Table of Contents

 

 

 

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D. C. 20459**

 

**FORM 10-Q**

 

**(Mark One)**

 
| **x** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |
|-------|---------------------------------------------------------------------------------------------------------------|

 
| **For the quarterly period ended December 31,  2008** |
|------------------------------------------------------------|

 
| **Or** |
|--------|

 
| **o** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|-------|---------------------------------------------------------------------------------------------------------------|

 
| **For the transition period from               to           ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

**COMMISSIONFILE NUMBER 0-20970**

 

**VISION-SCIENCES, INC.**

(Exact name ofregistrant as specified in its charter)

 

| **Delaware**                                                     | ** ** | **13-3430173**                         |
|------------------------------------------------------------------|------------|----------------------------------------|
| (State or other jurisdiction of   incorporation or organization) |       | (IRS Employer   Identification Number) |
| ** **                                                       | ** ** | ** **                             |
| **40 Ramland Road South, Orangeburg, NY**                        | ** ** | **10962**                              |
| (Address of principal executive offices)                         |       | (Zip Code)                             |

 

**(845) 365-0600**

(Registrant’stelephone number, including area code)

 

**None**

(Former name,former address, and

former fiscalyear if changed since last report)

 

Indicate bycheck mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirement for the past 90 days.

 

Yes x  No o

 

Indicate bycheck mark whether the registrant is a large accelerated filer, acceleratedfiler, non-accelerated filer, or smaller reporting company. See definitions of“accelerated filer”, “large accelerated filer”, and “smaller reporting company”in Rule 12b-2 of the Exchange Act.

 
| Large accelerated filer o |   | Accelerated filer o |   | Non-accelerated filer o |   | Smaller reporting company x |
|------------------------------------------|--------|-------------------------------|--------|-----------------------------------|--------|--------------------------------------------|
|                                     |   |                          |   | (Do not check if a smaller        |   |                                       |
|                                     |   |                          |   | reporting company)                |   |                                       |

 

Indicate by check mark whether the registrantis a shell company (as defined by Rule 12b-2 of the Exchange Act).

 

Yes o  No x

 

Indicate the number of sharesoutstanding of each of the issuer’s classes of common stock, as of February 13,2009

 

| **Common Stock, par value of $.01** | ** ** | **36,780,104**     |
|-------------------------------------|------------|--------------------|
| (Title of Class)                    |       | (Number of Shares) |

 

 

 

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Tableof Contents

 

**VISION-SCIENCES, INC.**

**TABLE OF CONTENTS**

 
| Part I.  |   | Financial Information |   |                                                                                        |
|---------------|--------|-----------------------|--------|---------------------------------------------------------------------------------------------|
|          |   | Item 1.          |   | Financial  Statements                                                                       |   |   |
|          |   |                  |   | Consolidated Balance Sheets                                                                 |   | 3 |
|          |   |                  |   | Consolidated Statements of Operations                                                       |   | 4 |
|          |   |                  |   | Consolidated Statement of Stockholders’  Equity                                        |   | 5 |
|          |   |                  |   | Consolidated Statements of Cash Flows                                                       |   | 6 |
|          |   |                  |   | Notes to Consolidated Financial Statements                                                  |   | 7 |
|          |   | Item 2.          |   | Management’s Discussion and Analysis of  Financial Condition and Results of Operations |   | 14 |
|          |   | Item 3.          |   | Quantitative and Qualitative Disclosures  about Market Risk                                 |   | 27 |
|          |   | Item 4.          |   | Controls and Procedures                                                                     |   | 27 |
|          |   | Item 4T.         |   | Controls and Procedures                                                                     |   | 27 |
| Part II. |   | Other Information     |   | 28                                                                                          |
|          |   | Item 1.          |   | Legal Proceedings                                                                           |   | 28 |
|          |   | Item 1A.         |   | Risk Factors                                                                                |   | 28 |
|          |   | Item 2.          |   | Unregistered Sales of Equity Securities and  Use of Proceeds                                |   | 38 |
|          |   | Item 3.          |   | Defaults Upon Senior Securities                                                             |   | 38 |
|          |   | Item 4.          |   | Submission of Matters to a Vote of  Stockholders                                            |   | 38 |
|          |   | Item 5.          |   | Other Information                                                                           |   | 38 |
|          |   | Item 6.          |   | Exhibits                                                                                    |   | 38 |
|          |   | Signatures            |   | 39                                                                                          |

 

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**PART I—FINANCIAL INFORMATION**

**Item 1: Financial Statements**

**VISION-SCIENCES, INC. AND SUBSIDIARIES**

**CONSOLIDATED BALANCE**

**SHEETS**

 
| ** **                                                                                                                                                              | ** ** | **December 31** | ** **     | **March 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------|----------------|--------------------|------------|
| ** **                                                                                                                                                              | ** ** | **2008**             | ** **     | **2008 (A)**       | ** ** |
| ** **                                                                                                                                                              | ** ** | **(unaudited)**      | ** **     | ** **         | ** ** |
| **ASSETS**                                                                                                                                                              |       |                 |           |               |       |
| **Current assets:**                                                                                                                                                     | ** ** | ** **           | ** **     | ** **         | ** ** |
| Cash and cash equivalents                                                                                                                                               |       | $                    | 1,539,811      |               | $          | 10,641,482 |   |
| Short term investments                                                                                                                                                  |       | 9,573,462            |           | 8,062,418          |       |
| Accounts receivable, net of allowance for  doubtful accounts of $301,923 and $162,800, respectively                                                                     |       | 2,261,274            |           | 974,835            |       |
| Inventories, net                                                                                                                                                        |       | 6,746,443            |           | 4,021,077          |       |
| Prepaid expenses and deposits                                                                                                                                           |       | 439,674              |           | 442,835            |       |
| Current assets of discontinued operations                                                                                                                               |       | 13,589               |           | 135,023            |       |
| **Total current assets**                                                                                                                                                | ** ** | **20,574,253**       | ** **     | **24,277,670**     | ** ** |
| ** **                                                                                                                                                              | ** ** | ** **           | ** **     | ** **         | ** ** |
| **Property and equipment, at cost:**                                                                                                                                    | ** ** | ** **           | ** **     | ** **         | ** ** |
| Machinery and equipment                                                                                                                                                 |       | 5,578,226            |           | 4,936,201          |       |
| Furniture and fixtures                                                                                                                                                  |       | 215,869              |           | 390,586            |       |
| Leasehold improvements                                                                                                                                                  |       | 596,743              |           | 594,953            |       |
|                                                                                                                                                                    |       | 6,390,838            |           | 5,921,740          |       |
| Property and equipment of discontinued  operations                                                                                                                      |       | —               |           | 137,500            |       |
| Less—Accumulated depreciation and  amortization                                                                                                                    |       | 4,532,619            |           | 4,259,866          |       |
| Less - Accumulated depreciation and  amortization of discontinued operations                                                                                            |       | —               |           | 22,917             |       |
| **Total property and equipment, net**                                                                                                                                   | ** ** | **1,858,219**        | ** **     | **1,776,457**      | ** ** |
| Other assets, net of accumulated  amortization of $75,609 and $72,200, respectively                                                                                     |       | 50,815               |           | 68,725             |       |
| Other assets of discontinued operations                                                                                                                                 |       | —               |           | 294,500            |       |
| **Total assets**                                                                                                                                                        | ** ** | **$**                | **22,483,287** | ** **         | **$**      | **26,417,352** | ** ** |
| ** **                                                                                                                                                              | ** ** | ** **           | ** **     | ** **         | ** ** |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                          | ** ** | ** **           | ** **     | ** **         | ** ** |
| **Current liabilities:**                                                                                                                                                | ** ** | ** **           | ** **     | ** **         | ** ** |
| Capital lease obligations                                                                                                                                               |       | $                    | 29,266         |               | $          | 56,810 |   |
| Accounts payable                                                                                                                                                        |       | 1,378,168            |           | 1,768,859          |       |
| Accrued expenses                                                                                                                                                        |       | 1,787,160            |           | 2,415,990          |       |
| Current liabilities of discontinued  operations                                                                                                                         |       | 6,864                |           | 23,169             |       |
| **Total current liabilities**                                                                                                                                           | ** ** | **3,201,458**        | ** **     | **4,264,828**      | ** ** |
| Capital lease obligations, net of current  portion                                                                                                                      |       | 81,083               |           | 81,083             |       |
| **Total liabilities**                                                                                                                                                   | ** ** | **3,282,541**        | ** **     | **4,345,911**      | ** ** |
| ** **                                                                                                                                                              | ** ** | ** **           | ** **     | ** **         | ** ** |
| **Commitments and contingencies**                                                                                                                                       |       | —               |           | —             |       |
| ** **                                                                                                                                                              | ** ** | ** **           | ** **     | ** **         | ** ** |
| **Stockholders’ equity:**                                                                                                                                          | ** ** | ** **           | ** **     | ** **         | ** ** |
| Preferred stock, $.01 par value—                                                                                                                                   |       |                 |           |               |       |
| Authorized—5,000,000 shares issued and  outstanding—none                                                                                                      |       | —               |           | —             |       |
| Common stock, $.01 par value—                                                                                                                                      |       |                 |           |               |       |
| Authorized—50,000,000 shares issued and  outstanding—36,770,104 shares and 35,647,512 shares at December 31, 2008  and March 31, 2008, respectively |       | 367,701              |           | 356,474            |       |
| Additional paid-in capital                                                                                                                                              |       | 80,274,826           |           | 77,477,690         |       |
| Accumulated deficit                                                                                                                                                     |       | (61,441,781          | )              | (55,762,723        | )          |
| **Total stockholders’ equity**                                                                                                                                     | ** ** | **19,200,746**       | ** **     | **22,071,441**     | ** ** |
| **Total liabilities and stockholders’ equity**                                                                                                                     | ** ** | **$**                | **22,483,287** | ** **         | **$**      | **26,417,352** | ** ** |

 

----

(A) Restated for discontinued operations

 

Seeaccompanying notes to consolidated financial statements.

 

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**VISION-SCIENCES, INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

**(Unaudited)**

 
| ** **                                                                 | ** ** | **Three Months Ended** | ** **     | **Nine Months Ended** | ** ** |
|----------------------------------------------------------------------------|------------|----------------------------------|----------------|---------------------------------|------------|
| ** **                                                                 | ** ** | **December 31,**            | ** **     | **December 31,**           | ** ** |
| ** **                                                                 | ** ** | **2008**                         | ** **     | **2007 (A)**                    | ** ** | **2008** | ** ** | **2007 (A)** | ** ** |
|                                                                       |       |                             |           |                            |       |   |   |   |   |
| **Net sales**                                                              | ** ** | **$**                            | **3,610,033**  | ** **                      | **$**      | **1,844,749** | ** ** | **$** | **9,090,956** | ** ** | **$** | **7,402,150** | ** ** |
| Cost of sales                                                              |       | 2,845,386                        |           | 1,397,911                       |       | 7,451,968 |   | 5,135,257 |   |
| **Gross profit**                                                           | ** ** | **764,647**                      | ** **     | **446,838**                     | ** ** | **1,638,988** | ** ** | **2,266,893** | ** ** |
|                                                                       |       |                             |           |                            |       |   |   |   |   |
| Selling, general and administrative  expenses                              |       | 2,426,591                        |           | 1,858,100                       |       | 7,692,873 |   | 5,607,068 |   |
| Research and development expense                                           |       | 1,478,402                        |           | 649,689                         |       | 4,163,289 |   | 2,610,343 |   |
| Reversal of restructuring charge                                           |       | —                           |           | —                          |       | (97,856 | ) | — |   |
| **Loss from operations**                                                   | ** ** | **(3,140,346**                   | **)**          | **(2,060,951**                  | **)**      | **(10,119,318** | **)** | **(5,950,518** | **)** |
|                                                                       |       |                             |           |                            |       |   |   |   |   |
| Interest income                                                            |       | 85,029                           |           | 288,637                         |       | 237,352 |   | 857,749 |   |
| Interest expense                                                           |       | —                           |           | (7,011                          | )          | (15,926 | ) | (7,011 | ) |
| Other income (expense), net                                                |       | 12,094                           |           | 132,036                         |       | 35,863 |   | 717,351 |   |
| Gain on sale of product line, net of direct  costs                         |       | —                           |           | —                          |       | 4,985,411 |   | — |   |
| Loss in equity investment                                                  |       | —                           |           | (118,912                        | )          | — |   | (332,006 | ) |
| **Loss before provision for income taxes**                                 |       | (3,043,223                       | )              | (1,766,201                      | )          | (4,876,618 | ) | (4,714,435 | ) |
| Provision for income taxes                                                 |       | 9,861                            |           | 180,000                         |       | 18,983 |   | — |   |
| **Loss before discontinued operations**                                    | ** ** | **(3,053,084**                   | **)**          | **(1,946,201**                  | **)**      | **(4,895,601** | **)** | **(4,714,435** | **)** |
| **Loss from discontinued operations, net**                                 | ** ** | **(10,066**                      | **)**          | **(53,451**                     | **)**      | **(783,457** | **)** | **(53,451** | **)** |
| **Net Loss**                                                               | ** ** | **$**                            | **(3,063,150** | **)**                           | **$**      | **(1,999,652** | **)** | **$** | **(5,679,058** | **)** | **$** | **(4,767,886** | **)** |
| ** **                                                                 | ** ** | ** **                       | ** **     | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Basic and diluted (loss) per common share**                              | ** ** | ** **                       | ** **     | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| From continuing operations                                                 |       | $                                | (0.08          | )                               | $          | (0.06 | ) | $ | (0.14 | ) | $ | (0.13 | ) |
| From discontinued operations                                               |       | —                           |           | —                          |       | (0.02 | ) | (0.01 | ) |
| Net (loss)                                                                 |       | $                                | (0.08          | )                               | $          | (0.06 | ) | $ | (0.16 | ) | $ | (0.14 | ) |
| **Weighted Average Shares Used in Computing net  (Loss) per common share** | ** ** | 36,754,852                       | ** **     | 35,263,031                      | ** ** | 36,208,808 | ** ** | 35,263,031 | ** ** |

 

----

(A) Restated for discontinued operations

 

Seeaccompanying notes to consolidated financial statements.

 

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**VISION-SCIENCES, INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENT OF STOCKHOLDERS’ EQUITY**

**(Unaudited)**

 
| ** **                             | ** ** | **Preferred Stock** | ** ** | **Common Stock** | ** ** | **Additional**     | ** **     | ** **         | ** ** | **Total**   | ** ** |
|----------------------------------------|------------|--------------------------|------------|-----------------------|------------|--------------------|----------------|--------------------|------------|-------------|------------|
| ** **                             | ** ** | **Number**               | ** ** | **$0.01**             | ** ** | **Number**         | ** **     | **$0.01**          | ** ** | **Paid-in** | ** ** | **Accumulated** | ** ** | **Stockholders’** | ** ** |
| ** **                             | ** ** | **of Shares**       | ** ** | **Par Value**    | ** ** | **of Shares** | ** **     | **Par Value** | ** ** | **Capital** | ** ** | **Deficit** | ** ** | **Equity** | ** ** |
| **Balance, March 31, 2008**       | ** ** | **5,000,000**            | ** ** | **$**                 | **—** | ** **         | **35,647,512** | ** **         | **$**      | **356,474** | ** ** | **$** | **77,477,690** | ** ** | **$** | **(55,762,723** | **)** | **$** | **22,071,441** | ** ** |
| ** **                             | ** ** | ** **               | ** ** | ** **            | ** ** | ** **         | ** **     | ** **         | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Exercise of stock options and warrants |       | —                   |       | —                |       | 1,122,592          |           | 11,227             |       | 1,531,520   |       | — |   | 1,542,747 |   |
| Stock based compensation  expense      |       | —                   |       | —                |       | —             |           | —             |       | 1,265,616   |       | — |   | 1,265,616 |   |
| Net loss                               |       | —                   |       | —                |       | —             |           | —             |       | —      |       | (5,679,058 | ) | (5,679,058 | ) |
| **Balance December 31, 2008**     | ** ** | **5,000,000**            | ** ** | **$**                 | **—** | ** **         | **36,770,104** | ** **         | **$**      | **367,701** | ** ** | **$** | **80,274,826** | ** ** | **$** | **(61,441,781** | **)** | **$** | **19,200,746** | ** ** |

 

Seeaccompanying notes to consolidated financial statements.

 

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**VISION-SCIENCES, INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(Unaudited)**

 
| ** **                                                                   | ** ** | **Nine Months Ended** | ** **     | **Nine Months Ended** | ** ** |
|------------------------------------------------------------------------------|------------|---------------------------------|----------------|---------------------------------|------------|
| ** **                                                                   | ** ** | **December 31, 2008** | ** **     | **December 31, 2007** | ** ** |
| **Cash flows from operating activities:**                                    |       |                            |           |                            |       |
| **Net loss**                                                                 | ** ** | **$**                           | **(5,679,058** | **)**                           | **$**      | **(4,767,886** | **)** |
| Adjustments to reconcile net loss to net  cash used in operating activities: |       |                            |           |                            |       |
| Depreciation and amortization                                                |       | 276,162                         |           | 167,761                         |       |
| Gain on sale of product line                                                 |       | (4,985,411                      | )              | —                          |       |
| Gain on sale of fixed assets                                                 |       | (22,917                         | )              | —                          |       |
| Loss in equity investment                                                    |       | —                          |           | 332,006                         |       |
| Stock-based compensation                                                     |       | 1,265,616                       |           | 591,300                         |       |
| Changes in assets and liabilities:                                           |       |                            |           |                            |       |
| Accrued interest receivable                                                  |       | (58,616                         | )              | (465,573                        | )          |
| Accounts receivable                                                          |       | (1,199,711                      | )              | 280,433                         |       |
| Inventories                                                                  |       | (2,725,366                      | )              | (1,154,123                      | )          |
| Prepaid expenses and deposits                                                |       | 115,342                         |           | (639,612                        | )          |
| Other Assets                                                                 |       | 309,004                         |           | (24,902                         | )          |
| Accounts payable                                                             |       | (359,808                        | )              | (119,164                        | )          |
| Accrued expenses                                                             |       | (645,161                        | )              | 89,880                          |       |
| Income taxes payable                                                         |       | —                          |           | (549,000                        | )          |
| **Net cash used in operating activities**                                    | ** ** | **(13,709,924**                 | **)**          | **(6,258,880**                  | **)**      |
| **Cash flows from investing activities:**                                    |       |                            |           |                            |       |
| Purchase of short term investments                                           |       | (15,617,287                     | )              | (20,197,372                     | )          |
| Sale of short term investments                                               |       | 14,056,525                      |           | —                          |       |
| Purchase of property and equipment                                           |       | (469,099                        | )              | (627,286                        | )          |
| Net proceeds from sale of product line                                       |       | 4,985,411                       |           | —                          |       |
| Purchase of equity investment                                                |       | —                          |           | (1,000,000                      | )          |
| Advance payment for acquisition                                              |       | —                          |           | (450,000                        | )          |
| Proceeds from sales of fixed assets                                          |       | 137,500                         |           | —                          |       |
| **Net cash provided by (used in) investing  activities**                     | ** ** | **3,093,050**                   | ** **     | **(22,274,658**                 | **)**      |
| **Cash Flows from financing activities:**                                    |       |                            |           |                            |       |
| Payments of acceptances payable to a bank                                    |       | —                          |           | (36,453                         | )          |
| Payments on capital leases                                                   |       | (27,544                         | )              | —                          |       |
| Exercise of stock options                                                    |       | 1,542,747                       |           | 20,666                          |       |
| **Net cash provided by (used in) financing  activities**                     | ** ** | **1,515,203**                   | ** **     | **(15,787**                     | **)**      |
| **Net decrease in cash and cash equivalents**                                |       | (9,101,671                      | )              | (28,549,325                     | )          |
| **Cash and cash equivalents, beginning of  period**                          |       | 10,641,482                      |           | 28,955,497                      |       |
| **Cash and cash equivalents, end of period**                                 | ** ** | **$**                           | **1,539,811**  | ** **                      | **$**      | **406,172** | ** ** |
|                                                                         |       |                            |           |                            |       |
| **Supplemental disclosure of cash flow  information:**                       |       |                            |           |                            |       |
| Cash paid during the period for interest                                     |       | $                               | 15,926         |                            | $          | — |   |
|                                                                         |       |                            |           |                            |       |
| Cash paid during the period for income  taxes                                |       | $                               | —         |                            | $          | 549,000 |   |
|                                                                         |       |                            |           |                            |       |
| **Supplemental disclosure of non-cash  financing activities:**               |       |                            |           |                            |       |
| Capital leases entered into for equipment  purchases                         |       | $                               | —         |                            | $          | 162,257 |   |

 

Seeaccompanying notes to consolidated financial statements.

