**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

**FORM 10-K/A**

**Amendment No. 2**

 

**ý****        ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934 (FEE REQUIRED)**

 

**For fiscal year ended December 31, 2003**

 

**OR**

 

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

 

**For the transition period from          to         .**

 

**Commission File Number:  0-22743**

 

**VISTA MEDICAL TECHNOLOGIES, INC.**

(Exact name of Registrant as specified in itscharter)

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

 

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

(Address of principal executive offices)

 

**(760) 603-9120**

(Registrant’s telephone number, including area code)

 

Securities registered pursuant toSection 12(b) of the Act:  **None**

 

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

 

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

 

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

 

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

 

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

 

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

 

DOCUMENTS INCORPORATED BY REFERENCE

 

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

 

**EXPLANATORY NOTE**

 

We are filing this Amendment to our Annual Report on Form 10-K for thefiscal year ended December 31, 2003 to restate our previously issuedfinancial statements for the year ended December 31, 2003 to reflect ourVisualization Technology business as a discontinued operation.  Such information is set forth in fullherein.  On April 15, 2004, wecompleted the sale of our Visualization Technology business as contemplated.

 

 

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**Vista Medical Technologies, Inc.Form 10-K/AFor the Fiscal Year Ended December 31, 2003**

 

**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       |   |
| Item 9A  | Controls and Procedures                                                                     |   |
|     |                                                                                        |   |
| Part III |                                                                                        |   |
| Item 10. | Directors and Executive Officers of the  Registrant                                         |   |
| Item 11. | Executive Compensation                                                                      |   |
| Item 12. | Security Ownership of Certain Beneficial  Owners and Management                             |   |
| Item 13. | Certain Relationships and Related  Transactions                                             |   |
| Item 14. | Principal Accountant Fees and Services                                                      |   |
|     |                                                                                        |   |
| Part IV  |                                                                                        |   |
| Item 15. | Exhibits, Financial Statement Schedules,  and Reports on Form 8-K                           |   |
|     | Signatures                                                                                  |   |
|     | Index to Consolidated Financial Statements                                                  |   |

 

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PART I

 

Forward Looking Statements

 

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

 

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

 

Item 1.BUSINESS

 

OVERVIEW OF OUR BUSINESS

 

We operate two business units. The Obesity Surgical and Medical Management Services business (operatedvia our wholly-owned subsidiary, VOW Solutions, Inc.), based in Carlsbad, CA,provides services to physicians and hospitals involved in the surgicaltreatment of morbid obesity.  Ourservices include management of our original product offering, the LaparoscopicBariatric Surgery Preceptorship, a comprehensive introduction to starting aminimally invasive gastric bypass surgical program.  We now offer, in addition, systems,consulting and program management services, which enable the efficientoperation of obesity surgery programs. The Visualization Technology business, based in Westborough, MA,develops, manufactures and markets products that provide information tophysicians performing minimally invasive general surgical, cardiac surgical andother selected endoscopic and interventional procedures.  Our technology products combine a headmounted display with video cameras to provide surgeons with critical visualinformation during complex minimally invasive procedures, and also incorporatethe benefit of viewing complementary information in a voice-controlled,picture-in-picture format, to facilitate real-time decision making duringsurgery.  The Visualization Technologybusiness also manufactures compact, high-resolution endoscopic cameras fororiginal equipment manufacturer customers and strategic partners.  On December 22, 2003 we signed anagreement to sell the Visualization Technology business to Viking Systems,Inc., (see pages 9 and10 for a description of the terms of the transaction),subject to the approval of our stockholders.

 

**Background to Obesity Surgery and MedicalManagement Services (VOW Solutions, Inc.)**

 

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

 

We believe that our VOW products and services can be instrumental inthe implementation and/or optimization of a hospital’s successful bariatricsurgery program.  The obesity epidemic isnot over; in fact, the rate of increase of severely obese Americans isaccelerating.  Obesity-relatedcomorbidities cost the United States healthcare system $102 billionannually.  Laparoscopic gastric bypasssurgery safely and effectively treats morbidly obese patients by allowing themto eliminate 96% of their comorbidities and average an 80% loss of excess bodyweight, within one year of surgery.  VOWSolutions’ complement of bariatric management and consulting services positionsa hospital to enter the field of bariatric surgery, as well as to optimize theoperation and efficiency of an existing program for future growth.

 

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**Background to Visualization TechnologyProducts**

 

***Minimally invasive surgery***

 

The development and subsequent widespread adoption of minimally invasivesurgical procedures have revolutionized many surgical fields, including generalsurgery, 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 invasive microsurgery is an extension of minimally invasivesurgery, characterized by greater complexity and precision.  Minimally invasive microsurgical procedureshave been made possible primarily by recent advances in medical technology.  These procedures are usually performed invery confined areas of the body, involve critical parts of the body, and oftenrequire dissection, reconstruction and removal of body parts.  As a result of the inherent complexityinvolved in these procedures, we believe that for surgeons to adopt theprocedures, they must have access to specialized instruments and technology,including technology which will provide them with better visualization of theprocedure being performed.  Examples ofminimally invasive microsurgery are emerging in general surgery and cardiacsurgery, as well as in the fields of gynecology and urology.

 

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

 

*Conventionaltreatments.*

 

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

 

*Minimallyinvasive microsurgery*.

 

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

 

*The VistaMedical solution*.

 

We believe that the generaltechnology required to drive renewed growth in complex minimally invasiveprocedures for general surgery is now being undertaken by many companies infields complementary to ours, for example, in surgical robotics, electrosurgeryand surgical instrument design.  Webelieve that our advanced visualization and information technology willcontribute to this renewed growth by providing the surgeon with enhanced depthperception when performing complicated, physically intricate tasks, and willprovide the surgeon with the ability to view additional information in a voice-controlled,picture-in-picture format, to facilitate real-time decision making during aprocedure.  We believe that conventional2-D visualization systems compromise the ability of a surgeon to maneuver,especially in complex reconstructive surgery, and that our natural 3-D picturewill provide the surgeon with an advantage in these cases.

 

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**OurBusiness Strategy**

 

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

 

When we founded our company in 1993 it was primarily to developadvanced visualization technologies for complex minimally invasive surgicalprocedures and it was through the application of this technology inlaparoscopic gastric bypass surgery that we subsequently developed ourportfolio of consulting products and services for the initiation, operation andmanagement of Obesity Surgery Programs. Since early 2003, our Visualization Technology business, located inWestborough, Massachusetts, and our Obesity Surgery and Medical Management Servicesbusiness unit (now incorporated in a wholly owned subsidiary VOW Solutions,Inc.), located in Carlsbad, California, have functioned as individual businessunits.  We intend to become a nichehealth care services pure play, focused on the disease state management ofchronic or morbid obesity.  The businessstructure of the company, after the planned divestiture of the VisualizationTechnology business, will be as follows:

 

 

**Business Overview**

 

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

 

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We believe that, to meet the demand for the present form of obesitysurgery, and to offer patients the choice of many new therapies which areeither recently introduced or in development, requires a rapid expansion ofhigh quality surgical programs and related patient medical and wellnessservices.  This comprehensive approach isnot the present organizational norm and we believe, based on both marketunderstanding and research, that there is an opportunity to leverage Vista’spresent expertise, market position and relationships, into a turnkey programmanagement solution (the VOW Centers.) This represents a natural extension of our current business model intothe direct management of the infrastructure of obesity surgical care via anational network of company-owned clinical programs, established initially inpartnership with hospitals, surgeons and physicians, and, in due course, withinsurance companies, managed care and employers.

 

**Market Opportunity**

 

Obesity is defined as an excessively high amount of body fat or adiposetissue in relation to lean body mass. Weight standards are most often determined by the Body Mass Index (BMI),a measure expressing the ratio of weight-to-height.  Individuals with a BMI of 25 to 29.9 areconsidered overweight; a BMI of 30 or more is considered obese, and 40 or moreis very severely, or morbidly, obese. The Centers for Disease Control and Prevention (CDC) speak of “anepidemic of obesity” in the United States, with prevalence increasing to 24% ofthe adult population in 2003, from 12% in 1991. The increase in obesity cuts across all ages, racial and ethnic groups,and both genders.  Obesity, which studiesshow is associated with an increased risk of diabetes, as well as other seriousco-morbidities, is a major cause of mortality. It is estimated that 600,000 US adults die each year from causes relatedto obesity.  The Surgeon-General, in aCall to Action, estimates that the economic cost of obesity in the UnitedStates was about $117 billion in 2000.  Arecent Rand Corp. study found that the health care costs linked to obesity arenow greater than those related to smoking or alcohol abuse and “is like aging20 years” when measured by the onset of chronic medical problems.  The fact that obesity is a major healthproblem, and is increasing at an alarming rate has been well publicized in themedia.  Also, the IRS, in a recentruling, declared that obesity is a disease in its own right and that the costof physician-directed weight loss programs may be included as a deductiblemedical expense.  Given that medicalexpenses may be deducted only to the extent that they exceed 7.5% of adjustedgross income, and that less than 5% of taxpayers deduct medical expenses, theruling is probably significant more as an indicator of governmental concernover obesity than as a financial incentive to individuals.  As a further example of this, the federalagency in charge of Medicaid and Medicare is conducting a review to determinewhether it should consider obesity as a disease.  However, the principle that obesity itself isa disease, and not merely a symptom or precursor of a disease, is still acontentious issue, and such a classification is resisted by private insurers.

 

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

 

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

 

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

 

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**Our Strategy**

 

Our goal over the next five years (2004-2008) is to become a leadingprovider of consulting and management services to bariatric surgical programsthus becoming a national leader in the provision of state-of-the-art care tothe morbidly obese patient seeking a surgical solution to effectively lose, andmaintain the loss of, an adequate amount of weight.  We then plan to leverage the market platformthat our centers provide to extend our provision of care to obese patients whoare not candidates for surgery, and to market our consulting services andback-office systems capability to other bariatric surgical programs.  We intend to realize these objectives throughthe execution of the following strategies:

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

***Institute best-practice surgical protocols***.  Our experience with the LaparoscopicBariatric Surgical (LBS) Preceptorship has permitted us, under the direction ofour Clinical Faculty, to offer the most comprehensive surgical training coursein state-of-the-art laparoscopic gastric bypass surgery which is availableanywhere.  This training program will beavailable to surgeons who affiliate with VOW; the training process will also includesubsequent proctoring by our faculty during cases.

 

***Maximizing operating efficiencies***.  This is key to leveraging economies of scale,and we will devote considerable resources to the further development of astandardized operating system.  Also,many of the functions of a bariatric surgical program are common and can becentralized for efficiency and cost-saving reasons.  We believe that independent programs willneed to generate very high patient volumes to justify the infrastructurenecessary to operate efficiently.  Forexample, we know of existing programs with case volumes in the 750-1000 peryear which have between 30 and 50 staff. As many as 75% of these employees are performing functions which thatwould be handled centrally in the VOW model. We believe that in a very short time low volume programs will simply beunable to compete effectively with high-volume centrally managed programs.

 

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

 

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Our patients come from a group that has suffered psychologicallybecause of their illness, often at the hands of the medical profession.  We have learned by our experience to datethat the provision of a sensitive and supportive environment is vital tosuccess.  At the same time, the processtowards surgery must be efficient:  Thereare many steps in the process, and it is easy for patients to become lost or discouragedif the system, and the staff dealing with them, is haphazard in itsapproach.  Standardized systems acrossall managed programs are designed to shepherd patients through the process withEfficient Empathy.

 

***Develop and leverage our consulting business***.  Our consulting business, originally based onprovision of clinical training in laparoscopic gastric bypass surgery, hasexpanded to include management, operational, financial and marketingservices.  It is this business that hascreated our reputation within bariatrics and has given us a total customer baseof approximately 80 hospitals (including some 60 LBS Centers).  We are currently developing new and valuableproducts to meet the emerging needs of the maturing developing market.  We expect our consulting business to be afertile source of referrals for VOW partnerships.

 

***Build our consumer business***.  Gastric bypass patients have a lifelong needfor *specialized* vitamins and nutritionalsupport.  We are already marketingVistaVitamins as a specific solution to the bariatrics-vitamin issue and intendto increase marketing and distribution efforts and extend the productline.  With one million post-surgicalgastric bypass patients by 2005, we estimate that the total available annualmarket is $500 million.

 

**Our Solution:  VOW Centers (VistaObesity to Wellness Centers)**

 

The number of physicians who are treating bariatric patients isgrowing, in both the medical and the surgical arena.  For example, it is estimated that there arenow between 1,200 to 1,500 active bariatric surgeons.  However, the expertise essential for high-volumepatient acquisition, and the infrastructure required for quality patient careat these levels are often beyond the scope, or the willingness to invest, ofmany programs.  Even when bariatriccenters are established in conjunction with a supportive hospital, the properstaffing, knowledge and time required to efficiently market, educate, collect acomprehensive medical and diet history, verify insurance and obtain thenecessary authorizations can be a management challenge, one that many simplycannot handle cost-effectively.  Many ofthese functions are much more efficiently and effectively handled in acentralized fashion (where one centralized department handles the work fordozens of programs).  A focused team ofprofessionals with centralized support is necessary to properly handle all theunique and multifaceted issues involved in securing and serving large numbers(400 — 500 cases per year) of bariatric patients.

 

It is for this reason that we have seen increasing interest fromhospitals and physicians in an outsourced management solution which bringstogether the resources necessary for establishment and/or operation ofsuccessful medical and surgical bariatric programs.  Our plan is to offer ongoing hands-onmanagement support to such medical providers by delivering a cost-effectiveoutsourced solution to the provision of multi-disciplinary medical and surgicalcare to a high volume of morbidly obese patients.

 

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

 

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

 

**VOW Consulting Services**

 

**Our Solution:**

 

Our consulting services are organized as specific “products” which offerclients a basic standardized set of deliverables, with several customizableoptions.  Our primary consulting productsare as follows:

 

*Blueprint*

 

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

 

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

 

*Implementation Consulting Service*

Our implementation team spends up to 2 days on-site educating ahospital and program staff on the five fundamental phases of a successfulbariatric surgery program.  Thispreparation emphasizes patient introduction, the pre-admission/operativeperiod, the peri-operative period, post-operative recovery and discharge, andpost-discharge care.  Included in theservice are templates, tools and training components integral to the ongoingviability of a program.  These includeinformed consent, sensitivity and in-patient/office training, insuranceauthorization strategies, marketing tools, patient education, diet counseling,physical therapy and exercise plans and support group coaching.  Subsequent to this service, a program’s staffwill be educated in delivering efficient, best-practice care in a sensitiveenvironment.

 

*Laparoscopic Bariatric Surgery (LBS)Preceptorship*

The LBS Preceptorship allows a hospital team to more quickly implementminimally invasive laparoscopic gastric bypass surgery into a hospital and surgicalpractice.  The 3-4 day course includesclinical observation, laboratory training, surgical lecture and didactictraining that incorporates cadaver experience. The Preceptorship includes observation by the entire OR team (primarysurgeon, first assistant, surgical technician and nursing circulator) and is aCME and CEU accredited event.

 

*Optimization Consulting Service*

VOW’s Optimization Consulting Service concentrates on improving anexisting bariatric surgery program’s efficiency, effectiveness and profitability.  Recommendations focus on optimizing thefinance, operations and marketing of a bariatric program.  The work-up of a program’s financialperformance will facilitate an institutional ability to resolve issuespertaining to revenue, expense attribution, capital investments and payorenvironment.  Operational recommendationstarget a patient’s migration through the program and improved efficiencybetween surgeons and the hospital.  Thecomprehensive marketing assessment analyzes referral patterns, per-patient costof acquisition and overall effectiveness.

 

*Marketing Materials*

The Bariatric Surgery Marketing Materials help to create and/or enhancea hospital’s identity as a Bariatric Center, lending credibility and fosteringcommunity support.  The media toolsenable a hospital to capitalize on varying marketing venues including publicspeaking, print publications, radio and television.  The package includes a customizable “Decisionof a Lifetime” video and television advertisement, a 60-second radioadvertisement, a print advertisement, a patient brochure and a communitylecture template on PowerPoint.  Themessage focuses on the experience of a diverse group of actual patients, theirlife-long struggle with obesity, and the satisfaction they have realizedthrough gastric bypass surgery.

 

**VisualizationTechnology Business**

 

Terms of transaction to sell the Visualization Technology Business

 

We entered into an Asset Purchase Agreement with Viking Systems Inc.regarding the sale of all the assets of the Visualization Technology Businesson December 22, 2003, subject to the approval of our stockholders.  The transaction closed on April 15,2004.  Viking and its principals are notaffiliated with us; and our officers, directors, and, to our knowledge, principalstockholders are not affiliated with Viking. Viking formerly conducted a software business, but those operations wereunsuccessful.  Recently, a group ofinvestors purchased control of Viking, with the approval of Viking’s Board ofDirectors, and Viking’s current business plan, as stated in its public filingswith the SEC, is to engage in the medical device market.

 

The most material terms of the Asset Sale are as follows:

 

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

 

•                  Viking paid us$132,000 of cash at closing.

 

•                  Viking issued tous 3,054,000 shares of its common stock representing approximately ten percent(10%) of the fully diluted shares of Vikings stock.

 

•                  We entered intoa License Agreement with Viking pursuant to which we will exclusively licenseto Viking all intellectual property and product rights used in operation of thelicensed business.  In exchange for thislicense grant, Viking will pay us royalties over the next five (5) years basedon sales of the licensed products by Viking. The License Agreement contain minimum royalties of $150,000 in year one,$300,000 in each of years two, three and four, and

 

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$375,000 in year five.  Theroyalties payable by Viking are capped at a maximum of $4,500,000 in theaggregate over the five year period.  Wewill retain ownership of all intellectual property and product rights under theLicense Agreement until at least the minimum royalty obligations have beensatisfied, at which point we will transfer ownership to Viking.

 

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

 

We operated theVisualization Technology business entirely out of ourWestborough, Massachusetts location.  Asa result, this entire facility, less a few selected assets of minimal dollarvalue, will be transferred to Viking in connection with the Asset Sale.

 

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

 

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

 

**Ourtechnology:**

 

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

 

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maximizes hand-eye coordination without strain.

 

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

 

***Head mounted display***

 

The head mounted display was originally developed for criticalapplications in military aerospace by Kaiser Aerospace.  We subsequently determined that the headmounted display was the optimal solution to the challenge of displayinginformation during minimally invasive microsurgery.  The fundamental technology and human factorsexperience incorporated in our surgical head mounted display is the result ofsubstantial investment and development by Kaiser Aerospace, originally formilitary applications.  This humanfactors knowledge, derived from many years of analysis of the displaycharacteristics which enable pilots performing critical physical tasks tosimultaneously absorb and react to crucial information, is a key element in ourhead mounted display design.  Kaiser’soriginal know-how and technical knowledge have been transferred to us under ourdevelopment agreement with Kaiser Electro-Optics, Inc., a subsidiary of KaiserAerospace.  We have performed significantadditional development work, and have proprietary rights, in the surgical headmounted display 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, the surgeoncan also perform surgery “in-line”—meaning with the eyes, hands, instrumentsand subject in-line.  In-line surgerycannot be performed when the surgeon is observing the anatomy on aremotely-positioned video monitor.

