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 1934For
      the quarterly period ended December 31, 2009oro
            TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
      EXCHANGE ACT OF 1934For
      the transition period
      from                          to




COMMISSION
FILE NUMBER 0-20970




VISION-SCIENCES, INC.


(Exact
name of registrant 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’s
telephone number, including area code)







(Former
name, former address, and


former
fiscal year if changed since last report)




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




Indicate
by check mark whether the Registrant has submitted electronically and posted on
its corporate website, if any every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding
12 months (or for such shorter period that the Registrant was required to submit
and post such files). Yes o  No  o





Indicate
by check mark whether the registrant is a large accelerated filer, accelerated
filer, 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
              (Do
      not check if a smaller reporting company)
            Smaller reporting company x




Indicate
by check mark whether the registrant is a shell company (as defined by
Rule 12b-2 of the Exchange
Act).         Yes o    No x




Indicate
the number of shares outstanding of each of the issuer’s classes of common
stock, as of February 11, 2010




Common
      Stock, par value of $0.01
            36,855,776(Title
      of Class)
            (Number
      of Shares)








VISION-SCIENCES, INC.


TABLE
OF CONTENTS




Part I.
            Financial
      InformationItem 1.
            Financial
      StatementsConsolidated
      Balance Sheets
            3Consolidated
      Statements of Operations
            4Consolidated
      Statement of Stockholders’ Equity
            5Consolidated
      Statements of Cash Flows
            6Notes
      to Consolidated Financial Statements
            7Item 2.
            Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
            15Item 3.
            Quantitative
      and Qualitative Disclosures about Market Risk
            26Item 4.
            Controls
      and Procedures
            26Part II.
            Other
      InformationItem 1.
            Legal
      Proceedings
            27Item 1A.
            Risk
      Factors
            27Item 2.
            Unregistered
      Sales of Equity Securities and Use of Proceeds
            27Item 3.
            Defaults
      Upon Senior Securities
            27Item 4.
            Submission
      of Matters to a Vote of Stockholders
            27Item 5.
            Other
      Information
            27Item 6.
            Exhibits
            28Signatures
            29




2


PART
I—FINANCIAL INFORMATION


Item 1:
Financial Statements




Vision-Sciences, Inc.
and Subsidiaries


Condensed
Consolidated Balance Sheets


(In
thousands, except per share amounts)




December
      31,
              
              
              March
      31,2009
              
              
              2009ASSETS
              
              (
      unaudited )Current
      assets:Cash
      and cash equivalents
              
              $
              394
              
              
              $
              1,975Short-term
      investments
              
              
              2,112
              
              
              
              7,948Accounts
      receivable, net of allowance for doubtful accounts of $357and
      $283, respectively
              
              
              1,244
              
              
              
              1,818Inventories,
      net
              
              
              5,262
              
              
              
              5,486Prepaid
      expenses and other current assets
              
              
              634
              
              
              
              397Current
      assets of discontinued operations
              
              
              -
              
              
              
              9Total
      current assets
              
              
              9,646
              
              
              
              17,633Property
      and equipment, at cost:Machinery
      and equipment
              
              
              3,389
              
              
              
              3,069Furniture
      and fixtures
              
              
              225
              
              
              
              132Leasehold
      improvements
              
              
              351
              
              
              
              1633,965
              
              
              
              3,364Less—accumulated
      depreciation and amortization
              
              
              2,065
              
              
              
              1,576Total
      property and equipment, net
              
              
              1,900
              
              
              
              1,788Other
      assets, net of accumulated amortization of $82 and $76,respectively
              
              
              84
              
              
              
              65Deferred
      debt cost, net
              
              
              209
              
              
              
              -Total
      assets
              
              $
              11,839
              
              
              $
              19,486LIABILITIES
      AND STOCKHOLDERS' EQUITYCurrent
      liabilities:Capital
      lease obligations
              
              $
              39
              
              
              $
              61Accounts
      payable
              
              
              720
              
              
              
              1,014Accrued
      expenses
              
              
              2,081
              
              
              
              1,966Current
      liabilities of discontinued operations
              
              
              -
              
              
              
              6Total
      current liabilities
              
              
              2,840
              
              
              
              3,047Capital
      lease obligations, net of current portion
              
              
              19
              
              
              
              28Total
      liabilities
              
              
              2,859
              
              
              
              3,075Commitments
      and Contingencies (Note 5)Stockholders’
      equity:Preferred
      stock, $0.01 par value—Authorized—5,000,000
      sharesissued
      and outstanding—none
              
              
              -
              
              
              
              -Common
      stock, $0.01 par value—Authorized—50,000,000
      sharesissued
      and outstanding—36,855,776 shares and 36,817,941 sharesat
      December 31, 2009 and March 31, 2009, respectively
              
              
              369
              
              
              
              368Additional
      paid-in capital
              
              
              81,471
              
              
              
              80,031Accumulated
      deficit
              
              
              (72,860
              )
              
              
              (63,988
              )Total
      stockholders’ equity
              
              
              8,980
              
              
              
              16,411Total
      liabilities and stockholders’ equity
              
              $
              11,839
              
              
              $
              19,486




See
accompanying notes to consolidated financial statements.


3




Vision-Sciences, Inc.
and Subsidiaries


Condensed
Consolidated Statements of Operations


(In
thousands, except per share amounts)


(Unaudited)







Three
      Months Ended
              
              
              Nine
      Months EndedDecember
      31,
              
              
              December
      31,2009
              
              
              2008
              
              
              2009
              
              
              2008Net
      sales
              
              $
              2,600
              
              
              $
              3,610
              
              
              $
              8,807
              
              
              $
              9,091Cost
      of sales
              
              
              2,250
              
              
              
              2,845
              
              
              
              7,204
              
              
              
              7,452Gross
      profit
              
              
              350
              
              
              
              765
              
              
              
              1,603
              
              
              
              1,639Selling,
      general, and administrative expenses
              
              
              2,919
              
              
              
              2,427
              
              
              
              8,108
              
              
              
              7,693Research
      and development expenses
              
              
              659
              
              
              
              1,478
              
              
              