 

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**VISION-SCIENCES, INC. AND SUBSIDIARIES**

 

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**(Unaudited)**

 

**1.****                                      Basisof Presentation**

 

Vision-Sciences, Inc. and subsidiaries(the Company or we) have prepared the consolidated financial statementsincluded herein accordance with generally accepted accounting principles in theUnited States of America, without audit, pursuant to the rules andregulations of the Securities and Exchange Commission and include, in theopinion of management, all adjustments that we consider necessary for a fairpresentation of such information.  Wehave condensed or omitted certain information and footnote disclosures normallyincluded in financial statements pursuant to such rules and regulations.We believe, however, that our disclosures are adequate to make the informationpresented not misleading. The results for the interim periods presented are notnecessarily indicative of results to be expected for the full fiscal year. Ourfiscal year-end is on March 31 of each year. The year ended March 31,2009 is our current fiscal year (FY09). Q3 09 refers to the period from October 1,2008 to December 31, 2008, our current fiscal quarter, and Q3 08refers to the period from October 1, 2007 to December 31, 2007.  These consolidated financial statementsshould be read in conjunction with the consolidated financial statements andthe notes thereto included in our Annual Report on Form 10-K for thefiscal year ended March 31, 2008 (FY08).

 

***All amounts in the financialnotes except for share and per-share data are reported in ($000’s), unlessotherwise indicated.***

 

**2.****                                      Summaryof Significant Accounting Policies**

 

Theaccompanying consolidated financial statements reflect the application ofcertain accounting policies described below:

 

a.               *Principles of Consolidation:*  The accompanying consolidated financialstatements include the accounts of the Company and its wholly-ownedsubsidiaries. All material intercompany accounts and transactions wereeliminated in consolidation.

 

b.              *Basic and Diluted Net Income (Loss) per Common Share:*  Basic net income (loss) per share iscalculated by dividing the net income (loss) by the weighted average number ofcommon shares outstanding. For the periods ended December 31, 2008 and December 31,2007, the diluted net loss per common share is the same as basic net loss percommon share, as the inclusion of other shares of stock issuable pursuant tostock options and warrants would be anti-dilutive. In addition to the abovecalculation, we have calculated the discontinued operations basic and dilutednet loss per common share as well.

 

c.               *Depreciation and Amortization:*  We calculate depreciation and amortizationusing the straight-line method in amounts that allocate the cost of the assetsover their estimated useful lives, as follows:

 
| **Asset Classification** | ** ** | **Estimated  Useful Life** | ** ** |
|-------------------------------|------------|---------------------------------|------------|
| Machinery and equipment       |       | 3 - 5 years      |       |
| Furniture and fixtures        |       | 5 years                    |       |
| Intangible assets             |       | 6 - 15 years     |       |

 

Leaseholdimprovements are amortized over the shorter of their estimated useful lives orthe lease lives.

 

d.         *Revenue Recognition:*  We recognize revenue in accordance with SECStaff Accounting Bulletin No. 104, *RevenueRecognition in Financial Statements.* This bulletin requires thatfive basic criteria must be met before revenue can be recognized: (1) persuasiveevidence that an arrangement exists, (2) delivery has occurred or serviceswere rendered, (3) the fee is fixed and determinable, (4) collectabilityis reasonably assured and (5) the fair value of undelivered elements, ifany, exists. Determination of criterion (4) above is based on management’sjudgment regarding the collectability of invoices for products and servicesdelivered to customers. Should changes in conditions cause management todetermine this criterion is not met for certain future transactions, this couldreduce revenue recognized for the relevant reporting period. We recognizerevenue when title passes to the customer, generally upon shipment of ourproducts F.O.B. shipping point.

 

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e.               *Inventories:*  Inventories are measured at the lower of costor market using the first-in, first-out (FIFO) method and consist of thefollowing:

* *
| ** **      | ** ** | **December 31, 2008** | ** ** | **March 31, 2008** | ** ** |
|-----------------|------------|---------------------------------|------------|------------------------------|------------|
| ** **      | ** ** | **(unaudited)**                 | ** ** | ** **                   | ** ** |
| Raw materials   |       | $                               | 4,973      |                         | $          | 2,924 |   |
| Work-in-process |       | 356                             |       | 497                          |       |
| Finished goods  |       | 1,417                           |       | 600                          |       |
| ** **      | ** ** | **$**                           | **6,746**  | ** **                   | **$**      | **4,021** | ** ** |

 

Raw materials include components purchased fromindependent suppliers.  While some of the components areavailable from multiple sources, several key components are onlyavailable to us from one supplier with whom we do not have along term fixed supply agreement. Although we have had a long term supplyagreement with Pentax for our fiberscope parts, such contract is expiring in February 2009,and will not be renewed. While we believe we have sufficient Pentax componentsin inventory for new sales of our existing line of fiberscopes until the timethat our new line of fiberscopes (without Pentax parts), the 4000 series, isexpected to be available in the quarter ended June 30, 2009 of our fiscalyear ended March 31, 2010 (Q1 10), there can be no assurance that oursupply in inventory will be adequate through such time or that our newfiberscope product line will be available for sale when anticipated by Q1 10.Any such gap in time in which we are unable to sell the existing line offiberscopes, or our new fiberscope line, would result in a material adverseimpact on our business and financial condition. For more information with respect to our Pentax components inventory,see Risk Factors — Sourcing of critical components.

 

Work-in-process and finished goods inventoriesconsist of materials, labor and manufacturing overhead.

 

f.               *Income Taxes:*  We account for income taxes under theliability method, and deferred tax assets or liabilities are computed based onthe differences between the financial statement and income tax basis of assetsand liabilities as measured by the enacted tax rates.

 

g.     *Foreign Currency Transactions:*  We charge to operations all foreign currencyexchange gains or losses in connection with our purchases of products fromforeign vendors. For the periods ended December 31, 2008 and December 31,2007, these amounts were immaterial.

 

h.           *Cashand Cash Equivalents:*  Weclassify investments with original maturities of ninety days or less,consisting of commercial paper and a money market account at a bank, as cashequivalents. Cash equivalents are stated at amortized cost, which approximatesmarket value.

 

i.      *Short Term Investments:*  We classify investments with originalmaturities of greater than 90 days in government securities and high gradecommercial paper as short term investments. We intend to hold these investmentsto maturity. The following table summarizes these securities classified as heldto maturity:

 
| ** **                                                   | ** ** | **December 31, 2008** | ** ** | ** **                   | ** ** | ** **          | ** ** |
|--------------------------------------------------------------|------------|---------------------------------|------------|------------------------------|------------|---------------------|------------|
| ** **                                                   | ** ** | **(unaudited)**                 | ** ** | **March 31, 2008** | ** ** |
| ** **                                                   | ** ** | **Fair Value**             | ** ** | **Cost**                     | ** ** | **Fair Value** | ** ** | **Cost** | ** ** |
| **Held to maturity less than one year:**                     |       |                            |       |                         |       |                |       |   |   |
| Government securities                                        |       | $                               | 7,958      |                         | $          | 7,962               |       | $ | 6,563 |   | $ | 6,512 |   |
| Commercial paper                                             |       | 1,656                           |       | 1,720                        |       | 1,534               |       | 1,550 |   |
| **Total short term investments including  accrued interest** | ** ** | **$**                           | **9,614**  | ** **                   | **$**      | **9,682**           | ** ** | **$** | **8,097** | ** ** | **$** | **8,062** | ** ** |

 

j.                  *Stock-based Compensation Arrangements:*  Effective April 1, 2006 we beganaccounting for compensation expense related to stock options in accordance withSFAS No. 123 (Revised 2004) *Share-BasedPayment* (SFAS 123R). Weaccount for equity instruments issued to non-employees in accordance with theprovisions of SFAS No. 123R and Emerging Issues Task Force (EITF)Abstract No. 96-18, *Accounting forEquity Instruments that are Issued to Other than**Employees for Acquiring, or in Conjunction withSelling, Goods or Services* EITF 96-18.

 

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Compensationcosts associated with stock options include: (i) amortization related tothe remaining unvested portion of all stock options outstanding at March 31,2006, based on the fair value determined on the grant date in accordance withthe original provisions of SFAS No. 123, and (ii) amortizationrelated to all stock option awards granted subsequent to March 31, 2006,based upon the fair value estimated in accordance with SFAS No. 123R.The compensation expense for stock-based compensation awards under SFAS No. 123Ris recognized over the vesting period of the options, and includes an estimatefor forfeitures.

 

In accordancewith SFAS 123R and EITF 96-18, we recorded stock-based compensationexpense for Q3 09 and Q3 08, respectively, and for the nine months ended December 31,2008 (YTD 09) and December 31, 2007 (YTD 08) respectively, in thefollowing expense categories:

 
| ** ** | ** ** | **(Unaudited)**                  | ** ** |
|------------|------------|----------------------------------|------------|
| ** ** | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
| ** ** | ** ** | **December 31,**            | ** ** | **December 31,** | ** ** |
| ** ** | ** ** | **2008**                         | ** ** | **2007** | ** ** | **2008** | ** ** | **2007** | ** ** |
| COGS       |       | $                                | 17         |   | $ | 18 |   | $ | 88 |   | $ | 48 |   |
| SG&A   |       | 177                              |       | 143 |   | 555 |   | 438 |   |
| R&D    |       | 226                              |       | 39 |   | 623 |   | 105 |   |
| **Total**  | ** ** | **$**                            | **420**    | ** ** | **$** | **200** | ** ** | **$** | **1,266** | ** ** | **$** | **591** | ** ** |

 

The totalcompensation expense for the nine months ending December 31, 2008 includea one-time adjustment of $299, recorded in Q2 09, of which $176 representsexpense for fiscal year (FY) 07 and FY 08, for stock based compensation expensefor non-employees consultants that should have been calculated and recognizedaccording to EITF 96-18 for the period between September 2006 and June 2008.During Q2 09, we discovered that we had accounted for our non-employeesconsultants compensation expenses according to SFAS 123R instead of accordingto EITF 96-18. The adjustment impacted COGS by $23, SG&A by $22 and R&Dby $254. We reviewed the impact of these adjustments on the results ofoperations for fiscal 07 ($75), FY 08 ($101) and Q1 09 ($123), and found it tobe immaterial.

 

At December 31,2008, total unamortized stock-based compensation was approximately $3,274. Wewill expense that amount over periods ending through June 30, 2013. We donot expect to realize any tax benefits from future disqualifying dispositions,if any, since we currently have a full valuation allowance against our deferredtax asset.

 

In the ninemonths ended December 31, 2008, we granted options to purchase a total of1,552,958 shares of our common stock to employees, non-employee consultants anddirectors. The fair value of these options measured at the option grant datewas approximately $4,079, determined using the Black-Scholes option-pricingmodel. This amount is reduced by an estimated forfeiture rate and is beingrecorded as an expense over the vesting period. We used the followingassumptions in the Black-Scholes option-pricing model in that period:

 
| Risk-free interest rate                |   | 1.71% - 3.55 | %      |
|----------------------------------------|--------|--------------|--------|
| Expected dividend yield                |   | —       |   |
| Expected life                          |   | 6.25 years   |   |
| Expected volatility                    |   | 82           | %      |
| Weighted grant average value per share |   | $            | 2.74   |   |
|                                        |        |              |        |  |

 

We grantoptions with vesting periods ranging from immediate to six years. We use thesimplified method of calculating the expected option term, which averages anaward’s weighted average vesting period and its contractual term. Thecontractual term of our options is ten years. The risk-free rate is based uponthe daily treasury yield curve for a period approximately equal to the expectedoption term. We used historical data to estimate the expected price volatilityand forfeiture rate. The expected dividend yield is 0%, based on our history ofnot paying dividends.

 

k.               *Recently Issued Accounting Standards:*

 

In November 2008, theFinancial Accounting Standard Board (FASB) ratified EITF Issue No. 08-6, *Equity Method Investment Accounting Considerations*.EITF 08-6 clarifies the accounting for certain transactions and impairmentconsiderations involving equity method investments. EITF 08-6 is effectivefor fiscal years beginning after December 15, 2008, with early

 

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adoption prohibited. We donot currently have any investments that are accounted for under the equitymethod. The adoption of EITF 08-6 is not expected to have an impact on ourconsolidated financial statements.

 

In November 2008, theFASB ratified Emerging Issues Task Force Issue No. 08-7, *Accounting for Defensive Intangible Assets*.EITF 08-7 clarifies the accounting for certain separately identifiableintangible assets which an acquirer does not intend to actively use but intendsto hold to prevent its competitors from obtaining access to them.EITF 08-7 requires an acquirer in a business combination to account for adefensive intangible asset as a separate unit of accounting which should beamortized to expense over the period the asset diminishes in value.EITF 08-7 is effective for fiscal years beginning after December 15,2008, with early adoption prohibited. Since we currently do not have any suchdefensive intangible assets, the adoption of EITF 08-7 is not expected to havean impact on our consolidated financial statements.

 

On April 1,2008, we adopted the provisions of FASB Statement No. 159, *The Fair Value Option for Financial Assets andFinancial Liabilities.* This statement allows companies to measureeligible financial instruments at fair value. Such election, which may beapplied on an instrument by instrument basis, is typically irrevocable onceelected. We have elected not to apply the fair value option to any of ourfinancial instruments, except for those expressly required by U.S. GAAP.

 

In April 2008, the FASB issued FASB Staff Position (FSP)FAS 142-3*, Determination of the UsefulLife of Intangible Assets*. FSP FAS 142-3 amends the factorsthat should be considered in developing renewal or extension assumptions usedto determine the useful life of a recognized intangible asset under FASBStatement No. 142, *Goodwill and OtherIntangible Assets*. FSP FAS 142-3 is effective for fiscal yearsbeginning after December 15, 2008 and early adoption is prohibited. We arecurrently evaluating the impact of the pending adoption of FSP FAS 142-3on our consolidated financial statements.

 

In March 2008,the FASB issued SFAS No. 161, Disclosures about Derivative Instruments andHedging Activities, an amendment to FASB Statement No. 133(SFAS 161), which requires additional disclosures about the objectives ofusing derivative instruments, the method by which the derivative instrumentsand related hedged items are accounted for under FASB Statement No. 133and its related interpretations, and the effect of derivative instruments andrelated hedged items on financial position, financial performance, and cashflows. SFAS 161 also requires disclosure of the fair values of derivativeinstruments and their gains and losses in a tabular format. SFAS 161 iseffective for financial statements issued for fiscal years and interim periodsbeginning after November 15, 2008 (which for our company would befinancial statements for the fourth quarter and fiscal year ended 3/31/09),with early adoption encouraged. We are currently assessing the impact that theadoption of SFAS 161 will have on our financial statement disclosures.

 

In December 2007,the FASB issued Statement No. 141(R), *BusinessCombinations—A Replacement of FASB Statement No. 141.* Thisstatement significantly changes the principles and requirements for how anacquisition is recognized and measured in a company’s financial statementsincluding the identifiable assets acquired and the liabilities assumed. Thisstatement also provides guidance for recognizing and measuring goodwillacquired in a business combination and required disclosures to enable users ofthe financial statements to evaluate the nature and financial effects of thebusiness combination. This statement was adopted on January 1, 2009 and iseffective prospectively, except for certain retrospective adjustments todeferred income tax balances. We currently do not have any businesscombinations, and therefore the adoption of this statement is not expected tohave an impact on our consolidated financial statements.

 

In December 2007,the FASB issued Statement No. 160, *NoncontrollingInterests in Consolidated Financial Statements*, *an amendment of ARB No. 51.* This statementsignificantly changes the financial accounting and reporting of noncontrolling(or minority) interests of a subsidiary in consolidated financial statements.This statement became effective prospectively as of January 1, 2009. Theadoption of this statement does not have any impact on our financial position.

 

**3.****                                      StockOption Plans**

 

Our firststock option plan (the 1990 Plan) allowed us to grant key employees andnon-employee consultants incentive and non-statutory stock options at the fairvalue of the stock on the date of grant. Options became exercisable at varyingdates ranging up to five years from the date of grant. Under the 1990 Plan, ourBoard of Directors (our Board) had authorized the issuance of options for thepurchase of up to 4,375,000 shares of our common stock. This plan expired in2001 and was replaced with the 2000 Plan. The terms of the 2000 Plan aresubstantially the same as the 1990 Plan. Under the 2000 Plan, our Board andstockholders authorized the issuance of options for the purchase of up to4,500,000 shares of our common stock, of which 20,655 shares remain availablefor future grants.

 

In August 2007,our stockholders approved our 2007 Stock Incentive Plan (the 2007 Plan). Underthe 2007 Plan, we are authorized to issue options for the purchase of up to4,000,000 shares of our common stock. The terms of the 2007 Plan aresubstantially the same as the 2000 Plan. As of December 31, 2008, thereremain 968,500 shares available for future grants. In the 2007

 

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Plan, we grant options to both employees andnon-employee consultants, with vesting periods ranging from immediate to sixyears. For options granted under the 2007 plan, we have chosen to employ thesimplified method of calculating the option term, which averages an award’sweighted average vesting period and its contractual term. The contractual termof our options is ten years.

 

On December 31,2008, the total unamortized stock-based compensation for the 1990, 2000 and2007 plans is approximately $3,274, which will be expensed through the periodending June 30, 2013. We do not expect to realize any tax benefits fromfuture disqualifying dispositions, if any, since we currently have a fullvaluation allowance against our deferred tax assets.