 

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

 

***Three-dimensional image acquisition***

 

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

 

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

 

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

 

***Information management***

 

Medicine is an information rich discipline, but the ability of a surgeonto obtain relevant information in real-time during a procedure has not beendeveloped to the levels attained, for example, in military aviation.  The head mounted display is designed to givethe surgeon real-time access on demand to critical information integrated withthe anatomical images generated by our camera systems.  In addition to real-time display, theinformation can be stored or transmitted within the hospital or transmitted toremote locations for training, advisory or administrative purposes.  The applications software to control thisflow of information is a key element in our long-term product strategy whichpositions visualization within the context of a total information managementsystem for the surgeon.

 

**Visualization Technology Products**

 

We develop products based on our core technology and product platformdescribed above, that are customized for the specific general surgical, cardiacsurgical and other procedures to which they are directed.  Our product lines are as follows:

 

***EndoSite:  3-D visualization andinformation system for general surgery and other complex endoscopic procedures***

 

The most recent application of our platform technology is complexprocedures in general surgery.  Our firstpublic demonstration of this platform was in October 2002, principallytargeted at the emerging procedure of minimally invasive gastric bypass tocontrol morbid obesity, but also applicable to many emerging minimally invasiveprocedures. Our advanced visualization system is designed to be modular andconsists of the following major components:

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

 

All necessary 510(k) clearances which are required to market thecomponents of the EndoSite have been received.

 

***OEM Endoscopic Cameras***

 

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

 

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

 

**Strategic Alliances**

 

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

 

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

 

***In June 2001, we entered into an agreement with EthiconEndo-Surgery, Inc. (EES) providing that the companies will work together indeveloping the surgical weight reduction market.  This alliance primarily involves sales 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 in certaintraining programs sponsored by the Company for the benefit of its customerswith no obligation by the Company or its customers to purchase***anyEES equipment. This original agreement expiredin November 2003, and a new agreement with EES was entered into for thedevelopment of optimization programs, and is currently in force untilDecember 1, 2004.

*** ***

***Kaiser Electro-Optics***

 

In July 1995, we entered into a Manufacturing Supply Agreementwith Kaiser Electro-Optics, a subsidiary of Kaiser Aerospace.  This agreement was then amended inDecember 1997.  InDecember 1997, we entered into a Technology Strategic Alliance: Memorandumof Understanding with Kaiser Aerospace, which superseded a similar agreemententered into with Kaiser Electro-Optics in July 1995.  The technology strategic alliance providesthat Kaiser Aerospace will cooperate with us in joint development programsrelated to our current generation head mounted display to be negotiated on anarms-length and project-by-project basis for a five-year term.  We will also contract with KaiserElectro-Optics for development and manufacturing services related to the headmounted display, including initial production quantities.  The manufacturing supply agreement withKaiser Electro-Optics provides that they will be our preferred supplier for afive-year period for not less than 75% of our requirements for the opticalsubassembly of the head mounted display, provided that pricing and other termsare competitive and mutually agreed upon. Under the technology strategic alliance with Kaiser Aerospace, theygranted us a right of first refusal to exclusively license independentlydeveloped new technology or devices for medical applications.  Reciprocally, in December 1997, weentered into a License Agreement with Kaiser Aerospace under which weexclusively licensed to Kaiser Aerospace the right to manufacture anddistribute industrial and professional versions of our head mounted display inmarket segments other than medicine in return for an up-front payment and royaltiesbased on sales.

 

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

 

**License Agreements**

 

We have licensed aspects of our technology from third parties.

 

***McKinley Optics, Inc.***

 

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

 

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

 

***Fuji***

 

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

 

***Carl Zeiss***

 

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

 

**Intellectual property protection**

 

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

 

Our future success will depend, in part, on our ability to continue todevelop patentable products, enforce our patents and obtain patent protectionfor our products both in the United States and in other countries.  The patent positions of medical devicecompanies, however, are generally uncertain and involve complex legal andfactual questions.  We are not certainthat patents will issue from any patent applications owned by or licensed to usor that, if patents do issue, the claims allowed will be sufficiently broad toprotect our technology.  In addition, wecannot assure you that any issued patents owned by or licensed to us will notbe challenged, invalidated or circumvented, or that the rights grantedthereunder will provide us with competitive advantages.

 

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

 

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

 

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countries relating to such research or development.

 

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

 

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

 

**Governmental Regulation: 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’s participating surgeons andhospitals are also subject to a wide variety of laws and regulations that couldaffect the nature and scope of their relationships with us.

 

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

 

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

 

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

 

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

 

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

 

**Governmental Regulation: Medical Devices**

 

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

 

***Device Classes***

 

In the United States, medical devices are classified into one of threeclasses, Class I, II or III, on the basis of the controls deemed by the FDA tobe necessary to reasonably ensure their safety and effectiveness.  Our products to date have either beenclassified as Class I or Class II devices.

 

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

 

***Device approval***

 

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

 

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

 

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

 

***Investigational device exemption application***

 

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

 

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

 

***Foreign requirements***

 

Sales of medical device products outside the United States are subjectto foreign regulatory requirements that vary from country to country.  The time required to obtain approvalsrequired by foreign countries may be longer or shorter than that required forFDA clearance, and requirements for licensing may differ from FDArequirements.  Our failure to comply withregulatory requirements would jeopardize our ability to market ourproducts.  The current regulatoryenvironment in Europe for medical devices differs significantly from that inthe United States.  Since June 1998,all medical devices sold in the European Union must bear the CE mark.  Devices are now classified by manufacturersaccording to the risks they represent with a classification system giving ClassIII as the highest risk devices and Class I as the lowest.  Once the device has been classified, themanufacturer can follow one of a series of conformity assessment routes,typically through a registered quality system, and demonstrate compliance to a“European Notified Body.”  After that,the CE mark may be applied to the device. Maintenance of the system is ensuredthrough annual on-site audits by the notified body and a post-marketsurveillance system requiring the manufacturer to submit serious complaints tothe appropriate governmental authority.

 

**Marketing and Sales**

 

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

 

***International sales***

 

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

 

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**Competition**

 

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

 

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

 

**Clinical Advisory Boards**

 

We consult frequently 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, 2004, we had 32 full-time employees, 13 in ourbariatric service business, of whom two hold an advanced degree, and 19 in ourvisualization technology business.  Noneof our employees is represented by a collective bargaining agreement, nor havewe experienced work stoppages.  Webelieve our relations with our employees are good.

 

**Web Site Access to SEC Filings**

 

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

 

**Recent Developments**

 

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

 

In May 2004 we sold to a group of accredited investors 5,454,544 unitsof our securities for $0.85 per unit, each unit consisting of one share ofcommon stock and one warrant to purchase one-half share of common stock, foraggregate gross proceeds of approximately $4,545,000 or $4,100,000 net ofexpenses.  The warrants are exercisableat a price of $0.95 per share and expire in May 2009.  The proceeds are to be used to fund ourobesity disease state management business unit. As part of the May 2004 unit sale, we issued warrants to the placementagent to purchase up to 818,181 shares of our common stock.  545,454 of these warrants are exercisable ata price of $1.02 per share and the remaining 272,727 warrants are exercisableat a price of $0.95 per share.  Thewarrants expire in May 2009.

 

In June 2004 we amended our Series A Certificate of Designationsto allow us the right to issue equity securities for a price under $2.00.  For that right, the Series A holders received1,400,000 shares of Viking common stock that we held valued at $28,000.  As part of the amendment, we were required toredeemed 85,000 Series A Shares for $200,000. In addition, we have the right to redeem an additional 300,000 at anytime on or before January 15, 2006 in exchange for $500,000. If we chooseto redeem the additional 300,000 Series A Shares, we will use cash that wouldotherwise fund our business operations.

 

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We received notification on March 1, 2004 of a Nasdaq StaffDetermination indicating that we fail to comply with the Stockholders’ Equityrequirement for continued listing set forth in Marketplace Rule 4310(c)(2)(B),and that our common stock is, therefore, subject to delisting from the NasdaqSmallCap Market.  We requested a hearingbefore a Nasdaq Listing Qualifications Panel to review the Staff Determination,which stayed the delisting of our common stock pending the Panel’sdecision.  On May 7, 2004 we received adecision from the Nasdaq Listing Qualifications Panel to continue the listingof our common stock on the Nasdaq SmallCap Market pursuant to the followingexceptions:  On or about June 1,2004 we must have made a public filing with the SEC and Nasdaq includingdisclosure that we raised at least $3,600,000 in additional equity, net ofexpenses, as well as a description of the completed event or transaction(s)that enabled us to satisfy the $2,500,000 shareholders’ equity requirements; anaffirmative statement that, as of the date of the report, we believe we haveregained compliance with the $2,500,000 shareholders’ equity requirement basedupon the event or transaction(s) referenced therein; and a disclosure that thePanel will continue to monitor our ongoing compliance with the minimumshareholders’ equity threshold until we have evidenced compliance with thatrequirement via a publicly filed balance sheet and demonstrated an ability tosustain compliance with the minimum shareholders’ equity requirement over thelong term.  With the closing of ourrecent financing, we achieved these requirements and made the required filings.In addition, on or before August 16, and November 15, 2004 we mustfile Forms 10-Q for the quarters ending June 30, and September 30,2004, respectively, with the SEC and Nasdaq, evidencing our continued compliancewith the $2,500,000 shareholders’ equity requirement.  In order to fully comply with the terms ofthis exception, we must be able to demonstrate compliance with all requirementsfor continued listing on the Nasdaq SmallCap Market.  If we are unable to do so, our securitieswill be delisted from the Nasdaq SmallCap Market.

 

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RISKS AND UNCERTAINTIES

 

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

 

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

 

At December 31, 2003, we had cash, cash equivalents and short-terminvestments of $636,000.  We believe thatthese cash resources, together with cash from operations and the additionalequity raised in February and May 2004, will not be sufficient resourcesto operate our business beyond June 2005.  This cash requirement is very serious.  We need additional funding to meet currentcommitments and continue development of our business.  Our current cash resources will only allow usto continue our business at its current levels for our immediate needs.  If we do not receive additional funding, ourability to continue as a going concern cannot be assured.  We are also dependent on the divestiture ofthe Visualization Technology business to reduce operating costs and providecash.  This divestiture closed inmid-April, after obtaining the approval of our stockholders.

 

**Failure to divest our Visualization Technology business will create aserious cash drain on our company.**

 

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

 

**We are not in compliance with therequirements to maintain the listing of our common stock on The Nasdaq SmallCapMarket and have received notification of de-listing, which could negativelyaffect the liquidity of our stock and our ability to raise capital.**

 

The quantitative standards for continued listing on the Nasdaq SmallCapMarket requires a company to have stockholders’ equity of at least $2,500,000(or satisfy alternative requirements). Failure to comply with these requirements subjects a company tode-listing proceedings.  We receivednotification on March 1, 2004 of a Nasdaq Staff Determination indicatingthat we fail to comply with the Stockholders’ Equity requirement for continuedlisting set forth in Marketplace Rule 4310(c)(2)(B), and that our common stockis, therefore, subject to delisting from the Nasdaq SmallCap Market.  We requested a hearing before a NasdaqListing Qualifications Panel to review the Staff Determination, which stayedthe delisting of our common stock pending the Panel’s decision.  On May 7, 2004 we received a decision fromthe Nasdaq Listing Qualifications Panel to continue the listing of our commonstock on the Nasdaq SmallCap Market pursuant to the following exceptions:  On or about June 1, 2004 we must havemade a public filing with the SEC and Nasdaq including disclosure that weraised at least $3,600,000 in additional equity, net of expenses, as well as adescription of the completed event or transaction(s) that enabled us to satisfythe $2,500,000 shareholders’ equity requirements; an affirmative statementthat, as of the date of the report, we believe we have regained compliance withthe $2,500,000 shareholders’ equity requirement based upon the event ortransaction(s) referenced therein; and a disclosure that the Panel willcontinue to monitor our ongoing compliance with the minimum shareholders’equity threshold until we have evidenced compliance with that requirement via apublicly filed balance sheet and demonstrated an ability to sustain compliancewith the minimum shareholders’ equity requirement over the long term.  With the closing of our recent financing, weachieved these requirements and made the required filings. In addition, on orbefore August 16, and November 15, 2004 we must file Forms 10-Q forthe quarters ending June 30, and September 30, 2004, respectively,with the SEC and Nasdaq, evidencing our continued compliance with the$2,500,000 shareholders’ equity requirement. In order to fully comply with the terms of this exception, we must beable to demonstrate compliance with all requirements for continued listing onthe Nasdaq SmallCap Market.  If we areunable to do so, our securities will be delisted from the Nasdaq SmallCapMarket. The delisting of our common stock from the Nasdaq SmallCap Market maymaterially impair our stockholders’ ability to buy and sell shares of ourcommon stock and could have an adverse effect on the market price of, and theefficiency of the trading market for, our common stock.  In addition, the delisting of our commonstock could significantly impair our ability to raise capital should we desireto do so in the future.  The continuedlisting of our common stock on the Nasdaq SmallCap Market is therefore veryimportant to us.

 

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**As a company, we do not have direct experience in the ownership andmanagement of health care service businesses**.

 

As a company we do not have direct experience in the management ofbariatric surgical programs.  We havebeen involved in the development of bariatric surgical programs since 2000, buthave never directly managed these programs. As such, we have only a limited and indirect operating history uponwhich an evaluation of our prospects can be based.  Our prospects therefore, must be consideredin light of the risks, expenses and difficulties frequently encountered bycompanies in their early stages of development, particularly when involved innew and rapidly evolving markets.  Toaddress these risks, we must, among other things, respond to competitivedevelopments and attract, retain and motivate qualified staff.  There can be no assurance that we will besuccessful in addressing such risks or in implementing our businessstrategy.  There can be no assurance thatwe will be able to achieve or sustain revenue growth or profitability.

 

**Roll-out of our VOW Centers depends on our entering into agreementswith hospitals and surgeons; the time to conclude these agreements may beextended and thereby delay or prevent the implementation of our strategy.**

 

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

 

**We may need additional funding for our future operating plans beyondthat currently contemplated.  These fundsmay not be available on acceptable terms, if at all.**

 

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

 

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

•                  the speed withwhich we can execute our plan;

•                  the levels ofreimbursement for procedures performed;

•                  the extent ofcompetition.

 

**We have a history of losses and may notbecome profitable.**

 

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

 

**The terms of our March, 2003,preferred stock financing confer senior rights on the holders of Series AConvertible Preferred Stock, and these rights may impair the interests of ourcommon stockholders or impact our results of operations.**

 

We issued 1,000,000shares of our Series A Convertible Preferred Stock (the “Series A Shares”) inMarch, 2003, which were created pursuant to the terms of a Certificate ofDesignations, for an aggregate of $950,000 in cash.  In connection with this financing, thepurchasers of Series A Shares were granted several significant rights senior tothe rights of holders of our common stock. Among other rights, in the event of a liquidation, dissolution orwinding up of our company (including consolidations, mergers or other sales),holders of Series A Shares will be entitled to receive up to $3.80 per shareheld by them, in preference to any distribution to the holders of commonstock.  Also, pursuant to the Certificateof Designations, we must obtain the consent of the holders of at least two-thirdsof the outstanding Series A Shares in order to undertake certain actions,including capital expenditures and the issuance of securities.  Additionally, for so long as any Series AShares remain outstanding after three hundred ninety (390) days following theinitial issuance of any Series A Shares, the holders of Series A Shares will beentitled to elect the greater of (i) two members of our Board of Directors or(ii) twenty-five percent (25%) of the total members of our Board ofDirectors.  As a result, in the event wedo not achieve the criteria necessary for us to redeem some or all of theSeries A Shares (e.g., a sale of all or a portion of our VisualizationTechnology business), the holders of Series A Shares will have the right tocontrol at least one-fourth of the seats on our Board of Directors.

 

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

 

The holders of Series A Shares are also entitled to require us toregister their shares.  We may berequired to register their shares on Form S-3 within 30 days after request, andin any event prior to four hundred (400) days following the initial issuance of

 

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Series A Shares.  Thisregistration will consume management time and effort as well as some cashresources.  We have not yet registeredthese shares and may be subject to monetary penalties.

 

**We need to increase market awareness and acceptance of our products andservices.**

 

To our company’s knowledge, the comprehensive services offered by ourVOW Solutions business Centers have not been available to date on a nationallevel.  In order to accomplish ourstrategic and business plans, we will have to quickly and effectively increasemarket awareness of our services and convince doctors, hospitals and patientsof the benefits of our services.  Amongother things, this will require that we:

 

•                  increaseawareness of the availability of our services;

•                  strengthen ourbrand name to combat competition;

•                  continue toupgrade and expand our services; and

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

 

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

 

**After establishing VOW Centers, we must continue to prove our valueproposition.**

 

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

 

**The provision of health care services is subject to considerableregulation by state and federal agencies.**

 

The Centers will need to comply with many laws and regulations, bothstate and federal, which govern the provision of health care services.  If they fail to comply with any such laws andregulations, then the penalties involved could be serious, time-consuming formanagement and expensive.  Inexperiencein health care services could contribute to an inadvertent breach of laws orregulations.

 

**We operate in a competitive market; new technologies, procedures, orpharmaceuticals could radically change the modality of treatment of morbidobesity and negatively impact the economics of our obesity surgery business**.

 

The market for products and services that address obesity iscompetitive and new offerings and technologies are becoming availableregularly.  We are aware of severaldevelopments, primarily involving nerve stimulation or balloon technology,which may come to the market in the next few years.  These devices would be implanted or placed ina relatively simple endoscopic procedure. If they prove to be more effective than gastric bypass surgery in curingmorbid obesity, then the economic structure of the industry and the Centerscould be negatively impacted.  Also, manypharmaceutical companies are researching drug therapies for combatingobesity.  If they prove successful infinding a more effective solution for morbid obesity than gastric bypasssurgery, then demand for surgery is likely to decline substantially.  We cannot guarantee that we will competesuccessfully against our current or potential competitors, especially thosewith significantly greater financial resources or brand name recognition.

 

**If we fail to retain our key personnel and hire, train and retainadditional qualified and experienced employees, we may not be able to competeeffectively, or expand our consulting business and the number of Centers asplanned, both of which could result in reduced revenues.**

 

Our future success will depend to a large extent on retaining our coreoperating management team and recruiting sufficient qualified employees tomanage and staff our Centers.  There islikely to be a competitive labor market for such staff and there is noassurance that we will be able to attract and retain an adequate number ofsuitable employees.  If we are unable todo this, then we may not be able to operate and expand our Centers as planned,which may reduce our revenues.

 

To be successful, we must strengthen awareness of our services throughour marketing efforts and through establishment of additional VOW Centers.  We have a limited marketing and businessdevelopment force through which the efforts will be conducted, and we will relyheavily on each of these individuals.  Wecannot assure you that we will be able to attract and retain sufficient qualifiedpersonnel.