              2,342
              
              
              
              4,163Restructuring
      charge reversal
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (98
              )Loss
      from operations
              
              
              (3,228
              )
              
              
              (3,140
              )
              
              
              (8,847
              )
              
              
              (10,119
              )Interest
      income
              
              
              14
              
              
              
              85
              
              
              
              85
              
              
              
              237Interest
      expense
              
              
              (6
              )
              
              
              -
              
              
              
              (52
              )
              
              
              (16
              )Debt
      cost expense
              
              
              (12
              )
              
              
              -
              
              
              
              (12
              )
              
              
              -Other,
      net
              
              
              -
              
              
              
              12
              
              
              
              (28
              )
              
              
              36Gain
      on sale of product line, net of direct costs
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              4,985Loss
      before provision for income taxes
              
              
              (3,232
              )
              
              
              (3,043
              )
              
              
              (8,854
              )
              
              
              (4,877
              )Provision
      for income taxes
              
              
              2
              
              
              
              10
              
              
              
              18
              
              
              
              19Net
      loss from continuing operations
              
              
              (3,234
              )
              
              
              (3,053
              )
              
              
              (8,872
              )
              
              
              (4,896
              )Net
      loss from discontinued operations
              
              
              -
              
              
              
              (10
              )
              
              
              -
              
              
              
              (783
              )Net
      loss
              
              $
              (3,234
              )
              
              $
              (3,063
              )
              
              $
              (8,872
              )
              
              $
              (5,679
              )Net
      loss per common share - basic and diluted:Continuing
      operations
              
              $
              (0.09
              )
              
              $
              (0.08
              )
              
              $
              (0.24
              )
              
              $
              (0.14
              )Discontinued
      operations
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (0.02
              )Net
      loss per common share - basic and diluted
              
              $
              (0.09
              )
              
              $
              (0.08
              )
              
              $
              (0.24
              )
              
              $
              (0.16
              )Shares
      used in computing net lossper
      common share
              
              
              36,855,429
              
              
              
              36,754,852
              
              
              
              36,852,628
              
              
              
              36,208,808




See
accompanying notes to consolidated financial statements.




4




Vision-Sciences, Inc.
and Subsidiaries


Condensed
Consolidated Statements of Stockholders’ Equity


(In
thousands, except per share amounts)


(Unaudited)




Preferred Stock
              
              
              Common Stock
              
              
              Additional
              
              
              
              
              
              TotalNumber
              
              
              $0.01
              
              
              Number
              
              
              $0.01
              
              
              Paid-in
              
              
              Accumulated
              
              
              Stockholders’of Shares
              
              
              Par Value
              
              
              of Shares
              
              
              Par Value
              
              
              Capital
              
              
              Deficit
              
              
              EquityBalance,
      March 31, 2008
              
              
              5,000
              
              
              $
              -
              
              
              
              35,648
              
              
              $
              356
              
              
              $
              77,478
              
              
              $
              (55,763
              )
              
              $
              22,071Exercise
      of stock options
              
              
              -
              
              
              
              -
              
              
              
              1,170
              
              
              
              12
              
              
              
              1,587
              
              
              
              -
              
              
              
              1,599Stock
      based compensationexpense
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              966
              
              
              
              -
              
              
              
              966Net
      loss
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (8,225
              )
              
              
              (8,225
              )Balance,
      March 31, 2009
              
              
              5,000
              
              
              
              -
              
              
              
              36,818
              
              
              
              368
              
              
              
              80,031
              
              
              
              (63,988
              )
              
              
              16,411Exercise
      of stock options
              
              
              -
              
              
              
              -
              
              
              
              38
              
              
              
              1
              
              
              
              42
              
              
              
              -
              
              
              
              43Issuance
      of stock warrants
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              221
              
              
              
              -
              
              
              
              221Stock
      based compensationexpense
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              1,177
              
              
              
              -
              
              
              
              1,177Net
      loss
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (8,872
              )
              
              
              (8,872
              )Balance,
      December 31, 2009
              
              
              5,000
              
              
              $
              -
              
              
              
              36,856
              
              
              $
              369
              
              
              $
              81,471
              
              
              $
              (72,860
              )
              
              $
              8,980









See
accompanying notes to consolidated financial statements.
 5




Vision-Sciences, Inc.
and Subsidiaries


Condensed
Consolidated Statements of Cash Flows


(In
thousands)


(Unaudited)







Nine
      Months EndedDecember
      31,2009
              
              
              2008Cash
      flows from operating activities:Net
      loss
              
              $
              (8,872
              )
              
              $
              (5,679
              )Adjustments
      to reconcile net loss to net cash used in operating
    activitiesDepreciation
      and amortization
              
              
              494
              
              
              
              276Gain
      on sale of product line
              
              
              -
              
              
              
              (4,985
              )Gain
      on sale of fixed assets
              
              
              -
              
              
              
              (23
              )Stock-based
      compensation expense
              
              
              1,177
              
              
              
              1,266Loss
      on investments
              
              
              34
              
              
              
              -Debt
      cost expense
              
              
              12
              
              
              
              -Changes
      in assets and liabilities:Accrued
      interest receivable
              
              
              48
              
              
              
              (59
              )Accounts
      receivable
              
              
              574
              
              
              
              (1,200
              )Inventories
              
              
              224
              
              
              
              (2,725
              )Prepaid
      expenses and other current assets
              
              
              (221
              )
              
              
              115Other
      assets
              
              
              (23
              )
              
              
              309Accounts
      payable
              
              
              (294
              )
              
              
              (360
              )Accrued
      expenses
              
              
              109
              
              
              
              (645
              )Net
      cash used in operating activities
              
              
              (6,738
              )
              
              
              (13,710
              )Cash
      flows from investing activities:Purchase
      of short-term investments
              
              
              (2,572
              )
              
              
              (15,617
              )Proceeds
      from short-term investment sales/maturities
              
              
              8,310
              
              
              
              14,057Purchase
      of property and equipment
              
              
              (601
              )
              
              
              (469
              )Proceeds
      from sale of product line, net of direct costs
              
              
              -
              
              
              