 

A summary ofthe stock option activity for employees and non-employee consultants under the1990, 2000 and 2007 plans for the nine months period ended December 31,2008 is as follows:

 
| ** **                             | ** ** | ** **         | ** ** | ** **              | ** ** | ** **                | ** ** | **Weighted Average** | ** ** |
|----------------------------------------|------------|--------------------|------------|-------------------------|------------|---------------------------|------------|---------------------------|------------|
| ** **                             | ** ** | **Number**         | ** ** | **Exercise**            | ** ** | **Weighted Average** | ** ** | **Remaining**             | ** ** |
| ** **                             | ** ** | **of Shares** | ** ** | **Price Range**    | ** ** | **Exercise Price**   | ** ** | **Contractual Life** | ** ** |
| **Outstanding March 31, 2008**    |       | 6,130,369          |       | $0 .79-$4.30            |       | $                         | 1.49       |                      | 6.25 years |   |
| Granted                                |       | 1,552,958          |       | 3.62 -  5.10       |       | 3.91                      |       |                      |       |
| Exercised                              |       | (922,880           | )          | 0.79  -  4.00 |       | 1.61                      |       |                      |       |
| Canceled                               |       | (138,250           | )          | 2.05   - 3.20 |       | 2.91                      |       |                      |       |
| **Outstanding December 31, 2008** |       | 6,614,697          |       | $0 .79-$5.10            |       | $                         | 1.98       |                      | 7.43 years |   |
| **Exercisable December 31, 2008** |       | 3,255,593          |       | $0 .79-$4.30            |       | $                         | 1.41       |                      | 5.60 years |   |

 

In August 1993,we adopted the 1993 Director Option Plan (the 1993 Plan) under which we maygrant up to 200,000 non-statutory stock options to non-employee directors ofthe Company at the fair value of the stock on the date of grant. Options becomeexercisable over a four-year period from the date of grant. We reserved 200,000shares of common stock for the exercise of stock options under the 1993 Plan.We no longer grant options under this plan.

 

In July 2003,we adopted, and our stockholders approved, a 2003 Director Option Plan (the2003 Plan). The terms of the 2003 Plan were similar to the 1993 Plan, andincluded automatic grants of 4,000 shares to each outside member of our Boardon the date of the annual meeting of stockholders, so long as such outsidedirector does not hold at that time any outstanding options to purchase commonstock under the 1993 Plan, which options are not fully exercisable. Optionsgranted under the 2003 Plan are fully vested on the date of grant.

 

During ourAnnual Stockholders Meeting held on August 28, 2008, our stockholdersapproved our Board’s recommendation of new compensation for our outsidedirectors (the Amended 2003 Plan). The Amended 2003 Plan increased the annualautomatic grant to 10,000 options per director per year, and increased themaximum number of options available under the Amended 2003 Plan from 200,000 to450,000. During this Annual Shareholders meeting, 10,000 options were grantedto each our five outside directors. If the number of outside directors remainsunchanged, we would be required to grant options to purchase an aggregate of50,000 shares at each of the Annual Shareholder’s meetings scheduled in August 2009and August 2010. As of December 31, 2008, there remain 352,000 sharesavailable for future grants under the Amended 2003 Plan.

 

A summary ofthe director option plans activity is as follows:

 
| ** **                             | ** ** | **Number**         | ** ** | **Exercise**         | ** ** | **Weighted Average** | ** ** |
|----------------------------------------|------------|--------------------|------------|----------------------|------------|---------------------------|------------|
| ** **                             | ** ** | **of Shares** | ** ** | **Price Range** | ** ** | **Exercise Price**   | ** ** |
| **Outstanding March 31, 2008**    |       | 104,000            |       | $1.00-$2.10          |       | $                         | 1.39       |   |
| Granted                                |       | 54,000             |       | 4.09-4.88            |       | 4.15                      |       |
| Exercised                              |       | —             |       | —               |       | —                    |       |
| Canceled                               |       | (20,000            | )          | 1.50-1.50            |       | 1.50                      |       |
| **Outstanding December 31, 2008** |       | 138,000            |       | $1.00-$4.88          |       | $                         | 2.47       |   |
| **Exercisable December 31, 2008** |       | 138,000            |       | $1.00-$4.88          |       | $                         | 2.47       |   |

 

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**4. Segment Information**

 

As of November 1,2008, due to the asset sale of our health services segment, we returned tooperating in the two reportable segments, ***medical and industrial***,in which we operated from April 07 (FY08) through September 30, 2007(Q2 08).  From October 1, 2007 (Q308) through October 30, 2008, (Q3 09), we operated in three reportablesegments, ***medical,industrial and health services.***

 

***Our medical segment***designs, manufactures, and sells our advanced line of endoscopy-based productsfor a variety of specialties, including our state-of-the-art flexibleendoscopes and our Slide-On EndoSheath technology.

 

***Our industrial segment,***through our wholly-owned subsidiary, Machida, Inc., designs, manufacturesand sells borescopes to a variety of users, primarily in the aircraftengine-manufacturing and aircraft engine-maintenance industries. A borescope isan instrument that uses optical fibers for the visual inspection of narrowcavities.

 

***Our former health services segment***consisted of our wholly-owned subsidiary BEST DMS Inc., (BEST-DMS) which wasestablished in October 2007. BEST-DMS was a service-based segment,providing the Bedside Endoscopic Swallowing Test (BEST) to nursing homes,rehabilitation centers, and assisted living facilities. (Please refer to Note5, Discontinued Operations and AssetSale, below).

 

Our twocurrent segments follow the accounting policies described in the *Summary of Significant Accounting Policies*, above. Weevaluate segment performance based upon operating income. Identifiable assetsare those used directly in the operations of each segment and general corporateassets, such as cash and marketable securities are allocated to each segment.

 

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Our segmentsare described in the following tables:

 
| ** **                                        | ** ** | ** **  | ** ** | ** **     | ** ** | ** **      | ** ** | **Total**           | ** ** | ** **       | ** ** | ** ** | ** ** |
|---------------------------------------------------|------------|-------------|------------|----------------|------------|-----------------|------------|---------------------|------------|------------------|------------|------------|------------|
| **Three Months Ended**                  | ** ** | ** **  | ** ** | ** **     | ** ** | ** **      | ** ** | **Prior to**   | ** ** | **Discontinued** | ** ** | ** ** | ** ** |
| **December 31, 2008 (Q3 09)** | ** ** | **Medical** | ** ** | **Industrial** | ** ** | **Adjustments** | ** ** | **Disc. Ops.** | ** ** | **Operations**   | ** ** | **Total**  | ** ** |
| **Sales to external customers**                   | ** ** | **$**       | **2,776**  | ** **     | **$**      | **834**         | ** ** | **$**               | **—** | ** **       | **$**      | **3,610**  | ** ** | **$** | **82** | ** ** | **$** | **3,692** | ** ** |
| Gross Profit                                      |       | 431         |       | 334            |       | —          |       | 765                 |       | (12              | )          | 753        |       |
| Income (Loss) from operations                     |       | (3,248      | )          | 108            |       | —          |       | (3,140              | )          | (10              | )          | (3,150     | )          |
| Interest and other income (expense), net          |       | 97          |       | —         |       | —          |       | 97                  |       | —           |       | 97         |       |
| Depreciation and amortization                     |       | 88          |       | 8              |       | —          |       | 96                  |       | (25              | )          | 71         |       |
| Stock-based compensation                          |       | 420         |       | —         |       | —          |       | 420                 |       | —           |       | 420        |       |
| Expenditures for fixed assets                     |       | 71          |       | —         |       | —          |       | 71                  |       | (24              | )          | 47         |       |
| Total Assets                                      |       | 23,325      |       | 3,016          |       | (3,872          | )*         | 22,469              |       | 14               |       | 22,483     |       |
|                                              |       |        |       |           |       |            |       |                |       |             |       |       |       |
| **2007 (Q3 08)**                                  |       |        |       |           |       |            |       |                |       |             |       |       |       |
| **Sales to external customers**                   | ** ** | **$**       | **1,246**  | ** **     | **$**      | **599**         | ** ** | **$**               | **—** | ** **       | **$**      | **1,845**  | ** ** | **$** | **175** | ** ** | **$** | **2,020** | ** ** |
| Gross Profit                                      |       | (149        | )          | 596            |       | —          |       | 447                 |       | 68               |       | 515        |       |
| Income (Loss) from operations                     |       | (2,530      | )          | 469            |       | —          |       | (2,061              | )          | (53              | )          | (2,114     | )          |
| Interest and other income (expense), net          |       | 414         |       | —         |       | —          |       | 414                 |       | —           |       | 414        |       |
| Depreciation and amortization                     |       | 78          |       | 3              |       | —          |       | 81                  |       | —           |       | 81         |       |
| Stock-based compensation                          |       | 197         |       | 3              |       | —          |       | 200                 |       | —           |       | 200        |       |
| Loss in equity investment                         |       | (119        | )          | —         |       | —          |       | (119                | )          | —           |       | (119       | )          |
| Expenditures for fixed assets                     |       | 193         |       | —         |       | —          |       | 193                 |       | 72               |       | 265        |       |
| Total Assets                                      |       | 25,511      |       | 2,753          |       | —          |       | 28,264              |       | 130              |       | 28,394     |       |

 
| ** **                                         | ** ** | ** **  | ** ** | ** **     | ** ** | ** **      | ** ** | **Total**           | ** ** | ** **       | ** ** | ** ** | ** ** |
|----------------------------------------------------|------------|-------------|------------|----------------|------------|-----------------|------------|---------------------|------------|------------------|------------|------------|------------|
| **Nine Months Ended**                    | ** ** | ** **  | ** ** | ** **     | ** ** | ** **      | ** ** | **Prior to**   | ** ** | **Discontinued** | ** ** | ** ** | ** ** |
| **December 31, 2008 (YTD 09)** | ** ** | **Medical** | ** ** | **Industrial** | ** ** | **Adjustments** | ** ** | **Disc. Ops.** | ** ** | **Operations**   | ** ** | **Total**  | ** ** |
| **Sales to external customers**                    | ** ** | **$**       | **6,917**  | ** **     | **$**      | **2,174**       | ** ** | **$**               | **—** | ** **       | **$**      | **9,091**  | ** ** | **$** | **583** | ** ** | **$** | **9,674** | ** ** |
| Gross Profit                                       |       | 802         |       | 837            |       | —          |       | 1,639               |       | 116              |       | 1,755      |       |
| Income (Loss) from operations                      |       | (10,280     | )          | 161            |       | —          |       | (10,119             | )          | (783             | )          | (10,902    | )          |
| Interest and other income (expense), net           |       | 257         |       | —         |       | —          |       | 257                 |       | —           |       | 257        |       |
| Depreciation and amortization                      |       | 251         |       | 25             |       | —          |       | 276                 |       | —           |       | 276        |       |
| Stock-based compensation                           |       | 1,266       |       | —         |       | —          |       | 1,266               |       | —           |       | 1,266      |       |
| Expenditures for fixed assets                      |       | 469         |       | —         |       | —          |       | 469                 |       | (138             | )          | 331        |       |
| Total Assets                                       |       | 23,325      |       | 3,016          |       | (3,872          | )*         | 22,469              |       | 14               |       | 22,483     |       |
|                                               |       |        |       |           |       |            |       |                |       |             |       |       |       |
| **2007 (YTD 08)**                                  |       |        |       |           |       |            |       |                |       |             |       |       |       |
| **Sales to external customers**                    | ** ** | **$**       | **5,623**  | ** **     | **$**      | **1,779**       | ** ** | **$**               | **—** | ** **       | **$**      | **7,402**  | ** ** | **$** | **175** | ** ** | **$** | **7,577** | ** ** |
| Gross Profit                                       |       | 1,248       |       | 1,019          |       | —          |       | 2,267               |       | 68               |       | 2,335      |       |
| Income (Loss) from operations                      |       | (6,437      | )          | 487            |       | —          |       | (5,950              | )          | (54              | )          | (6,004     | )          |
| Interest and other income (expense), net           |       | 1,568       |       | —         |       | —          |       | 1,568               |       | —           |       | 1,568      |       |
| Depreciation and amortization                      |       | 148         |       | 20             |       | —          |       | 168                 |       | —           |       | 168        |       |
| Stock-based compensation                           |       | 582         |       | 9              |       | —          |       | 591                 |       | —           |       | 591        |       |
| Loss in equity investments                         |       | (332        | )          | —         |       | —          |       | (332                | )          | —           |       | (332       | )          |
| Expenditures for fixed assets                      |       | 789         |       | 1              |       | —          |       | 790                 |       | 72               |       | 862        |       |
| Total Assets                                       |       | 25,511      |       | 2,753          |       | —          |       | 28,264              |       | 130              |       | 28,394     |       |

 

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*Adjustments include the following elimination entries:
| Discontinued Operations   |       | $     | 450       |       |
|---------------------------|------------|-------|-----------|------------|
| Intercompany eliminations |       | 2,457 |      |
| Investment in subs        |       | 965   |      |
| **Total**                 | ** ** | **$** | **3,872** | ** ** |

 

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**5. Discontinued Operations and Asset Sale**

 

*Sale of non-core health servicessegment*

 

Since our October 2007acquisition of the assets of Best Dysphasia Management Services, Inc. partof our management and financial resources were diverted towards managing andgrowing our unprofitable health services segment. As a result of our desire tofocus our attention and financial resources on our core business in the medicalsegment, where we are currently launching the videoscope family of products, weevaluated the health services segment for possible sale.

 

After careful evaluation, wesold the assets of the health services segment (the BEST-DMS assets) toGhiglieri Winchester Inc., the successor to Best Dysphasia Management Services, Inc.This transaction was signed on November 7, 2008, closed on November 10,2008 and was effective October 28, 2008.

 

Consistent with theprovisions of Statement 144, *Accounting forthe Impairment or Disposal of Long-lived Assets*(Statement 144), weclassified the BEST-DMS assets that were sold as discontinued operations forall periods presented. Accordingly, depreciation and amortization associatedwith these assets was discontinued. Additionally, since all assets were part ofthe health services segment, we determined that these assets comprisedoperations and cash flows that can be clearly distinguished, operationally andfor financial reporting purposes, from the rest of the Company.

 

As a result of the BEST-DMSasset sale, we recorded a loss of $10 in Q3 09 and a loss of $783 for YTD 09 asa separate component in our consolidated statement of operations, entitled “Lossfrom discontinued operations, net.” Additionally, net income from the healthservices segment were classified as discontinued operations in the consolidatedstatements of operations, in the first nine months of FY 08 and FY 09,respectively. The net assets related to the health services segment wereclassified as discontinued operations as of December 31, 2008. We receivednet proceeds of $137, which were recorded in this quarter.

 

*Summarized Financial Information ofDiscontinued Operations*

 

Summarized operating results of discontinuedoperations are as follows:

 
| ** **                                                    | ** ** | **3 Months Ended** | ** ** | **9 Months Ended** | ** ** |
|---------------------------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| **Description**                                               | ** ** | **12/31/2008**               | ** ** | **12/31/2007**               | ** ** | **12/31/2008** | ** ** | **12/31/2007** | ** ** |
| Revenue                                                       |       | $                            | 82         |                         | $          | 175 |   | $ | 583 |   | $ | 175 |   |
|                                                          |       |                         |       |                         |       |   |   |   |   |
| Gross margin                                                  |       | (12                          | )          | 68                           |       | 116 |   | 68 |   |
|                                                          |       |                         |       |                         |       |   |   |   |   |
| **Loss from discontinued operations (net of  taxes of zero)** |       |                         | **(10**    | **)**                        | ** ** | **(53** | **)** | ** ** | **(783** | **)** | ** ** | **(53** | **)** |

 

**Item 2.  Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

 

**Executive Summary**

 

This QuarterlyReport on Form 10-Q contains forward-looking statements within the meaningof The Private Securities Litigation Reform Act of 1995, which are subject tovarious risks and uncertainties that could cause our actual results to differmaterially from those expressed or implied in such statements. These factorsinclude, but are not limited to: pricing pressures, including cost-containmentmeasures which could adversely affect the price of, or demand for our products;availability of parts on acceptable terms; our ability to design new productsand the success of such new products; maintaining our manufacturing anddistribution arrangement with Medtronic on acceptable terms; changes ineconomic conditions that may adversely affect the level of demand for ourproducts; changes in foreign exchange markets; and changes in financial marketsand changes in the competitive environment. Other examples of forward-lookingstatements include statements about expectations about future financialresults, future products and future sales of new and existing products, futureexpenditures, and capital resources to meet anticipated requirements.Generally, words such as expect, believe, anticipate, may, will, plan, intend,estimate, could, and other similar expressions are intended to identifyforward-looking statements. The forward-looking statements are based on ourfuture plans, strategies, projections and predictions and involve risks anduncertainties, and our actual results may differ significantly from those discussedin the forward-looking statements. Factors that might cause such a differencecould include the availability of capital resources, the availability ofthird-party reimbursement, government regulation, the availability of rawmaterial components, our dependence on certain key distributors and customers,competition, technological difficulties, general economic conditions and other

 

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risks detailed in our most recent AnnualReport on Form 10-K and any subsequent periodic filings we make with theSecurities and Exchange Commission (SEC). (Please refer to the section entitled“Risk Factors” in Part II of this Form 10-Q). We do not undertake anobligation to update our forward-looking statements to reflect future events orcircumstances.

 

**RegisteredTrademarks, Trademarks and Service Marks**

 

Vision-Sciences, Inc.and its subsidiaries own the registered trademarks Vision Sciences®, Slide-On® andEndoSheath®.

 

Our fiscalyear-end is on March 31 of each year, and is referred to herein as FY 08and FY 09 (our current fiscal year), respectively.  Q3 09 refers to the period from October 1,2008 to December 31, 2008 and Q3 08 refers to the period from October 1,2007 to December 31, 2007.

 

We design,develop, manufacture and market products for endoscopy - the science of usingan instrument, known as an endoscope - to provide minimally invasive access toareas not readily visible to the human eye.

 

We wereincorporated in Delaware in 1987 under the name Machida Incorporated (Machida).Since that time, we acquired by merger Cyberex Corporation (October 1988),Vascu-Care, Inc. (March 1989), and we acquired Opielab, Inc.through a share exchange (September 1990). In December 1990, wechanged our name to Vision-Sciences, Inc. and Machida became a whollyowned subsidiary. Another of our subsidiaries, Vision Sciences Ltd., anIsraeli corporation, has been inactive since the fiscal year ended March 31,2002.

 

Vision-Sciencesoperates primarily in the medical segment, while Machida operates primarily inthe industrial segment. In October, 2007 we purchased the assets of BESTDysphagia Management Services, Inc., a Florida based speech pathologycompany, which specialized in providing what is referred to as the BedsideEndoscopic Swallowing Test (BEST) to nursing homes, rehabilitation centers andassisted living, facilities, via our wholly-owned subsidiary BEST DMS Inc.(BEST-DMS). BEST-DMS was our health services segment. In Q3 09 we sold theassets of BEST-DMS, and as part of the asset sale agreement changed thesubsidiary name to VSI Services Inc. For more information, please refer to Item1, Note 5. Discontinued Operations andAsset Sale, above.

 

Our principalexecutive offices are currently located at 40 Ramland Road South,Orangeburg, New York 10962. Our telephone number is (845) 365-0600. Ourcorporate website is *www.visionsciences.com*.Through a link on the Investor Relations section of our website, we makeavailable all our SEC filings as soon as reasonably practicable after they areelectronically filed with or furnished to the SEC.  All such filings are available free ofcharge.