 

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**Our future financial results will fluctuate significantly.**

 

As a result of our limited operating history, we cannot predict ourfuture revenues or operating results.  Wedo, however, expect our future revenues and operating results to fluctuate dueto a combination of factors, including the potential costs of establishing VOWCenters.

 

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

 

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

 

**Our liquidity and capital requirements will be difficult to predict.**

 

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

 

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

 

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

 

•                  The progress andscope of product evaluations;

 

•                  The timing andcosts of filing future regulatory submissions;

 

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

 

•                  The timing andcosts of product and services introductions;

 

•                  The extent ofour ongoing research and development programs;

 

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

 

•                  The costs ofdeveloping marketing and distribution capabilities.

 

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

 

**Our failure to effectively manage our growth could have a materialadverse effect on our business.**

 

Growth in our business will place a significant strain on ourmanagement systems and resources.  Wewill need to continue to improve our operational and financial systems andmanagerial controls and procedures, and we will need to continue to expand,train and manage our workforce.  Weexpect that the number of our employees will continue to increase for theforeseeable future.  We will have tomaintain close coordination among our technical, accounting, finance, marketingand sales departments.

 

**We depend on our intellectual property for the establishment andoperation of our VOW Centers.**

 

We rely on a combination of trade secrets, know-how and confidentialityrestrictions for the establishment and operation of our VOW Centers.  We have expended significant efforts devisingthe types of products and services we will offer and the manner in which thesewill be delivered.  Our ability tomaintain the secrecy and confidentiality of our trade secrets and internalknowledge are crucial to the success of our business.  Any failure to do so may negatively impactour prospects.

 

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**If we dispose of ourVisualization Technology business, our future success will depend solely on ourability to establish and grow our obesity surgery management business.**

 

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

 

**We have been, to a significant extent,dependent on distribution partners to sell our Visualization Technologyproducts.**

 

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 of ourprimary distribution agreements were terminated in 2000 and the arrangementwith Jomed N.V. to manage distribution in cardiac surgery and to continuesupporting our cardiac customer base was terminated in 2003.  We now depend primarily on our direct salesforce to sell our 3D products.

 

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

** **

Evaluations of visualization technology, such as ours, which have beenconducted to date, have shown that there is a learning process involved forsurgeons and other members of the surgery team to become proficient with theuse of the systems.  Based on theclinical and laboratory procedures performed to date, we cannot assure you thatvisualization and information system enhancements incorporated, or to beincorporated, in our products will prove suitable for use by a substantialnumber of surgeons.  If they proveunsuitable for a large number of surgeons to use, the potential markets andapplications for our products would be significantly limited.

 

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

** **

We have never established high-volume manufacturing operations and ifwe are required to do so to meet market demand or to become profitable, we maynot be able to establish or maintain reliable operations at commerciallyreasonable costs.  We may also requireadditional manufacturing facilities if production volumes increase.  Acquisition of new manufacturing facilitieswould also likely involve relocation. Difficulties in scaling up manufacturing of products could result fromproblems involving:

 

•                                          qualitycontrol and assurance,

•                                          componentand service availability,

•                                          adequacyof control policies and procedures,

•                                          lackof qualified personnel,

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

•                                          otherproduction constraints.

 

We have considered and will continue to consider as appropriate, theinternal manufacture of sub-assemblies currently provided by third-partysubcontractors, as well as the implementation of new production processes.  Our manufacturing yields or costs mayincrease as a result of the transition to in-house production or to newproduction processes when such efforts are undertaken.  In addition, costs to comply with FDA goodmanufacturing practices or changes in such practices may exceed ourexpectations.

 

**We may face component shortages and aredependent in some instances on single sources of supply.**

 

Any significant supply interruption, or inventory shortage or overage,would negatively impact our ability to manufacture our products.  We use and rely on specific components andservices used in our systems for which we have only a single source of supply.  The manufacture of our products in largercommercial quantities will require a substantial increase in component suppliesand will likely necessitate the replacement of current suppliers or theaddition of new suppliers.  Thequalification of additional or replacement vendors for specified components orservices is a lengthy process.  Inaddition, the substitution of replacement vendors may entail re-engineeringtime and cost and could delay the supply of our products.

 

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We expect to manufacture our products based on forecasted productorders and intend to purchase subassemblies and components prior to receipt ofpurchase orders from customers.  Leadtimes for ordered materials and components vary significantly and depend on factorssuch as the business practices of the specific supplier, contract terms andgeneral demand for a component at a given time. Some components used in our products have long lead times.  As a result, there is a risk of excess orinadequate inventory if orders do not match forecasts.

 

**We are subject to significant domestic andinternational regulation and may not be able to obtain necessary regulatoryclearances to sell our products.**

 

The manufacture and sale of medical devices intended for commercialdistribution are subject to extensive governmental regulation.  Our failure to comply with regulatoryrequirements would jeopardize our ability to market our products.  Noncompliance with applicable requirementscan result in failure of the regulatory agency to grant pre-market clearance orapproval for devices, withdrawal or suspension of approval, total or partialsuspension of production, fines, injunctions, civil penalties, refunds, recallor seizure of products and criminal prosecution.

 

Medical devices are regulated in the United States primarily by the FDAand, to a lesser extent, by state agencies. Sales of medical device products outside the United States are subjectto foreign regulatory requirements that vary from country to country.  Generally, medical devices require pre-marketclearance or pre-market approval prior to commercial distribution.  A determination that information available onthe medical device is not sufficient to grant the needed clearance or approvalwill delay market introduction of the product. In addition, material changes or modifications to, and changes inintended use of, medical devices also are subject to FDA review and clearanceor approval.  The FDA regulates theresearch, testing, manufacture, safety, effectiveness, labeling, storage,record keeping, promotion and distribution of medical devices in the UnitedStates and the export of unapproved medical devices from the United States toother countries.  The time required toobtain approvals required by foreign countries may be longer or shorter thanthat required for FDA clearance, and requirements for licensing may differ fromFDA requirements.  The current regulatoryenvironment in Europe for medical devices differs significantly from that inthe United States.

 

**Our profitability in our visualizationtechnology business is directly related to the level of reimbursements forsurgical procedures using our products.**

 

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

 

We expect that our products typically will be used by hospitals andsurgical centers, which bill various third-party payors, such as governmentalprograms and private insurance plans, for the health care services provided totheir patients.  Third-party payorscarefully review and increasingly challenge the prices charged for medicalproducts and services or negotiate a flat rate fee in advance.  Payment rates from private companies alsovary depending on the procedure performed, the third-party payor, the insuranceplan and other factors.  Medicarecompensates hospitals at a predetermined fixed amount for the costs associatedwith an in-patient hospitalization based on the patient’s discharge diagnosis andcompensates physicians at a pre-determined fixed amount based on the procedureperformed, regardless of the actual costs incurred by the hospital or physicianin furnishing 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 will bemade in the reimbursement methods utilized by such third-party payors.

 

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

 

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include both government sponsored health care programs and privateinsurance.  We cannot assure you thatthese financing systems will endorse the use of our products.

 

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

** **

We have limited experience in directly marketing our productsoverseas.  Changes in overseas economicconditions, currency exchange rates, foreign tax laws or tariffs or other traderegulations could negatively impact our business.  The anticipated international nature of ourbusiness is also expected to subject our representatives, agents anddistributors to laws and regulations of the foreign jurisdictions in which theyoperate or in which our products 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 may be subject to product liability claimsand have limited insurance coverage.**

 

We face an inherent and significant business risk of exposure toproduct liability claims in the event that the use of our products results inpersonal injury or death.  Also, in theevent that any of our products proves to be defective, we may be required torecall or redesign such products.  Ourcurrent product liability insurance coverage limit is $10.0 million peroccurrence and in the aggregate.  Ourcoverage limits may not be adequate to protect us from any liabilities we mightincur in connection with the development, manufacture and sale of ourproducts.  In addition, increased productliability coverage 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 brought againstus in excess of our insurance coverage or a product recall would negativelyimpact our business.

 

**If we are unable to protect our intellectualproperty, we may be unable to prevent other companies from using our technologyin competitive products.**

 

Our future success will depend, in part, on our ability to continuedeveloping patentable products, enforcing our patents and obtaining patentprotection for our products both in the United States and in othercountries.  The patent positions of medicaldevice companies, however, are generally uncertain and involve complex legaland factual questions.  Patents may neverissue from any patent applications owned by or licensed to us.  Even if patents do issue, the claims allowedmay not be sufficiently broad to protect our technology.  In addition, issued patents owned by orlicensed to us may be challenged, invalidated or circumvented, or the rightsgranted thereunder may not provide us with competitive advantages.

 

The medical device industry has been characterized by extensivelitigation regarding patents and other intellectual property rights.  Litigation, which would result in substantialexpense, may be necessary to enforce any patents issued or licensed to usand/or to determine the scope and validity of proprietary rights of third partiesor whether our products, processes or procedures infringe any such third-partyproprietary rights.  We may also have toparticipate in interference proceedings declared by the United States Patentand Trademark Office, which could result in substantial expense, to determinethe priority of inventions covered by our issued United States patents orpending patent applications. Furthermore, we may have to participate at substantial cost inInternational Trade Commission proceedings to enjoin importation of productswhich would compete unfairly with our products. Any adverse outcome of any patent litigation, including interferenceproceedings, could subject us to significant liabilities to third parties,require disputed rights to be licensed from or to third parties or require usto cease using the technology in dispute. Any such licenses may not be available on acceptable terms, if atall.  Furthermore, parties making such claimsmay be able to obtain injunctive or other equitable relief that could effectivelyblock our ability to make, use, sell or otherwise practice our intellectualproperty, whether or not patented or described in pending patent applications,or to further develop or commercialize our products in the United States andabroad and could result in the award of substantial damages.  Defense of any lawsuit or failure to obtainany such license could damage our business.

 

In addition to patents,we rely on unpatented trade secrets to protectour proprietary technology.  Others mayindependently develop or otherwise acquire the same or substantially equivalenttechnologies or otherwise gain access to our proprietary technology or disclosethis technology.  It is difficult toprotect rights to unpatented proprietary technology.  Third parties may obtain patent rights tothese unpatented trade secrets, which patent rights could be used to assertinfringement claims against us.  We alsorely on confidentiality agreements with our collaborators, employees, advisors,vendors and consultants to protect our proprietary technology.  These agreements may be breached, we may nothave adequate remedies for any breach and our trade secrets may

 

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otherwise become 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 have licensed some aspects of our productsfrom third parties and may lose the rights to these essential aspects under theagreements which govern those relationships.**

 

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

 

**If we are not able to attract and retain keymanagement and technical personnel and doctors to participate in our advisoryboards, it may adversely affect our ability to obtain financing or develop ourproducts.**

 

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

 

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

 

**Our stock price could continue to be volatile and your investment inour common stock could suffer a decline in value, adversely affecting ourability to raise additional capital.**

 

The market prices and trading volumes for securities of emergingcompanies, like ours, have historically been highly volatile and haveexperienced significant fluctuations unrelated to the operating performance.  The market price of our common stock hashistorically been highly volatile and may be significantly affected by factorssuch as:

 

•                                          actual oranticipated fluctuations in our operating results,

•                                          our abilityto remain listed on Nasdaq,

•                                          changesin financial estimates by securities analysts,

•                                          announcementsof technological innovations,

•                                          newproducts or new contracts by us or our competitors,

•                                          regulatoryannouncements,

•                                          developmentswith respect to patents or proprietary rights,

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

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

•                                          generalmarket conditions.

 

In addition, the stock market has from time to time experiencedsignificant price and volume fluctuations that have particularly affected themarket prices for shares of early stage companies.  These broad market fluctuations may adverselyaffect the market price of our common stock. In the past, following periods of volatility in the market price of aparticular company’s securities, securities class action litigation has oftenbeen brought against that company.  Suchlitigation, if brought against us, could result in substantial costs and a diversionof management’s attention and resources.

 

27

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**There is a limited market for our common stock andtherefore investors may not be able to liquidate their investment in theforeseeable future, if at all.**

** **

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

 

**Our use of hazardous materials may result inunexpected and substantial claims against us for which we do not havesufficient financial resources.**

 

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

 

**We do not anticipate paying any dividends andany gains from your investment in our stock will have to come from increases inthe price of such stock.**

 

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

 

**Our charter documents may prevent us fromparticipating in transactions that could be beneficial to you.**

 

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

 

Item 2.PROPERTIES

 

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

 

Item 3. LEGALPROCEEDINGS

 

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

 

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

 

None.

 

28

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PART II

 

Item 5. MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDERMATTERS

 

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

 

Our Common Stock is traded on the over-the-counter market and pricesare quoted on the Nasdaq SmallCap Market under the symbol “VMTI.”  The following table sets forth the high andlow sale prices for our Common Stock on the Nasdaq SmallCap Market fromJanuary 1, 2002 through December 31, 2003.

 

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

 

On August 5, 2004 the last reported sale price of our Common Stockwas $2.31.  As of July 30, 2004,there were approximately 190 holders of record of our Common Stock.

 

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

 

(b)                                 Equity CompensationPlan Information

 

The following table contains aggregated information regarding ourequity compensation plans as of December 31, 2003.

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

 

----

(1)                                  Equity compensationplans approved by our security holders include our 1997 Stock Option/StockIssuance Plan and our 1997 Employee Stock Purchase Plan.

 

29

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Item 6. SELECTED FINANCIAL DATA 

 

SELECTED FINANCIAL DATA

 

The selected financial data set forth below should be read inconjunction with “Management’s Discussion and Analysis of Financial Conditionand Results of Operations” and our financial statements and notes theretoappearing elsewhere in this Form 10-K. This data has been restated for all periods presented to reflect theVisualization Technology business as a discontinued operation.

 
| ** **                                                 | ** ** | **YEARS ENDED DECEMBER 31,**                    | ** ** |
|------------------------------------------------------------|------------|------------------------------------------------------|------------|
| **STATEMENT  OF OPERATIONS DATA:**                         | ** ** | **1999**                                             | ** ** | **2000** | ** ** | **2001** | ** ** | **2002** | ** ** | **2003** | ** ** |
| ** **                                                 | ** ** | **(Restated)**                                       | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** |
| ** **                                                 | ** ** | **(IN THOUSANDS, EXCEPT SHARE AND  PER SHARE DATA)** | ** ** |
|                                                       |       |                                                 |       |   |   |   |   |   |   |   |   |
| Revenues                                                   |       | $                                                    | —     |   | $ | — |   | $ | — |   | $ | 3,543 |   | $ | 2,489 |   |
| Cost and  expenses:                                        |       |                                                 |       |   |   |   |   |   |   |   |   |
| Cost of  revenues                                          |       | —                                               |       | — |   | — |   | 797 |   | 575 |   |
| Sales and  marketing                                       |       | —                                               |       | — |   | — |   | 2,139 |   | 1,755 |   |
| General and  administrative                                |       | 894                                                  |       | 892 |   | 1,003 |   | 1,082 |   | 1,226 |   |
| Total costs  and expenses                                  |       | 894                                                  |       | 892 |   | 1,003 |   | 4,018 |   | 3,556 |   |
| Loss from  continuing operations                           |       | (894                                                 | )          | (892 | ) | (1,003 | ) | (475 | ) | (1,066 | ) |
| Interest  income                                           |       | 218                                                  |       | 213 |   | 70 |   | 17 |   | 32 |   |
| Net loss from  continuing operations                       |       | (676                                                 | )          | (679 | ) | (933 | ) | (458 | ) | (1,034 | ) |
| Net loss from  discontinued operations                     |       | (10,047                                              | )          | (2,935 | ) | (2,289 | ) | (689 | ) | (1,014 | ) |
| Less accretion  of dividends on preferred stock            |       | —                                               |       | — |   | — |   | — |   | (119 | ) |
| Net loss  applicable to common stockholders                |       | $                                                    | (10,723    | ) | $ | (3,614 | ) | $ | (3,222 | ) | $ | (1,147 | ) | $ | (2,167 | ) |
| Basic and  diluted net loss per share                      |       | $                                                    | (3.16      | ) | $ | (0.80 | ) | $ | (0.66 | ) | $ | (0.23 | ) | $ | (0.43 | ) |
| Shares used in  computing basic and diluted loss per share |       | 3,398,000                                            |       | 4,495,000 |   | 4,906,000 |   | 4,969,000 |   | 5,004,000 |   |

 
| ** **                                         | ** ** | **DECEMBER 31,** | ** ** |
|----------------------------------------------------|------------|-----------------------|------------|
| **BALANCE  SHEET DATA:**                           | ** ** | **1999**              | ** ** | **2000** | ** ** | **2001** | ** ** | **2002** | ** ** | **2003** | ** ** |
| ** **                                         | ** ** | **(Restated)**        | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** |
| ** **                                         | ** ** | **(IN THOUSANDS)**    | ** ** |
|                                               |       |                  |       |   |   |   |   |   |   |   |   |
| Cash, cash  equivalents and short-term investments |       | $                     | 1,658      |   | $ | 2,934 |   | $ | 1,317 |   | $ | 829 |   | $ | 636 |   |
| Working  capital                                   |       | 1,658                 |       | 2,934 |   | 1,317 |   | 2,073 |   | 1,093 |   |
| Total assets                                       |       | 7,367                 |       | 7,155 |   | 4,823 |   | 4,182 |   | 2,991 |   |
| Long-tern debt                                     |       | —                |       | — |   | — |   | 7 |   | 19 |   |
| Accumulated  deficit                               |       | (57,941               | )          | (61,555 | ) | (64,777 | ) | (65,925 | ) | (68,092 | ) |
| Total  stockholders’ equity                   |       | 4,584                 |       | 6,151 |   | 3,091 |   | 2,081 |   | 1,108 |   |
|                                                    |            |                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

30

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Item 7.                                     MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

This annual report may contain predictions, estimates and otherforward-looking statements that involve a number of risks and uncertainties,including those discussed earlier at “risks and uncertainties.”  While this outlook represents our currentjudgment on the future direction of our business, such risks and uncertaintiescould cause actual results to differ materially from any future performancesuggested below.  We undertake noobligation to release publicly the results of any revisions to theseforward-looking statements to reflect events or circumstances arising after thedate of this annual report.  Thefollowing discussion should be read in conjunction with our consolidatedfinancial statements and the notes thereto. 

 

**Overview of our Business**

 

We operate two business units. The Obesity Surgical and Medical Management Services business (operatedvia our wholly-owned subsidiary, VOW Solutions, Inc.), based in Carlsbad, CA,provides services to physicians and hospitals involved in the surgicaltreatment of morbid obesity.  Ourservices include management of our original product offering, the LaparoscopicBariatric Surgery Preceptorship, a comprehensive introduction to starting aminimally invasive gastric bypass surgical program.  We now offer, in addition, systems,consulting and program management services, which enable the efficient operationof obesity surgery programs.  TheVisualization Technology business, based in Westborough, MA, develops,manufactures and markets products that provide information to physiciansperforming minimally invasive general surgical, cardiac surgical and otherselected endoscopic and interventional procedures.  Our technology products combine a headmounted display with video cameras to provide surgeons with critical visualinformation during complex minimally invasive procedures, and also incorporatethe benefit of viewing complementary information in a voice-controlled,picture-in-picture format, to facilitate real-time decision making duringsurgery.  The Visualization Technologybusiness also manufactures compact, high-resolution endoscopic cameras for originalequipment manufacturer customers and strategic partners.  On December 22, 2003 we signed anagreement to sell the Visualization Technology business to Viking Systems,Inc., (see pages 9 and 10 for a description of the terms of the transaction),subject to the approval of our stockholders.