              4,985Proceeds
      from sale of fixed assets
              
              
              -
              
              
              
              137Net
      cash provided by investing activities
              
              
              5,137
              
              
              
              3,093Cash
      flows from financing activities:Payments
      on capital leases
              
              
              (31
              )
              
              
              (28
              )Exercise
      of stock options
              
              
              43
              
              
              
              1,543Net
      cash provided by financing activities
              
              
              12
              
              
              
              1,515Net
      decrease in cash and cash equivalents
              
              
              (1,589
              )
              
              
              (9,102
              )Cash
      and cash equivalents from continuing operations, beginning of
      period
              
              $
              1,975
              
              
              $
              10,642Cash
      and cash equivalents from discontinued operations, beginning of
      period
              
              
              8
              
              
              
              -Cash
      and cash equivalents from continuing operations, end of
    period
              
              $
              394
              
              
              $
              1,540Supplemental
      disclosure of cash flow information:Cash
      paid during the period for:Interest
              
              $
              -
              
              
              $
              16Income
      taxes
              
              $
              18
              
              
              $
              -Non-cash
      financing activities:Stock
      warrants issuance
              
              $
              221
              
              
              $
              -


See
accompanying notes to consolidated financial statements.




6


VISION-SCIENCES, INC.
AND SUBSIDIARIES


NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited,
in thousands except per share amounts)




Note
1.    Basis of Presentation




Vision-Sciences, Inc.
and subsidiaries (the “Company” – which may be referred to as “our”, “us” or
“we”) have prepared the consolidated financial statements included herein
according to generally accepted accounting principles in the United States of
America (“U.S. GAAP”), without audit, pursuant to the rules and regulations
of the Securities and Exchange Commission (“SEC”) and include, in the opinion of
management, all adjustments that we consider necessary for a fair presentation
of such information.  We have condensed or omitted certain information
and footnote disclosures normally included in financial statements pursuant to
those rules and regulations. We believe, however, that our disclosures are
adequate to make the information presented not misleading. The results for the
interim periods presented are not necessarily indicative of results to be
expected for the full fiscal year. Please read these consolidated financial
statements in conjunction with the consolidated financial statements and the
notes thereto included in our Annual Report on Form 10-K for the fiscal
year ended March 31, 2009.





The
condensed consolidated statements of operations for the three and nine months
ended December 31, 2008 have been reclassified to reflect discontinued
operations. Events subsequent to December 31, 2009 were evaluated until the time
of the filing of this Form 10-Q with the SEC on February 11, 2010.





Note
2.    Summary of Significant Accounting
Policies





Our
consolidated financial statements are prepared in accordance with U.S. GAAP.
These accounting principles require us to make certain estimates, judgments and
assumptions. We believe that the estimates, judgments and assumptions upon which
we rely are reasonable, based upon information available to us at the time that
these estimates, judgments and assumptions are made. These estimates, judgments
and assumptions can affect the reported amounts of assets and liabilities as of
the date of the financial statements as well as the reported amounts of revenues
and expenses during the periods presented. To the extent there are any
differences (other than nominal differences) between these estimates, judgments
or assumptions and actual results, our financial statements will be affected.
The accounting policies that reflect our more significant estimates, judgments
and assumptions and which we believe are the most critical to aid in fully
understanding and evaluating our reported financial results include the
following:





• Revenue
recognition


•
Accounting for income taxes


• Other
contingencies


•
Stock-based compensation expense


•
Allowances for doubtful accounts


•
Inventory obsolescence reserves





The
accompanying condensed consolidated financial statements reflect the accounts of
the Company. All significant inter-company accounts and transactions have been
eliminated in consolidation.





In many
cases, the accounting treatment of a particular transaction is specifically
dictated by U.S. GAAP and does not require management’s judgment in its
application. There are also areas in which management’s judgment in selecting
among available alternatives would not produce a materially different result.
Management has reviewed these critical accounting policies and related
disclosures with the Audit Committee of the Board of Directors (the
“Board”).





During
the first nine months of fiscal 2010, there were no significant changes in our
critical accounting policies and estimates. You should refer to Critical Accounting Policies and
Estimates in Part IV, Page F-6 of our Annual Report on
Form 10-K for the fiscal year ended March 31, 2009 for a more complete
discussion of our critical accounting policies and estimates.





Recently
Adopted Accounting Standards





In June
2009, the Financial Accounting Standards Board (the “FASB”) issued its final
Statement of Financial Accounting Standards (“SFAS”) No. 168, The FASB Accounting Standards
Codification and the Hierarchy of Generally Accepted Accounting Principles – A
Replacement of FAS Statement No. 162(“SFAS 168”). SFAS 168 made the FASB
Accounting Standards Codification (the “Codification”) the single source of U.S.
GAAP used by nongovernmental entities in the preparation of financial
statements, except for rules and interpretive releases of the SEC under
authority of federal securities laws, which are sources of authoritative
accounting guidance for SEC registrants. The Codification is meant to simplify
user access to all authoritative accounting guidance by reorganizing U.S. GAAP
pronouncements into roughly 90 accounting topics within a consistent structure;
its purpose is not to create new accounting and reporting guidance. The
Codification supersedes all existing non-SEC accounting and reporting standards
and was effective for us beginning July 1, 2009. The adoption of the
Codification changed our references to U.S. GAAP accounting standards, but did
not impact our results of operations, financial position, or
liquidity.





7


In August
2009, the FASB issued Accounting Standards Update No. 2009-05 (“ASC Update
2009-05”), an update to Accounting Standards Codification (“ASC”) 820 (Topic
820, Fair Value Measurements
and Disclosures). This update provides amendments to reduce potential
ambiguity in financial reporting when measuring the fair values of liabilities.
Among other provisions, this update provides clarification that in circumstances
in which a quoted price in an active market for the identical liability is not
available, a reporting entity is required to measure fair value using one or
more of the valuation techniques described in ASC Update 2009-05. The adoption
of ASC Update 2009-05 did not have a material effect on our results of
operations, financial position, or liquidity.