 

As of November 1,2008, due to the asset sale of our health services segment, we are returning tooperate in two reportable segments, ***medical and industrial***,in which we operated from April 07 (FY08) in which we operated from April 07(FY08) through September 30, 2007 (Q2 08). Between October 1, 2007(Q308) and October 30, 2008, (Q4 09), we operated in three reportablesegments, ***medical,industrial and health service.***

 

***Our medical segment***designs, manufactures, and sells our advanced line of endoscopy based productsfor a variety of specialties, including our state-of-the-art flexibleendoscopes and our Slide-On EndoSheath technology.

 

Ourlongstanding primary line of high-quality fiber-based flexible endoscopes isnow augmented with our first generation CCD (charge coupled device) basedflexible digital video endoscope systems, which were announced and cleared forsale by the Food & Drug Administration (FDA) in Q3 and Q4 of FY 08. Weexpect this new high-performance imaging technology platform to redefine ourplace in the minimally invasive device market. These flexible video endoscopesare unlike conventional endoscopes, and when utilized with the EndoSheathtechnology, offer a multitude of benefits and advantages to the healthcarepractice.

 

EndoSheathendoscopy, the differentiating term we give to procedures performed with ourunique technology, consists of a reusable flexible endoscope combined with asingle-use, sterile, protective disposable sheath, which is placed onto theinsertion tube (patient contact area) of the endoscope. The use of theEndoSheath technology gives healthcare providers clinical and economicadvantages, as it allows them to avoid the elaborate high level disinfectionand sterilization routines required of conventional endoscopes. This design of“always ready” equipment, which allows for a rapid and less caustic cleaningprocess, provides a multitude of benefits such as: less capital inventoryinvestment, less service and maintenance costs of capital equipment, less staffexposure to toxic chemicals, increased patient scheduling flexibility, improvedstaff productivity and a more practical implementation of office-basedendoscopy.

 

We believeEndoSheath technology allows for unprecedented practice efficiency in a wide arrayof healthcare settings, from private practices to busy academic hospitals. Inaddition, each EndoSheath disposable is a sterile device, providing patientswith a 

 

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contaminant-free insertion tube for eachprocedure and reducing the risk of cross-contamination found with the reuse ofconventional flexible endoscopes, which are difficult to clean and disinfectand cannot be sterilized.

 

We target fourmain areas for our fiber and video scopes and our EndoSheath technology: ENT(ear, nose and throat), urology, gastroenterology (GI) and pulmonology. Withinthe ENT area, we manufacture ENT endoscopes and sell these scopes exclusivelyto Medtronic.  In March 2007 wecompleted the sale to Medtronic of our ENT EndoSheath product line, whichMedtronic now manufactures and distributes along with our ENT endoscopes. OurTNE (trans-nasal esophagoscopy) endoscopes and EndoSheaths which sold only toENT physicians are manufactured by us, but they are marketed and distributed byMedtronic.  Within the urology area, wemanufacture, market and sell our cystoscopes and EndoSheaths to urologists andother uro-gyn related physicians.  Withinthe GI area, we manufacture, market and sell our TNE scopes and EndoSheaths toGI physicians and primary care and other physicians with a GI focus as part oftheir practice.  We intend tomanufacture, market and sell our soon expected to be introduced bronchoscopesand EndoSheaths to pulmonologists, oncologists, thoracic surgeons and otherpulmonology related physicians.

 

***Our industrial segment,***through our wholly-owned subsidiary, Machida, Inc., designs, manufacturesand sells borescopes to a variety of users, primarily in the aircraft enginemanufacturing and aircraft engine maintenance industries. A borescope is aninstrument using optical fibers for the visual inspection of narrowcavities.  Our borescopes are used toinspect aircraft engines, casting parts and ground turbines, among other items.Machida’s quality line of borescopes includes a number of advanced standardfeatures normally found only in custom designed instruments.

 

***Our former health services segment***consisted of our wholly-owned subsidiary BEST-DMS, which was established in October 2007.BEST-DMS was a service-based segment, providing the Bedside EndoscopicSwallowing Test (BEST) to nursing homes, rehabilitation centers, and assistedliving facilities. (Please refer to Note 5. Discontinued Operations and Asset Sale, above).

 

***Research and Development***

 

At the end ofQ1 09 we released our new family of flexible videoscopes, with a miniaturedigital camera mounted on the distal, or far, end of the insertion tube. Thisvideoscope line includes the ENT-5000 (ear, nose and throat) videoscope, theTNE-5000 videoscope and our urology video-based flexible cystoscope, theCST-5000. We expect to release our video-based bronchoscope for the pulmonologyarea in the spring.

 

We continue todevelop our next generation of improved family of medical and industrialfiberscopes, which will no longer have any Pentax parts. We anticipate that wewill have completed the development and the FDA approval process for our newline of fiberscopes by the end of FY 09. While we believe we have enough Pentaxparts inventory until we launch our new 4000 series line of fiberscopes,expected to occur in Q1 10, there can be no assurance that our supply ofinventory will be adequate through such time when our new series of fiber scopesis launched.

 

We are alsoworking on improving our manufacturing processes, which we believe will resultin lower costs to produce our endoscopes and EndoSheaths. We are at variousstages of exploration of opportunities in, and development of products for usein the medical fields of ENT, urology, gynecology, pulmonology andgastroenterology, among others.

 

***Other Developments***

 

**(i)****                                    SpineViewDevelopment and Supply Agreement**

 

On June 19,2008 we entered into a Development and Supply Agreement with SpineView, Inc.(the SpineView Agreement), pursuant to which we are to develop and supply aCCD-based video endoscope to SpineView for use with SpineView’s products.SpineView is engaged in the development and manufacture of miniature, minimallyinvasive, disposable spine surgery devices that include reusable endoscopes forvisualization and image guidance.

 

SpineViewagreed to pay us $225 for certain non-recurring engineering costs, and toreimburse us for up to $40 of our out-of-pocket costs. After the completion ofcertain milestones and delivery of a prototype, SpineView has agreed to placean initial firm order with us for 50 video endoscopes at a purchase price of$27 per unit (the Initial Order), for a total of $1,350. Following delivery ofthe Initial Order, SpineView is to submit a forecast for the following12 months, of which the first six months will be considered a firm orderat a price of $23.5 per video endoscope. Payment for certain of these items issubject to the closing of certain of SpineView’s fundraising activities. We arealso to be the exclusive supplier to SpineView of visualization means for usewith certain future SpineView products. We are currently working with SpineView on the first prototype ofCCD-based video endoscope.

 

The initialterm of the SpineView Agreement is for four years from the date of delivery ofthe Initial Order and will automatically renew for successive one year periods,unless either party gives the other notice of its intention not to renew.

 

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Mr. LewisC. Pell, the chairman of our Board, is the chairman of the SpineView board ofdirectors and an investor in SpineView. Mr. Ron Hadani, our president andchief executive officer and a member of our Board, and Mr. Katsumi Oneda,a member of our Board, are also investors in SpineView.

 

Our policywith respect to transactions in which any of our directors or officers may havean interest requires that such transaction be on terms no less favorable to usthan could be obtained from unaffiliated third parties and be approved by amajority of the uninterested, outside members of the Board.

 

At a Boardmeeting held on May 29, 2008, the Board reviewed the terms of the finaldraft of the SpineView Agreement, outside of the presence of Mr. Pell, Mr. Onedaand Mr. Hadani. The remaining uninterested members of our Board determinedthat the SpineView Agreement was fair, properly negotiated, and would be atleast as favorable to us as could have been obtained from unaffiliated thirdparties, and accordingly, after discussion, it was approved.

 

**(ii)****                                Gainon Sale of Product Line to Medtronic**

 

In March of2007, we completed the sale to Medtronic of certain assets with respect to ourENT EndoSheath business. As part of the transaction, we granted to Medtronic anexclusive, royalty-free worldwide license to certain of our intellectualproperty, for use in making and selling EndoSheath products solely within thefield of ENT. Additionally, as part of the transaction and under a separatetransition agreement, we transferred our ENT production lines for theEndoSheath ENT products from our Natick, MA facility to a Medtronic facility inJacksonville, FL. Medtronic now distributes, markets and sells our ENTendoscope products worldwide, on a co-branded basis, through Medtronic’sdedicated sales force.

 

Under theterms of the agreement, Medtronic paid us $34,000 as follows:

 

·                  $27,000 atthe closing;

 

·                  $3,000 inthe quarter ending June 30, 2008, representing the portion of the purchaseprice that was held back at closing for potential indemnification claims and toensure that we complied with our obligations under the agreement withMedtronic;

 

·                  $4,000relating to the transition agreement in several installments, based on agreedupon milestones.

 

The table belowsummarizes the payment stream since the closing of the transaction.

All payments under thisagreement are now complete.

 

**Medtronic Transaction Payments**

 
| ** **                           | ** ** | **10K**        | ** ** | **10Q**    | ** ** | **10Q**    | ** ** | ** ** | ** ** | **10K**        | ** ** | **10Q**    | ** ** | **10Q**    | ** ** | **Total**       | ** ** |
|--------------------------------------|------------|----------------|------------|------------|------------|------------|------------|------------|------------|----------------|------------|------------|------------|------------|------------|-----------------|------------|
| **Date**                             | ** ** | **FY 07** | ** ** | **Sep-08** | ** ** | **Dec-08** | ** ** | **Mar-08** | ** ** | **FY 08** | ** ** | **Jun-08** | ** ** | **Sep-08** | ** ** | **Transaction** | ** ** |
| Revenues - Asset Purchase Agreement  |       | $              | 27,000     |       | $          | —     |       | $          | —     |           | $          | —     |       | $          | —     |            | $          | 3,000 |   | $ | — | ** ** | **$** | **30,000** | ** ** |
| Revenues — Transition Agreement |       | —         |       | 750        |       | 250        |       | 750        |       | 1,750          |       | 250        |       | 2,000      | ** ** | **4,000**       | ** ** |
| Expenses                             |       | (903           | )          | (163       | )          | (118       | )          | (35        | )          | (316           | )          | (20        | )          | (244       | **)**      | **(1,483**      | **)**      |
| **Gain on Sale of Product Line**     | ** ** | **$**          | **26,097** | ** ** | **$**      | **587**    | ** ** | **$**      | **132**    | ** **     | **$**      | **715**    | ** ** | **$**      | **1,434**  | ** **      | **$**      | **3,230** | ** ** | **$** | **1,756** | ** ** | **$** | **32,517** | ** ** |

 

All payments were offsetby certain expenses related to the transaction, as follows:

 

·                  Duringfiscal 07 (FY 07), upon receipt at the closing of $27,000, we recognized a netgain of $26,097 from the transaction. This gain reflects the initial payment of$27,000 received at the closing, less the net book value of the assets sold toMedtronic. The effect of this was to reduce our basis in the assets sold toMedtronic to zero;

 

·                  Totalpayments of $1,750 received during FY 08, were offset by $316 of expenses,primarily relating to the cost of a new production machine which we purchasedand sold to Medtronic,  and travelexpenses related to the transition agreement, for a net gain of $1,434;

 

·                  Totalpayments of $3,250 received during Q1 09, which were offset by $20 of mainlytravel expenses related to the transition agreement for a net gain of $3,230;

 

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·                  A payment of$2,000 received during Q2 09 which was offset by legal, travel and othertransition related expenses related to the transition agreement, for a net gainof $1,756.

 

Overall, as of the endof Q2 09, we booked a net gain of $32,517 out of total payments of $34,000.

 

**(iii)****                            Terminationof a Material Definitive Agreement**

 

On May 1,2008, we entered into a definitive lease agreement with a landlord, RamlandRealty Associates, L.L.C., for new premises, consisting of approximately 34,795square feet at One Ramland Road, Orangeburg, New York.

 

On December 31, 2008,we signed a Surrender and Acceptance Agreement with the landlord whichcancelled the lease. We never occupied the facility and no payments were madeor received in connection with the lease. (Please refer to Restructuring Chargein this section below).

 

***Critical AccountingPolicies and Estimates***

 

Thisdiscussion and analysis of our financial condition and results of operations isbased upon our Consolidated Financial Statements, which have been prepared inaccordance with generally accepted accounting principles (GAAP) in the UnitedStates of America (see the Notes to the Consolidated Financial Statementsincluded elsewhere herein). Certain of our accounting policies require theapplication of judgment in selecting the appropriate assumptions forcalculating financial estimates. By their nature these judgments are subject toan inherent degree of uncertainty. We periodically evaluate the judgments andestimates used for our critical accounting policies to ensure that suchjudgments and estimates are reasonable for our interim and year-end reportingrequirements. These judgments and estimates are based upon our historicalexperience, current trends and information available from other sources, asappropriate. If different conditions result from those assumptions used in ourjudgment, the results could be materially different from our estimates. Ourcritical accounting policies include the following:

 

*Revenue Recognition*

 

We recognizerevenue in accordance with SEC Staff Accounting Bulletin No. 104, *Revenue Recognition in Financial Statements.*This pronouncement requires that five basic criteria must be met before revenuecan be recognized: (1) persuasive evidence that an arrangement exists (2) deliveryhas occurred or services were rendered (3) the fee is fixed anddeterminable (4) collectability is reasonably assured and (5) thefair value of undelivered elements, if any, exists. Determination of criterion (4) aboveis based on management’s judgment regarding the collectability of invoices forproducts and services delivered to customers. Should changes in conditionscause management to determine this criteria is not met for certain futuretransactions, revenue recognized for any reporting period could be adverselyaffected. We recognize revenue when title passes to the customer, generallyupon shipment of our products F.O.B. shipping point.

 

*Options Issued*

 

Effective April 1,2006 we began accounting for compensation expense related to stock options inaccordance with SFAS No. 123 (Revised 2004) *Share-Based Payment* (SFAS 123R). Prior to April 1,2006, we accounted for stock options according to Accounting Principles Board(APB) Opinion 25, *Accounting for StockIssued to Employees.* Weaccount for equity instruments issued to non-employees in accordance with theprovisions of SFAS No. 123R and Emerging Issues Task Force Abstract No. 96-18,*Accounting for Equity Instruments that areIssued to Other than**Employeesfor Acquiring, or in Conjunction with Selling, Goods or Services*(EITF 96-18).

 

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***Three months ended December 31, 2008(Q309)***

 

In accordancewith SFAS 123R and EITF 96-18, we recorded $420 and $200 of stock-basedcompensation expense for Q3 09 and for Q3 08, respectively, in thefollowing expense categories:

 
| ** ** | ** ** | **(Unaudited)**                  | ** ** |
|------------|------------|----------------------------------|------------|
| ** ** | ** ** | **Three Months Ended** | ** ** |
| ** ** | ** ** | **December 31,**            | ** ** |
| ** ** | ** ** | **2008**                         | ** ** | **2007** | ** ** |
| COGS       |       | $                                | 17         |   | $ | 18 |   |
| SG&A   |       | 177                              |       | 143 |   |
| R&D    |       | 226                              |       | 39 |   |
| Total      |       | $                                | 420        |   | $ | 200 |   |

 

***Nine months ended December 31, 2008(YTD09)***

 

In accordancewith SFAS 123R and EITF 96-18, we recorded $1,266 and $591 of stock-basedcompensation expense in the statement of operations for YTD 09 and for the ninemonth period ended December 31, 2007 (YTD 08), in the following expensecategories:

 
| ** ** | ** ** | **(Unaudited)**                 | ** ** |
|------------|------------|---------------------------------|------------|
| ** ** | ** ** | **Nine Months Ended** | ** ** |
| ** ** | ** ** | **December 31,**           | ** ** |
| ** ** | ** ** | **2008**                        | ** ** | **2007** | ** ** |
| COGS       |       | $                               | 88         |   | $ | 48 |   |
| SG&A   |       | 555                             |       | 438 |   |
| R&D    |       | 623                             |       | 105 |   |
| Total      |       | $                               | 1,266      |   | $ | 591 |   |

 

The totalcompensation expense for YTD 09, 2008 includes a one-time adjustment of $299,recorded in Q2 09, of which $176 represents expense for FY 07 and FY 08,representing stock based compensation expense for non-employees consultantsthat should have been calculated and recognized according to EITF 96-18 for theperiod between September 2006 and June 2008. During Q2 09, wediscovered that we had accounted for our non-employees consultants compensationexpenses according to SFAS 123R instead of according to EITF 96-18. The adjustmentimpacted COGS by $23, SG&A by $22 and R&D by $254. We reviewed theimpact of these adjustments on the results of operations for FY 07 ($75), FY 08($101) and Q1 09 ($123), and found it to be immaterial.

 

At December 31, 2008, the total value ofunamortized stock based compensation was approximately $3,274. We will expensethat amount over periods ending through June 30, 2013. We do not expect torealize any tax benefits from future disqualifying dispositions, if any, sincewe currently have a full valuation allowance on our deferred tax assets.

 

In the nine months ended December 31,2008, we granted options to purchase a total of 1,522,958 shares of our commonstock, as follows: (i) a total of 1,467,958 options were granted from the2007 Plan; (ii) 31,000 options were granted from the 2000 Plan and (iii) 54,000options were granted from our 2003 Plan. The fair value of these optionsmeasured at the option grant date was approximately $4,079, determined usingthe Black-Scholes option-pricing model. This amount is reduced by an estimatedforfeiture rate and is being recorded as an expense over the vesting period.Our assumptions used in the Black-Scholes option-pricing model in the periodwere as follows:

 
| Risk-free interest rate                |   | 1.71% - 3.55 | %      |
|----------------------------------------|--------|--------------|--------|
| Expected dividend yield                |   | —       |   |
| Expected life                          |   | 6.25 years   |   |
| Expected volatility                    |   | 82           | %      |
| Weighted grant average value per share |   | $            | 2.74   |   |
|                                        |        |              |        |  |

 

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We account foroptions issued to directors, non-employees, consultants and employees inaccordance with the provisions of SFAS 123R and EITF 96-18. We grantoptions with vesting periods ranging from immediate to six years. We use the simplifiedmethod of calculating the expected option term, which averages an award’sweighted average vesting period and its contractual term. The contractual termof our options is ten years. The risk-free rate is based upon the dailytreasury yield curve for a period approximately equal to the expected optionterm. We used historical data to estimate the expected price volatility andforfeiture rate. The expected dividend yield is 0%, based on our history of notpaying dividends.

 

*Income Taxes*

 

We account forincome taxes under the liability method, and deferred tax assets or liabilitiesare computed based on the differences between the financial statement andincome tax basis of assets and liabilities as measured by the enacted taxrates. We have recorded a valuation allowance equal to our net deferred taxasset due to the uncertainty of realizing the benefit of this asset.

 

**Results of Operations**

 

***Net Sales***

 

***Three months ended December 31,2008 (Q3 09) compared to the three months ended December 31, 2007 (Q308)***

 

Net sales forQ3 09 were $3,610, an increase of $1,766, or 96%, compared to sales of $1,844for Q3 08. During Q3 09 net sales of our medical segment increased by $1,530,or 123%, from $1,246 to $2,776, and net sales of our industrial segment increasedby $236, or 39%, from $598 to $834. Our sales growth this quarter is a resultof (i) additional fiberscope sales over Q3 08, when our sales wereseverely impacted by the shortage of parts due to our dispute with Pentax; (ii) theavailability of our new videoscopes, which were not available in Q3 08, and (iii) higherunit prices for our videoscope product line than for our fiberscope productline.