 

At December 31, 2003, we had 32 employees.  We expect staffing to increase from ourObesity Management Services business, while there would be an elimination of 19employees from the sale of our Visualization Technology business in ourWestborough facility.   We expect thatthere will be a steady increase in employees during 2004 within the ObesityManagement Services business, which would bring us to approximately 22employees by the end of 2004.

 

2002 was the first year in which we separately reported revenues andexpenses from our obesity surgery services business.  In 2001 while exploring businessopportunities associated with marketing our visualization technology equipmentfor use in laparascopic bariatricsurgery, we identified a variety of consulting services in the obesitysurgery market that were not dependent on our technology equipment.  It was not until 2002 that we began marketingthese consulting services, separate from the visualization technology business.   Prior to that, we had no meaningful obesitysurgery transactions or separate business and thus no separate continuingoperations to report.  

 

**Critical Accounting Policies**

 

The discussion and analysis of our financial condition and results ofoperations are based upon our consolidated financial statements, which havebeen prepared in accordance with accounting principles generally accepted inthe United States.  The presentation ofthese financial statements requires us to make estimates and judgments thataffect the reported amounts of assets and liabilities, revenues and expenses,and related disclosure at the date of our financial statements.  The significant accounting policies, which webelieve are most critical in gaining an understanding of our financialstatements, include policies and judgments relating to revenue recognition andinventories.  Actual results could differmaterially from these estimates.  Oursignificant accounting policies are summarized in the notes to our consolidatedfinancial statements.  The significantaccounting policies which we believe are the most critical in gaining fullunderstanding and evaluating our reported financial results include thefollowing:

 

Revenue Recognition

 

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

 

Within the Obesity Surgery Management Services business, the Company’srevenues are derived from consulting and training services, from sales ofvitamins and from contract revenue associated with our supply and promotionalagreement with Ethicon Endo-Surgery, Inc. Consulting and training services revenue is recognized upon delivery ofrelated marketing materials and completion of the related training component,provided all of the criteria of SAB 104 are met. 

 

31

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

 

**Inventory**

 

Inventories are stated at lower of cost (determined on a first-in,first-out basis) or market and include only finished goods related to ourdisease state management of morbid obesity business. 

 

**Assets and liabilities related todiscontinued operations**

 

Due to the sale of our Visualization Technology business inApril 2004, we have recorded the assets and liabilities associated withthe Visualization Technology business in these separate accounts at the end ofeach year so as to separately present the assets and liabilities of thecontinuing and discontinued operations. ** **

 

For 2003 the continuing operations were accounted for as a separate anddistinct business from the Visualization Technology business. Although separatestatements of operations were maintained, the allocation of certain operatingexpenses was necessary to reflect the continuing operations as a stand-alonepublicly traded business.  Theseallocations included public company expenses, such as filing fees, transferagent fee, legal and accounting fees, directors and officers liabilityinsurance and investor relations costs, along with insurance and to a lesserdegree sales and marketing expenses.

 

Prior to 2003 our operations were accounted for as one business.  In 2002, which was the first year with twodistinct businesses, a review of the accounts and related support was performedto separate the two businesses.  Todevelop the statement of operations for the continuing operations for 2002,revenue and expenses that were not distinct to the continuing operations wereallocated between continuing and discontinued operations. Where revenues werebundled with the Visualization Technology, the revenue allocation wasdetermined using comparable transactions from unbundled revenues fromcontinuing operations.  Expenses wereallocated based on departmental accounting by business activity and byheadcount activity for departments that provided support for bothbusinesses.  For 2002 and 2001 generaland administrative expenses for continuing operations included all publiccompany expenses, such as filing fees, transfer agent fee, legal and accountingfees, directors and officers liability insurance and investor relations costs,along with corporate salaries and related facility costs.

 

**Our Results of Operations**

 

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

 

Revenues

 

Revenues from continuing operations were $2,489,000 for the year endedDecember 31, 2003 as compared to revenues from continuing operations of$3,543,000 for the year ended December 31, 2002, representing a decreaseof $1,054,000 or 30%.  This decease inrevenues in 2003 was primarily due to fewer Training Programs related to ourbariatric surgery preceptorships along with lower contract revenues and offsetby an increase in vitamin sales.  Onlyone customer exceeded 10% or more of total revenues for the year endedDecember 31, 2003 and those revenues represented 37%.  

 

Costs and expenses 

 

| ** **                 | ** ** | **2002**  | ** ** | **2003**  | ** ** |
|----------------------------|------------|-----------|------------|-----------|------------|
| Cost of revenues           |       | $         | 797,528    |      | $          | 574,599 |   |
| Sales and marketing        |       | 2,138,639 |       | 1,755,215 |       |
| General and administrative |       | 1,082,003 |       | 1,226,145 |       |
|                       |       |      |       |      |       |
| Total costs and expenses   |       | $         | 4,018,170  |      | 3,555,959  |   |
|                            |            |           |            |           |            |  |  |

 

Cost of revenues.  Our cost ofrevenues were $575,000 and $798,000 for the years ended December 31, 2003and 2002, respectively.  Our grossmargins were 77% for both years.  Cost ofrevenues includes costs associated with the manufacturing of our vitamins anddirect cost associated with consulting and training services.  Our gross margins are expected to fluctuatein the future due to product mix.

 

32

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Sales and marketing expenses. Our sales and marketing expenses were $1,755,000 and $2,139,000 for theyears ended December 31, 2003 and 2002, respectively, representing adecrease of $384,000 or 18%.  Thedecrease in sales and marketing expenses during 2003 was primarily attributableto lower consulting services as well as lower promotional and advertisingexpenses.  We do however, expect a steadyincrease in sales and marketing expenses during 2004 as we ramp up our fieldactivities for the obesity surgery market.

 

General and administrative expenses. Our general and administrative expenses were $1,226,000 and $1,082,000for the years ended December 31, 2003 and 2002, respectively, representingan increase of $144,000 or 13%.  Theincrease in general and administrative expenses during 2003 was primarilyattributable to increased professional services for legal and audit.  We expect our general and administrativeexpenses to increase in future years to support our business growth efforts.

 

Other income and losses

 

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

 

Loss from discontinued operations

 

| ** **                        | ** ** | **2002**  | ** ** | **2003**  | ** ** |
|-----------------------------------|------------|-----------|------------|-----------|------------|
| Revenue                           |       | $         | 7,563,247  |      | $          | 6,220,091 |   |
|                              |       |      |       |      |       |
| Cost of revenues                  |       | 5,191,353 |       | 4,610,239 |       |
| Research and development          |       | 1,709,534 |       | 1,177,656 |       |
| Sales and marketing               |       | 551,393   |       | 323,177   |       |
| General and administrative        |       | 800,257   |       | 1,123,270 |       |
|                              |       |      |       |      |       |
| Total costs and expenses          |       | 8,252,537 |       | 7,234,342 |       |
|                              |       |      |       |      |       |
| Loss from discontinued operations |       | $         | (689,290   | )         | $          | (1,014,251 | ) |

 

Revenues.  The decrease inrevenues from $7,563,000 for the year ended December 31, 2002 to $6,220,000in December 31, 2003 was primarily due to a $1,000,000 write offassociated with the bankruptcy of a customer and a decrease in camera sales toour original equipment manufacturer customers.

 

Cost of revenues.  Our cost ofrevenues were $4,610,000 and $5,191,000 for the years ended December 31,2003 and 2002, respectively.  Our grossmargins were 26% and 31% for the years ended December 31, 2003 and 2002,respectively.  The decrease in grossmargin was primarily due to lower sales of higher margin equipment.

 

Research and development.  Ourresearch and development expenses were $1,178,000 and $1,709,000 for the yearsended December 31, 2003 and 2002, respectively, representing a decrease of$532,000 or 31%.  The decrease inresearch and development expenses during 2003 was primarily attributable tohigher spending on the next generation product development in 2002 as comparedto 2003. 

 

Sales and marketing.  Thedecrease in sales and marketing expense from $551,000 in 2002 to $323,000 in2003 was primarily due to a reduced selling and marketing effort in the sale ofequipment.

 

General and administrative.  Theincrease in general and administrative expenses from $800,000 in 2002 to$1,123,000 in 2003 was due to higher professional fees.

 

Income Taxes

 

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

 

33

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

 

Revenues 

 

Revenues from continuing operations for the year endedDecember 31, 2002 were $3,543,000. 2002 was the first year of reporting revenues from our obesity surgeryservices market.  Prior to 2001, ourrevenues, and related expenses, for the obesity surgery services market wereincluded in our Visualization Technology business as part and parcel of thesale of visualization technology equipment. It was not until 2002 that we recognized the obesity surgery servicesmarket as a viable stand-alone business without the need for technology.  Revenues for 2002 were generated fromconsulting and training services, from sales of vitamins and from contractrevenue associated with our supply and promotional agreement with Ethicon Endo-Surgery,Inc.  Only one customer exceeded 10% ormore of total revenues for the year ended December 31, 2002 and thoserevenues represented 28%.

 

Costs and expenses 

 

Cost of revenues.  Our cost ofrevenues was $798,000 for the year ended December 31, 2002.  Our gross margin was 77% for the year.  Cost of revenues includes costs associatedwith the manufacturing of our vitamins and direct cost associated withconsulting and training services.

 

Sales and marketing expenses. Our sales and marketing expenses were $2,139,000 for the year endedDecember 31, 2002.  Sales andmarketing expenses include costs for staffing the sales and marketing effortand related advertising and promotions expenses associated with obtain andmaintaining existing customers in the obesity surgery services market.  

 

General and administrative expenses. Our general and administrative expenses were $1,082,000 for the yearended December 31, 2002.  Theseexpenses represent the costs associated with providing support to the obesitysurgery services market and being a public company.

 

Other income and losses

 

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

 

Loss from discontinued operations

 

| ** **                        | ** ** | **2001**   | ** ** | **2002**  | ** ** |
|-----------------------------------|------------|------------|------------|-----------|------------|
| Revenue                           |       | $          | 9,326,490  |      | $          | 7,563,247 |   |
|                              |       |       |       |      |       |
| Cost of revenues                  |       | 6,405,340  |       | 5,191,353 |       |
| Research and development          |       | 1,945,433  |       | 1,709,534 |       |
| Sales and marketing               |       | 2,237,108  |       | 551,393   |       |
| General and administrative        |       | 1,027,520  |       | 800,257   |       |
|                              |       |       |       |      |       |
| Total costs and expenses          |       | 11,615,401 |       | 8,252,537 |       |
|                              |       |       |       |      |       |
| Loss from discontinued operations |       | $          | (2,288,911 | )         | $          | (689,290 | ) |

 

Revenue.  We had revenues fromproduct sales and contract revenue of $7,563,000 for the year endedDecember 31, 2002 and product sales and contract revenue of $9,326,000 forthe year ended December 31, 2001. The decrease in revenue is primarily due to separating the bariatricservices business from the technology business for all of 2002. This decreasewas offset by having received during 2003 $500,000 more in contract revenueunder our agreement with Ethicon Endo-Surgery, Inc. than in 2001.  Sales to individual customers exceeding 10%or more of revenues in the years ended December 31, were as follows:  during 2002, one customer accounted for 14%of revenues, and during 2001, three customers accounted for 22%, 18% and 10% ofrevenues, respectively.  

 

Cost of revenues.  Our cost ofrevenues were $5,191,000 and $6,405,000 for the years ended December 31,2002 and 2001, respectively.  Our grossmargins for both years was 31%, however the gross margin from product sales in2002 would have been 21%

 

34

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as compared to 27% for 2001 when adjusting revenues for contractrevenue, which had no related cost of revenues. This decrease in gross marginsis a result of separating the higher margin bariatric services business fromthe technology business.  

 

Research and development expenses. Our research and development expenses were $1,709,000 and $1,945,000 forthe years ended December 31, 2002 and 2001, respectively.  The decrease in research and developmentexpenses during 2002 was primarily attributable to significant development workcompleted on the next generation product. Since 2000, the Company’s principal development efforts have focused onnew products and services within the surgical obesity market.  Approximately $600,000 of the $1,709,000 inresearch and development expenses was spent on the next generation Head MountedDisplay that started shipping in the fourth quarter of 2002.  There were no other individually significantresearch projects.  The Company’s futurespending on research and development will be focused on further expansion ofLBS peripheral products and services and development of the next generationHead Mounted Display.                  

 

Sales and marketing expenses. Our sales and marketing expenses were $551,000 and $2,237,000 for theyears ended December 31, 2002 and 2001, respectively.  The decrease in sales and marketing expensesduring 2002 reflects a total shift in focus of the sales and marketing effortfrom technology to field activities and infrastructure for the obesity surgerymarket.  

 

General and administrative expenses. Our general and administrative expenses were $800,000 and $1,027,000 forthe years ended December 31, 2002 and 2001, respectively.  The decrease during 2002 was primarily due tolower personnel and related costs, depreciation and facility charges.

 

**Liquidity and Capital Resources**                  

 

Our principal sources of liquidity have been funds raised from publicand private placements of our capital stock and, to a lesser degree, cash flowsgenerated from operations.  AtDecember 31, 2003, we had cash, cash equivalents and short-terminvestments of $636,000.  In addition, inFebruary 2004, we raised $588,000 through a private placement of commonstock and in May 2004 we raised an additional $4,545,000 through a separateprivate placement of common stock.

 

Net cash used in operating activities was approximately $1,321,000,$542,000 and $1,642,000 in 2003, 2002 and 2001, respectively.  The increase in net cash used in operatingactivities during 2003 compared to 2002 was primarily attributable to increasingnet losses due to lower revenues and an increase in the change in assets andliabilities related to discontinued operations. The decrease in net cash used in operating activities during 2002compared to 2001 was primarily attributable to decreasing net losses due to therecognition of revenues from our obesity surgery services market in 2002 as astand-alone business. 

 

Net cash provided from investing activities was approximately $163,000and $128,000 in 2003 and 2002, respectively, and cash used in 2001 forinvesting activities was $172,000.  Theincrease in cash provided from investing activities in 2003 was primarilyattributable to maturities of short-term investments, partially offset byincreased purchases of property and equipment. The increase in net cash provided by investing activities in 2002compared to 2001 was primarily attributable to maturities of short-terminvestments.

 

Cash flows from financing activities were $1,150,000, $71,000 and$25,000 in 2003, 2002 and 2001, respectively. The cash flows from financing activities in 2003 were primarilyattributable to proceeds from a private placement of preferred stock forapproximately $950,000 and short term bank borrowings of $200,000.The cashflows from financing activities in 2002 and 2001 were primarily attributable toproceeds from purchase of stock by employees through our employee stockpurchase plan and the exercise of stock options. 

 

We incurred operating losses in 2001, 2002 and 2003, and atDecember 31, 2003, had an accumulated deficit of $68.1 million.  At December 31, 2003, we had cash andshort-term investments of $636,000.  InFebruary 2004, we sold $588,000 of common stock in a private placement andin May 2004, we sold an additional $4,545,000 of common stock in a separate privateplacement.   In addition, we have amountsavailable under a $2.0 million bank line of credit facility, which expires inOctober 2004 and is subject to annual renewals.  We believe that these sources of liquidity,together with anticipated 2004 product revenues and interest income, will notbe sufficient to operate our business beyond June 2005.  These factors raise substantial doubt aboutthe Company’s ability to continue as a going concern.  We are pursuing several alternatives toaddress this situation, including raising additional funding.  However, there can be no assurance that therequisite fundings will be consummated in the necessary time frame or on termsacceptable to us.  Should we be unable toraise sufficient funds, we may be required to curtail our operating plans andpossibly relinquish rights to portions of our technology or products.  In addition, increases in expenses or delaysin product development may adversely impact our cash position and requirefurther cost reductions.  No assurancecan be given that we will be able to operate profitably on a consistent basis,or at all, in the future.

 

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**Borrowing Arrangements**

 

In October 2001, we secured a $2,000,000 line of credit Facility(the Facility) with a bank for one year with automatic yearly renewals.  The current line of credit agreement expiresin October 2004.  The Facility issecured by qualified accounts receivable and bears interest at the rate ofprime plus 2% (4.5% at December 31, 2003). Borrowings under the Facility are limited to 80% of qualified accountsreceivable.  At December 31, 2003,there was $200,000 of borrowings outstanding , and $730,000 available under theFacility.  It is unlikely that we will beable to draw on this credit facility since the amounts receivable from Vikingrelated to the sale of the Visualization Technology business will not beconsidered qualified accounts receivable.

 

**Contractual Obligations**

 

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

 

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

 

**Related Party Transactions**

 

We have a sublease agreement for our California office space.  The sublease agreement has been executed withanother company, of which our Chairman of the Board is also a Director.  Total rental payments of $104, 500 were paidto this company in 2003.

 

**Off-Balance Sheet Arrangements**

 

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

 

**Inflation**

 

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

 

**New Accounting Pronouncements**

 

InJanuary 2003 FASB Interpretation No. 46, “Consolidation of VariableInterest Entities” was issued. This interpretation requires a company toconsolidate variable interest entities (“VIE”) if the enterprise is a primarybeneficiary (holds a majority of the variable interest) of the VIE and the VIEpasses specific characteristics. It also requires additional disclosures forparties involved with VIEs.  InDecember 2003, the FASB issued a revision of Interpretation No. 46 (theRevised Interpretation 46). Revised Interpretation 46 codifies both theproposed modifications and other decisions previously issued through certainFASB Staff Positions (FSPs) and supersedes the original Interpretation No. 46to include: (1) deferring the effective date of the Interpretation’s provisionsfor certain variable interests, (2) providing additional scope exceptions forcertain other variable interests, (3) clarifying the impact of troubled debtrestructurings on the requirement to reconsider (a) whether an entity is a VIEor (b) which party is the primary beneficiary of a VIE, and (4) revisingAppendix B of the Interpretation to provide additional guidance on whatconstitutes a variable interest. Accordingly, the Company will adopt RevisedInterpretation No. 46 effective the first quarter 2004 and does not expect theadoption of this interpretation will have an impact on its consolidatedfinancial position or results of operations.

 

InDecember 2003, the SEC issued Staff Accounting Bulletin (SAB) No. 104,“Revenue Recognition”, which codifies, revises and rescinds certain sections ofSAB No. 101, Revenue Recognition, in order to make this interpretive guidanceconsistent with current authoritative accounting and auditing guidance and SECrules and regulations.  The changes notedin SAB No. 104 did not have a material effect on the Company’s results ofoperations, financial position or cash flows.

 

InMay 2003, the FASB issued SFAS No. 150, “*Accounting for CertainFinancial Instruments with Characteristics of Both Liabilities and Equity*.”  SFAS No. 150 establishes standards for how anissuer classifies and measures certain financial instruments withcharacteristics of both liabilities and equity. Many of these instruments were previously classified as equity.  SFAS No. 150 is 

 

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effective for financial instruments entered into or modified after May31, 2003, and otherwise was effective at the beginning of the first interimperiod beginning after June 15, 2003. The adoption of this Statement did not have an effect on the Company’sfinancial statements.