Accounting
Standards Updates Not Yet Effective





In
January 2010, the FASB issued Accounting Standards Update No. 2010-06 (“ASC
Update 2010-06”), an update to ASC 820. This update provides amendments to add
new requirements for disclosures about transfers into and out of Levels 1 and 2
and separate disclosures about purchases, sales, issuances, and settlements
relating to Level 3 measurements. It also clarifies existing fair value
disclosures about the level of disaggregation and about inputs and valuation
techniques used to measure fair value. ASC Update 2010-06 will become effective
for us with the reporting period beginning January 1, 2010, except for the
disclosure on the roll forward activities for Level 3 measurements, which will
become effective for us with the reporting period beginning April 1, 2011 (our
fiscal year 2012). We do not expect that the provisions of the update will have
a material effect on our results of operations, financial position, or
liquidity.





Note
3.    Inventories





Inventories
are stated at the lower of cost or market using the first-in, first-out (“FIFO”)
method and consist of the following:






December
      31,
              
              
              March
      31,2009
              
              
              2009Raw
      materials
              
              $
              4,146
              
              
              $
              4,253Work-in-process
              
              
              442
              
              
              
              369Finished
      goods
              
              
              674
              
              
              
              864$
              5,262
              
              
              $
              5,486





Raw
materials include components purchased from independent suppliers. Most
purchased components are available from multiple sources. However, some
components are available only from a limited number of suppliers, and several
key components are supplied to us by single source suppliers, with whom we have
long-term supply arrangements, but no long-term supply agreements.





Note
4.    Financial Instruments





Short-Term
Investments





We
classify investments with original maturities of greater than 90 days in
certificates of deposit, corporate bonds, and government securities as
short-term investments. We intend to hold these investments to maturity. Our
short-term investments are carried at amortized cost in our condensed
consolidated balance sheets.





The
following table summarizes these securities classified as held to
maturity.




December
      31, 2009
              
              
              March 31,
      2009Held
      to maturity less than one year:
              
              Fair
      Value
              
              
              Cost
              
              
              Fair
      Value
              
              
              CostCertificates
      of deposit
              
              $
              2,126
              
              
              $
              2,112
              
              
              $
              4,262
              
              
              $
              4,299Corporate
      bonds
              
              
              -
              
              
              
              -
              
              
              
              2,768
              
              
              
              2,875Government
      securities
              
              
              -
              
              
              
              -
              
              
              
              774
              
              
              
              774Total
      short-term investments
              
              $
              2,126
              
              
              $
              2,112
              
              
              $
              7,804
              
              
              $
              7,948







Fair
Value Measurements





The
carrying amounts reflected in our condensed consolidated balance sheets for cash
and cash equivalents, accounts receivable, other current assets, accounts
payable, accrued expenses, and capital lease obligations approximate fair value
due to their short-term nature.





8


Note
5.    Commitments and Contingencies





Revolving
Loan Agreement





On
November 9, 2009, we entered into a three-year $5.0 million revolving loan
agreement (the “Loan”) with our Chairman, Lewis C. Pell (the “Lender”). Any
amounts drawn against the Loan (an “Advance”) accrue interest at a per annum
rate of 7.5%. The Lender will receive an availability fee equal to a per annum
rate of 0.5% on the unused portion of the Loan calculated based on the
difference between the average annual principal amount of the outstanding
Advances under the Loan and the maximum advance of $5.0 million. The
availability of advances under the Loan is subject to customary conditions.
Subject to the terms of the Loan, we will be required to prepay all amounts
outstanding under the Loan in the event of a change of control of the Company
and we will be required to prepay part or all of the amounts outstanding in the
event we secure other financing or consummate a sale or license of assets, in
each case resulting in net proceeds of $5.0 million or greater.





In
connection with the Loan, the Lender received  a five-year warrant
(the “Initial Warrant Shares”) to purchase up to 272,727 shares of our common
stock at an exercise price of $1.375 per share (representing 7.5% warrant
coverage, or approximately 0.7% of our outstanding common stock), which was
immediately vested upon issuance. The second five-year warrant (the “Additional
Warrant Shares”) to purchase up to an additional 378,788 shares of our common
stock at an exercise price of $1.65 per share (representing up to an additional
12.5% warrant coverage, or approximately 1.0% of our outstanding common stock)
vests at the time that each Advance is made in an amount equal to (i) the
product of the amount of the Additional Warrant Shares multiplied by (ii) a
ratio, (A) the numerator of which shall be the amount of the new Advance and (B)
the denominator of which shall be $5.0 million.





On the
date of issuance, the fair value of the Initial and Additional Warrant Shares
was approximately $221 thousand and $249 thousand, respectively. We defer costs
associated with securing a line-of-credit or revolving loan agreement over the
applicable term. These costs are amortized as debt cost expense in our condensed
consolidated statement of operations. Accordingly, we recorded the $221 thousand
associated with the Initial Warrant Shares as a deferred debt cost asset with a
corresponding amount as additional paid-in capital. The cost will be amortized
on a straight-line basis over the three-year term of the Loan. In the third
quarter of fiscal 2010, we began amortizing the deferred debt cost resulting in
the recognition of $12 thousand as debt cost expense. Upon an Advance of the
Loan, the fair value of the Additional Warrant Shares will be recalculated and
recognized as debt cost expense over the remaining life of the Loan using the
effective interest method.





At
December 31, 2009, we had no outstanding borrowings under the Loan. The $5.0
million revolving loan expires in November 2012. During the three and nine
months ended December 31, 2009, we recorded approximately $4 thousand as
interest expense related to the availability fee in our condensed consolidated
statement of operations.





Note
6.    Stock-Based Awards




Stock
Option Plans





Our first
stock option plan (the “1990 Plan”) allowed us to grant key employees and
consultants incentive and non-statutory stock options at the fair value of the
stock on the date of grant. Options became exercisable at varying dates ranging
up to five years from the date of grant. The Board had authorized the issuance
of options for the purchase of up to 4,375,000 shares of common stock under the
1990 Plan. This plan expired in 2001 and was replaced with the 2000 Plan. The
terms of the 2000 Plan are substantially the same as the 1990 Plan. Under the
2000 Plan, the Board and our stockholders authorized the issuance of options for
the purchase of up to 4,500,000 shares of common stock of which 261,587 shares
remain available for future grants as of December 31, 2009. We do not grant any
new options under the 1990 Plan.