 

Sales bysegment and category in Q3 09 and Q3 08 were as follows:

 
| **Segment:**                         | ** ** | **Q3 09** | ** ** | **Q3 08** | ** ** | **Difference** | ** ** | **Percentage** | ** ** |
|--------------------------------------|------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|
| *Medical*                            |       |           |       |           |       |           |       |           |       |
| Scopes                               |       | $              | 1,804      |           | $          | 456            |       | $              | 1,348      |   | 296 | % |
| EndoSheaths                          |       | 327            |       | 488            |       | (161           | )          | (33            | )%         |
| Repairs, Peripherals and Accessories |       | 645            |       | 302            |       | 343            |       | 114            | %          |
| **Total Medical**                    | ** ** | **2,776**      | ** ** | **1,246**      | ** ** | **1,530**      | ** ** | **123**        | **%**      |
| ** **                           | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** |
| *Industrial*                         | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** |
| Borescopes and Accessories           |       | $              | 664        |           | $          | 423            |       | $              | 241        |   | 57 | % |
| Repairs                              |       | 170            |       | 175            |       | (5             | )          | (3             | )%         |
| Total Industrial                     |       | 834            |       | 598            |       | 236            |       | 39             | %          |
| ** **                           | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** |
| **Total Sales**                      | ** ** | **$**          | **3,610**  | ** **     | **$**      | **1,844**      | ** ** | **$**          | **1,766**  | ** ** | **96** | **%** |

 

*Medical Sales—Scope Products*

 

Net sales tothe medical scope market include products used for ENT (including TNE), urologyand other markets were as follows:

 
| **Medical Scope Market** | ** ** | **Q3 09** | ** ** | **Q3 08** | ** ** | **Difference** | ** ** | **Percentage** | ** ** |
|------------------------------------|------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|
| ENT and TNE                        |       | $              | 1,768      |           | $          | 311            |       | $              | 1,457      |   | 468 | % |
| Urology and Other                  |       | 36             |       | 145            |       | (109           | )          | (75            | )%         |
| **Total Scopes**                   | ** ** | **$**          | **1,804**  | ** **     | **$**      | **456**        | ** ** | **$**          | **1,348**  | ** ** | **296** | **%** |

 

Overallendoscope sales increased by $1,348, or 296%, from $456 to $1,804, mainly dueto sale of ENT videoscopes to Medtronic, which started selling this new productline at the end of Q2 09. Overall sales of ENT and TNE scopes rose by $1,457,or 468%, from $311 in Q3 08 to $1,768 in Q3 09. Sales to our urology and othermarkets decreased by $109, or 75%, from $145 in Q3 

 

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08 to $36 in Q3 09. This decrease in mainlydue to changes we are making in our domestic distribution channel, byselectively replacing our independent sales representatives with a direct salesforce.

 

Our ENT scopesare marketed and distributed globally by Medtronic’s ENT division. As a resultof our exclusive ENT distribution agreement with Medtronic, the success of ourENT endoscope lines depends and thereby our financial condition depends substantiallyupon the success of Medtronic’s marketing and sales activities, over which wehave limited control.

 

*Medical Sales—EndoSheath Products*

 

Net sales ofEndoSheaths include products used for our ENT and TNE, urology and othermarkets as follows:

 
| **Products**          | ** ** | **Q3 09** | ** ** | **Q3 08** | ** ** | **Difference** | ** ** | **Percentage** | ** ** |
|-----------------------|------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|
| ENT and TNE           |       | $              | 126        |           | $          | 343            |       | $              | (217       | ) | (63 | )% |
| Urology and Other     |       | 201            |       | 145            |       | 56             |       | 39             | %          |
| **Total EndoSheaths** | ** ** | **$**          | **327**    | ** **     | **$**      | **488**        | ** ** | **$**          | **(161**   | **)** | **(33** | **)%** |

 

Sales of ourEndoSheaths decreased from $488 in Q3 08 to $327 in Q3 09, a reduction of $161,or 33%. This decrease was mainly as a result of our ENT and TNEEndoSheaths sales, which decreased from $343 in Q3 08 to $126 in Q3 09, adecreased of $217, or 63%. In December 2007, Medtronic stopped purchasingENT EndoSheaths from us, as it is now manufactures the ENT EndoSheaths as partof its purchase of this product line. This decrease was partially offset by anincrease in sales of urology and other EndoSheaths of $56, or 39%, from $145 inQ3 08 to $201 in Q3 09, resulting  fromsales of new scope sales and re-orders from existing users.

 

*Medical Sales—Repairs, Peripherals andAccessories*

 

Revenue fromrepairs together with sales of peripherals and accessories increased in Q3 09by $343, or 114%, from $302 to $645, as compared to Q3 08.

 

*Industrial Segment*

 

Net sales ofthe industrial segment increased by $236, or 39%, from $598 in Q3 08 to $834 inQ3 09. The bulk of the sales growth, $240, or 57%, was derived from sales ofnew borescopes and accessories, offset by a slight decline in repairs of $5, or3%.  Although sales grew this quarter ascompared to the same quarter last year, future sales in this segment may benegatively impacted by the slowdown in purchases from the airline industry.

 

***Nine months ended December 31, 2008 (YTD09) compared to the nine months ended December 31, 2007 (YTD 08)***

 

Net sales for YTD 09 were $9,091, an increaseof $1,689, or 23%, compared to $7,402 in YTD 08. During YTD 09, net sales ofthe medical segment increased by $1,294, or 23%, from $5,623 to $6,917, and netsales of the industrial segment increased by $395, or 22%, from $1,779 to$2,174. Our sales growth for YTD 09 is a result of (i) additionalfiberscope sales in Q3 09 versus Q3 08, when our sales were severely impactedby the shortage of parts due to our dispute with Pentax, and (ii) theavailability of our new videoscopes, which were not available in Q3 08, andwhich command higher unit prices than our fiberscopes and (iii) higherunit prices.

 

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Sales bysegment and category were as follows:

 
| **Segment:**                         | ** ** | **YTD 09** | ** ** | **YTD 08** | ** ** | **Difference** | ** ** | **Percentage** | ** ** |
|--------------------------------------|------------|-----------------|------------|-----------------|------------|----------------|------------|----------------|------------|
| *Medical*                            |       |            |       |            |       |           |       |           |       |
| Scopes                               |       | $               | 4,607      |            | $          | 2,454          |       | $              | 2,153      |   | 88 | % |
| EndoSheaths                          |       | 816             |       | 2,007           |       | (1,191         | )          | (59            | )%         |
| Repairs, Peripherals and Accessories |       | 1,494           |       | 1,162           |       | 332            |       | 29             | %          |
| **Total Medical**                    | ** ** | **6,917**       | ** ** | **5,623**       | ** ** | **1,294**      | ** ** | **23**         | **%**      |
| ** **                           | ** ** | ** **      | ** ** | ** **      | ** ** | ** **     | ** ** | ** **     | ** ** |
| *Industrial*                         | ** ** | ** **      | ** ** | ** **      | ** ** | ** **     | ** ** | ** **     | ** ** |
| Borescopes and Accessories           |       | $               | 1,569      |            | $          | 1,151          |       | $              | 418        |   | 36 | % |
| Repairs, Peripherals and Accessories |       | 605             |       | 628             |       | (23            | )          | (4             | )%         |
| **Total Industrial**                 | ** ** | **2,174**       | ** ** | **1,779**       | ** ** | **395**        | ** ** | **22**         | **%**      |
| ** **                           | ** ** | ** **      | ** ** | ** **      | ** ** | ** **     | ** ** | ** **     | ** ** |
| **Total Sales**                      | ** ** | **$**           | **9,091**  | ** **      | **$**      | **7,402**      | ** ** | **$**          | **1,689**  | ** ** | **23** | **%** |

 

*Medical Sales-Scope Products*

 

Net sales to the medical scope market includeproducts for ENT and TNE, urology and other markets as follows:

 
| **Medical Scope Market** | ** ** | **YTD 09** | ** ** | **YTD 08** | ** ** | **Difference** | ** ** | **Percentage** | ** ** |
|------------------------------------|------------|-----------------|------------|-----------------|------------|----------------|------------|----------------|------------|
| ENT and TNE                        |       | $               | 3,724      |            | $          | 2,071          |       | $              | 1,653      |   | 80 | % |
| Urology and Other                  |       | 883             |       | 383             |       | 500            |       | 131            | %          |
| **Total Scopes**                   | ** ** | **$**           | **4,607**  | ** **      | **$**      | **2,454**      | ** ** | **$**          | **2,153**  | ** ** | **88** | **%** |

 

Endoscopesales increased by $2,153, or 88%, from $2,454 to $4,607, mainly due to sale ofENT videoscopes to Medtronic, which started selling this new product at the endof Q2 09. Overall sales of ENT and TNE scopes rose by $1,653, or 80%, from$2,071 in Q3 08 to $3,724 in Q3 09. Sales to our urology and other marketsincreased by $500, or 131%, from $383 in Q3 08 to $883 in Q3 09, due to strongsales in the first six months of our fiscal year.

 

As a result ofour exclusive ENT distribution agreement with Medtronic, the success of our ENTendoscope lines and thereby our financial condition depends substantially uponthe success of Medtronic’s marketing and sales activities , over which we havelimited control.

 

*Medical Sales-EndoSheath Product*

 

Net sales of EndoSheaths include productsused for the ENT and TNE, urology and other markets as follows:

 
| **Products**          | ** ** | **YTD 09** | ** ** | **YTD 08** | ** ** | **Difference** | ** ** | **Percentage** | ** ** |
|-----------------------|------------|-----------------|------------|-----------------|------------|----------------|------------|----------------|------------|
| ENT and TNE           |       | $               | 156        |            | $          | 1,624          |       | $              | (1,468     | ) | (90 | )% |
| Urology and Other     |       | 660             |       | 383             |       | 277            |       | 72             | %          |
| **Total EndoSheaths** | ** ** | **$**           | **816**    | ** **      | **$**      | **2,007**      | ** ** | **$**          | **(1,191** | **)** | **(59** | **)%** |

 

Sales of ourENT and TNE EndoSheaths decreased by $1,468, or 90%, in YTD 09, comparedto YTD 08, as Medtronic ceased its ENT EndoSheaths purchases from us as of December 2007,a result of purchasing our ENT EndoSheath product line. Medtronic nowmanufactures and sells the ENT EndoSheaths as part of this product line.  We expect that our ENT EndoSheath sales toMedtronic will be limited to initial quantities for new products going forward,the effect of which will be immaterial.

 

The increasein sales of urology and other EndoSheaths of $277, or 72%, from $383 in YTD 08to $660 in YTD 09 is a result of new fiberscopes and videoscope sales, andre-orders from existing users.

 

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***Gross Profit***

 

***Three months ended December 31,2008 (Q3 09) compared to the three months ended December 31, 2007 (Q308)***

 

Gross profitof $765 in Q3 09 increased by $318 compared to gross profit of $447 in Q3 08.For Q3 09, gross profit by segment was $431 and $334 for the medical andindustrial segments, respectively.  Ourgross profit as a percentage of net sales was 21% in Q3 09, vs. 24% in Q3 08.This 3% decrease is due to our higher than expected production start up costfor our videoscope line of products.

 

***Nine months ended December 31, 2008 (YTD09) compared to the nine months ended December 31, 2007 (YTD 08)***

 

Gross profitof $1,639 in YTD 09 decreased by $628 compared to gross profit of $2,267 in YTD08. For YTD 09, gross profit by segment was $802 and $838 for the medical andindustrial segments, respectively.  Ourgross profit as a percentage of net sales was 18% in YTD 09, vs. 31% in YTD 08.This decrease is mainly attributable to startup costs of our videoscope line ofproducts.

 

***Operating Expenses***

 

***Three months ended December 31, 2008(Q3 09) compared to the three months ended December 31, 2007 (Q3 08)***

 

*Selling, General and Administrative Expenses*

 

Selling,general and administrative (SG&A) expenses in Q3 09 were $2,427, anincrease of $569, or 31%, compared to SG&A expenses of $1,858 in Q3 08.This increase in SG&A expenses is primarily from increases of $280 in salesand marketing expenses due to increased sales activity and additional tradeshows attended, $175 in legal and accounting fees, and $110 of architecturaland engineering expenses related to the consolidation of our Natick, MA andOrangeburg, NY, which was cancelled in Q2 09 (for more information, pleaserefer to *Restructuring Charge* on page 24below).

 

*Research and Development Expenses*

 

Researchand development (R&D) expenses in Q3 09 were $1,478, an increase of $828,or 127%, as compared to expenses of $650 in Q3 08. This increase resultedprimarily from (i) expenses related to videoscope development of $380, (ii) expensesrelated to our new fiberscope line (the 4000 series) and other products underdevelopment of $160, and (iii) a feasibility study on a potential new productof $200. We have also hired additional personnel to develop our newlines of videoscope and EndoSheath products.

 

*Discontinued Operations*

 

Since our October 2007acquisition of the assets of Best Dysphasia Management Services, Inc.,part of our management and financial resources were diverted towards managingand growing our unprofitable health services segment. As a result of our desireto focus our attention and financial resources on our core business in themedical segment, where we are currently launching the videoscope family ofproducts, we evaluated the health services segment for possible sale.

 

After careful evaluation, wesold BEST-DMS’ assets to Ghiglieri Winchester Inc., the successor to BestDysphasia Management Services, Inc. This transaction was signed on November 7,2008, closed on November 10, 2008 and was effective October 28, 2008.

 

Consistent with theprovisions of Statement 144, *Accounting forthe Impairment or Disposal of Long-lived Assets*(Statement 144), weclassified the BEST-DMS assets that were sold as discontinued operations forall periods presented. Accordingly, depreciation and amortization associatedwith these assets was discontinued. Additionally, since all assets were part ofthe health services segment, we determined that these assets compriseoperations and cash flows that can be clearly distinguished, operationally andfor financial reporting purposes, from the rest of the Company.

 

As a result of the BEST-DMSasset sale, we recorded a loss of $10 in Q3 09 and a loss of $53 in Q3 08, as aseparate component in our consolidated statement of operations, entitled “Lossfrom discontinued operations, net.” The net assets related to the healthservices segment were classified as discontinued operations as of December 31,2008.

 

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***Nine months ended December 31, 2008(YTD 09) compared to the Nine months ended December 31, 2007 (YTD 08)***

 

*Selling, General and Administrative Expenses*

 

SG&Aexpenses in YTD 09 were $7,693, an increase of $2,086, or 37%, compared toSG&A expenses of $5,607 in YTD 08. This increase in SG&A primarilyresulted from increases of (i) $860 in additional personnel expenses anddirectors fees, (ii) $390 in sales, marketing and advertising expenses dueto increased sales activity and additional trade shows attended, (iii) $230in legal and accounting fees, (iv) $200 in non-cash stock—basedcompensation expense, and (v) $110 of architectural and engineeringexpenses related to the consolidation of our Natick, MA and Orangeburg, NYfacilities, which was cancelled in Q2 09 (for more information, please refer to*Restructuring Charge* on page 24below).

 

*Research and Development Expenses*

 

R&Dexpenses in YTD 09 were $4,163, an increase of $1,553, or 60%, as compared toexpenses of $2,610 in YTD 08. This increase resulted primarily from (i) expensesrelated to videoscope development of $750, (ii) additional personnelexpenses of $330, (iii) expenses related to the new fiberscope line (the4000 series) and other new products under development of $270, and (iv) afeasibility study on a potential new product of $200.

 

*Discontinued Operations*

 

Since our acquisition of theassets of Best Dysphasia Management Services, Inc. in October 2007,part of our management and financial resources were diverted towards managingand growing the unprofitable health services segment. As a result of our desireto focus our attention and financial resources on our core business in themedical segment, where we are currently launching the videoscope family ofproducts, we evaluated the health services segment for possible sale.

 

After careful evaluation, wesold BEST-DMS’ assets to Ghiglieri Winchester Inc., the successor to BestDysphasia Management Services, Inc. This transaction was signed on November 7,2008, closed on November 10, 2008 and was effective October 28, 2008.

 

Consistent with theprovisions of Statement 144, *Accounting forthe Impairment or Disposal of Long-lived Assets*, we classified theBEST-DMS assets that were sold as discontinued operations for all periodspresented. Accordingly, depreciation and amortization associated with theseassets was discontinued. Additionally, since all assets were part of the healthservices segment, we determined that these assets comprise operations and cashflows that can be clearly distinguished, operationally and for financialreporting purposes, from the rest of the Company.

 

As a result of the BEST-DMS assetsale, we recorded a loss of $783 and $53 in YTD 09 and YTD 08, respectively, ina separate component in our consolidated statement of operations, entitled“Loss from discontinued operations, net”. The net assets related to the healthservices segment were classified as discontinued operations as of December 31,2008.

 

*Restructuring Charge*

 

DuringFY 08 our Board decided to consolidate our Natick facility and our 40 RamlandRoad, Orangeburg, NY facility under one roof, in a new location at One Ramland Road,Orangeburg, NY. Because of a disagreement with the landlord of the proposed newfacility regarding increased costs to us of renovations relating to our move,there was a delay with the landlord’s renovation of the location, a processinitially expected to be completed by December 2008. On December 31,2008 we signed a Surrender and Acceptance Agreement with the landlord, whichcancelled the lease. We never occupied the facility and no payments were madeor received in connection with the lease.

 

Wealso re-evaluated our plans to close down our Natick facility and decided thatin order to protect our EndoSheath business we would remain in Natick. In orderto reduce costs, however, we reduced our Natick staff by approximately 50%.  These staff reductions were effective November 17,2008, and we have extended our lease with the Natick facility landlord to December 31,2012.

 

InQ4 08, based on SFAS 146, we recognized a liability of $660 for costsassociated with closing our Natick facility and moving the production of ourEndoSheath products to the proposed One Ramland Road facility. As a result ofnot doing the proposed consolidation of the facilities, and the severance costof staff reduction in our Natick facility, we reversed the remainingrestructuring charge, as reflected by a credit $98.

 

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***Loss from Operations***

 

***Three months ended December 31, 2008(Q3 09) compared to the three months ended December 31, 2007 (Q3 08)***

 

Lossfrom operations by segment was as follows:

 
| **Segment** | ** ** | **Q3 09** | ** ** | **Q3 08** | ** ** | **Difference** | ** ** | **Percentage** | ** ** |
|-------------|------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|
| Medical     |       | $              | (3,248     | )              | $          | (2,530         | )          | $              | (718       | ) | 28 | % |
| Industrial  |       | 108            |       | 469            |       | (361           | )          | (77            | )%         |
| **Total**   | ** ** | **$**          | **(3,140** | **)**          | **$**      | **(2,061**     | **)**      | **$**          | **(1,079** | **)** | **52** | **%** |

 

Totalloss from operations in Q3 09 was $3,140, as opposed to a loss of $2,061 in Q308, an increase of $1,079, or 52%. In the medical segment, the increased lossfrom operations is primarily due to (i) an increase in our COGS, mainlydue to startup costs of production for our new videoscope line of products and (ii) increasesin our SG&A and R&D expenses, as discussed in detail above.