 

Item 7A.                           QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

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

 

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

 

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

 

Item 8.                                     FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA

 

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

 

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

 

Not applicable.

 

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PART III

 

Item 9A.   CONTROLS AND PROCEDURES

 

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

 

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

 

Item 10.       DIRECTORS AND EXECUTIVE OFFICERS OF THEREGISTRANT

 

(a)                                  Identificationof Directors.  The name, age and year inwhich the term expires of each member of our Board of Directors is set forthbelow:

 

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

 

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

 

***JOHN R. LYON.***  Mr. Lyon co-founded our Company inJuly 1993 and has served as President since July 1993, as ChiefExecutive Officer since December 1996 and as a Director since July 1995.Prior to co-founding Vista Medical, Mr. Lyon served for three years withCooper Companies, as President of the International Division within Cooper’sHealth Care Group from January 1991 through December 1992, and asPresident of Cooper Surgical, a manufacturer and distributor of minimallyinvasive surgical products, from January 1992 through January 1993.Mr. Lyon also was employed by Kaiser Aerospace in a business developmentrole from February 1993 until Vista Medical was founded in July 1993.Mr. Lyon holds a B.A. from the University of Durham, United Kingdom.

 

***SCOTT R. PANCOAST.***  Mr. Pancoast was elected a Director inMarch 2003, following the resignation of Nicholas Binkley.Mr. Pancoast has been the Executive Vice President of Western States InvestmentGroup, a privately owned investment firm with a venture-capital focus, since1994. Prior to Western States, he was Senior Vice President and a Director ofNational Sanitary Supply, where he founded and managed the company’s MidwestDivision. Mr. Pancoast was also Chief Financial Officer of NationalSanitary Supply from 1986, when it went public, until 1988. Mr. Pancoastholds a B.A. in Economics from the University of Virginia and an MBA fromHarvard Business School.

 

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

 

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***GEORGE B. DEHUFF.***  Mr. DeHuff has served as a Director sinceJune 2001. Mr DeHuff was appointed President and Chief Executive Officerof BI Incorporated in May 2001. Prior to BI, Mr. DeHuff was Presidentand Chief Executive Officer of Davita Inc. (formerly Total Renal Care)from 1999. From 1994 to 1999 Mr. DeHuff served in various senior executivecapacities with American Medical Response, including President and ChiefExecutive Officer from 1997. From 1991 to 1994 Mr. DeHuff was Presidentand Chief Executive Officer of LifeFleet, Inc. Mr. DeHuff holds anMBA from the University of Michigan-Ann Arbor.

 

***MICHAEL H. OWENS.***  Dr. Owens is a physician executive withover 20 years of executive healthcare, managed care, physician practicemanagement, marketing and strategic planning experience, as well as15 years of clinical practice experience. Prior to joining Vista,Dr. Owens was President of Imhotep Health Systems, Inc., a healthcareand managed care consulting firm specializing in strategic business andclinical resource planning and implementation. His previous experience includessenior management roles with CIGNA HealthCare, the Watts Health Foundation andthe U.S. Public Health Service. His professional certifications and membershipsinclude Fellow, American College of Physician Executives; Diplomat, American Collegeof Physician Executives; Diplomat, American Board of Quality Assurance andUtilization Review; and, Diplomat, American Board of Internal Medicine. Heearned his MD degree from Yale University School of Medicine, his MPH inHospital Administration from Yale University School of Public Health and his ABdegree Cum Laude with a major in Chemistry from Bowdoin College, Brunswick, ME.Dr. Owens completed his Hospital Administration Residency at MontefioreHospital, in Bronx, NY, and his Internal Medicine Residency at the Universityof Washington in Seattle.

 

There are no family relationships among any of our directors orexecutive officers.

 

*Audit Committee.*  The Audit Committee of the Board of Directorscurrently consists of Mr. Pancoast, Mr. DeHuff and Dr. Osterink. TheBoard has determined that all members of the Audit Committee are independentdirectors under the rules of the Nasdaq Stock Market and each of them is ableto read and understand fundamental financial statements. Mr. Pancoast is anaudit committee financial expert. The purpose of the Audit Committee is tooversee our accounting and financial reporting processes and audits of ourfinancial statements. The responsibilities of the Audit Committee includeappointing and providing the compensation of the independent accountants toconduct the annual audit of our accounts, reviewing the scope and results ofthe independent audits, reviewing and evaluating internal accounting policies,and approving all professional services to be provided to the Company by itsindependent accountants. The Board of Directors has adopted a formal writtencharter for the Audit Committee.

 

We reimburse our directors for all reasonable and necessary travel andother incidental expenses incurred in connection with their attendance atmeetings of the Board. Under our 1997 Stock Option/Issuance Plan, as amended(the “Plan”), which was adopted in February 1997 and amended inMarch and May 1997, and again in June 2001, beginning with thefirst Annual Meeting following our initial public offering in July 1997,each non-employee director who is first elected to the Board will automaticallyreceive an option to purchase 3,750 shares of Common Stock for the first yearof the director’s Board term and 1,250 shares of Common Stock for eachadditional year remaining on the director’s Board term following the automaticoption grant. Each director who is currently serving on the Board will receivean option to purchase 1,250 shares of Common Stock for each additional year forwhich he is elected as a director. Therefore, each of the nominees, if elected,will receive an option to purchase 1,250 shares of Common Stock for eachadditional year for which he is elected as a director. These options will havean exercise price equal to 100% of the fair market value of the Common Stock onthe grant date. The grant of 3,750 shares will become exercisable in equalmonthly installments over four years of Board service completed by the directorfollowing such grant, and the grants of 1,250 shares will become exercisable atthe end of one year of Board service completed by the director following thedate of grant. However, the shares will immediately vest in full upon changesin control or ownership or upon the optionee’s death or disability.

 

Under our 1995 Stock Option Plan (the “Predecessor Plan”), eachnon-employee director received a fully vested option to purchase 1,125 sharesof Common Stock in December 1996, and Mr. Lyon received an option topurchase 2,812 shares of Common Stock. The option grant to Mr. Lyon vestedover five years from the date of grant.

 

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

 

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

 

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(1)                                  Mr. Gorgol ceasedbeing an employee of ours as of July 1, 2004. As of that date, our newChief Financial Officer and Secretary is Howard Sampson.

 

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

 

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

 

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

 

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

 

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

 

The members of the Board of Directors, our executive officers andpersons who hold more than 10% of our outstanding Common Stock are subject tothe reporting requirements of Section 16(a) of the Securities Exchange Actof 1934 which require them to file reports with respect to their ownership ofthe Common Stock and their transactions in such Common Stock. Based on a reviewof the copies of such reports furnished to us, or representations regarding thenecessity to file such reports, we have identified the following failures tofile reports: George DeHuff with 4 late reports and transactions, StephenGorgol with 6 late reports and filings, John Lyon with 2 late reports andfilings, Larry Osterink with 4 late filings and reports, Michael Owens with 1late report and filing and Scott Pancoast with 1 late report and filing. Wehave been informed that all such reports have now been filed and eachindividual has undertaken a policy of future compliance.

 

**CODE OF ETHICS**

 

We have adopted a code of ethics that applies to all officers andemployees, including its principal executive officer, principal financialofficer and controller. This code of ethics is available on our website at *http://www.vistamt.com.*

 

Item 11.       EXECUTIVE COMPENSATION

 

The following table provides summary information concerning thecompensation earned by our Chief Executive Officer and each of our three othermost highly compensated executive officers, who earned more than $100,000 forservices rendered in all capacities for the fiscal year ended December 31,2003. No executive officers who would have otherwise been included in suchtable on the basis of salary and bonus earned for the 2003 fiscal year has beenexcluded by reason of his or her termination of employment or change inexecutive status during that year. The listed individuals shall be hereinafterreferred to as the “Named Executive Officers” in this Proxy Statement.

 

**SUMMARY COMPENSATION TABLE(1)**

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

 

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(1)                                  Includes amountsdeferred pursuant to our 401(k) Plan.

 

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

 

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**STOCK OPTIONS AND STOCK APPRECIATION RIGHTS**

 

The following table sets forth information concerning stock optiongrants made to each of the Named Executive Officers for the 2003 Fiscal Year,and the potential realizable value of those grants (on a pre-tax basis)determined in accordance with SEC rules. The information in this table showshow much the named executive officers may eventually realize in future dollarsunder two hypothetical situations: if the price of the common stock increases5% or 10% in value per year, compounded over the life of the options. Theseamounts represent assumed rates of appreciation, and are not intended toforecast future appreciation of the common stock.

 

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

 

**OPTION GRANTS IN LAST FISCAL YEAR**

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

 

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(1)                                  The exercise priceper share of options granted represented the fair market value of theunderlying shares of Common Stock on the dates the respective options weregranted as determined by the Board in accordance with certain provisions of the1997 Stock Option/Stock Issuance Plan based on the closing selling price pershare of a share of Common Stock on the date in question as reported by theNasdaq SmallCap Market. The exercise price may be paid in cash or in shares ofCommon Stock valued at fair market value on the exercise date or may be paidwith the proceeds from a same-day sale of the purchased shares. We also haveauthority to finance the optionee’s exercise of the option by loaning suchindividual on a full-recourse basis sufficient funds to cover the exerciseprice for the purchased shares, together with any federal and state withholdingtax liability incurred by the optionee in connection with the option purchase.

 

(2)                                  The 5% and 10%assumed annual rates of compounded stock price appreciation are mandated byrules of the Commission. The price used for computing this appreciation is theexercise price of the options. There is no assurance provided to any executiveofficer or any other holder of our securities that the actual stock priceappreciation over the 10-year option term will be at the assumed 5% or 10%levels or at any other defined level.

 

(3)                                  Each of the optionsgranted have a maximum term of ten years measured from the applicable grantdate, subject to earlier termination in the event of the optionee’s cessationof service with us. Each of the options granted will become exercisable inequal monthly installments over the next 36 months of service thereafter.However, each of the options will immediately become exercisable for all of theoption shares in the event we are acquired by a merger or asset sale, unlessthe options are assumed by the acquiring entity, or in the event there is ahostile change in control or ownership. The grant date for the options grantedto the Executive Officers is September 8, 2003.

 

**OPTION EXERCISES AND HOLDINGS**

 

The following table provides information concerning option exercisesduring 2003 by the Named Executive Officers and the value of unexercisedoptions held by each of the Named Executive Officers as of December 31,2003. No SARs were exercised during 2003 or outstanding as of December 31,2003.

 

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

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

 

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(1)                                  “Value realized” iscalculated on the basis of the fair market value of the Common Stock on thedate of exercise minus the exercise price and does not necessarily indicatethat the optionee sold such stock.

 

(2)                                  The options areimmediately exercisable; however, any shares purchased upon exercise may besubject to rights of repurchase our part which lapse at various times over thenext five years.

 

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

 

**STOCK PERFORMANCE GRAPH**

 

The graph depicted below shows a comparison of our cumulative totalstockholder returns, the CRSP Total Return Index for the Nasdaq Stock Market(U.S. Companies) (the “Nasdaq Stock Market—U.S. Index”) and the Nasdaq MedicalDevice Manufacturer Index. The graph covers the period from December 31,1998 to December 31, 2003. The total return for our Common Stock and eachindex assumes that $100 was invested on December 31, 1997 and that alldividends were reinvested, although dividends have not been declared on ourCommon Stock. The stockholder return shown on the graph below is notnecessarily indicative of future performance and we will not make or endorseany predictions as to future stockholder returns.

 

**Vista Medical Technologies, Inc.**

**Nasdaq Medical Device Manufacturers Index**

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

 

 

43

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Item 12.                               SECURITY OWNERSHIP OFCERTAIN BENEFICIAL OWNERS AND MANAGEMENT

 

**OWNERSHIP OF SECURITIES**

 

The following table sets forth certain information known to us withrespect to the beneficial ownership of our Common Stock as of March 31,2004, by (i) all persons who are beneficial owners of five percent (5%) ormore of our Common Stock, (ii) each director and nominee for director,(iii) the executive officers named in the Summary Compensation Table ofthe Executive Compensation and Related Information section of this ProxyStatement and (iv) all current directors and executive officers as agroup.

 

Except as indicated in the footnotes to this table, the persons namedin the table have sole voting and investment power with respect to all sharesof Common Stock shown as beneficially owned by them, subject to communityproperty laws, where applicable. Share ownership in each case includes sharesissuable upon exercise of certain outstanding options as described in thefootnotes below. The address for those individuals for which an address is nototherwise indicated is: 2101 Faraday Avenue, Carlsbad, California 92008.

 

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

 

----

*                                         Less than 1%

 

(1)                                  Percentage ofownership is based on 5,011,251 shares of Common Stock and 1,000,000 shares ofSeries A Convertible Preferred Stock outstanding on March 31, 2004.Shares of Common Stock subject to stock options which are currently exercisableor will become exercisable within 60 days after March 31, 2004, aredeemed outstanding for computing the percentage of the person or group holdingsuch options, but are not deemed outstanding for computing the percentage ofany other person or group.

 

(2)                                  Includes 1,030,182shares beneficially owned by Domain Partners III, L.P., 15,468 sharesbeneficially owned by DP III Associates, L.P. and 4,875 shares beneficiallyowned by Domain Associates L.L.C. Dr. Blair is a managing member of DomainAssociates L.L.C.

 

44

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(3)                                  Includes 7,396 sharesissuable upon exercise of options exercisable within 60 days ofMarch 31, 2004. Also includes 1,030,182 shares beneficially owned byDomain Partners III, L.P., 15,468 shares beneficially owned by DP IIIAssociates, L.P. and 4,875 shares beneficially owned by Domain AssociatesL.L.C. Dr. Blair is a managing member of Domain Associates L.L.C.

 

(4)                                  Includes 1,250 sharesbeneficially owned by The Binkley Family Trust and 452,523 shares beneficiallyowned by SBIC Partners, L.P., a Texas limited partnership (“SBIC Partners”).Also includes 368,421 shares of Series A Convertible Preferred Stockacquired in a Preferred Stock financing on March 3, 2003 by SBIC Partners,L.P. SBIC Partners is the beneficial owner of all shares of the Company’s CommonStock registered in its name. Forrest Binkley & Brown L.P., a Texaslimited partnership (“FBB”), is the managing general partner of SBIC Partners,and Forrest Binkley & Brown Venture Co., a Texas corporation (“VentureCo.”), is the sole general partner of FBB. Nicholas Binkley, a limited partnerof FBB and an executive officer, director and shareholder of Venture Co.,resigned as one of our directors on February 21, 2003

 

(5)                                  Includes 3,438 sharesissuable upon exercise of options exercisable within 60 days ofMarch 31, 2004. Also includes 631,579 shares of Series A ConvertiblePreferred Stock beneficially owned by Vectra Partners LLC.

 

(6)                                  Includes 12,271shares issuable upon exercise of options exercisable within 60 days ofMarch 31, 2004. Also includes 161,728 shares beneficially owned by OneLiberty Fund III, L.P. Mr. Holland is a general partner of One LibertyPartners III, L.P., which is a general partner of One Liberty Fund III, L.P.Mr. Holland disclaims beneficial ownership with respect to all shares ofCommon Stock owned by One Liberty Fund III, L.P.

 

(7)                                  Includes 102,472shares issuable upon exercise of options exercisable within 60 days ofMarch 31, 2004.

 

(8)                                  Includes 13,333shares issuable upon exercise of options exercisable within 60 days of March 31,2004.

 

(9)                                  Includes 48,582shares issuable upon exercise of options exercisable within 60 days ofMarch 31, 2004.

 

(10)                            Includes 12,271 sharesissuable upon exercise of options exercisable within 60 days ofMarch 31, 2004.

 

(11)                            Includes 35,514 sharesissuable upon exercise of options exercisable within 60 days ofMarch 31, 2004.

 

(12)                            Includes 12,222 sharesissuable upon exercise of options exercisable within 60 days ofMarch 31, 2004.

 

(13)                            Includes 247,499 sharesissuable upon exercise of options exercisable within 60 days ofMarch 31, 2004. See also footnotes 2, 3, 4, 5 and 6.

 

45

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Item 13.                               CERTAIN RELATIONSHIPSAND RELATED TRANSACTIONS

 

We have entered into indemnification agreements with our directors andexecutive officers. Such agreements require us, among other things, toindemnify our officers and directors, other than for liabilities arising fromwillful misconduct of a culpable nature, and to advance their expenses incurredas a result of any proceedings against them as to which they could beindemnified.

 

Pursuant to an agreement entered into on December 28, 1998, wehave agreed to continue to pay Mr. Lyon his salary, and to continue toprovide certain health care benefits, for a period of twelve (12) monthsin the event of his involuntary termination following a change in control.

 

Pursuant to an agreement entered into on January 29, 2003, we haveagreed to continue to pay Mr. Gorgol and Mr. Kennedy their salary,and to continue to provide health care benefits, for a period of(6) months in the event of their involuntary termination following achange in control. The sale of the Visualization Technology business inApril 2004 could result in the envoking of these agreements withMr. Gorgol and Mr. Kennedy.

 

Fifty percent of certain unvested shares subject to options outstandingto our executive officers will immediately vest if we are acquired by a mergeror asset sale, unless our repurchase rights with respect to those shares aretransferred to the acquiring entity. The other fifty percent of these sharesvest if the employee is terminated without cause within two years of the mergeror asset sale.

 

All of our officers are employed at will.

 

Our Second Restated Certificate of Incorporation eliminates, subject tocertain exceptions, directors’ personal liability to us or our stockholders formonetary damages for breaches of fiduciary duties. The Second RestatedCertificate of Incorporation does not, however, eliminate or limit the personalliability of a director for (i) any breach of the director’s duty ofloyalty to us or our stockholders, (ii) acts or omissions not in goodfaith or which involve intentional misconduct or a knowing violation of law,(iii) unlawful payments of dividends or unlawful stock repurchases orredemptions as provided in Section 174 of the Delaware General CorporationLaw or (iv) any transaction from which the director derived an improperpersonal benefit.

 

Our Restated Bylaws provide that we shall indemnify its directors andexecutive officers to the fullest extent permitted under the Delaware GeneralCorporation Law and may indemnify its other officers, employees and otheragents as set forth in the Delaware General Corporation Law. In addition, wehave entered into indemnification agreements with our directors and officers.The indemnification agreements contain provisions that require us, among otherthings, to indemnify our directors and executive officers against certainliabilities (other than liabilities arising from intentional or knowing andculpable violations of law) that may arise by reason of their status or serviceas directors or executive officers of ours or other entities to which theyprovide service at our request and to advance expenses they may incur as aresult of any proceeding against them as to which they could be indemnified. Webelieve that these provisions and agreements are necessary to attract andretain qualified directors and officers. We have obtained an insurance policycovering directors and officers for claims that such directors and officers mayotherwise be required to pay or for which we are required to indemnify them,subject to certain exclusions.