In August
2007, our stockholders approved our 2007 Stock Incentive Plan (the “2007 Plan”).
Under the 2007 Plan, we are authorized to issue options for the purchase of up
to 4,000,000 shares of common stock. The terms of the 2007 Plan are
substantially the same as the 2000 Plan. Under the 2007 Plan, we grant options
to both employees and consultants with vesting periods ranging from immediate to
six years. As of December 31, 2009, there remain 1,117,776 shares available for
future grants under the 2007 Plan.





In July
2003, we adopted, and our stockholders approved, the 2003 Director Option Plan,
which was amended in August 2008 (the “Amended 2003 Plan”). The Amended 2003
Plan increased the annual automatic grant from 4,000 options to 10,000 options
per outside director per year, and increased the maximum number of options
available under the Amended 2003 Plan from 200,000 to 450,000. The automatic
grant is issued at the annual shareholder’s meeting, typically held in September
of each year. During each of our 2008 and 2009 annual meetings held in August
2008 and September 2009, respectively, 10,000 options were granted to each of
our then five outside directors. Currently, we have four outside directors. If
the number of outside directors remains unchanged, we would be required to grant
options to purchase an aggregate of 40,000 shares at each of the annual
shareholder’s meeting scheduled for September 2010.





The
Amended 2003 Plan also provides for granting newly elected outside directors a
one-time grant of 10,000 options. In May and June 2009, two outside directors
resigned for personal reasons and were replaced by two new outside directors.
Accordingly, in July 2009, the two new outside directors were each granted
10,000 options. As of December 31, 2009, there remain 282,000 shares available
for future grants under the Amended 2003 Plan.





9


Stock-Based
Compensation Expense




We
account for stock-based awards issued to employees in accordance with the
provisions of ASC 718 (Topic 718, Compensation – Stock
Compensation). We recognize stock-based compensation expense on a
straight-line uniform basis over the service period of the award, which is
generally four years for employees. Stock-based awards issued to consultants are
accounted for in accordance with the provisions of ASC 718 and ASC 505-50
(Subtopic 50 “Equity-Based Payments to Non-Employees” of Topic 505, Equity). Options granted to
consultants are periodically revalued as the options vest, and are recognized as
an expense over the related period of service or the vesting period, whichever
is longer.





We are
required to estimate the stock awards that we ultimately expect to vest and to
reduce stock-based compensation expense for the effects of estimated forfeitures
of awards over the expense recognition period. Although we estimate forfeitures
based on historical experience, actual forfeitures in the future may differ. In
addition, to the extent our actual forfeitures are different than our estimates,
we record a true-up for the difference in the period that the awards vest, and
such true-ups could materially affect our operating results. We also consider,
each quarter, whether there have been any significant changes in facts and
circumstances that would affect our forfeiture rate.





We
recorded stock-based compensation expense for the three and nine months ended
December 31, 2009 and 2008 in the condensed consolidated statement of operations
as follows:




Three
      Months Ended
              
              
              Nine
      Months EndedDecember
      31,
              
              
              December
      31,2009
              
              
              2008
              
              
              2009
              
              
              2008Cost
      of sales
              
              $
              85
              
              
              $
              17
              
              
              $
              288
              
              
              $
              88Selling,
      general, and administrative expenses
              
              
              135
              
              
              
              177
              
              
              
              781
              
              
              
              555Research
      and development expenses
              
              
              41
              
              
              
              226
              
              
              
              108
              
              
              
              623Total
      stock-based compensation expense
              
              $
              261
              
              
              $
              420
              
              
              $
              1,177
              
              
              $
              1,266







The fair
value of the stock options granted was estimated on the date of grant using a
Black-Scholes valuation model that used the assumptions noted in the following
table. The risk-free interest rate assumption we use is based upon United States
Treasury interest rates appropriate for the expected life of the awards. The
expected life (estimated period of time that we expect employees, consultants
and directors to hold their stock options) was estimated based on historical
rates for two group classifications, (i) employees and consultants and (ii)
outside directors. Expected volatility was based on historical volatility of our
stock price for a period equal to the stock option’s expected life and
calculated on a daily basis. The expected dividend rate is zero since we do not
currently pay cash dividends on our common stock and do not anticipate doing so
in the foreseeable future. Under the provisions of ASC 718, members of the Board
are considered employees for calculation of stock-based compensation
expense.






Three
      Months Ended
              
              Nine
      Months EndedDecember
      31,
              
              December
      31,2009
              
              2008
              
              2009
              
              2008Risk-free
      interest rate
              
              3.00%
              
              2.45%
              
              2.66%
              
              2.50%Expected
      life (in years)
              
              7.04
              
              6.17
              
              6.51
              
              5.95Expected
      volatility
              
              87%
              
              83%
              
              87%
              
              84%Expected
      dividend yield
              
              --
              
              --
              
              --
              
              --





The
following table summarizes stock options activity for the nine months ended
December 31, 2009:




Weighted
      Avg.RemainingNumber
              
              
              Exercise
              
              
              Weighted
      Avg.
              
              
              Contractual
      Lifeof
      Shares
              
              
              Price
      Range
              
              
              Exercise
      Price
              
              
              in
      YearsOutstanding,
      March 31, 2009
              
              
              5,940,694
              
              
              
              $0.79
      – $5.10
              
              
              
              $2.04
              
              
              
              6.61Granted
              
              
              1,231,136
              
              
              
              $0.85
      – $1.50
              
              
              
              1.21Exercised
              
              
              (37,835
              )
              
              
              $1.12
      – $1.28
              
              
              
              1.13Canceled
              
              
              (728,928
              )
              
              
              $0.98
      – $4.88
              
              
              
              1.71Outstanding,
      December 31,  2009
              
              
              6,405,067
              
              
              
              $0.79
      – $5.10
              
              
              
              $1.93
              
              
              
              5.86Vested
      and expected to vest, December 31, 2009
              
              
              5,614,799
              
              
              
              $0.79
      – $5.10
              
              
              
              $1.84
              
              
              
              5.44Exercisable,
      December 31, 2009
              
              
              4,098,069
              
              
              
              $0.79
      – $5.10
              
              
              
              $1.62
              
              
              
              4.17







At
December 31, 2009, unrecognized stock-based compensation expense related to
stock options was approximately $2.1 million and is expected to be recognized
over a weighted average period of approximately 2.7 years.