 

***Nine months ended December 31, 2008 (YTD 09) compared to thenine months ended December 31, 2007 (YTD 08)***

 

Operatingincome (loss) by segment was as follows:

 
| **Segment** | ** ** | **YTD 09** | ** **  | **YTD 08** | ** ** | **Difference** | ** ** | **Percentage** | ** ** |
|-------------|------------|-----------------|-------------|-----------------|------------|----------------|------------|----------------|------------|
| Medical     |       | $               | (10,280     | )               | $          | (6,437         | )          | $              | (3,843     | ) | 60 | % |
| Industrial  |       | 161             |        | 486             |       | (325           | )          | (67            | )%         |
| **Total**   | ** ** | **$**           | **(10,119** | **)**           | **$**      | **(5,951**     | **)**      | **$**          | **(4,168** | **)** | **70** | **%** |

 

Totalloss from operations in YTD 09 was $10,119, as opposed to a loss of $5,951 inYTD 08, an increase of $4,168, or 70%. In the medical segment, the increasedloss from operations is primarily due to (i) an increase in our COGS,mainly due to startup costs of production for our new videoscope line ofproducts and (ii) increases in our SG&A and R&D expenses, asdiscussed in detail above.

 

***Liquidity and Capital Resources***

 

AtDecember 31, 2008 our principal source of liquidity was working capital ofapproximately $17,373, including $11,113 in cash and short term investments.

 

Duringthe first nine months of FY 09 we purchased $15,617 and sold $14,057 of shortterm investments for a net investment of $1,560. Net cash used in operatingactivities of $13,741 included (i) an increase of $2,725 in inventory,mainly for parts and sub- assemblies related to the videoscope production andfor our newly developed line of fiberscopes, (ii) an increase of $1,200 inaccounts receivable, mainly due to higher sales volume, and (iii) adecrease in accounts payable and accrued expenses of $1,036. In addition, werecorded $4,985 in net proceeds from milestone-based payment related to thesale of our ENT EndoSheath product line to Medtronic.

 

Ourcash and cash equivalents decreased by approximately $9,133 in YTD 09 ascompared to a decrease of $28,549 in YTD 08. The decrease in YTD 09 is due tothe purchase of short term investments.

 

Weexpect that our current balance of cash and short term investments andavailability under our loan agreement will be sufficient to fund our operationsfor the next twelve months. We are currently evaluating financing andcost-cutting options. Should such financing options not be available onacceptable terms, it will have a material adverse impact on our financialcondition.

 

InJanuary 2008, we entered into a $10,000 revolving line of credit agreementwith Merrill Lynch Bank USA (the Bank), pursuant to the terms of a MerrillLynch Loan Management Account Agreement (the Loan Agreement). The Loan Agreementpermits us to borrow funds from the Bank from time-to-time at fixed, variableor term rates. The current rate for our borrowing is set at LIBOR plus 1.75%.Any outstanding amounts for variable rate borrowings may be repaid at ouroption at any time without penalty or premium. If we repay a fixed advance orterm advance prior to its scheduled repayment date, we may be required to pay abreakage fee to the Bank. The amount of advances available under the LoanAgreement varies from time to time and is based on the value of, 

 

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and secured by, thesecurities we maintain with Merrill Lynch, Pierce, Fenner & Smith Incorporated.Under the Loan Agreement, the Bank has the right to demand repayment, in wholeor in part, at any time, of any outstanding amounts. As of December 31,2008, we have not requested any advances under the Loan Agreement.

 

Wehave incurred losses since our inception, and losses are expected to continuethrough at least fiscal 2010. We have funded the losses principally withproceeds from operations, proceeds from public and private equity financings,and payments from Medtronic related to the sale of certain assetsrelated to our ENT EndoSheath business.

 

Duringthe remainder of FY 09, we expect total spending for property and equipment tobe approximately $250.

 

Weconduct our operations in certain leased facilities. These leases expire onvarious dates through December 31, 2013. In addition, we have operatingleases for certain office equipment. At December 31, 2008, our minimumlease and rent commitments are as follows:

 
| **Fiscal Year** | ** ** | ** ** | ** ** |
|----------------------|------------|------------|------------|
| 2009                 |       | $          | 117        |   |
| 2010                 |       | 443        |       |
| 2011                 |       | 247        |       |
| 2012                 |       | 133        |       |
| 2013                 |       | 90         |       |
| ** **           | ** ** | **$**      | **1,030**  | ** ** |

 

*Notes tothe lease commitments table:*

 

(i)             SFAS 146indicates that costs associated with the termination of a lease contract beforethe end of its term shall be recognized when the entity terminates the contractor moves out and does not use the facility.

 

(ii)          Theabove table includes a new lease for our current premises at 6 Mercer Road inNatick, MA, which started on January 1, 2009 and will expire on December 31,2012. The premises consist of 9,835 square feet of office, production and warehousespace.

 

Wehave no off-balance sheet arrangements that have, or are reasonably likely tohave, a current or future effect on our financial condition, changes infinancial condition, revenues or expenses, results of operations, liquidity,capital expenditures or capital resources.

 

***Recently Issued Accounting Standards***

 

In November 2008, theFASB ratified EITF Issue No. 08-6, *EquityMethod Investment Accounting Considerations*. EITF 08-6clarifies the accounting for certain transactions and impairment considerationsinvolving equity method investments. EITF 08-6 is effective for fiscalyears beginning after December 15, 2008, with early adoption prohibited.We do not currently have any investments that are accounted for under theequity method. The adoption of EITF 08-6 is not expected to have an impacton our consolidated financial statements.

 

In November 2008, theFASB ratified EITF Issue No. 08-7, *Accountingfor Defensive Intangible Assets*. EITF 08-7 clarifies theaccounting for certain separately identifiable intangible assets which anacquirer does not intend to actively use but intends to hold to prevent itscompetitors from obtaining access to them. EITF 08-7 requires an acquirerin a business combination to account for a defensive intangible asset as aseparate unit of accounting which should be amortized to expense over theperiod the asset diminishes in value. EITF 08-7 is effective for fiscalyears beginning after December 15, 2008, with early adoption prohibited. Sincewe currently do not have any such defensive intangible assets, the adoption ofEITF 08-07 is not expected to have an impact on our consolidated financialstatements.

 

On April 1,2008, we adopted the provisions of FASB Statement No. 159, *The Fair Value Option for Financial Assets andFinancial Liabilities.* This Statement allows companies the option tomeasure eligible financial instruments at fair value. Such election, which maybe applied on an instrument by instrument basis, is typically irrevocable onceelected. We have elected not to apply the fair value option to any of ourfinancial instruments, except for those expressly required by U.S. GAAP.

 

In April 2008, the FASB issued FASB Staff Position (FSP)FAS 142-3*, Determination of the UsefulLife of Intangible Assets*. FSP FAS 142-3 amends the factorsthat should be considered in developing renewal or extension assumptions usedto determine 

 

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the useful life of arecognized intangible asset under FASB Statement No. 142, *Goodwill and Other Intangible Assets*. FSPFAS 142-3 is effective for fiscal years beginning after December 15,2008 and early adoption is prohibited. We currently do not have any such defensive intangible assets that wouldhave an impact on our financial statements.

 

In March 2008,the FASB issued SFAS No. 161, Disclosures about Derivative Instruments andHedging Activities, an amendment to FASB Statement No. 133 (SFAS 161),which requires additional disclosures about the objectives of using derivativeinstruments, the method by which the derivative instruments and related hedgeditems are accounted for under FASB Statement No. 133 and its relatedinterpretations, and the effect of derivative instruments and related hedgeditems on financial position, financial performance, and cash flows.SFAS 161 also requires disclosure of the fair values of derivativeinstruments and their gains and losses in a tabular format. SFAS 161 iseffective for financial statements issued for fiscal years and interim periodsbeginning after November 15, 2008 (which for our company would befinancial statements for the fourth quarter and fiscal year ended 3/31/09),with early adoption encouraged. We are currently assessing the impact that theadoption of SFAS 161 will have on our financial statement disclosures.

 

In December 2007,the FASB issued Statement No. 141(R), *BusinessCombinations—A Replacement of FASB Statement No. 141.* Thisstatement significantly changes the principles and requirements for how anacquisition is recognized and measured in a company’s financial statementsincluding the identifiable assets acquired and the liabilities assumed. Thisstatement also provides guidance for recognizing and measuring goodwillacquired in a business combination and required disclosures to enable users ofthe financial statements to evaluate the nature and financial effects of thebusiness combination. This statement was adopted on January 1, 2009 and iseffective prospectively, except for certain retrospective adjustments todeferred income tax balances. We currently do not have any businesscombinations, and therefore the adoption of this statement is not expected tohave an impact on our consolidated financial statements.

 

In December 2007,the FASB issued Statement No. 160, *NoncontrollingInterests in Consolidated Financial Statements*, *an amendment of ARB No. 51.* Thisstatement significantly changes the financial accounting and reporting ofnoncontrolling (or minority) interests of a subsidiary in consolidatedfinancial statements. This statement became effective prospectively as of January 1,2009. The adoption of this statement does not have any impact on our financialposition.

 

**Item 3. Quantitative and Qualitative Disclosures About Market Risk**

 

Weare a smaller reporting company, as defined in Rule 12b-2 of the ExchangeAct and are not required to provide the information required by this item.

 

**Item 4. Controls and Procedures**

 

SeeItem 4T of this Part I

 

**Item 4T. Controls and Procedures**

 

DisclosureControls and Procedures

 

Wemaintain disclosure controls and procedures that are designed to ensure thatinformation required to be disclosed in our Exchange Act reports are recorded,processed, summarized and reported within the time periods specified in theSEC’s rules and forms, and that such information is accumulated andcommunicated to our management, including our Chief Executive Officer and ChiefFinancial Officer, as appropriate, to allow timely decisions regarding requireddisclosure based on the definition of disclosure controls and procedures in Rule 13a-15(e).In designing and evaluating the disclosure controls and procedures, managementrecognizes that any controls and procedures, no matter how well designed andoperated, can provide only reasonable assurance of achieving the desiredcontrol objectives, and management necessarily is required to apply itsjudgment in evaluating the cost-benefit relationship of possible controls andprocedures.

 

Wehave evaluated, under the supervision and with the participation of our seniormanagement, including our Chief Executive Officer and Chief Financial Officer,the effectiveness of the design and operation of our disclosure controls andprocedures as of December 31, 2008. Based on this evaluation, our ChiefExecutive Officer and Chief Financial Officer concluded that our disclosurecontrols and procedures were not effective as of December 31, 2008 due to thetransition of new employees in the accounting and finance department. In March 2008we retained a new controller, and since then have added two additional senioraccountants and retained an outside certified public accounting firm on a 

 

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consulting basis for Sarbanes-Oxley compliance. In September 2008we hired a new CFO and retained our former CFO as an accounting and financeconsultant.

 

Changesin Internal Controls Over Financial Reporting

 

Therehave been no changes in our internal controls over financial reporting duringthe quarter ended December 31, 2008 that have materially affected, or arereasonably likely to materially affect our internal controls over financialreporting.

 

**PART II—OTHERINFORMATION**

 

**Item 1. Legal Proceedings**

 

None

 

**Item 1A. Risk Factors**

 

Youshould carefully consider the risks and uncertainties we describe below and theother information in this Quarterly Report or incorporated by reference beforedeciding to invest in, or retain, shares of our common stock. These are not theonly risks and uncertainties that we face. Additional risks and uncertaintiesthat we do not currently know about or that we currently believe areimmaterial, or that we have not predicted, may also harm our businessoperations or adversely affect us. If any of these risks or uncertaintiesactually occurs, our business, financial condition, operating results orliquidity could be materially harmed.

 

***The effects of the recent global economic crisis may impact ourbusiness, operating results or financial condition***

 

The recent global economiccrisis has caused a general tightening in the credit markets, lower levels ofliquidity, increases in the rates of default and bankruptcy, and extremevolatility in credit, equity and fixed income markets. These macroeconomicdevelopments could negatively affect our business, operating results orfinancial condition in a number of ways.

 

For example, current or potentialcustomers may be unable to fund endoscope and EndoSheath purchases, which couldcause them to delay, decrease or cancel purchases of our products and services,or to not pay us or to delay paying us for previously purchased products andservices. As a result, we may require more customers to purchase our productsand services on a cash basis.  Inaddition, any material adverse condition occurring with a supplier ordistributor, including Medtronic, would have a material adverse affect on ourbusiness.

 

Additionally, our investmentportfolio, which includes short-term debt securities, is generally subject togeneral credit, liquidity, counterparty, market and interest rate risks thatmay be exacerbated by the recent global financial crisis. If the banking systemor the fixed income, credit or equity markets continue to deteriorate or remainvolatile, our investment portfolio may be impacted and the values and liquidityof our investments could be adversely affected. Financing alternatives also may not be available to us on acceptableterms, if at all.

 

***We have a history of operatinglosses and we may not achieve or maintain profitability in the future***

 

Wehave incurred substantial operating losses since our inception (our net incomein FY 07 resulted from the sale of our ENT EndoSheath product line toMedtronic) and there can be no assurance that we will achieve a profitablelevel of operations in the future. We anticipate a negative cash flow during FY09, because of additional spending for research and development, increasing ourglobal network of independent sales representatives and distributors andinvesting in a direct sales force for the North American market, generalbusiness operations and capital expenditures. As of December 31, 2008, wehad cash and cash equivalents including short term investments totaling $11.1million. We expect that our current balance of cash and short term investmentswill be sufficient to fund our operations for the next twelve months. We arecurrently evaluating financing and cost-cutting options. Should such optionsnot be available on acceptable terms, it will have a material adverse impact onour financial condition.  However, therecan be no assurance that such financing will be available on terms acceptableto us, if at all.

 

***Our stock price is volatile, and youmay not be able to sell your shares for a profit***

 

Thetrading price of our common stock is volatile. Our common stock price could besubject to fluctuations in response to a number of factors, including:

 

·                  actual or anticipated variations in quarterlyoperating results;

 

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·                  conditions or trends in the medical devicemarket;

 

·               announcementsby us or our competitors of significant customer wins or losses, gains orlosses of distributors, technological innovations, new products or services;

 

·                  addition or departures of key personnel;

 

·                  sales of a large number of shares of ourcommon stock;

 

·                  adverse litigation;

 

·                  unfavorable legislative or regulatorydecisions;

 

·                  variations in interest rates;

 

·                  general market conditions;

 

·                  anyof the other factors described in “Risk Factors”.

 

Inthe past, companies that have experienced volatility in the market price oftheir stock have been the target of securities class action litigation. We maybecome the target of this type of litigation in the future. Securitieslitigation against us could result in substantial costs and divert managementattention, which could seriously harm our business.

 

***Rapid growth and a rapidly changingoperating environment may strain our limited resources***

 

Ourgrowth strategy includes our efforts to build our brand, develop new products,increase market penetration of our new videoscopes and develop a new line offiber-based scopes to replace those manufactured with components supplied byPentax. This growth strategy requires significant capital resources, and we maynot generate an adequate return on our investment. Our growth may involve theacquisition of new technologies, businesses, products or services or thecreation of strategic alliances in areas in which we do not currently operate.This could require our management to develop expertise in new areas, manage newbusiness relationships and attract new types of customers. We may alsoexperience difficulties integrating these acquired businesses, products orservices into our existing business and operations. The success of our growthstrategy also depends in part on our ability to utilize our financial,operational and management resources and to attract, train, motivate and managean increasing number of employees. The success of our growth strategy dependson a number of internal and external factors, such as:

 

·                  thegrowth of the market for medical devices and supplies;

 

·                  theeffectiveness of our new direct sales force in North America;

 

·                  ourability to simultaneously develop a new line of fiber-based scopes and expandour videoscope family;

 

·                  increasecustomer awareness and acceptance of our products;

 

·                  continuedenhancement of our research and development capabilities;

 

·                  competitionfrom other manufacturers of these devices; and

 

·                  competitionfrom other companies that offer these products, many of which are beyond ourcontrol.

 

·                  Wemay not be able to implement our growth strategy successfully or manage ourexpansion effectively.

 

Further,as we ramp up our manufacturing operations to accommodate our planned growth,we may encounter difficulties associated with increasing production scale,including shortages of qualified personnel to operate our equipment, assembleour products or manage manufacturing operations, as well as shortages of keyraw materials or components for our products. In addition, we may alsoexperience difficulties in producing sufficient quantities of products or inachieving desired product quality. If we are unable to successfully operate andmanage our manufacturing operations to meet our needs, we may not be able to provideour customers with the quantity or quality of products they require in a timelymanner. This could cause us to lose customers and result in reduced productsale revenues.

 

***Our inability to continue to hireand retain key employees could have a negative impact on our future operatingresults***

 

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Oursuccess depends on the services of our senior management team and other keyemployees in our research and development, manufacturing, operations,accounting and sales and marketing departments. If we are unable to recruit,hire, develop and retain a talented, competitive work force, we may not be ableto meet our strategic business objectives.

 

***Our products and manufacturingpractices are subject to regulation by the FDA and by other state and foreignregulatory agencies***

 

Ourproducts are medical devices and therefore subject to extensive regulation inthe United States and in the foreign countries where we do business.

 

Inthe U.S., we are subject to regulation by the FDA and other regulatoryagencies. The process of obtaining required regulatory clearances can belengthy and expensive, and compliance with the FDA’s Quality Systems Regulation(QSR) can be burdensome. FDA regulations govern, among other things, thefollowing activities that we perform, and will continue to perform, inconnection with our products: design and development, product testing;manufacturing, labeling and packaging, storage, shipping and receiving,pre-market clearance or approval, advertising and promotion and sales,distribution, and servicing.

 

Therecan be no assurance that the required regulatory clearances will be obtained,and those obtained may include significant limitations on the uses of theproduct in question. In addition, changes in existing regulations or theadoption of new regulations could make regulatory compliance by us moredifficult in the future. The failure to obtain required regulatory clearancesor to comply with applicable regulations may result in fines, delays,suspensions of clearances, seizures, recalls of products, operatingrestrictions or criminal prosecutions, and could have a material adverse effecton our operations.

 

Foreigngovernment regulations vary substantially from country to country. The timerequired to obtain approval by a foreign country may be longer or shorter thanthat required for FDA approval, and the requirements may differ significantly.

 

TheEuropean Union has adopted legislation, in the form of directives to beimplemented in each member state, concerning the regulation of medical deviceswithin the European Union. The directives include, among others, the MedicalDevices Directive that establishes standards for regulating the design,manufacture, clinical trials, labeling, and vigilance reporting for medicaldevices. We have received CE (Conformité Européne) certification fromUnderwriters Laboratories UK for conformity with the European Union MedicalDevices Directive allowing us to use the CE mark on our product lines. Thisquality system has been developed by the International Organization forStandardization to ensure that companies are aware of the standards of qualityto which their products will be held worldwide. While no additional pre-marketapprovals in individual European Union countries are required prior tomarketing of a device bearing the CE mark, practical complications with respectto marketing introduction may occur. For example, differences among countrieshave arisen with regard to labeling requirements. Failure to maintain the CEmark will preclude us from selling our products in the European Union. We maynot be successful in maintaining certification requirements necessary fordistribution of our products in the European Union.

 

Underthe Canadian Medical Devices Regulations, all medical devices are classifiedinto four classes, Class I being the lowest risk class and Class IVbeing the highest risk. Class I devices include among others, devices thatmake only non-invasive contact with the patient. Classes II, III andIV include devices of increasingly higher risk as determined by such factors asdegree of invasiveness and the potential consequences to the patient if thedevice fails or malfunctions. Our current products sold in Canada generallyfall into Classes II and III. All Class II, III and IV medicaldevices must have a valid Medical Device License issued by the TherapeuticProducts Directorate of Health Canada before they may be sold in Canada (Class Idevices do not require such a license). We have obtained applicable MedicalDevice Licenses for many of our products. Failure to maintain required MedicalDevice Licenses in Canada or to meet other requirements of the Canadian MedicalDevices Regulations (such as quality system standards and labelingrequirements) for our products will preclude us from selling our products inCanada. We may not be successful in continuing to meet the medical devicelicensing requirements necessary for distribution of our products in Canada.