 

46

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Item 14.                               PRINCIPAL ACCOUNTANT FEES AND SERVICES

 

The Audit Committee has appointed Ernst & Young LLP as ourindependent auditors for the fiscal year ending December 31, 2004.

 

The following table shows the fees paid or accrued by us for the auditand other services provided by Ernst & Young LLP for fiscal 2003 and2002.

 

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

 

----

(1)                                  Audit fees representfees for professional services provided in connection with the audit of ourfinancial statements and review of our quarterly financial statement and auditservices provided in connection with other statutory or regulatory filings.

 

(2)                                  Audit-related feesconsisted primarily of accounting consultations, employee benefit plan audits,services related to business acquisitions and divestitures and otherattestation services.

 

(3)                                  For fiscal 2003 and2002 tax fees principally included tax compliance fees.

 

(4)                                  All other feesprincipally include miscellaneous consulting services, of which there werenone.

 

47

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PART IV

 

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

 
| (a) |   | (1) |   | Financial Statements |
|-----|--------|-----|--------|----------------------|

 

The financial statements required by this item are submitted in aseparate section beginning on Page F-1 of this report.

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

 

(2)                                  FinancialStatement Schedules

 

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

 

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

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

 

(c)                                  Exhibits

 
| **NUMBER  EXHIBIT** | ** ** | **DESCRIPTION**                                                                                                                                                              |
|---------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                |       |                                                                                                                                                                         |
| 3.1(1)              |       | Second Restated Certificate of Incorporation                                                                                                                                 |
| 3.4(2)              |       | Restated Bylaws.                                                                                                                                                             |
| 3.2(14)             |       | Certificate of Amendment of Second Restated Certificate of  Incorporation                                                                                                    |
| 3.3(15)             |       | Certificate of Designations of Series A Convertible Preferred Stock                                                                                                          |
| 4.1(2)              |       | Form of certificate for common stock.                                                                                                                                        |
| 4.2(15)             |       | Registration Rights Agreement datd March 3, 2003, with  the parties listed on Exhibit A therto.                                                               |
| 10.1(2)             |       | Series A-1 Preferred Stock Purchase Agreement with the purchasers  listed on Schedule A thereto, dated July 27, 1995.                                    |
| 10.2*(2)            |       | Manufacturing Supply Agreement with Kaiser Electro-Optics, Inc., dated  July 19, 1995.                                                                   |
| 10.3(2)             |       | Amended and Restated Investors’ Rights Agreement with the  stockholders listed on Schedule A thereto, dated  November 27, 1996.                     |
| 10.4(2)             |       | Amendment to the Amended and Restated Investors’ Rights Agreement  with Heartport and the stockholders listed on Exhibit A thereto, dated  February 22, 1997. |
| 10.5(2)             |       | Letter Agreement regarding Investment Representations and  Registration Rights between us and Urohealth Systems, Inc., dated  December 13, 1996.                   |
| 10.5(b)(15)         |       | Preferred Stock Purchase Agreement dated March 3, 2003, with the  parties listed on Schedule A therto.                                                             |
| 10.6*(2)            |       | Consulting Agreement with Harry R. McKinley, dated  September 15, 1995, as amended.                                                                                |

 

48

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

 

49

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| 10.57(12)  |   | Cooperative Technology Agreement with Jomed International, dated as  of May 19, 2000.                                 |
|------------|--------|-----------------------------------------------------------------------------------------------------------------------|
| 10.58*(13) |   | Exclusive Supply and Promotion Agreement with Ethicon Endo-Surgery,  Inc., dated as of June 22, 2001.            |
| 10.59(16)  |   | Asset Purchase Agreement with Viking Systems, Inc. dated as of  December 22, 2003.                               |
| 23.1**     |   | Consent of Ernst & Young LLP, Independent Registered Public  Accounting Firm                                      |
|       |   |                                                                                                                  |
| 31.1**     |   | Certification of Principal Executive Officer pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.         |
| 31.2**     |   | Certification of Principal Financial Officer pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.         |
| 32.1**     |   | Certification pursuant to 18 U.S.C. 1350, as adapted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002. |

 

----

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

**                                  Filed herewith

 

SUPPLEMENTAL INFORMATION

 

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

 

50

----

 

SIGNATURES

 

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

 

 
|                          |   | VISTA MEDICAL TECHNOLOGIES, INC. |
|-------------------------------|--------|----------------------------------|
|                          |   |                             |
|                          |   |                             |
| Date: September 29, 2004 | By:    | /s/ John R. Lyon                 |   |
|                          |   |                             | John R. Lyon |
|                          |   |                             | President and Chief Executive Officer |

 

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

 
| **SIGNATURE**      | ** ** | **TITLE**                                                             | ** ** | **DATE**                |
|--------------------|------------|-----------------------------------------------------------------------|------------|-------------------------|
|               |       |                                                                  |       |                    |
| /s/ John R. Lyon   |       | President, Chief Executive Officer,                                   |       | September 29, 2004 |
| (John R. Lyon)     |       | Chairman of the Board and Director  (Principal Executive Officer)     |       |                    |
|               |       |                                                                  |       |                    |
| /s/ Howard Sampson |       | Vice President of Finance and                                         |       | September 29, 2004 |
| (Howard Sampson)   |       | Chief Financial Officer (Principal  Financial and Accounting Officer) |       |                    |
|               |       |                                                                  |       |                    |
| *                  |       | Director                                                              |       | September 29, 2004 |
| (George B. DeHuff) |       |                                                                  |       |                    |
|               |       |                                                                  |       |                    |
| *                  |       | Director                                                              |       | September 29, 2004 |
| (James D. Durham)  |       |                                                                  |       |                    |
|               |       |                                                                  |       |                    |
| *                  |       | Director                                                              |       | September 29, 2004 |
| (James Hornthal)   |       |                                                                  |       |                    |
|               |       |                                                                  |       |                    |
| *                  |       | Director                                                              |       | September 29, 2004 |
| (Michael Owens)    |       |                                                                  |       |                    |
|               |       |                                                                  |       |                    |
| *                  |       | Director                                                              |       | September 29, 2004 |
| (Scott Pancoast)   |       |                                                                  |       |                    |
|               |       |                                                                  |       |                    |
| *                  |       | Director                                                              |       | September 29, 2004 |
| (C. Fred Toney)    |       |                                                                  |       |                    |

 

----

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

 

51

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Vista Medical Technologies, Inc.

 

Index to Consolidated Financial Statements

 

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

 

F-1

----

 

Report ofIndependent Registered Public Accounting Firm

 

The Board of Directors and Stockholders

Vista Medical Technologies, Inc.

 

We have audited the accompanying consolidated balance sheets of VistaMedical Technologies, Inc. as of December 31, 2002 and 2003 and therelated consolidated statements of operations, stockholders’ equity, and cashflows for each of the three years in the period ended December 31,2003.  Our audit also included thefinancial statement schedule listed in the index at Item 15(a).  These financial statements are the responsibilityof the Company’s management. Our responsibility is to express an opinion onthese financial statements based on our audits.

 

We conducted our audits in accordance with the standards of the PublicCompany Accounting Oversight Board (United States). Those standards requirethat we plan and perform the audit to obtain reasonable assurance about whetherthe financial statements are free of material misstatement. An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements.  An audit alsoincludes assessing the accounting principles used and significant estimatesmade by management, as well as evaluating the overall financial statementpresentation. We believe that our audits provide a reasonable basis for ouropinion.

 

In our opinion, the financial statements referred to above presentfairly, in all material respects, the consolidated financial position of VistaMedical Technologies, Inc. at December 31, 2002 and 2003, and theconsolidated results of its operations and its cash flows for each of the threeyears in the period ended December 31, 2003, in conformity with accountingprinciples generally accepted in the United States.  Also, in our opinion, the related financial statement schedule,when considered in relation to the basic financial statements taken as a whole,presents fairly in all material respects the information set forth therein.

 

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

 
|               |   | /s/ Ernst & Young LLP |
|--------------------|--------|---------------------------|
|               |   |                      |
| September 22, 2004 |   |                      |

 

F-2

----

 

Vista Medical Technologies, Inc.

 

ConsolidatedBalance Sheets

 
|                                                                                                        |   | **DECEMBER 31,** |      |
|-------------------------------------------------------------------------------------------------------------|--------|------------------|-----------|
|                                                                                                        |   | **2002**         |      | **2003** |   |
|                                                                                                        |   | **Restated**     |      | **Restated** |   |
| ASSETS                                                                                                      |   |             |      |   |   |
|                                                                                                        |   |             |      |   |   |
| Current assets:                                                                                             |   |             |      |   |   |
| Cash and cash equivalents                                                                                   |   | $                | 457,052   |   | $ | 448,943 |   |
| Short-term investments                                                                                      |   | 372,320          |      | 187,209 |   |
| Accounts receivable                                                                                         |   | 647,884          |      | 286,152 |   |
| Inventories                                                                                                 |   | 57,421           |      | 45,275 |   |
| Net assets related to  discontinued operations                                                              |   | 2,579,576        |      | 1,881,237 |   |
| Other current assets                                                                                        |   | 60,148           |      | 108,322 |   |
| Total current assets                                                                                        |   | 4,174,401        |      | 2,957,138 |   |
| Property and equipment, net                                                                                 |   | 7,757            |      | 34,023 |   |
| Total Assets                                                                                                |   | $                | 4,182,158 |   | $ | 2,991,161 |   |
|                                                                                                        |   |             |      |   |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                   |   |             |      |   |   |
|                                                                                                        |   |             |      |   |   |
| Current liabilities:                                                                                        |   |             |      |   |   |
| Accounts payable                                                                                            |   | $                | 177,189   |   | $ | 141,631 |   |
| Current portion of capital  leases                                                                          |   | —           |      | 16,517 |   |
| Short-term bank borrowings                                                                                  |   | —           |      | 200,000 |   |
| Accrued compensation                                                                                        |   | 109,618          |      | 134,156 |   |
| Deferred revenue                                                                                            |   | 494,167          |      | 442,500 |   |
| Liabilities related to  discontinued operations                                                             |   | 1,031,480        |      | 755,550 |   |
| Accrued liabilities                                                                                         |   | 288,747          |      | 174,019 |   |
| Total current liabilities                                                                                   |   | 2,101,201        |      | 1,864,373 |   |
| Long- term portion of capital  leases                                                                       |   | —           |      | 18,624 |   |
| TOTAL LIABILITIES                                                                                           |   | 2,101,201        |      | 1,882,997 |   |
| Stockholders’ equity:                                                                                  |   |             |      |   |   |
| Preferred stock, $.01 par  value:                                                                           |   |             |      |   |   |
| Authorized shares – 5,000,000                                                                          |   |             |      |   |   |
| Issued and outstanding shares –  none in 2002 and 1,000,000 in 2003  (Liquidation Value of $3,800,000) |   | —           |      | 1,068,686 |   |
| Common stock, $.01 par value:                                                                               |   |             |      |   |   |
| Authorized shares – 35,000,000                                                                         |   |             |      |   |   |
| Issued and outstanding shares –  5,001,749 in 2002 and 5,007,918 in 2003                               |   | 50,018           |      | 50,079 |   |
| Additional paid-in capital                                                                                  |   | 68,079,861       |      | 68,111,244 |   |
| Notes receivable from  stockholders                                                                         |   | (78,375          | )         | — |   |
| Deferred compensation                                                                                       |   | (45,947          | )         | (29,856 | ) |
| Accumulated deficit                                                                                         |   | (65,924,600      | )         | (68,091,989 | ) |
| Total stockholders’ equity                                                                             |   | 2,080,957        |      | 1,108,164 |   |
|                                                                                                        |   |             |      |   |   |
| Total liabilities and  stockholders’ equity                                                            |   | $                | 4,182,158 |   | $ | 2,991,161 |   |

 

SEE ACCOMPANYING NOTE

 

F-3

----

 

Vista Medical Technologies, Inc.

 

Consolidated Statements of Operations

 

 
|                                                                |   | **YEARS ENDED DECEMBER 31,** |       |
|---------------------------------------------------------------------|--------|------------------------------|------------|
|                                                                |   | **2001**                     |       | **2002** |   | **2003** |   |
|                                                                |   | **Restated**                 |       | **Restated** |   | **Restated** |   |
|                                                                |   |                         |       |   |   |   |   |
| Revenues                                                            |   | $                            | —     |   | $ | 3,542,883 |   | $ | 2,489,117 |   |
| Cost and expenses:                                                  |   |                         |       |   |   |   |   |
| Cost of revenues                                                    |   | —                       |       | 797,528 |   | 574,599 |   |
| Sales and marketing                                                 |   | —                       |       | 2,138,639 |   | 1,755,215 |   |
| General and administrative                                          |   | 1,003,397                    |       | 1,082,003 |   | 1,226,145 |   |
| Total costs and expenses                                            |   | 1,003,397                    |       | 4,018,170 |   | 3,555,959 |   |
| Loss from operations                                                |   | (1,003,397                   | )          | (475,287 | ) | (1,066,842 | ) |
| Other income, net                                                   |   | 69,879                       |       | 17,426 |   | 32,390 |   |
| Net loss from continuing  operations                                |   | (933,518                     | )          | (457,861 | ) | (1,034,452 | ) |
| Loss from discontinued  operations                                  |   | (2,288,911                   | )          | (689,290 | ) | (1,014,251 | ) |
| Net loss                                                            |   | $                            | (3,222,429 | ) | $ | (1,147,151 | ) | $ | (2,048,703 | ) |
| Less- Accretion of dividends on  preferred stock                    |   | —                       |       | — |   | (118,686 | ) |
| Net loss applicable to common  stockholders                         |   | $                            | (3,222,429 | ) | $ | (1,147,151 | ) | $ | (2,167,387 | ) |
|                                                                |   |                         |       |   |   |   |   |   |   |   |
| Net loss per share basic and  diluted:                              |   |                         |       |   |   |   |   |   |   |   |
| Continuing operations                                               |   | $                            | (0.19      | ) | $ | (0.09 | ) | $ | (0.23 | ) |
| Discontinued operations                                             |   | $                            | (0.47      | ) | $ | (0.14 | ) | $ | (0.20 | ) |
| Basic and diluted loss per  share applicable to common stockholders |   | $                            | (0.66      | ) | $ | (0.23 | ) | $ | (0.43 | ) |
|                                                                |   |                         |       |   |   |   |   |   |   |   |
| Shares used in computing basic  and diluted net loss per share      |   | 4,906,197                    |       | 4,968,519 |   | 5,004,126 |   |

 

SEE ACCOMPANYINGNOTES

 

F-4

----

 

Vista Medical Technologies, Inc.

 

Consolidated Statements of Stockholders’ Equity

 
|                                                        |   | **PREFERRED  STOCK** |   | **COMMON  STOCK** |      | **ADDITIONAL  PAID IN** |      | **NOTES  RECEIVABLE  FROM** |   | **DEFERRED** |       | **ACCUMULATED**  |       |             |    |
|-------------------------------------------------------------|--------|----------------------|--------|-------------------|-----------|-------------------------|-----------|-----------------------------|--------|--------------|------------|------------------|------------|------------------|---------|
|                                                        |   | **SHARES**           |   | **AMOUNT**        |      | **SHARES**              |      | **AMOUNT**                  |   | **CAPITAL**  |       | **STOCKHOLDERS** |       | **COMPENSATION** |    | **DEFICIT** |   | **TOTAL** |   |
| Balance at December 31, 2000                           |   |                 |   | $                 |      |                    |      | 4,897,342                   |   | $            | 48,973     |             | $          | 68,003,535       |    | $ | (78,375 | ) | $ | (267,951 | ) | $ | (61,555,020 | ) | $ | 6,151,162 |   |
|                                                        |   |                 |   |              |      |                    |      |                        |   |         |       |             |       |             |    |   |   |   |   |
| Exercise of stock options for cash                          |   |                 |   |              |      | 4,325                   |      | 43                          |   | 3,438        |       |             |       |             |    |   |   | 3,481 |   |
| Issuance of stock under employee stock purchase plan        |   |                 |   |              |      | 11,364                  |      | 114                         |   | 21,295       |       |             |       |             |    |   |   | 21,409 |   |
| Forfeitures of non employee stock options                   |   |                 |   |              |      |                    |      |                        |   | (21,387      | )          |             |       | 21,387           |    |   |   | –– |   |
| Deferred compensation- issuance of options to consultants   |   |                 |   |              |      |                    |      |                        |   | 99,900       |       |             |       | (99,900          | )       |   |   | –– |   |
| Amortization of deferred compensation                       |   |                 |   |              |      |                    |      |                        |   | 274,787      |       |             |       | 274,787          |    |   |   |   |   |
| Recapture of deferred compensation                          |   |                 |   |              |      |                    |      |                        |   | (132,694     | )          |             |       | (4,628           | )       |   |   | (137,322 | ) |
| Net loss                                                    |   |                 |   |              |      |                    |      |                        |   |         |       |             |       |             |    | (3,222,429 | ) | (3,222,429 | ) |
|                                                        |   |                 |   |              |      |                    |      |                        |   |         |       |             |       |             |    |   |   |   |   |
| Balance at December 31, 2001                           |   | ––         |   | ––      |      | 4,913,031               |      | 49,130                      |   | $            | 67,974,087 |             | (78,375    | )                | (76,305 | ) | (64,777,449 | ) | 3,091,088 |   |
|                                                        |   |                 |   |              |      |                    |      |                        |   |         |       |             |       |             |    |   |   |   |   |
| Exercise of stock options and warrants for cash             |   |                 |   |              |      | 64,808                  |      | 649                         |   | 34,982       |       |             |       |             |    |   |   | 35,631 |   |
| Issuance of stock under employee stock purchase plan        |   |                 |   |              |      | 23,910                  |      | 239                         |   | 34,792       |       |             |       |             |    |   |   | 35,031 |   |
| Deferred compensation- issuance of options to consultants   |   |                 |   |              |      |                    |      |                        |   | 36,000       |       |             |       | (36,000          | )       |   |   | –– |   |
| Amortization of deferred compensation                       |   |                 |   |              |      |                    |      |                        |   |         |       |             |       | 66,358           |    |   |   | 66,358 |   |
| Net loss                                                    |   |                 |   |              |      |                    |      |                        |   |         |       |             |       |             |    | (1,147,151 | ) | (1,147,151 | ) |
|                                                        |   |                 |   |              |      |                    |      |                        |   |         |       |             |       |             |    |   |   |   |   |
| Balance at December 31, 2002                           |   | ––         |   | ––      |      | 5,001,749               |      | 50,018                      |   | 68,079,861   |       | (78,375          | )          | (45,947          | )       | (65,924,600 | ) | 2,080,957 |   |
|                                                        |   |                 |   |              |      |                    |      |                        |   |         |       |             |       |             |    |   |   |   |   |
| Exercise of stock options for cash                          |   |                 |   |              |      | 1,333                   |      | 13                          |   | 1,986        |       |             |       |             |    |   |   | 1,999 |   |
| Issuance of stock under employee stock purchase plan        |   |                 |   |              |      | 4,836                   |      | 48                          |   | 6,397        |       |             |       |             |    |   |   | 6,445 |   |
| Deferred compensation - issuance of options to consultants  |   |                 |   |              |      |                    |      |                        |   | 23,000       |       |             |       | (23,000          | )       |   |   | –– |   |
| Amortization of deferred compensation                       |   |                 |   |              |      |                    |      |                        |   |         |       |             |       | 39,091           |    |   |   | 39,091 |   |
| Issuance of stock – Series A preferred stock financing |   | 1,000,000            |   | 950,000           |      |                    |      |                        |   |         |       |             |       |             |    |   |   | 950,000 |   |
| Forgiveness of notes receivable                             |   |                 |   |              |      |                    |      |                        |   |         |       | 78,375           |       |             |    |   |   | 78,375 |   |
| Accretion of Preferred Stock dividends                      |   |                 |   | 118,686           |      |                    |      |                        |   |         |       |             |       |             |    | (118,686 | ) | — |   |
| Net loss                                                    |   |                 |   |              |      |                    |      |                        |   |         |       |             |       |             |    | (2,048,703 | ) | (2,048,703 | ) |
| Balance at December 31, 2003                           |   | 1,000,000            |   | $                 | 1,068,686 |                    | 5,007,918 |                        | $      | 50,079       |       | $                | 68,111,244 |             | $       | –– |   | $ | (29,856 | ) | $ | (68,091,989 | ) | $ | 1,108,164 |   |
|                                                             |        |                      |        |                   |           |                         |           |                             |        |              |            |                  |            |                  |         |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

SEE ACCOMPANYING NOTES

 

F-5

----

 

Vista Medical Technologies, Inc.