10


The
weighted average fair value of options granted during the three months ended
December 31, 2009 and 2008 was $0.96 and $1.57 per share, respectively. The
weighted average fair value of options granted during the nine months ended
December 31, 2009 and 2008 was $0.91 and $1.37 per share,
respectively.





The total
intrinsic value (the excess of the market price over the exercise price) was
approximately $413 thousand for stock options outstanding, $351 thousand for
stock options exercisable, and $393 thousand for stock options vested and
expected to vest as of December 31, 2009. The total intrinsic value for stock
options exercised during the three months ended December 31, 2009 and 2008 was
approximately $1 thousand and $19 thousand, respectively. The total intrinsic
value for stock options exercised during the nine months ended December 31, 2009
and 2008 was approximately $6 thousand and $2.5 million,
respectively.





We do not
expect to realize any tax benefits from future disqualifying dispositions, if
any, because we currently have a full valuation allowance against our deferred
tax assets.





Stock
Warrants





The
following table summarizes stock warrants activity related to the Loan with the
Lender for the nine months ended December 31, 2009:




Number
              
              
              Exercise
              
              
              Weighted
      Avg.of
      Shares
              
              
              Price
      Range
              
              
              Exercise
      PriceNonvested,
      March 31, 2009
              
              
              --
              
              
              
              --
              
              
              
              --Granted
              
              
              651,515
              
              
              
              $1.375
      – $1.65
              
              
              
              $1.53Vested
              
              
              (272,727
              )
              
              
              $1.375
              
              
              
              1.375Forfeited
              
              
              --
              
              
              
              --
              
              
              
              --Nonvested,
      December 31,  2009
              
              
              378,788
              
              
              
              $1.65
              
              
              
              $1.65







The
weighted average fair value of warrants granted during the three and nine months
ended December 31, 2009 was $0.72 per share.





At
December 31, 2009, unrecognized debt cost expense related to the Initial Warrant
Shares was approximately $209 thousand,  which  is expected
to be recognized over a weighted average period of approximately 2.8 years. Upon
an Advance of the Loan, the fair value of the Additional Warrant Shares will be
recalculated and recognized as debt cost expense over the remaining life of the
Loan using the effective interest method (see Note 5. Commitments and
Contingencies).





Note
7.  Discontinued Operations





During
the third quarter of fiscal 2009, we sold the assets of BEST DMS Inc.
(“BEST-DMS”) to Ghiglieri 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.
BEST-DMS formerly constituted our health services segment.





In
accordance with the provisions of ASC 205-20 (Subtopic 20 “Discontinued
Operations” of Topic 205, Presentation of Financial
Statements), we classified the BEST-DMS assets that were sold as
discontinued operations for all periods presented. Accordingly, depreciation and
amortization associated with those assets was discontinued. Additionally, since
all assets were part of the health services segment, we determined that these
assets comprised operations and cash flows that can be clearly distinguished,
operationally and for financial reporting purposes, from the rest of our
operations.





Net sales
and pretax loss from discontinued operations for the three and nine months ended
December 31, 2008 are shown below. There was no impact for discontinued
operations in our condensed consolidated statement of operations for the current
fiscal year.




Net
      Sales
              
              
              Pretax
      LossThree
      months ended December 31, 2008
              
              $
              82
              
              
              $
              (9
              )Nine
      months ended December 31, 2008
              
              $
              583
              
              
              $
              (783
              )







11


Note
8. Segment Information





We
design, develop, manufacture, and market products for endoscopy in two
reportable segments, medical and industrial.





Our
medical segment designs, manufactures, and sells our advanced line of
endoscopy-based products, including our state-of-the-art flexible endoscopes and
our Slide-On EndoSheath® technology, for a variety of specialties and
markets.





Our
industrial segment, through our wholly-owned subsidiary, Machida, Inc.
(“Machida”), designs, manufactures, and sells borescopes to a variety of users,
primarily in the aircraft engine-manufacturing and aircraft engine-maintenance
industries. A borescope is an instrument that uses optical fibers for the visual
inspection of narrow cavities.





Our two
current reportable segments follow the accounting policies described in the
Critical Accounting Policies
and Estimatessection of our Form 10-K for fiscal 2009, on page F-6. We
evaluate segment performance based upon operating income. Identifiable assets
are those used directly in the operations of each segment and general corporate
assets, such as cash and short-term investments are allocated to each
segment.





12


The
following table presents key financial highlights, by reportable
segments:




ContinuingThree
      months ended December 31,
              
              Medical
              
              
              Industrial
              
              
              Adjustments
      *
              
              
              Operations2009Net
      sales to external customers (1)
              
              $
              1,842
              
              
              $
              758
              
              
              $
              -
              
              
              $
              2,600Gross
      profit
              
              
              8
              
              
              
              342
              
              
              
              -
              
              
              
              350Operating
      (loss) income
              
              
              (3,324
              )
              
              
              96
              
              
              
              -
              
              
              
              (3,228
              )Interest
      income, net
              
              
              8
              
              
              
              -
              
              
              
              -
              
              
              
              8Depreciation
      and amortization
              
              
              184
              
              
              
              5
              
              
              
              -
              
              
              
              189Stock-based
      compensation
              
              
              239
              
              
              
              22
              
              
              
              -
              
              
              
              261Total
      assets
              
              
              11,631
              
              
              
              2,570
              
              
              
              (2,362
              )
              
              
              11,839Expenditures
      for fixed assets
              
              
              162
              
              
              
              8
              
              
              
              -
              
              
              
              1702008Net
      sales to external customers
              
              $
              2,776
              
              
              $
              834
              
              
              $
              -
              
              
              $
              3,610Gross
      profit
              
              
              431
              
              
              