 

Theprocess of obtaining required regulatory clearances can be lengthy andexpensive, and compliance with ISO 13485, CMDR, MDD and the FDA’s QSR andregulatory requirements can be burdensome. Moreover, there can be no assurancethat the required regulatory clearances will be obtained, and those obtainedmay include significant limitations on the uses of the product in question. Inaddition, changes in existing regulations or the adoption of new regulationscould make regulatory compliance by us more difficult in the future. Thefailure to obtain the required regulatory clearances or to comply withapplicable regulations may result in fines, delays or suspensions ofclearances, seizures, recalls of products, operating restrictions or criminalprosecutions, and could have a material adverse effect on our operations.

 

***Reimbursements from third-partyhealthcare payers is uncertain because of factors beyond our control, andchanges in third-party healthcare payers’ policies could adversely affect oursales growth***

 

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Inthe U.S. and other foreign countries, government-funded or private insuranceprograms, or third-party payers, pay a significant portion of the cost of apatient’s medical expenses. There is no uniform policy of reimbursement amongall these payers. We believe that reimbursement is an important factor to the successof our product sales.

 

AllU.S. and foreign third-party reimbursement programs, whether government fundedor commercially insured, are developing increasingly sophisticated methods ofcontrolling healthcare costs through prospective reimbursement and capitationprograms, group purchasing, redesign of benefits, careful review of bills, andexploring more cost-effective methods of delivering healthcare. These types ofprograms can potentially limit the amount which healthcare providers may bewilling to pay for our products.

 

Therecan be no assurance that third-party reimbursement will continue to beavailable for procedures performed with our products. In addition,reimbursement standards and rates may change. We believe that the failure ofusers of our products to obtain adequate reimbursement from third-party payershas had a materially adverse effect on our sales, as we do not receive separatereimbursement for our EndoSheath disposable.

 

***Sourcing of critical components***

 

Inour medical and industrial segments, certain critical components for themajority of our fiberscopes, and components for our newly developedvideoscopes, are generally only available from one source. For example, somecritical parts for our existing line of fiberscopes are purchased solely from akey supplier, Pentax, which is a competitor of ours. These components are beingpurchased pursuant to a supply agreement that will expire in February 2009.

 

Asa result of the approaching expiration of our supply agreement with Pentax, wehave been designing a new line of fiberscopes, our 4000 series line, that donot use any parts manufactured by Pentax. We anticipate that we will havecompleted the redesign and FDA approval process for our new line of fiberscopesby the end of FY09, and we anticipate that our inventory of such existing lineof fiberscopes will be sufficient until such time when we launch the 4000series, expected to occur in Q110. However, there are no assurances that thenew line of fiberscopes will be available in such timeframe or that ourexisting inventory will be sufficient for any such period.  If we are not able to complete the redesignand approval process of the fiberscopes within this timeframe or we do not havesufficient inventory of our existing line of fiberscopes during such period,our results of operations will be materially and adversely impacted until thenew line of fiberscopes are available for sale.

 

Wemay not have sufficient Pentax components available to us to satisfy our repairand warranty claims under our existing line of fiberscopes containing Pentaxcomponents.  Our inability to providesuch parts could have a material and adverse effect on our financial conditionand results of operations.  We will haveto satisfy these obligations by attempting to obtain such parts or provideother acceptable alternatives in lieu of satisfying the warranty or repairobligations, which may result in significant expense or liability to theCompany.  There can be no assurance thatwe will have the ability to satisfy these obligations in a manner that wouldnot result in a material adverse event to the Company.

 

Furthermore,as with the fiberscopes produced with Pentax parts, certain critical componentsof our redesigned fiberscopes and our newly designed videoscopes are availableonly from one or two suppliers for which we do not have long term fixed supplyagreements. An interruption of supply from one of these suppliers, or ourinability to obtain a sufficient quantity of such critical components onfavorable terms, could materially adversely affect our business.

 

Inaddition, the success of our new videoscopes will depend in part on our abilityto manufacture these videoscopes in sufficient quantities to meet customerdemand. We do not have fixed long term supply agreements with our suppliers forour videoscopes. The failure or inability of one of these key suppliers to meetour production and quality needs on terms that are acceptable to us, if at all,could have a material adverse effect on the sales of our new videoscopes, theiracceptance into the marketplace and our long term prospects.

 

Inthe industrial segment, borescopes are assembled using components andsubassemblies purchased from independent vendors. While most components andsubassemblies are currently available from more than one supplier, certaincritical components are currently purchased only from two key suppliersincluding Pentax. Our failure to obtain a sufficient quantity of suchcomponents on favorable terms could materially adversely affect our business.

 

***In the past we have depended on asmall group of independent sales representatives and distributors for all ofour revenues, and a loss of these sales representatives and distributors mayhave a material adverse effect on our business. During this quarter we begantransitioning to a direct sales model in North America by hiring a direct salesforce, but there is no assurance that we will be able to manage themeffectively***

 

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Inour medical and industrial segments, we previously depended on independentsales representatives and distributors of medical devices, supplies, andindustrial equipment, respectively, for all of our product sales. Inparticular, in Q3 09 Medtronic accounted for 63% of our total sales and 81% ofour medical segment sales. We do not have long term contracts with ourindependent sales representatives and distributors, but rather typically sellto them on a unit-by-unit basis. We have limited experience in managing adirect sales force. As we begin to build our direct sales force in NorthAmerica, we cannot assure you that we will be able to maintain sales at theircurrent level, or increase sales. We also have no assurance that anydistributor will continue to purchase our products at the same levels as inprior years, will purchase our new products (such as our videoscopes) or thatsuch relationship will continue on favorable terms, if at all.

 

Thereis no assurance that we will succeed in expanding our distribution network inthe short term or successfully develop a direct sales force in North America.As we expand our distribution network and sales force, our inability toeffectively manage this group may adversely impact our reputation among endusers of our products, interfere with our ability to service existing customersand reduce our revenues from product sales.

 

***If we fail to effectively manage ourindependent sales representative and distribution network, our business,prospects and brand may be materially and adversely affected by actions takenby our independent sales representatives and distributors***

 

Wehave a limited ability to manage the activities of our third-party, outsidedistributors, who are independent from us. Our distributors could take one ormore of the following actions, any of which could have a material adverseeffect on our business, prospects and brand:

 

·                  sell products that compete with our productsin breach of their non-competition agreements with us;

 

·                  fail to adequately promote our products; or

 

·                  fail to provide proper service to ourend-users.

 

Failureto adequately manage our distribution network, or the non-compliance of thisnetwork with their obligations under agreements with us could harm ourcorporate image among end users of our products and disrupt our sales,resulting in a failure to meet our sales goals. Although we do not havesignificantly large overseas sales, foreign governments have increased theiranti-bribery efforts in the healthcare sector to reduce improper paymentsreceived by hospital administrators and doctors in connection with the purchaseof pharmaceutical products and medical devices. To our knowledge, none of ourindependent sales representatives or distributors engages in corrupt practices.However, our independent sales representatives or distributors may violatethese laws or otherwise engage in illegal practices with respect to their salesor marketing of our products which would adversely affect our corporate imageand business.

 

***Competition in our industry isintense, and many of our competitors have greater resources than we do***

 

Theflexible endoscopes and related products we currently sell and develop facecompetition primarily from medical products companies such as Olympus Group,Pentax Imaging Company, Karl Storz GmbH & Co. and StrykerCorp. In addition, any company that is able to significantly redesignconventional flexible endoscopes to simplify the cleaning process, orsignificantly improve the current methods of cleaning flexible endoscopes,would provide competition for our products.

 

Theprincipal competitors for our industrial products are Olympus, General Electric—InspectionTechnology and Karl Storz GmbH & Co. Many of our competitorsand potential competitors have far greater financial resources, research anddevelopment personnel, and manufacturing and marketing capabilities than wehave. Our competitors could utilize their greater financial resources toacquire other companies to gain enhanced name recognition and market share, aswell as to acquire new technologies or products that could effectively competewith our product lines. In addition, it is possible that other large healthcare companies may enter the flexible endoscope market in the future.

 

Ourability to compete effectively depends upon our ability to distinguish ourcompany and our products from our competitors and their products. Factors affectingour competitive position include:

 

·                  product performance design;

 

·                  ability to sell products tailored to meet theapplications needs of clients and patients;

 

·                  quality of customer support;

 

·                  product pricing;

 

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·                  product safety;

 

·                  sales, marketing, and distributioncapabilities;

 

·                  success and timing of new product developmentand introductions; and

 

·                  intellectual property protection.

 

***We need to expand our sales force tomaintain and grow our business and product sale revenues. Our failure to expandand maintain an effective sales force or successfully develop our relationshipwith other distributors, may materially and adversely affect our business,prospects and brand***

 

Wemarket and sell our existing videoscopes and fiberscopes for our ENT businessthrough a single distributor, Medtronic, and our other endoscopes andEndoSheaths through other outside distributors and independent salesrepresentatives.  During Q3 09 we startedbuilding a direct sales force in North America. We have limited experience inmanaging a direct sales force and we cannot assure you that we will be able tobuild an effective direct sales force, maintain a smaller effective independentsales force or successfully develop our relationships with third-party, outsidedistributors. If we fail to do any one of those, our sales could fail to growor could even decline, and our ability to grow our business could be adverselyaffected. The expansion of our sales force and distribution network is alsolikely to require an investment of financial resources and management efforts,and the benefits, if any, which we gain from such expansion, may not besufficient to generate an adequate return on our investment.

 

***If we fail to increase awareness andacceptance of our new videoscope system in the medical community, we will notbe able to grow or even sustain our business***

 

Ournew, digital, video-based flexible scopes, which come with an integratedbuilt-in LED light source, eliminating the need for a separate camera head,light cable and optical coupler, use new CCD technology, as opposed to olderfiber optic technology. To penetrate the potential market for this family ofvideoscopes, we must increase market awareness and use of our new technology,which depends on, among other things, the following:

 

·                  the general levels of awareness andacceptance in the medical community of our family of videoscopes;

 

·                  the effectiveness of our videoscope system,which we intend to further refine through research and development activities;

 

·                  the relative costs and benefits of treatmentusing our videoscope system as compared to other treatments;

 

·                  the financial or other benefits gained bydoctors that use our videoscopes with our EndoSheath system;

 

·                  the amount of resources we have available toincrease product awareness and to educate potential purchasers and users of ourvideoscope system;

 

·                  our ability to continue to develop andenhance our family of videoscopes;

 

·                  our ability to secure one or more effectivedistributors for our videoscopes on acceptable terms;

 

·                  our ability to provide good technical supportand customer service; and

 

·                  our ability to keep up with technologicalchanges and remain competitive.

 

Wemay not have the financial and operational resources required to promoteawareness and acceptance of our new videoscope systems as widely or rapidly asis necessary to grow or sustain our business. Even if we were to devote asubstantial portion of our resources to promoting our product, we may notsucceed in raising the levels of awareness and acceptance of our videoscopes asquickly as is necessary to grow or sustain our business, if at all. If we failto increase awareness and acceptance of our videoscopes in the medicalcommunity, we will not be able to grow or even sustain our business as planned,harming our financial condition and results of operations.

 

***We may not succeed in sustaining amarket for our new videoscopes***

 

Certainof our new line of videoscopes only recently received 510(k) clearancefrom the FDA. Going forward, the long-term success of our videoscope systemdepends on several factors, including our ability to:

 

·                  successfully promote product awareness of ourvideoscopes;

 

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·                  manufactureproducts in a timely and cost effective fashion on acceptable terms;

 

·                  competitively price our videoscopes andadd-on components;

 

·                  develop new applications to expand our familyof videoscopes;

 

·                  select effective distributors and build aneffective direct sales force in North America; and

 

·                  obtain additional regulatory approvals orclearances for new components or systems in a timely manner.

 

Existingvideoscope technology is a well-established method for obtaining clinicaldiagnoses. As a result, our videoscopes are competing in a market in whichthere are already several established industry players. We cannot assure youthat we will be able to successfully market or sell our videoscopes in thefuture. We also cannot assure you that our videoscopes or any futureenhancements to our videoscopes will generate adequate revenue to offset ourinvestments and costs in acquiring, developing or marketing our videoscopes. Ifthere is insufficient demand for our videoscopes, our business, financialcondition and results of operations may be harmed. In addition, anyannouncement of new products, services or enhancements by us or our competitorsmay cause our customers to cancel or postpone purchasing decisions for ourexisting products in anticipation of these new products, services orenhancements.

 

***New product development in themedical device and supply industry is both costly and labor intensive and has avery low rate of successful commercialization***

 

Oursuccess will depend in part on our ability to enhance our existing products andtechnologies, through the development of alternate manufacturing lines for ourfiberscopes, and to develop and acquire new products, such our videoscopes. Thedevelopment process for medical technology is complex and uncertain, as well astime consuming and costly. Product development requires the accurate assessmentof technological and market trends as well as precise technological execution.We cannot assure you that:

 

·                  our product or technology development will besuccessfully completed;

 

·                  necessary regulatory clearances or approvalswill be granted by the FDA or other regulatory bodies as required on a timelybasis, or at all; or

 

·                  any product or technology we develop can becommercialized or will achieve market acceptance.

 

Wemay also be unable to locate suitable products or technologies to acquire oracquire such products or technologies on commercially reasonable terms. Failureto develop or acquire, obtain necessary regulatory clearances or approvals for,or successfully commercialize or market potential new products or technologiescould have a material adverse effect on our financial condition and results ofoperations.

 

***If we do not continue to develop andcommercialize new products and identify new markets for our products andtechnologies we may not remain competitive, and our revenues and operatingresults could suffer***

 

Theendoscopy industry is subject to continuous technological development andproduct innovation. If we do not continue to innovate in developing newproducts and applications, our competitive position will likely deteriorate asother companies successfully design and commercialize new products andapplications. Accordingly, our success depends in part on developing new andinnovative applications of our endoscopy technology and identifying new marketsfor and applications of existing products and technology. If we are unable todevelop and commercialize new products and identify new markets for ourproducts and technology, our products and technology could become obsolete andour revenues and operating results could be adversely affected.

 

***Our operating results could benegatively impacted if we are unable to capitalize on research and developmentspending***

 

Wehave spent, and continue to spend, a significant amount of time and resourceson research and development projects, in order to develop and validate new andinnovative products. We believe that these projects will result in themanufacturing of new products and will create additional future sales. However,factors including regulatory delays, safety concerns or patent disputes couldslow down the introduction or marketing of new products. Additionally,unanticipated issues may arise in connection with current and future clinicalstudies which could delay or terminate a product’s development prior toregulatory approval. We may also experience an unfavorable impact on ouroperating results if we are unable to capitalize on those efforts by attainingthe proper FDA approval or other foreign regulatory approvals or tosuccessfully market new products, including the new family of videoscopeproducts or other flexible endoscope products.

 

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***We expect gross margins to vary overtime, and our level of product gross margins may not be sustainable***

 

Ourlevel of product gross margins may not be sustainable and may continue to beadversely affected by numerous factors, including:

 

·                  changes in customer, geographic, or productmix;

 

·                  introduction of new products, including theintroduction of the new family of videoscopes;

 

·                  our ability to reduce supply and productioncosts;

 

·                  our entry into new markets, including marketswith different pricing and cost structures, through acquisitions, or internaldevelopment;

 

·                  increases in material or labor costs;

 

·                  changes in shipment volume;

 

·                  loss of cost savings due to changes incomponent pricing including the affect of foreign exchange rates for componentspurchased overseas;

 

·                  increased price competition, especially dueto the anticipated introduction of our family of videoscopes;

 

·                  changes in distribution channels; and

 

·                  increased warranty costs.

 

***Product quality problems could leadto reduced revenue, gross margins and net income***

 

Weproduce highly complex videoscope products that incorporate leading-edgetechnology, including both hardware and software. Software typically containsbugs that can unexpectedly interfere with expected operations. There can be noassurance that our Quality Assurance testing programs will be adequate todetect all defects, either ones in individual products or ones that couldaffect numerous shipments, which might interfere with customer satisfaction, reducesales opportunities, or affect gross margins. In the past, we have had toreplace certain components and provide remediation in response to the discoveryof defects or bugs in products that we had shipped. Although the cost of suchremediation has not been material in the past, there can be no assurance thatsuch a remediation, depending on the product involved, would not have amaterial impact. An inability to cure a product defect could result in thefailure of a product line, temporary or permanent withdrawal from a product ormarket, damage to our reputation, inventory costs or product reengineeringexpenses, any of which could have a material impact on our revenue, margins,and net income.

 

***Our costs could substantiallyincrease if we experience a significant number of warranty claims***

 

Weprovide 12-month product warranties against technical defects of ourfiberscopes and videoscopes and we offer a lifetime warranty for the LED lightsource on our videoscopes. Our product warranty requires us to repair defectsarising from product design and production process, and if necessary, replacedefective components. Should we be required to make repairs of fiber scopesmade with Pentax parts and we do not have such parts, it may result insignificant expense of liability to us. Historically, we have received alimited number of warranty claims for our fiberscopes, but we recentlyintroduced a new line of videoscopes. The costs associated with our warrantyclaims have historically been relatively low. Thus, we generally do not accruea significant liability contingency for potential warranty claims. As we onlyrecently developed our videoscope line, we do not currently have historicaldata on potential warranty claims.

 

Ourvideoscope product is technologically superior to our fiberscope product, andwas designed, built and tested against substantially higher benchmarks than ourcurrent fiberscope product line. Although we have insufficient historicalwarranty data to estimate the expected warranty claims from our videoscopeproduct line, we expect that these warranty claims will be less than ourhistorical warranty claims for the fiberscope product line. As of December 31,2008, our warranty reserve was at 3.2% of our medical scope revenue, reflectingour expected future liability from fiberscopes and videoscopes warranty claims,based on our historical fiberscope warranty claims.

 

Wedo believe that by using the historical data of our fiberscope product line,and the superior technological nature of our videoscope product, our currentwarranty reserve is reasonable, and we believe that the fiberscope historicaldata represents a reasonable basis for the videoscopes’ warranty reserve. Wewill monitor the warranty data of our videoscope product line on a quarterly basis,and will update our warranty reserve accordingly.

 

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Ifwe experience an increase in warranty claims, or if our repair and replacementcosts associated with warranty claims increase significantly, we will begin toincur liabilities for potential warranty claims after the sale of our productsat levels that we have not previously incurred or anticipated. In addition, anincrease in the frequency of warranty claims or amount of warranty costs mayharm our reputation and could have a material adverse effect on our financialcondition and results of operations.

 

***Product liability suits against usmay result in expensive and time consuming litigation, payment of substantialdamages, and an increase in our insurance rates***

 

Thedevelopment, manufacture, and sale of our products involve a significant riskof product liability claims. We maintain product liability insurance andbelieve that our level of coverage is adequate, given our past sales levels,our anticipated sales levels for FY 09 and fiscal 10 (FY 10), and our claimsexperience. We have just completed our annual evaluation of the adequacy of thecoverage of all our insurance policies, and adjusted our coverage accordingly.No product liability claims have been brought against us to date. However,there can be no assurance that product liability insurance will continue to beavailable to us on acceptable terms, or that product liability claims in excessof our insurance coverage, if any, will not be successfully asserted against usin the future.

