCompany’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 any EES equipment.  The agreement grants EES with the right offirst negotiation to acquire certain Company technology.  The agreement has a five year term, but maybe terminated by EES upon 90 days notice. The Company recognizes revenue ratably over the term of the agreement.  The Company recognized $583,000 and$1,000,000 of revenue in 2001 and 2002, respectively, related to the EESagreement and had $417,000 of such revenue deferred at December 31, 2002.

 

4. CREDIT AGREEMENT

 

In October 2001, theCompany secured a $2,000,000 line of credit facility (the facility) with a bankfor one year with automatic yearly renewals. The current line of credit agreement expires in October 2003.  The facility is secured by qualifiedaccounts receivable and bears interest at the rate of prime plus 2% (4.5% atDecember 31, 2002).  Borrowings underthe facility are limited to 80% of qualified accounts receivable.  There were no borrowings outstanding atDecember 31, 2002.  There was $1,336,000available under this line at December 31, 2002.

 

5. MAJOR CUSTOMERS

 

Sales to individual customers exceeding 10% or more of revenues in theyears ended December 31, were as follows: during  2000, Richard Wolf, GmbH and Aesculap AG accounted for 51% and23% of revenues, respectively; during 2001, Richard Wolf, GmbH, Aesculap AG andJomed accounted for 22%, 18% and 10% of revenues, respectively; during 2002,Aesculap AG accounted for 14% of revenues.

 

6. COMMITMENTS

 

The Company leases its corporate facilities and certain equipment underoperating leases that expire on various dates through 2004. Annual futureminimum lease payments as of December 31, 2002 are as follows:

 
| **YEAR  ENDING DECEMBER 31,** |   |    |    |
|-------------------------------|--------|---------|---------|
| 2003                          |   | $       | 252,875 |   |
| 2004                          |   | 223,125 |    |
|                          |   | $       | 476,000 |   |

 

Rent expense wasapproximately $360,784, $360,624 and $405,691 for the years ended December 31,2000, 2001 and 2002, respectively.

 

7. STOCKHOLDERS’ EQUITY

 

1995 STOCK OPTION PLAN

 

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

 

F-14

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The exercise price of theincentive stock options must equal at least the fair market value of the stockon the date of grant. The exercise price of nonstatutory stock options mustequal at least 85% of the fair market value of the stock on the date of grant.The Company has the option, in the event of termination of employment, torepurchase unvested shares issued under the 1995 Plan at the original issueprice.

 

The Company recorded$36,000 of deferred compensation for options granted during the year endedDecember 31, 2002, representing the fair value of stock options granted toCompany consultants and advisors in 2002. These options vest over two to fouryears and the Company is recognizing the compensation expense over the vestingperiod.

 

F-15

----

 

1997 STOCK OPTION PLAN/ STOCK ISSUANCE PLAN

 

In February 1997, theCompany adopted the 1997 Stock Option Plan/Stock Issuance Plan (the “1997Plan”). The 1997 Plan incorporates the outstanding options under the 1995 Planand no further options will be granted under the 1995 Plan.  At December 31, 2002, the Company had atotal of 892,500 shares reserved for issuance under the 1997 Stock Option/StockIssuance Plan and 83,573 options 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, 1999 |   | 499,983               |   | $                    | .80    | -                                       | $      | 57.50 |   | $ | 7.16 |   |
| Granted                       |   | 89,625                |   | $                    | 1.88   | -                                       | $      | 5.00 |   | $ | 3.92 |   |
| Exercised                     |   | (7,153                | )      | $                    | .80    | -                                       | $      | 3.20 |   | $ | 1.72 |   |
| Canceled                      |   | (29,545               | )      | $                    | .80    | -                                       | $      | 57.50 |   | $ | 16.44 |   |
|                          |   |                  |   |                 |   |                                    |   |   |   |   |
| 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 |   | $ | .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 |   |

 

F-16

----

 
|                         |   | **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                                                          |   | 320,743 |   | 68 |   | $ | 1.57 |   | 288,931 |   | $ | 1.48 |   |
| $                            | 3.00   | -                              | $       | 4.13                                                          |   | 273,224 |   | 102 |   | $ | 3.61 |   | 110,553 |   | $ | 3.52 |   |
| $                            | 4.62   | -                              | $       | 6.12                                                          |   | 41,111 |   | 88 |   | $ | 4.95 |   | 36,340 |   | $ | 4.99 |   |
| $                            | 9.00   | -                              | $       | 9.75                                                          |   | 24,875 |   | 70 |   | $ | 9.37 |   | 21,213 |   | $ | 9.38 |   |
|                         |   | $                              | 20.25   |                                                          | 10,000 |   | 65 |   | $ | 20.25 |   | 9,500 |   | $ | 20.25 |   |
| $                            | 39.50  | -                              | $       | 45.50                                                         |   | 18,375 |   | 56 |   | $ | 40.25 |   | 18,375 |   | $ | 40.25 |   |
|                         | $      | 57.50                          |    | 1,000                                                         |   | 57 |   | $ | 57.50 |   | 1,000 |   | $ | 57.50 |   |
|                         |   |                           | 689,328 |                                                          | 66     |   | $ | 4.25 |   | 485,912 |   | $ | 4.50 |   |
|                              |        |                                |         |                                                               |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The weighted averageremaining life of the options outstanding at December 31, 2001 and 2002 was 65and 66 months, respectively.