              334
              
              
              
              -
              
              
              
              765Operating
      (loss) income
              
              
              (3,248
              )
              
              
              108
              
              
              
              -
              
              
              
              (3,140
              )Interest
      income, net
              
              
              85
              
              
              
              -
              
              
              
              -
              
              
              
              85Depreciation
      and amortization
              
              
              88
              
              
              
              8
              
              
              
              -
              
              
              
              96Stock-based
      compensation
              
              
              420
              
              
              
              -
              
              
              
              -
              
              
              
              420Total
      assets
              
              
              23,325
              
              
              
              3,016
              
              
              
              (3,872
              )
              
              
              22,469Expenditures
      for fixed assets
              
              
              71
              
              
              
              -
              
              
              
              -
              
              
              
              71Nine
      months ended December 31,2009Net
      sales to external customers (1)
              
              $
              6,695
              
              
              $
              2,112
              
              
              $
              -
              
              
              $
              8,807Gross
      profit
              
              
              552
              
              
              
              1,051
              
              
              
              -
              
              
              
              1,603Operating
      (loss) income
              
              
              (9,194
              )
              
              
              347
              
              
              
              -
              
              
              
              (8,847
              )Interest
      income, net
              
              
              33
              
              
              
              -
              
              
              
              -
              
              
              
              33Depreciation
      and amortization
              
              
              479
              
              
              
              15
              
              
              
              -
              
              
              
              494Stock-based
      compensation
              
              
              1,085
              
              
              
              92
              
              
              
              -
              
              
              
              1,177Expenditures
      for fixed assets
              
              
              593
              
              
              
              8
              
              
              
              -
              
              
              
              6012008Net
      sales to external customers
              
              $
              6,917
              
              
              $
              2,174
              
              
              $
              -
              
              
              $
              9,091Gross
      profit
              
              
              802
              
              
              
              837
              
              
              
              -
              
              
              
              1,639Operating
      (loss) income
              
              
              (10,280
              )
              
              
              161
              
              
              
              -
              
              
              
              (10,119
              )Interest
      income, net
              
              
              221
              
              
              
              -
              
              
              
              -
              
              
              
              221Depreciation
      and amortization
              
              
              251
              
              
              
              25
              
              
              
              -
              
              
              
              276Stock-based
      compensation
              
              
              1,266
              
              
              
              -
              
              
              
              -
              
              
              
              1,266Expenditures
      for fixed assets
              
              
              469
              
              
              
              -
              
              
              
              -
              
              
              
              469December
      31,*
      Adjustments
              
              
              2009
              
              
              
              2008Intercompany
      eliminations
              
              $
              (1,397
              )
              
              $
              (2,457
              )Investment
      in subsidiaries
              
              
              (965
              )
              
              
              (1,415
              )Total
      assets
              
              $
              (2,362
              )
              
              $
              (3,872
              )






(1)Includes $0.2 million of
milestone revenue from SpineView, Inc.(see Note 9. Related Party
Transaction).





13


Note
9. Related Party Transaction





In the
first quarter of fiscal 2009, we entered into a Development and Supply Agreement
with SpineView, Inc. (the “SpineView Agreement”), pursuant to which we were to
develop and supply a CCD-based video endoscope to SpineView for use with
SpineView’s products. In the third quarter of fiscal 2010, pursuant to the terms
of the SpineView, we recorded $0.2 million in connection with the milestone
achievement for delivery of the first working prototype of the SpineView
spinoscope. The milestone revenue related to non-recurring engineering costs for
the development of the spinoscope prototype.





Mr. Pell,
our Chairman, is the Chairman of the SpineView board and an investor in
SpineView. Mr. Katsumi Oneda, a member of our Board, is also an investor in
SpineView. Our policy with respect to transactions in which any of our directors
or officers may have an interest, requires that such transaction (i) be on terms
no less favorable to us than could be obtained from unaffiliated third parties
and (ii) be approved by a majority of the uninterested, outside members of the
Board.





At a
Board meeting held during the first quarter of fiscal 2009, the Board reviewed
the terms of the final draft of the SpineView Agreement, outside of the presence
of Messrs. Pell and Oneda. The remaining (uninterested) members of our Board
determined that the SpineView Agreement was fair, properly negotiated, and would
be at least as favorable to us as could have been obtained from unaffiliated
third parties, and accordingly, after discussion, it was approved.





Note
10. Subsequent Event





On
February 11, 2010, we announced that Medtronic will no longer serve as the
distributor for our ENT (ear, nose, and throat) endoscopes. Medtronic and we
have agreed to a transition period through April 1, 2010 during which time we
will continue to support the Medtronic sales force and Medtronic will assist us
in transitioning Medtronic’s customer service needs directly to us, among other
items. After April 1, 2010, we will sell our ENT endoscopes through our direct
sales force in the U.S. and through distributors internationally.




14


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





Forward
Looking Statements





This
Quarterly Report on Form 10-Q contains forward-looking statements within
the meaning of The Private Securities Litigation Reform Act of 1995, which are
subject to various risks and uncertainties that could cause our actual results
to differ materially from those expressed or implied in such statements. Such
factors include, but are not limited to, further weakening of economic
conditions that could adversely affect the level of demand for our products; our
ability to satisfactorily distribute our ENT endoscopes without an arrangement
with Medtronic; pricing pressures, including cost-containment measures which
could adversely affect the price of, or demand for, our products; availability
of parts on acceptable terms; our ability to design new products and the success
of such new products; changes in foreign exchange markets; changes in financial
markets and changes in the competitive environment. Examples of forward-looking
statements include statements about expectations about future financial results,
future products and future sales of new and existing products, future
expenditures, 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 identify
forward-looking statements. The forward-looking statements are based on our
future plans, strategies, projections and predictions and involve risks and
uncertainties, and our actual results may differ significantly from those
discussed in the forward-looking statements. Factors that might cause such a
difference could include the availability of capital resources; the availability
of third-party reimbursement; government regulation; the availability of raw
material components; our ability to satisfactorily distribute our ENT endoscopes
without an arrangement with Metronic; our dependence on certain distributors and
customers; competition; technological difficulties; general economic conditions
and other risks detailed in this Quarterly Report on Form 10-Q and any
subsequent periodic filings we make with the Securities and Exchange Commission
(“SEC”). While we believe the assumptions underlying such forward-looking
statements are reasonable, there can be no assurance that future events or
developments will not cause such statements to be inaccurate. All
forward-looking statements contained in this report are qualified in their
entirety by this cautionary statement. We do not undertake an obligation to
update our forward-looking statements to reflect future events or
circumstances.