 

***We sell our products in numerousinternational markets***

 

Ouroperating results may suffer if we are unable to manage our international salesand marketing activities effectively. We sell some of our products in foreigncountries, and we therefore are subject to risks associated with havinginternational sales, such as:

 

·                  foreign certification and regulatoryrequirements;

 

·                  maintenance of agreements with competentdistributors;

 

·                  import and export controls;

 

·                  currency exchange fluctuation; and

 

·                  political and economic instability.

 

***Our operating results could benegatively impacted by economic, political or other developments in countriesin which we do business***

 

Ourbusiness requires us to move some goods across international borders. Anyevents that interfere with, or increase the costs of, the transfer of goodsacross international borders could have a material adverse effect on ourbusiness.

 

Wetransport some of our goods across international borders, primarily those ofthe United States, Canada, Europe, Japan and Israel. Since September 11,2001, there has been more intense scrutiny of goods that are transported acrossinternational borders. As a result, we may face delays, and increase in costsdue to such delays in delivering goods to our customers. Any events thatinterfere with, or increase the costs of the transfer of goods acrossinternational borders could have a material adverse effect on our business.

 

***Conditions in Israel affect ouroperations and may limit our ability to produce and sell our products***

 

Political,economic and military conditions in Israel have a direct influence on usbecause we use several subcontractors in Israel to develop and produce some ofour products. Our operations could be adversely affected by current hostilitiesinvolving Israel and the Hamas, a U.S. State Department-designated foreignterrorist organization. Although the current hostilities in Israel have had noimmediate and direct impact on us, the interruption or curtailment of tradebetween Israel and its trading partners, or a significant downturn in theeconomic or financial condition of Israel, may adversely affect the flow ofvital components from our Israeli subcontractors to us.  We cannot assure you that ongoing hostilitiesrelated to Israel will not have a material adverse effect on our business or onour share price.

 

SinceIsrael frequently has been subject to terrorist activity, with varying levelsof severity, the United States Department of State has issued an advisoryregarding travel to Israel. Also, although it has not yet occurred, thepolitical and security situation in Israel may result in certain parties withwhom we have contracts claiming that they are not obligated to perform theircommitments pursuant to force majeure provisions of those contracts.

 

Inaddition, since some of the components of our manufacturing and research anddevelopment subcontractors are located in Israel, we could experiencedisruption of our manufacturing, and research and development activities due toterrorist attacks. If terrorist acts were to result in substantial damage toour sub-contractors facilities, our business activities would be disrupted, andour revenues may be severely impacted. Our business interruption insurance maynot adequately compensate us for losses that may occur, and any losses ordamages sustained by us could have a material adverse effect on our business.

 

***Currency exchange rate fluctuationscould adversely affect our operating results***

 

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Becausesome of our business includes international business transactions, costs andprices of our products or components in overseas countries are affected byforeign exchange rate changes. As a result, foreign exchange rate fluctuationsmay adversely affect our business, operating results and financial condition.Given the weakness of the dollar, it is likely that we will have to pay morefor certain components or subassemblies, which may harm our results,particularly as most of our sales take place in the United States.

 

Currently, we do not enter into foreign exchange forward contracts andwe do not hedge anticipated foreign currency cash flows.

 

***We are exposed to credit risk ofsome of our customers***

 

Mostof our sales are on an open credit basis, with typical payment terms of30 days in the United States and, because of local customs or conditions,longer in some markets outside the United States. We monitor individualcustomer payment capability in granting such open credit arrangements, seek tolimit such open credit to amounts we believe the customers can pay, andmaintain reserves we believe are adequate to cover exposure for doubtfulaccounts. Beyond our open credit arrangements, we have also experienced demandsfor customer financing and facilitation of leasing arrangements, which we referto leasing companies unrelated to us.

 

Ourexposure to the credit risks may increase due to the current economic slowdown.Although we have programs in place that are designed to monitor and mitigatethe associated risk, there can be no assurance that such programs will beeffective in reducing our credit risks. Future credit losses, if incurred,could harm our business and have a material adverse effect on our operatingresults and financial condition. We maintain estimated accruals and allowancesfor our business terms. However, distributors tend to have more limitedfinancial resources than other resellers and end-user customers and thereforerepresent potential sources of increased credit risk because they may be morelikely to lack the reserve resources to meet payment obligations.

 

***We may not be able to protect ourintellectual property rights or technology effectively***

 

Oursuccess depends in part on our ability to maintain patent protection for ourproducts, to preserve our trade secrets and to operate without infringing theproprietary rights of third parties. There can be no assurance that our pendingpatent applications will result in patents being issued, or that ourcompetitors will not circumvent, or challenge the validity of, any patentsissued to us. There can be no assurance that measures taken by us to protectour proprietary information will prevent the unauthorized disclosure or use ofthis information or that others will not be able to independently develop suchinformation. In addition, in the event that another party infringes our patentrights or other proprietary rights, the enforcement of such rights is at ouroption and can be a lengthy and costly process, with no guarantee of success.Moreover, there can be no assurance that claims alleging infringement by us ofother’s proprietary rights will not be brought against us in the future or thatany such claims will not be successful. If we are unable to maintain theproprietary nature of our technologies, our ability to market or be competitivewith respect to some or all of our products may be affected, which could reduceour sales and affect our ability to become profitable.

 

Therecan be no assurance that our pending patent applications will result in patentsbeing issued or that our competitors will not circumvent, or challenge thevalidity of, any patents issued to us. In addition, in the event that anotherparty infringes our patent rights, the enforcement of such rights is at ouroption and can be a lengthy and costly process, with no guarantee of success.

 

Someof the technology used in, and that may be important to, our products is notcovered by any patent or patent application. We seek to maintain theconfidentiality of our proprietary technology by requiring all our employees tosign confidentiality agreements, and by limiting access by outside parties tosuch confidential information. However, there can be no assurance that thesemeasures will prevent the unauthorized disclosure or use of this information,or that others will not be able to independently develop such information.Moreover, as is the case with our patent rights, the enforcement of our tradesecret rights can be lengthy and costly, with no guarantee of success.

 

***We may attempt toacquire new products or technologies, and if we are unable to successfullycomplete these acquisitions or to integrate acquired businesses, products,technologies or employees, we may fail to realize expected benefits or harm ourexisting business.***

 

Our success will depend, in part, on our ability toexpand our product offerings and grow our business in response to changingtechnologies, customer demands and competitive pressures. In some circumstances,we may determine to do so through the acquisition of complementary businesses,products or technologies rather than through internal development. Theidentification of suitable acquisition candidates can be difficult, timeconsuming and costly, and we may not be able to successfully completeidentified acquisitions. Furthermore, even if we successfully complete anacquisition, we may not be able to successfully integrate newly acquiredorganizations, products or technologies into our operations, and the process ofintegration could be expensive, time consuming and may strain our resources.Consequently, we may not achieve anticipated benefits of the acquisitions,which could harm our existing business. In addition, future acquisitions couldresult in potentially dilutive issuances of equity securities or the incurrence

 

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of debt, contingent liabilities or expenses, or other charges such asin-process research and development, any of which could harm our business andaffect our financial results or cause a reduction in the price of our commonstock.

 

**Item 2. Unregistered Sales of Equity Securities and Use of Proceeds**

 

N/A

 

**Item 3.  DEFAULTSUPON SENIOR SECURITIES**

 

N/A.

 

**Item 4. SUBMISSION OF MATTERS TO A VOTE OF STOCKHOLDERS**

 

N/A.

 

**Item 5. Other Information**

 

N/A.

 

**Item 6. Exhibits**

 

**See exhibits below.**

 
| **Exhibits** | ** ** | ** **                                                                                                                                                                          |
|--------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|         |       |                                                                                                                                                                                |
| 31.1         |       | Certification of Chief  Executive Officer pursuant to Rule 13a-15(e)/15d-15(e), promulgated  under the Securities Exchange Act of 1934, as amended.                            |
| 31.2         |       | Certification of Chief  Financial Officer pursuant to Rule 13a-15(e)/15d-15(e), promulgated  under the Securities Exchange Act of 1934, as amended.                            |
| 32           |       | Certification of Chief  Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. §1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |

 

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**SIGNATURES**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the Registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 
|                          | VISION-SCIENCES, INC.                                                                                                          |
|-------------------------------|-------------------------------------------------------------------------------------------------------------------------------------|
|                          |                                                                                                                                |
| Date: February 13,  2009 | /s/ RON HADANI                                                                                                                      |
|                          | Ron Hadani                                                                                                                          |
| * *                      | *President,  CEO (Duly Authorized Officer)*                                                                                         |
|                          |                                                                                                                                |
| Date: February 13,  2009 | /s/ KATHERINE L. WOLF                                                                                                               |
|                          | Katherine L. Wolf                                                                                                                   |
| * *                      | *EVP,  Corporate Development & Chief Financial Officer*

*(Principal  Financial Officer and Principal Accounting Officer)* |

 

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**VISION-SCIENCES, INC.**

 

**EXHIBIT INDEX**

 
| **Exhibit No.** | ** **         | **Description** |
|----------------------|--------------------|-----------------|
|                 |   3.1(1) |            | Amended and Restated  Certificate of Incorporation of the Company, as amended to date |
|                 |               |            |   |
|                 |   3.2(2) |            | By-laws, as amended to  date |
|                 |               |            |   |
| *                    | 10.1(3)            |            | 1990 Stock Option Plan, as  amended |
|                 |               |            |   |
| *                    | 10.2(19)           |            | 2003 Director Option Plan,  as amended |
|                 |               |            |   |
| *                    | 10.3(4)            |            | 2000 Stock Incentive Plan |
|                 |               |            |   |
|                 | 10.3.1(14)         |            | 2007 Stock Incentive Plan |
|                 |               |            |   |
| *                    | 10.4(2)            |            | Vision-Sciences, Inc.  401(k) Plan, as amended |
|                 |               |            |   |
| *                    | 10.5(2)            |            | Form of  Vision-Sciences, Inc. Invention, Non-Disclosure and Non-Competition  Agreement for employees |
|                 |               |            |   |
| *                    | 10.6(17)           |            | Letter Agreement between  the Company and Ron Hadani dated January 24, 2003 |
|                 |               |            |   |
|                 | 10.9(2)            |            | Registration Rights  Agreement dated as of February 28, 1992 among the Registrant and the  persons listed therein |
|                 |               |            |   |
|                 | 10.10(1)           |            | Piggyback Registration  Rights Agreement, dated January 2, 2001, between the Company and the  individuals and entities listed therein |
|                 |               |            |   |
|                 | 10.11(9)           |            | Supply Agreement dated  March 16, 1992 between the Registrant and Pentax Corporation (formerly  known as Asahi Optical Co., Ltd.) and amendment dated  October 1, 2002 |
|                 |               |            |   |
|                 | 10.12(15)          |            | Termination Agreement  between Pentax Corporation and Vision-Sciences, Inc. dated  February 12, 2008 |
|                 |               |            |   |
|                 | 10.14(6)           |            | License Agreement between  Vision-Sciences, Inc. and Advanced Polymers, Inc. dated  June 10, 1993 |
|                 |               |            |   |
|                 | 10.15(7)           |            | Amendment to License  Agreement between Vision-Sciences, Inc. and Advanced Polymers, Inc.  dated April 5, 1994 |
|                 |               |            |   |
|                 | 10.16(8)           |            | Amendment to License  Agreement between Vision-Sciences, Inc. and Advanced Polymers, Inc.  dated April 5, 1995 |
|                 |               |            |   |
|                 | 10.17(8)           |            | Amendment to License  Agreement between Vision-Sciences, Inc. and Advanced Polymers, Inc.  dated April 5, 1996 |
|                 |               |            |   |
| **                   | 10.19(5)           |            | License Agreement dated as  of August 6, 1998 between Vision-Sciences, Inc. and Pentax  Corporation (formerly Asahi Optical Co., Ltd.) |
|                 |               |            |   |
|                 | 10.21(4)           |            | Agreement of Lease between  30 Ramland Road LLC and Vision-Sciences, Inc. dated as of  March 23, 2000 |
|                 |               |            |   |
|                 | 10.26(10)          |            | Exclusive Distribution  Agreement between the Company and Medtronic Xomed, Inc. dated  August 6, 2003 |
|                 |               |            |   |
|                 | 10.31(11)          |            | Asset Purchase Agreement  dated as of January 16, 2007 by and between Medtronic Xomed, Inc.  and the Company |
|                 |               |            |   |
|                 | 10.32(11)          |            | Amended and Restated  Exclusive Distribution Agreement dated as of March 26, 2007 by and  between the Company and Medtronic Xomed, Inc. |
|                 |               |            |   |
|                 | 10.33(11)          |            | License Agreement dated as  of March 26, 2007 by and between the Company and Medtronic  Xomed, Inc. |
|                 |               |            |   |
| *                    | 10.34(17)          |            | Amendment dated  April 4, 2007 to Employment Letter Agreement of Yoav Cohen |
|                 |               |            |   |
| *                    | 10.35(17)          |            | Amendment dated  April 4, 2007 to Employment Letter Agreement of Ron Hadani |
|                 |               |            |   |
|                 | 10.36(12)          |            | Merrill Lynch Loan  Management Account Agreement (the “Agreement”) between  Vision-Sciences, Inc. and Merrill Lynch Bank USA (“Bank”) and  accompanying Commitment Letter from the Bank |
|                 |               |            |   |
|                 | 10.37(13)          |            | Lease Agreement dated as  of May 1, 2008 between Ramland Realty Associates LLC and Vision  Sciences, Inc. |

 

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| **Exhibit No.** | ** ** | **Description** |
|----------------------|------------|-----------------|
|                 | 10.38(17)  |            | Third Amendment to Lease  between 30 Ramland Road, LLC dated as December 26, 2006 LLC  and Vision Sciences, Inc. |
|                 |       |            |   |
|                 | 10.39(16)  |            | Development and Supply  Agreement between Vision-Sciences, Inc. and SpineView, Inc. dated  June 19, 2008 |
|                 |       |            |   |
|                 | 10.40(18)  |            | Employment Letter between  Katherine Wolf and the Company, effective September 16, 2008 |
|                 |       |            |   |
|                 | 10.41 (20) |            | Consulting Agreement  between NYC Advisors, LLC and the Company, effective October 1, 2008. |
|                 |       |            |   |
|                 | 10.42 (21) |            | Surrender and Acceptance  Agreement between Ramland Realty Associates L.L.C. and the Company dated  December 31, 2008. |
|                 |       |            |   |
|                 | 21.1(17)   |            | Subsidiaries of the  Company |
|                 |       |            |   |
|                 | 31.1       |            | Certification of Chief  Executive Officer pursuant to Rule 13a-14(a) and  Rule 15d-14(a), promulgated under the Securities Exchange Act of 1934,  as amended. |
|                 |       |            |   |
|                 | 31.2       |            | Certification of Chief  Financial Officer pursuant to Rule 13a-14(a) and  Rule 15d-14(a), promulgated under the Securities Exchange Act of 1934,  as amended. |
|                 |       |            |   |
|                 | 32         |            | Certification of Chief  Executive Officer and Chief Financial Officer pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |

 

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| *      |   | Management contract or  compensatory plan or arrangement filed as an exhibit to this  Form pursuant to Items 15(a) and 15(b) of Form 10-K.       |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                      |
| **     |   | Confidential treatment  granted as to certain portions, which portions have been deleted and filed  separately with the Securities and Exchange Commission.               |
|   |   |                                                                                                                                                                      |
| (1)    |   | Incorporated by reference  to the Annual Report on Form 10-K for the fiscal year ended March 31,  2001.                                                         |
|   |   |                                                                                                                                                                      |
| (2)    |   | Incorporated by reference  to the Registration Statement on Form S-1 (File No. 33-53490).                                                                       |
|   |   |                                                                                                                                                                      |
| (3)    |   | Incorporated by reference  to the Annual Report on Form 10-K for the fiscal year ended  March 31, 1994.                                                         |
|   |   |                                                                                                                                                                      |
| (4)    |   | Incorporated by reference  to the Annual Report on Form 10-K for the fiscal year ended  March 31, 2000.                                                         |
|   |   |                                                                                                                                                                      |
| (5)    |   | Incorporated by reference  to the Current Report on Form 8-K dated August 20, 1998.                                                                             |
|   |   |                                                                                                                                                                      |
| (6)    |   | Incorporated by reference  to the Quarterly Report on Form 10-Q for the quarter ended June 30,  1993.                                                           |
|   |   |                                                                                                                                                                      |
| (7)    |   | Incorporated by reference  to the Quarterly Report on Form 10-Q/A for the quarter ended  June 30, 1994.                                                         |
|   |   |                                                                                                                                                                      |
| (8)    |   | Incorporated by reference  to the Annual Report on Form 10-K for the fiscal year ended  March 31, 1996.                                                         |
|   |   |                                                                                                                                                                      |
| (9)    |   | Incorporated by reference  to the Quarterly Report on Form 10-Q/A for the quarter ended  December 31, 2002.                                                     |
|   |   |                                                                                                                                                                      |
| (10)   |   | Incorporated by reference  to the Quarterly Report on Form 10-Q for the quarter ended  September 30, 2003.                                                      |
|   |   |                                                                                                                                                                      |
| (11)   |   | Incorporated by reference  to the Proxy Statement dated March 6, 2007 filed with the Securities and  Exchange Commission on March 7, 2007 on Schedule 14A. |
|   |   |                                                                                                                                                                      |
| (12)   |   | Incorporated by reference  to the Current Report on Form 8-K filed on January 24, 2008.                                                                         |
|   |   |                                                                                                                                                                      |
| (13)   |   | Incorporated by reference  to the Current Report on Form 8-K filed on May 5, 2008.                                                                              |

 

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| (14)   |   | Incorporated by reference  to the Proxy Statement dated July 30, 2007 filed with the Securities and  Exchange Commission on July 27, 2007 on Schedule 14A. |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                      |
| (15)   |   | Incorporated by reference  to the current report on Form 8-K filed on February 15, 2008.                                                                        |
|   |   |                                                                                                                                                                      |
| (16)   |   | Incorporated by reference  to the current report on Form 8-K filed on June 23, 2008.                                                                            |
|   |   |                                                                                                                                                                      |
| (17)   |   | Incorporated by reference  to the Annual Report on Form 10-K for the fiscal year ended  March 31, 2008.                                                         |
|   |   |                                                                                                                                                                      |
| (18)   |   | Incorporated by reference  to the current report on Form 8-K filed on September 16, 2008.                                                                       |
|   |   |                                                                                                                                                                      |
| (19)   |   | Incorporated by reference  Registration Statement on Form S-8, filed on October 10, 2008                                                                        |
|   |   |                                                                                                                                                                      |
| (20)   |   | Incorporated by reference  to the Quarterly Report on Form 10-Q for the quarter ended  September 30, 2008.                                                      |
|   |   |                                                                                                                                                                      |
| (21)   |   | Incorporated by reference  to the current report on Form 8-K filed on January 6, 2009.                                                                          |

 

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