 

In December 2000, theCompany issued a warrant to a corporate partner to purchase 49,805 shares ofcommon stock at an exercise price of $0.01 per share.  The warrant is exercisable for seven years following the date ofissuance.  The estimated fair value ofthe warrant was $104,000, which was expensed at the time of issuance.  In May 2002, this warrant was exercised.

 

F-17

----

 

1997 EMPLOYEE STOCK PURCHASE PLAN

 

In February 1997, theCompany adopted the 1997 Employee Stock Purchase Plan (the “Purchase Plan”),which permits eligible employees of the Company to purchase shares of commonstock, at semi-annual intervals, through periodic payroll deductions.  Payroll deductions may not exceed 10% of theparticipant’s base salary, and the purchase price per share will not be lessthan 85% of the lower of the fair market value of the common stock at eitherthe beginning or the end of the semi-annual intervals.  The Company has authorized and reserved100,000 shares of common stock for issuance under the Purchase Plan.  There were 52,864, 41,504 and 17,594 sharesavailable at December 31, 2000, 2001 and 2002, respectively.

 

In 1996, $78,375 was advanced to certain employees and a director ofthe Company for their exercise of stock options.  Such amounts are classified as Notes Receivable fromStockholders.

 

8. INCOME TAXES

 

Significant components of the Company’s deferred tax assets as ofDecember 31, 2001 and 2002 are shown below. A valuation allowance has beenestablished to offset the deferred tax assets, as realization of such assets isuncertain.

 
|                                         |   | **December  31,** |       |
|----------------------------------------------|--------|-------------------|------------|
|                                         |   | **2001**          |       | **2002** |   |
|                                         |   |              |       |   |   |
| Deferred tax  assets:                        |   |              |       |   |   |
| Net operating  loss carry forwards           |   | $                 | 20,750,000 |   | $ | 21,515,000 |   |
| Research and  development credits            |   | 2,642,000         |       | 2,669,000 |   |
| Capitalized  research and development        |   | 678,000           |       | 714,000 |   |
| Depreciation                                 |   | 189,000           |       | 167,000 |   |
| Inventory  reserve                           |   | 613,000           |       | 417,000 |   |
| Other, net                                   |   | 346,000           |       | 366,000 |   |
|                                         |   |              |       |   |   |
| Total deferred  tax assets                   |   | 25,218,000        |       | 25,848,000 |   |
| Valuation  allowance for deferred tax assets |   | (25,218,000       | )          | (25,848,000 | ) |
| Net deferred  taxes                          |   | $                 | —     |   | $ | — |   |

 

As the Company was part of a consolidated group prior to the change inownership in July 1995, all tax loss and tax credit carryforwards up to thedate of change in ownership have been reported by the previous consolidatedgroup. All tax loss and tax credit carryforwards reflected in the accompanyingfinancial statements reflect activity only for the period beginning July 1995and ending December 31, 2002.

 

At December 31, 2002, the Company has federal and state tax net losscarryforwards of approximately $53,415,000 and $44,140,000, respectively. Thefederal tax loss carryforwards will begin to expire in 2010.  Approximately $1,080,000 of the state taxloss carryforwards expired in 2002, and will continue to expire in 2003 unlesspreviously utilized. At December 31, 2002, the Company also has federal andstate research tax credit carryforwards of approximately $2,133,000 and$536,000, respectively, which will begin to expire in 2010 unless previouslyutilized.

 

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

 

F-18

----

 

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 abilityto   utilize its existing tax loss andtax credit carryforwards.

 

9.  SEGMENT AND GEOGRAPHICINFORMATION

 

*SegmentInformation:* Prior to 2002, the Company operated in onebusiness segment, the Visualization Technology business.  Beginning in 2002, the Company reportsrevenue and certain operating expense information to the chief operatingdecision maker for its two operating segments, which are determined on the typeof customer or product. These segments consist of (1) the Obesity SurgeryManagement Services business and (2) Visualization Technology 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 development expenses.  Other operating expenses, including salesand marketing expenses and general and administrative expenses, are notallocated 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 year ended December 31,2002 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 | ) |

 

F-19

----

 

The Company reports assets on a consolidated basis to the chiefoperating decision maker and all assets are located within the United States.