ConsolidatedStatements of Cash Flows

 

 
|                                                                                    |   | **YEARS ENDED DECEMBER 31,** |     |
|-----------------------------------------------------------------------------------------|--------|------------------------------|----------|
|                                                                                    |   | **2001**                     |     | **2002** |   | **2003** |   |
|                                                                                    |   | **Restated**                 |     | **Restated** |   | **Restated** |   |
| **OPERATING ACTIVITIES**                                                                |   |                         |     |   |   |   |   |
| Net loss from continuing  operations                                                    |   | $                            | (933,518 | ) | $ | (457,861 | ) | $ | (1,034,452 | ) |
| Adjustments to reconcile net  loss to net cash used in continuing operating activities: |   |                         |     |   |   |   |   |
| Depreciation and amortization                                                           |   | —                       |     | 8,488 |   | 39,264 |   |
| Forgiveness of notes receivable                                                         |   | —                       |     | — |   | 78,375 |   |
| Amortization of deferred  compensation                                                  |   | 137,462                      |     | 66,358 |   | 39,091 |   |
| Changes in operating assets and  liabilities:                                           |   |                         |     |   |   |   |   |
| Accounts receivable                                                                     |   | —                       |     | (647,884 | ) | 361,732 |   |
| Inventories, net                                                                        |   | —                       |     | (57,421 | ) | 12,146 |   |
| Other current assets                                                                    |   | —                       |     | (60,148 | ) | (48,174 | ) |
| Accounts payable                                                                        |   | —                       |     | 177,189 |   | (35,558 | ) |
| Accrued compensation                                                                    |   | —                       |     | 109,618 |   | 24,538 |   |
| Deferred revenue                                                                        |   | —                       |     | 494,167 |   | (51,667 | ) |
| Accrued liabilities                                                                     |   | —                       |     | 288,747 |   | (114,728 | ) |
| Net cash used in continuing  operating activities                                       |   | (796,056                     | )        | (78,747 | ) | (729,433 | ) |
| Loss from discontinued  operations                                                      |   | (2,288,911                   | )        | (689,290 | ) | (1,014,251 | ) |
| Changes in assets and  liabilities related to discontinued operations                   |   | 1,443,249                    |     | 225,590 |   | 422,409 |   |
| Net cash used in discontinued  operations                                               |   | (845,662                     | )        | (463,700 | ) | (591,842 | ) |
| Net cash flows used in  operating activities                                            |   | (1,641,718                   | )        | (542,447 | ) | (1,321,275 | ) |
| **INVESTING ACTIVITIES**                                                                |   |                         |     |   |   |   |   |
| Purchases (maturities) of  short-term investments                                       |   | (171,631                     | )        | 144,535 |   | 185,111 |   |
| Purchase of property and  equipment                                                     |   | —                       |     | (16,245 | ) | (22,375 | ) |
| Net cash flows (used in)  provided by investing activities                              |   | (171,631                     | )        | 128,290 |   | 162,736 |   |
| **FINANCING ACTIVITIES**                                                                |   |                         |     |   |   |   |   |
| Issuance of common stock, net                                                           |   | 24,890                       |     | 70,662 |   | 8,444 |   |
| Issuance of Series A preferred  stock                                                   |   | —                       |     | — |   | 950,000 |   |
| Short term bank borrowings                                                              |   | —                       |     | — |   | 200,000 |   |
| Payments on capital leases                                                              |   | —                       |     | — |   | (8,014 | ) |
| Net cash flows provided by  financing activities                                        |   | 24,890                       |     | 70,662 |   | 1,150,430 |   |
| Net decrease in cash and cash  equivalents                                              |   | (1,788,459                   | )        | (343,495 | ) | (8,109 | ) |
| Cash and cash equivalents at  beginning of year                                         |   | 2,589,006                    |     | 800,547 |   | 457,052 |   |
| Cash and cash equivalents at  end of year                                               |   | $                            | 800,547  |   | $ | 457,052 |   | $ | 448,943 |   |
| Non-cash transactions:                                                                  |   |                         |     |   |   |   |   |
| Acquisition of equipment  through capital leases                                        |   | $                            | —   |   | $ | 23,514 |   | $ | 43,141 |   |
| Accretion of cumulative  dividends on preferred stock                                   |   | —                       |     | — |   | $ | 118,686 |   |
| Supplementary cash flow  information:                                                   |   |                         |     |   |   |   |   |
| Interest paid                                                                           |   | $                            | —   |   | $ | — |   | $ | 4,992 |   |

 

SEE ACCOMPANYING NOTES

 

F-6

----

 

Vista Medical Technologies, Inc.

 

Notes to Consolidated Financial Statements 

December 31, 2003 

 

1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTINGPOLICIES 

 

ORGANIZATION AND BUSINESSACTIVITY 

 

Vista Medical Technologies,Inc., through its wholly owned subsidiary VOW Solutions, Inc. is exclusivelyfocused on the disease state management of morbid obesity.

 

We previously conducted ouroperations through two separate business units.  The Obesity Surgical and Medical Management Services businessunit (now our disease state management of morbid obesity business operated viaour wholly-owned subsidiary, VOW Solutions, Inc.), based in Carlsbad, CA,provides services to physicians and hospitals involved in the surgicaltreatment of morbid obesity.  Ourservices include management of our original product offering, the LaparoscopicBariatric Surgery Preceptorship, a comprehensive introduction to starting aminimally invasive gastric bypass surgical program. We also offer systems,consulting and program management services, which enable the efficientoperation of obesity surgery programs. In addition, our former Visualization Technology business unit, based inWestborough, Massachusetts, developed, manufactured and marketed products thatprovide information to physicians performing minimally invasive generalsurgical, cardiac surgical and other selected endoscopic and interventionalprocedures.  On December 22, 2003we signed an agreement to sell the Visualization Technology business unit toViking Systems, Inc. (“Viking”).  Thissale was completed on April 15, 2004**. **Theseconsolidated financial statements have been****restated for all periods presented toreflect the Visualization Technology business as a discontinued operation.  Refer to our Proxy Statement filed with theSEC on March 25, 2004 for further details of the transaction.

 

As a result of the sale of ourVisualization Technology business unit, all of our operations are conductedthrough our subsidiary VOW Solutions, Inc., which we refer to as VOW, and areconcentrated in the field of bariatric surgery and bariatric medicine.  The vision of our VOW business is to enablehealthcare providers and organizations in the ongoing evolution of the higheststandards of treatment and services to optimize the quality of life formorbidly obese patients.  Our mission isto deliver the leading management portfolio of services and products for the clinicaland business development of continually successful obesity surgeryprograms.  

 

The Company incurred operatinglosses in 2001, 2002 and 2003, and at December 31, 2003, had an accumulateddeficit of $68.1 million.  At December31, 2003, the Company had cash, cash equivalents and short-term investments of$636,000.  In February 2004, the Companysold $588,000 of common stock in a private placement to several investors.   In addition, the Company has amounts availableunder a $2.0 million bank line of credit facility, which expires in October2004 and is subject to annual renewals. The Company believes that these sources of liquidity, together withanticipated 2004 product revenues and interest income, will not be sufficientto meet its anticipated capital requirements through January 2005.    These factors raise substantial doubt about the Company’s abilityto continue as a going concern.  Management is pursuing several alternatives to address this situation,including raising additional funding and the sale of the VisualizationTechnology business.    Should theCompany be unable to raise sufficient funds, the Company may be required tocurtail its operating plans and possibly relinquish rights to portions of theCompany’s technology or products.  Inaddition, increases in expenses or delays in product development may adverselyimpact the Company’s cash position and require further cost reductions.  No assurance can be given that the Companywill be able to operate profitably on a consistent basis, or at all, in thefuture.

 

The accompanying consolidatedfinancial statements have been prepared on a going concern basis, whichcontemplates the realization of assets and the satisfaction of liabilities inthe normal course of business.  Thefinancial statements do not include and adjustments relating to therecoverability and classification of assets or the amounts and classificationof liabilities that might be necessary should the Company be unable to continueas a going concern.

 

F-7

----

 

PRINCIPLES OF CONSOLIDATION 

 

The consolidated financialstatements include the accounts of the Company and its wholly-owned subsidiary.Significant intercompany accounts and transactions have been eliminated.

 

RECLASSIFICATIONS 

 

Certain account balances forthe prior years have been reclassified to conform to the current year financialstatement presentation.

 

USE OF ESTIMATES

 

The preparation of financialstatements in accordance with generally accepted accounting principles requiresmanagement to make estimates and assumptions that affect the amounts reportedin the financial statements and disclosures made in the accompanying notes tothe consolidated financial statements. Actual results could differ from those estimates.

 

REVENUE RECOGNITION 

 

The Company recognizes revenuepursuant to Staff Accounting Bulletin (“SAB”) No. 104 “RevenueRecognition”.    Accordingly, revenue isrecognized when all four of the following criteria are met: (i) persuasiveevidence of an arrangement exists; (ii) delivery of the product and/or serviceshas occurred; (iii) the selling price is fixed or determinable and; (iv)collectibility is reasonably assured. Sales returns are estimated based on the historical experience andmanagement’s expectations and are recorded at the time product revenue isrecognized.  Shipping and handling costsare included in cost of sales.

 

Revenue generated from ourdisease state management of morbid obesity business are recognized (i) withregard to management services, upon completion of the service period and (ii)with regard to training services or other consulting services, upon completionof the related training or consulting component, provided that a contractexists, there are no uncertainties regarding customer acceptance, the salesprice is fixed or determinable and collectibility is deemed probable.  Sales of vitamins are similarly recognizedupon shipment provided that a purchase order has been received, there are nouncertainties regarding customer acceptance, the sales price is fixed ordeterminable and collectibility is deemed probable

 

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

 

CASH, CASH EQUIVALENTS ANDSHORT-TERM INVESTMENTS 

 

Cash equivalents and short-terminvestments consist of money market funds, certificates of deposit andcommercial paper. The Company considers all highly liquid investments withmaturities of three months or less when purchased to be cash equivalents. TheCompany evaluates the financial strength of institutions at which significantinvestments are made and believes the related credit risk is limited to anacceptable level.  

 

The Company accounts for itsinvestments in accordance with Statement of Financial Accounting Standards(SFAS) No. 115, “Accounting for Certain Investments in Debt and EquitySecurities”, and has classified its cash equivalents and short-term investmentsas available-for-sale in accordance with that standard.  Available-for-sale securities are carried atfair value, with unrealized gains and losses, net of tax, reported in aseparate component of stockholders’ equity. At December 31, 2003 and 2002, thecost of cash equivalents and short-term investments was equivalent to fairvalue and the Company had no unrealized gains or losses.

 

F-8

----

 

As of December 31, 2002 and2003, the Company’s cash, cash equivalents and short-term investments consistedof:

 

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

 

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

 

FAIR VALUE OF FINANCIALINSTRUMENTS

 

The carrying amounts of theCompany’s financial instruments, which include cash and cash equivalents,short-term investments, accounts receivable, accounts payable, capital leasesand short-term bank borrowings, approximate their fair values at December 31,2002 and 2003, due to the short-term nature of these financial instruments.

 

INVENTORIES 

 

Inventories are stated at lowerof cost (determined on a first-in, first-out basis) or market and includefinished goods inventory at December 31, 2002 and 2003.

 

PROPERTY AND EQUIPMENT 

 

Property and equipment isstated at cost and include office computers, furniture and equipment atDecember 31, 2002 and 2003. The Company provides for depreciation on propertyand equipment using the straight-line method over the estimated useful lives ofthe assets, generally two to five years. Depreciation expense related to continuing operations for the yearsended 2001, 2002 and 2003 was $0, $8,488 and $39,264, respectively.

 

IMPAIRMENT OF LONG-LIVED ASSETS

 

The Company evaluates itslong-lived assets for impairment in accordance with SFAS No. 144, *Accounting forthe Disposal or Impairment of Long-Lived Assets*.  The Company records impairment losses onlong-lived assets used in operations when indicators of impairment are presentand the undiscounted cash flows estimated to be generated by those assets areless than the carrying value of the assets. There have not been any impairmentsof long-lived assets to date.  

 

INCOME TAXES 

 

The Company uses the asset andliability accounting method whereby deferred tax assets and liabilities arerecognized based on temporary differences between the financial statements andtax bases of assets and liabilities using current statutory tax rates. Avaluation allowance against net deferred tax assets is recorded if, based onthe available evidence, it is more likely than not that some or all of thedeferred tax assets will not be realized. Management evaluates on a quarterlybasis the ability to recover the deferred tax assets and the level of thevaluation allowance. 

 

F-9

----

 

COMPREHENSIVE INCOME  (LOSS) 

 

Comprehensive income  (loss) is comprised of net loss and othercomprehensive income (loss). Other comprehensive income (loss) includes certainchanges in equity that are excluded from net loss. For the years ended December31, 2001, 2002 and 2003, the Company had no items of comprehensive income(loss) other than its net loss.

 

SAVINGS PLANS

 

The Company has a 401(k) planfor U.S. employees, which include retirement income features consisting ofemployee tax deferred contributions. Contributions under all plans are investedin professionally managed portfolios. No Company contributions were made in 2001, 2002 and 2003.  

 

NET LOSS PER SHARE 

 

Basic net loss per share iscalculated 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 periodspresented.  Common stock equivalentsexcluded from the calculation of diluted weighted average shares were 564,130,689,328 and 806,286 as of December 31, 2001, 2002 and 2003, respectively.  

** **

STOCK-BASED COMPENSATION 

 

The Company applies theprinciples of Accounting Principles Board Opinion No. 25, “*Accounting for Stock Issued toEmployees*,” and related interpretations in accounting for its employeestock option compensation plans. Under APB No. 25, compensation expense ismeasured as the difference, if any, between the option exercise price and thefair value of the Company’s common stock at the date of grant.  The Company has historically granted optionsto employees and directors at exercise prices equal to the fair value of theCompany’s common stock. Accordingly, no compensation expense has beenrecognized for its employee stock-based compensation plans. 

 

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

 

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

 

F-10

----

 

The average estimated fairvalue of options granted during fiscal years 2001, 2002 and 2003, was $3.36,$3.47, and $1.09, respectively, and was estimated using the Black-Scholesoption-pricing model using the following weighted-average assumptions: 

 

 

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

 

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

 

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

 

NEW ACCOUNTING STANDARDS 

 

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

 

In May 2003, the FASB issuedSFAS No. 150, “*Accounting for Certain Financial Instruments with Characteristics ofBoth Liabilities and Equity*.” SFAS No. 150 establishes standards for how an issuer classifies and measurescertain financial instruments with characteristics of both liabilities andequity.  Many of these instruments werepreviously classified as equity.  SFASNo. 150 is effective for financial instruments entered into or modified after 

 

F-11

----

 

May 31, 2003, and otherwise waseffective at the beginning of the first interim period beginning after June 15,2003.  The adoption of this Statementdid not have an effect on the Company’s financial statements.

 

2. 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. This agreement expired in November 2003.  A new promotion agreement was executed in December 2003 underwhich $500,000 will be received in 2003 and 2004 for optimization services tobe provided, of which $250,000 was included in deferred revenue at December 31,2003.  No further payments are expectedfrom EES after this point.  The Companyrecognizes revenue ratably over the term of the agreement.  The Company recognized $917,000 of revenuein each of the years 2002 and 2003 related to the EES agreement. 

 

3. CREDIT AGREEMENT

 

In October 2001, the Companysecured a $2,000,000 line of credit Facility (the Facility) with a bank for oneyear with automatic yearly renewals. The current line of credit agreement expires in October 2004.  The Facility is secured by qualifiedaccounts receivable and bears interest at the rate of prime plus 2% (4.5% atDecember 31, 2003).  Borrowings underthe Facility are limited to 80% of qualified accounts receivable.  At December 31, 2003, there was $200,000 ofborrowings outstanding, and $730,000 available under the Facility. It isunlikely that we will be able to draw on this Facility since the amountsreceivable from Viking related to the sale of the Visualization Technologybusiness will not be considered qualified accounts receivable.

 

4.  COMMITMENTS 

 

At December 31, 2003, theCompany is obligated under an operating lease, principally related to realestate.  Additionally, the Company isobligated under capital leases related to computer hardware.  The following is a schedule of futureminimum payments, excluding taxes and other operating costs, as of December 31,2003:

 

| **YEAR ENDING DECEMBER 31,**              |   | **Operating  Leases** |    | **Capital  Leases** |    |
|-------------------------------------------|--------|-----------------------|---------|---------------------|---------|
| 2004                                      |   | $                     | 223,125 |                | $       | 30,422 |   |
| 2005                                      |   | 18,624                |    | 20,530              |    |
| 2006                                      |   | —                |    | 5,572               |    |
|                                      |   | $                     | 265,588 |                | $       | 56,524 |   |
| Less – Amounts representing interest |   |                  |    | (21,283             | )  |
| Principal capital lease obligation        |   |                  |    | $                   | 35,141  |   |

 

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

 

Rent expense related tocontinuing operations was $124,000, $128,000 and $104,000 for the years endedDecember 31, 2001, 2002 and 2003, respectively.  