 

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

 
|          |   | **2000**  |            | **2001**  |   | **2002**        |   |
|---------------|--------|-----------|-----------------|-----------|--------|-----------------|--------|
| United States |   | $         |  2,443,773 |      | $      |  5,015,113 |   | $ |  7,513,804 |   |
| Europe        |   | 4,095,440 |            | 4,311,377 |   | 3,592,326       |   |
| Total         |   | $         |  6,539,213 |      | $      |  9,326,490 |   | $ |  11,106,130 |   |

 

Sales to individual customers exceeding 10% or more of annual revenueswere as follows: in 2002 one customer accounted for 14% of revenues, in 2001three customers accounted for 22%, 18% and 10% of revenues, and in 2000 twocustomers accounted for 51% and 23% of revenues.

 

10.  SUBSEQUENT EVENT

 

On March 3, 2003 theCompany sold 1,000,000 shares of newly issued Series A Convertible PreferredStock (Series A Stock) to two accredited investors through a private placementfor gross proceeds of $950,000.  Theshares are convertible at any time into common shares on a one-for-one basis,subject to adjustment, accrue annual dividends, payable only if and whendeclared by the Company, at the rate of $.01425 per share and have aliquidation 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.  Suchspecified redemptions would be at prices of $2.67 to $2.90 per share.  As long as the Series A Stock isoutstanding, the Company will require the approval of the Series A Stockholdersto undertake various actions including a) sell common shares for less than$2.00 per share, b) revise terms of corporate governance, c) exceed certaincapital 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.

 

11. QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)

 

The following is a summary of the results of operations for the yearsended December 31, 2001 and 2002:

 
|                |   | **2001**     |      |
|---------------------|--------|--------------|-----------|
|                |   | **March 31** |      | **June 30** |   | **September  30** |   | **December  31** |   |
| Revenues            |   | $            | 1,932,532 |   | $ | 2,072,069 |   | $ | 2,281,486 |   | $ | 3,040,403 |   |
| Cost of revenues    |   | $            | 1,531,906 |   | $ | 1,731,686 |   | $ | 1,353,226 |   | $ | 1,788,522 |   |
| Net loss            |   | $            | (940,214  | ) | $ | (1,271,695 | ) | $ | (870,755 | ) | $ | (139,765 | ) |
| Net loss per  share |   | $            | (0.19     | ) | $ | (0.26 | ) | $ | (0.18 | ) | $ | (0.03 | ) |

 
|                |   | **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 | ) |
| Net loss per  share |   | $            | (0.08     | ) | $ | (0.08 | ) | $ | (0.06 | ) | $ | (0.02 | ) |

 

F-20

----

 

SCHEDULE II

 

VISTA MEDICALTECHNOLOGIES, INC.

 

VALUATION AND QUALIFYINGACCOUNTS

 
| **Reserve for  Obsolete and  Unusable Inventory** |   | **Balance at  Beginning of  Period** |      | **Charged to  Costs and  Expenses** |   | **Deductions** |   | **Balance  at End  of Period** |       |
|---------------------------------------------------|--------|--------------------------------------|-----------|-------------------------------------|--------|----------------|--------|--------------------------------|------------|
|                                              |   |                                 |      |                                |   |           |   |                           |       |
| Year ended  December 31, 2000                     |   | $                                    | 2,619,070 |                                | $      | 787,821        |   | $                              | (1,161,143 | ) | $ | 2,245,748 |   |
| Year ended  December 31, 2001                     |   | 2,245,748                            |      | 71,375                              |   | (795,427       | )      | 1,521,696                      |       |
| Year ended  December 31, 2002                     |   | 1,521,696                            |      | 191,213                             |   | (668,125       | )      | 1,044,784                      |       |
|                                                   |        |                                      |           |                                     |        |                |        |                                |            |  |  |  |  |

 

 
| **Allowance  for  Doubtful Accounts** |   | **Balance at  Beginning of  Period** |   | **Charged to  Costs and  Expenses** |   | **Deductions** |   | **Balance  at End  of Period** |    |
|---------------------------------------|--------|--------------------------------------|--------|-------------------------------------|--------|----------------|--------|--------------------------------|---------|
|                                  |   |                                 |   |                                |   |           |   |                           |    |
| Year ended  December 31, 2000         |   | $                                    | 33,775 |                                | $      | 1,165          |   | $                              | (21,631 | ) | $ | 13,309 |   |
| 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                        |    |
|                                       |        |                                      |        |                                     |        |                |        |                                |         |  |  |  |  |

 

F-21

----