 

F-12

----

 

5. STOCKHOLDERS’ EQUITY

 

COMMON STOCK RESERVED

 

At December 31, 2003, theCompany has reserved the following shares of common stock for future issuance:

 

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

 

PREFERRED STOCK

 

On March 3, 2003 the Companysold 1,000,000 shares of newly issued Series A Convertible Preferred Stock(Series A Stock) to two accredited investors through a private placement forgross proceeds of $950,000. The shares are convertible at any time into commonshares on a one-for-one basis, subject to adjustment, accrue annual dividends,payable only if and when declared by the Company at the rate of $.01425 pershare and have a liquidation value of $3,800,000 plus unpaid dividends.Although the shares are redeemable only at the option of the Company, theSeries A Stockholders will be entitled to a cash dividend of 15% per annum ifspecified redemptions are not effected within one year of the occurrence ofcertain events, including a sale of substantial assets or change ofcontrol.  Accordingly, the Companyrecorded accretion of preferred stock dividends in the amount of $118,686during 2003.  If redeemed, theredemption amount would be at prices of $2.67 to $2.90 per share. As long asthe Series A Stock is outstanding, the Company will require the approval of theSeries A Stockholders to undertake various actions including a) sell commonshares for less than $2.00 per share, b) revise terms of corporate governance,c) exceed certain capital expenditure limits, or d) expand current stock optionplans. The Series A Stockholders will also have the right to elect twodirectors to the Board of Directors after June 1, 2004.

 

1995 STOCK OPTION PLAN

 

The Company reserved 221,607shares of common stock under the 1995 Stock Option Plan (the “1995 Plan”) forissuance to eligible employees, officers, directors, advisors and consultants.The 1995 Plan provides for the grant of incentive and nonstatutory stockoptions. Terms of the stock option agreements, including vesting requirements, aredetermined by the Board of Directors, subject to the provisions of the 1995Plan. Options granted by the Company generally vest over four to five years andare exercisable from the date of grant for a period of ten years. 

 

The exercise price of the incentivestock options must equal at least the fair market value of the stock on thedate of grant. The exercise price of nonstatutory stock options must equal atleast 85% of the fair market value of the stock on the date of grant. TheCompany has the option, in the event of termination of employment, torepurchase unvested shares issued under the 1995 Plan at the original issueprice.  No additional shares areavailable for issuance under the 1995 Plan.

 

F-13

----

 

1997 STOCK OPTION PLAN/ STOCKISSUANCE PLAN 

 

In February 1997, the Companyadopted the 1997 Stock Option Plan/Stock Issuance Plan (the “1997 Plan”). The1997 Plan incorporates the outstanding options under the 1995 Plan and nofurther options will be granted under the 1995 Plan.  At December 31, 2003, the Company had a total of 1,092,500 sharesauthorized for issuance under the 1997 Stock Option/Stock Issuance Plan and179,579 options were available for future grant.

 

The following tables summarizesstock option activity under all option plans: 

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

 
|                         |   | **OUTSTANDING  STOCK OPTIONS** |   | **EXERCISABLE  STOCK OPTIONS**                                |   |
|------------------------------|--------|--------------------------------|--------|---------------------------------------------------------------|--------|
| **RANGE OF  EXERCISE PRICE** |   | **SHARES**                     |   | **WEIGHTED-  AVERAGE  REMAINING  CONTRACTUAL  LIFE (MONTHS)** |   | **WEIGHTED-  AVERAGE  EXERCISE  PRICE** |   | **SHARES** |   | **WEIGHTED-  AVERAGE  EXERCISE  PRICE** |   |
|                         |   |                           |   |                                                          |   |   |   |   |   |   |   |
| $                            | .80    | -                              | $      | 2.50                                                          |   | 468,251 |   | 89 |   | $ | 1.57 |   | 319,955 |   | $ | 1.51 |   |
| $                            | 3.00   | -                              | $      | 4.13                                                          |   | 250,924 |   | 101 |   | $ | 3.64 |   | 175,134 |   | $ | 3.62 |   |
| $                            | 4.62   | -                              | $      | 6.12                                                          |   | 41,111 |   | 88 |   | $ | 4.96 |   | 38,465 |   | $ | 4.97 |   |
| $                            | 9.00   | -                              | $      | 9.75                                                          |   | 21,125 |   | 70 |   | $ | 9.31 |   | 21,450 |   | $ | 9.31 |   |
|                         |   |                           | $      | 20.25                                                         |   | 10,000 |   | 65 |   | $ | 20.25 |   | 10,500 |   | $ | 20.25 |   |
| $                            | 39.50  | -                              | $      | 45.50                                                         |   | 13,875 |   | 56 |   | $ | 40.50 |   | 14,125 |   | $ | 40.58 |   |
|                         |   |                           | $      | 57.50                                                         |   | 1,000 |   | 57 |   | $ | 57.50 |   | 1,000 |   | $ | 57.50 |   |
|                         |   | 806,286                        |   | 63                                                            |   | $ | 3.56 |   | 580,629 |   | $ | 4.05 |   |
|                              |        |                                |        |                                                               |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

F-14

----

 

The weighted average remaininglife of the options outstanding at December 31, 2002 and 2003 was 66 and 63months, respectively.

 

WARRANTS

 

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

 

1997 EMPLOYEE STOCK PURCHASEPLAN 

 

In February 1997, the Companyadopted the 1997 Employee Stock Purchase Plan (the “Purchase Plan”), whichpermits eligible employees of the Company to purchase shares of common stock,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 less than85% of the lower of the fair market value of the common stock at either thebeginning or the end of the semi-annual intervals.  The Company has authorized and reserved 150,000 shares of commonstock for issuance under the Purchase Plan. There were 11,364, 23,910 and 4,836 shares issued under the PurchasePlan in 2001, 2002 and 2003, respectively.  There were 62,758 shares available for issuance at December 31, 2003.

 

NOTES RECEIVABLE FROMSTOCKHOLDERS

 

In 1996, $78,375 was advancedto certain employees and a director of the Company on a full recourse basis fortheir exercise of stock options.  Suchamounts were classified as notes receivable from stockholders.  In 2003, the notes were forgiven andrecorded as compensation expense.

 

6. INCOME TAXES 

 

Significantcomponents of the Company’s deferred tax assets as of December 31, 2002 and2003 are shown below. A valuation allowance has been established to offset thedeferred tax assets, as realization of such assets is uncertain.

 

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

 

At December 31, 2003, theCompany has federal and state tax net operating loss carryforwards ofapproximately $55,588,000 and $30,388,000, respectively. The federal tax losscarryforwards will begin to expire in 2010. Approximately $15,671,000 of the state tax loss carryforwards expired in2003, and will continue to expire in future periods unless previously utilized.At December 31, 2003, the Company also has federal and state research taxcredit carryforwards of approximately $2,248,000 and $902,000, respectively,which will begin to expire in 2010 unless previously utilized.  The Company has retained the federal andstate tax loss carryforwards

 

F-15

----

 

 

and other tax attributes of theVisualization Technology business.

 

The difference between thefederal and state tax loss carryforwards is primarily attributable to theexpiration of certain state net operating loss carryforwards, which have ashorter life than federal carryforwards.

 

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

 

7. RELATED PARTY TRANSACTION

 

The Company has a subleaseagreement for its California office space. The sublease agreement has been executed with another company, of whichVista’s Chairman of the Board is also a Director.  Total rental payments of $104,500 were paid to this company in2003.

 

8.  SUBSEQUENT EVENTS

 

In February 2004, the Companysold 439,000 shares of common stock in a private placement for gross proceedsof $588,000.  Additionally, 219,500warrants to purchase common stock were issued to the investors at an exerciseprice of $1.97 per share.  

 

We received notification onMarch 1, 2004 of a Nasdaq Staff Determination indicating that we fail tocomply with the Stockholders’ Equity requirement for continued listing setforth in Marketplace Rule 4310(c)(2)(B), and that our common stock is,therefore, subject to delisting from the Nasdaq SmallCap Market.  We requested a hearing before a NasdaqListing Qualifications Panel to review the Staff Determination, which stayedthe delisting of our common stock pending the Panel’s decision.  On May 7, 2004 we received a decision fromthe Nasdaq Listing Qualifications Panel to continue the listing of our commonstock on the Nasdaq SmallCap Market pursuant to the following exceptions:  On or about June 1, 2004 we must havemade a public filing with the SEC and Nasdaq including disclosure that weraised at least $3,600,000 in additional equity, net of expenses, as well as adescription of the completed event or transaction(s) that enabled us to satisfythe $2,500,000 shareholders’ equity requirements; an affirmative statementthat, as of the date of the report, we believe we have regained compliance withthe $2,500,000 shareholders’ equity requirement based upon the event ortransaction(s) referenced therein; and a disclosure that the Panel willcontinue to monitor our ongoing compliance with the minimum shareholders’equity threshold until we have evidenced compliance with that requirement via apublicly filed balance sheet and demonstrated an ability to sustain compliancewith the minimum shareholders’ equity requirement over the long term.  With the closing of our recent financing, weachieved these requirements and made the required filings. In addition, on orbefore August 16, and November 15, 2004 we must file Forms 10-Q forthe quarters ending June 30, and September 30, 2004, respectively,with the SEC and Nasdaq, evidencing our continued compliance with the$2,500,000 shareholders’ equity requirement. In order to fully comply with the terms of this exception, we must beable to demonstrate compliance with all requirements for continued listing onthe Nasdaq SmallCap Market.  If we areunable to do so, our securities will be delisted from the Nasdaq SmallCapMarket..

 

In May 2004 we sold to a groupof accredited investors 5,454,544 units of our securities for $0.85 per unit,each unit consisting of one share of common stock and one warrant to purchaseone-half share of common stock, for aggregate gross proceeds of approximately$4,545,000, or $4,100,000 net of expenses. The warrants are exercisable at a price of $0.95 per share and expire inMay 2009.  As part of the May 2004 unitsale, we issued warrants to the placement agent to purchase up to 818,181shares of our common stock.  545,454 ofthese warrants are exercisable at a price of $1.02 per share and the remaining272,727 warrants are exercisable at a price of $0.95 per share.  The warrants expire in May 2009.

 

In June 2004 we amendedour Series A Certificate of Designations to allow us the right to issue equitysecurities for a price under $2.00.  Forthat right, the Series A holders received 1,400,000 shares of Viking commonstock that we held valued at $28,000. As part of the amendment, we were required to redeemed 85,000 Series AShares for $200,000.  In addition, wehave the right to redeem an additional 300,000 at any time on or beforeJanuary 15, 2006 in exchange for $500,000. 

 

F-16

----

 

9. DISCONTINUED OPERATIONS

 

On April 15, 2004 we soldour Visualization Technology business unit to Viking Systems, Inc. (“Viking”)under an Asset Purchase Agreement (the “Asset Purchase Agreement”) signed onDecember 22, 2003.  In accordancewith SFAS No. 144 “Accounting for the Impairment or Disposal of Long-LivedAssets”, the financial results of this business have been reported separatelyas discontinued operations and the financial statements for all prior periodshave been restated accordingly.  Priorto the sale we conducted our operations through two separate businessunits.  The Obesity Surgical and MedicalManagement Services business unit (operated via our wholly-owned subsidiary,VOW Solutions, Inc.), based in Carlsbad, CA, provides services to physiciansand hospitals involved in the surgical treatment of morbid obesity.  In addition, our former VisualizationTechnology business unit, based in Westborough, Massachusetts, developed,manufactured and marketed products that provide information to physiciansperforming minimally invasive general surgical, cardiac surgical and otherselected endoscopic and interventional procedures.

 

Under the Asset PurchaseAgreement, we sold all the operating assets and related liabilities of theVisualization Technology business to Viking. In return, Viking agreed to (a) pay us $159,000 at closing, (b) issue tous 3,054,000 shares of Viking common stock, representing approximately tenpercent (10%) of its common shares outstanding on a fully diluted basis, and(c) remit to us the value of any former Visualization Technology inventory soldby Viking before April 15, 2005. We also entered into a license agreement with Viking that will pay usroyalties over the next five (5) years based on sales of the acquired productsof the Visualization Technology business with minimum royalties during the five(5) year period as follows: first year $150,000, years two through four$300,000 and year five $375,000 with a maximum aggregate royalties of$4,500,000 over the five (5) year period. We will maintain ownership rights of all intellectual property andproduct rights under the license agreement with Viking until at least theminimum royalty obligations have been satisfied, at which time we will transfersuch ownership rights to Viking.

 

The net operating assets soldto Viking and the total consideration paid or contractually due from Viking,exclusive of any proceeds from the subsequent sale of Visualization Technologyinventory by Viking, are as follows:

 

| Net assets sold      |   |      |      |
|----------------------|--------|-----------|-----------|
| Accounts receivable  |   | $         | 372,027   |   |
| Inventories          |   | 787,657   |      |
| Accounts payable     |   | (351,934  | )         |
| Other liabilities    |   | (61,136   | )         |
|                 |   | $         | 746,614   |   |
| Viking consideration |   |      |      |
| Cash                 |   | $         | 158,718   |   |
| Viking Common shares |   | 61,080    |      |
| Minimum royalties    |   | 1,425,000 |      |
|                 |   | $         | 1,644,798 |   |

 

Under generally acceptedaccounting principles, the transaction is principally the exchange ofnon-monetary assets between Viking and us. As a result, the value of the net assets sold ($746,614) is consideredto be equal to the value of the net assets received and we are not allowed torecognize a gain at the time of the transaction.  The Viking consideration, exclusive of cash, is considerednon-monetary because Viking is a relatively new company that has not raisedsubstantial funds and may be unable to raise sufficient funds to sustain itsoperations or fund its growth plan. Additionally, there can be no assurance that Viking’s business willsucceed.  As a result, all contractualamounts due us are at risk.  Allproceeds received from Viking will be first credited against the Due fromViking account.  All proceeds in excessof that balance will be recorded as a gain from discontinued operations whenreceived.

 

F-17

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Our financial results for theyears ended December 31, 2001, 2002 and 2003 have been reclassified toshow the results of operations for the Visualization Technology business as adiscontinued operation.  The operatingresults of the discontinued operations were as follows:

 

|                              |   | **Three  Years Ended December 31,** |       |
|-----------------------------------|--------|------------------------------------------|------------|
|                              |   | **2001**                                 |       | **2002** |   | **2003** |   |
| Revenues                          |   | $                                        | 9,326,490  |   | $ | 7,563,247 |   | $ | 6,220,091 |   |
| Costs and Expenses                |   |                                     |       |   |   |   |   |
| Cost of revenues                  |   | 6,405,340                                |       | 5,191,353 |   | 4,610,239 |   |
| Research and development          |   | 1,945,433                                |       | 1,709,534 |   | 1,177,656 |   |
| Sales and marketing               |   | 2,237,108                                |       | 551,393 |   | 323,177 |   |
| General and administrative        |   | 1,027,520                                |       | 800,257 |   | 1,123,270 |   |
| Total cost and expenses           |   | 11,615,401                               |       | 8,252,537 |   | 7,234,342 |   |
| Loss from discontinued operations |   | $                                        | (2,288,911 | ) | $ | (689,290 | ) | $ | (1,014,251 | ) |

 

The equipment financing costsassociated with the equipment sold to Viking has been included in discontinuedoperations.

 

The components of the netassets and liabilities of the discontinued operations were as follows:

 

|                                |   | **December  31,** |      |
|-------------------------------------|--------|-------------------|-----------|
|                                |   | **2002**          |      | **2003** |   |
| Assets                              |   |              |      |   |   |
| Accounts receivable                 |   | $                 | 1,022,596 |   | $ | 693,725 |   |
| Inventory                           |   | 1,435,857         |      | 1,113,932 |   |
| Prepaid expense                     |   | 48,388            |      | 66,144 |   |
| Property and equipment, net         |   | 69,674            |      | 7,436 |   |
| Patents                             |   | 3,061             |      | — |   |
| Total assets                        |   | $                 | 2,579,576 |   | $ | 1,881,237 |   |
|                                |   |              |      |   |   |
| Liabilities                         |   |              |      |   |   |
| Accounts payable                    |   | $                 | 759,517   |   | $ | 561,207 |   |
| Current portion of capital leases   |   | 12,474            |      | 7,467 |   |
| Accrued compensation                |   | 152,607           |      | 101,837 |   |
| Deferred revenue                    |   | 5,000             |      | 37,500 |   |
| Accrued liabilities                 |   | 95,101            |      | 47,539 |   |
| Long term portion of capital leases |   | 6,781             |      | — |   |
| Total liabilities                   |   | $                 | 1,031,480 |   | $ | 755,550 |   |

 

The Company had a severanceagreement with a former employee who became an employee of Viking upon the saleof the Visualization Technology business. Under the agreement, the Company may be required to pay the employee oneyear’s compensation (approximately $200,000) if the employee is terminatedunder certain circumstances within 18 months following the sale of the businessor October 2005.  No provision for suchpayment has been included in the results of discontinued operations and willnot be provided for until such payment is probable.

 

F-18

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10. QUARTERLY RESULTS OFOPERATIONS (UNAUDITED)

 

The following is a summary ofthe Restated quarterly results of operations for the years ended December 31,2002 and 2003: 

 

 
|                                            |   | **2002**     |    |
|-------------------------------------------------|--------|--------------|---------|
|                                            |   | **March 31** |    | **June 30** |   | **September  30** |   | **December  31** |   |
| Revenues                                        |   | $            | 910,002 |   | $ | 944,358 |   | $ | 722,376 |   | $ | 966,147 |   |
| Cost of revenues                                |   | 192,691      |    | 205,978 |   | 202,039 |   | 196,822 |   |
| Net loss from Continuing Operations             |   | (201,045     | )       | (154,448 | ) | (254,510 | ) | 152,141 |   |
| Net income (loss) from Discontinued  Operations |   | (175,030     | )       | (220,084 | ) | (28,862 | ) | (265,314 | ) |
| Basic and diluted net loss per share            |   |         |    |   |   |   |   |   |   |
| Continuing Operations                           |   | $            | (0.04   | ) | $ | (0.04 | ) | $ | (0.05 | ) | $ | 0.03 |   |
| Discontinued Operations                         |   | $            | (0.04   | ) | $ | (0.04 | ) | $ | (0.01 | ) | $ | (0.05 | ) |
| Total                                           |   | $            | (0.08   | ) | $ | (0.08 | ) | $ | (0.06 | ) | $ | (0.02 | ) |

 
|                                            |   | **2003**     | ** ** |
|-------------------------------------------------|--------|--------------|------------|
|                                            |   | **March 31** |       | **June 30** |   | **September 30** |   | **December 31** |   |
| Revenues                                        |   | $            | 668,274    |   | $ | 637,279 |   | $ | 750,635 |   | $ | 432,929 |   |
| Cost of revenues                                |   | 167,346      |       | 130,571 |   | 224,584 |   | 52,098 |   |
| Net loss from Continuing Operations             |   | (164,709     | )          | (237,459 | ) | (141,742 | ) | (490,542 | ) |
| Net income (loss) from Discontinued  Operations |   | 118,968      |       | (220,845 | ) | (555,834 | ) | (356,540 | ) |
| Basic and diluted net loss per share            |   |         |       |   |   |   |   |   |   |
| Continuing Operations                           |   | $            | (0.03      | ) | $ | (0.05 | ) | $ | (0.03 | ) | $ | (0.10 | ) |
| Discontinued Operations                         |   | $            | 0.02       |   | $ | (0.04 | ) | $ | (0.12 | ) | $ | (0.08 | ) |
| Total                                           |   | $            | (0.01      | ) | $ | (0.09 | ) | $ | (0.15 | ) | $ | (0.18 | ) |

 

F-19

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