Registered
Trademarks, Trademarks and Service Marks





Vision-Sciences, Inc.
owns the registered trademarks Vision Sciences®,
Slide-On®,
EndoSheath®, and
The Vision System®. Not
all products referenced in this report are approved or cleared for sale,
distribution, or use.





Executive
Summary





We
design, develop, manufacture, and market products for endoscopy - the science of
using an instrument, known as an endoscope - to provide minimally invasive
access to areas not readily visible to the human eye. We operate in two
segments, medical and industrial. Our medical segment designs, manufactures, and
sells our advanced line of endoscopy-based products, including our
state-of-the-art flexible fiber and video endoscopes and our Slide-On EndoSheath
technology, for a variety of specialties and markets. Our industrial
segment, through
our wholly-owned subsidiary, Machida, Inc. (“Machida”), designs, manufactures,
and sells borescopes to a variety of users, primarily in the aircraft
engine-manufacturing and aircraft engine-maintenance industries. A borescope is
an instrument that uses optical fibers for the visual inspection of narrow
cavities.





Medical
Segment Areas





Within
our medical segment we target four main areas for our fiber and video endoscopes
and our EndoSheath technology: ENT (ear, nose, and throat), urology,
gastroenterology (“GI”), and pulmonology. Within the ENT area, we manufacture
ENT endoscopes and have sold these scopes exclusively to Medtronic Xomed, Inc.,
the ENT subsidiary of Medtronic, Inc. (“Medtronic”) for use by ENT physicians.
On February 11, 2010, we announced that Medtronic will no longer serve as the
distributor for our ENT endoscopes.  Medtronic and we have agreed to a
transition period through April 1, 2010 during which time we will continue to
support the Medtronic sales force and Medtronic will assist us in transitioning
Medtronic’s customer service needs directly to us, among other items. After
April 1, 2010, we will sell our ENT endoscopes through our direct sales force in
the U.S. and through distributors internationally. Our TNE (trans-nasal
esophagoscopy) endoscopes are manufactured by us, and are marketed to ENT and GI
physicians. Within the urology area, we manufacture, market, and sell our
cystoscopes and EndoSheath technology to urologists and other urology-gynecology
related physicians.  Within the GI area, we manufacture, market, and
sell our TNE scopes and EndoSheath technology to GI physicians, primary care
physicians, and others with a GI focus as part of their practice. We
manufacture, market, and sell our recently released bronchoscope (an endoscope
that allows detailed viewing of the lungs) and EndoSheath technology for
bronchoscopy to pulmonologists, oncologists, thoracic surgeons, and other
pulmonology-related physicians.





15


Strategy
and Value Proposition





By
increasing our sales and marketing efforts in our medical segment, we intend to
transform ourselves from a research and development-focused company to a sales
and marketing-driven company, with the primary goal of increasing top line
revenue and margins. We believe our technology delivers significant value to our
customers – doctors, clinics and hospitals – through reduced capital, staff and
service costs, and increased patient throughput, practice revenue, and
profitability. Our EndoSheath technology allows our customers to buy fewer
endoscopes to service their patients and enables them to schedule more patient
appointments in a single day. Our single-use EndoSheath technology provides a
sterile barrier between patients and our reusable endoscopes, eliminating the
need for time-consuming reprocessing routines necessary with conventional
endoscopes. Our endoscopes are therefore typically ready for the next procedure
in ten minutes, unlike conventional endoscopes which may take from 45 minutes to
a day to reprocess. Our plan is to place significant efforts into branding,
messaging opportunities and clinical support research within all of our medical
segment areas to ensure that the value of our products is communicated more
effectively to our customers.





New
Product Releases





In the
first quarter of fiscal 2010, we began commercial manufacturing and sales of our
newly developed line of ENT-4000 products, a new line of products incorporating
state-of-the-art fiber optic technology to replace the ENT-2000, a standard
scope for office and hospital based laryngeal care, and the ENT-3000, a portable
laryngoscope utilizing a battery-powered LED light source.





In the
first quarter of fiscal 2010, we also initiated commercial manufacturing and
sales of the BRS-5000, our new, digital, video-based flexible bronchoscope (an
endoscope which allows detailed viewing of the lungs), which is utilized with
our EndoSheath technology. The BRS-5000 is a CCD-based video imaging endoscopy
system, which includes an integrated built-in LED light source and operates with
our streamlined, multi-functional 5000-Series processor. This streamlined
video-based system eliminates the need for a separate camera head, light source
and video monitor. It is marketed to pulmonologists, oncologists, thoracic
surgeons, and other pulmonology-related physicians.





Revolving
Loan Agreement





On
November 9, 2009, we entered into a three-year $5.0 million revolving loan
agreement (the “Loan”) with our Chairman, Lewis C. Pell (the “Lender”). Any
amounts drawn against the Loan (an “Advance”) accrue interest at a per annum
rate of 7.5%. The Lender will receive an availability fee equal to a per annum
rate of 0.5% on the unused portion of the Loan calculated based on the
difference between the average annual principal amount of the outstanding
Advances under the Loan and the maximum advance of $5.0 million. The
availability of advances under the Loan is subject to customary conditions.
Subject to the terms of the Loan, we will be required to prepay all amounts
outstanding under the Loan in the event of a change of control of the Company
and we will be required to prepay part or all of the amounts outstanding in the
event we secure other financing or consummate a sale or license of assets, in
each case resulting in net proceeds of $5.0 million or greater.





In
connection with the Loan, the Lender received  a five-year warrant
(the “Initial Warrant Shares”) to purchase up to 272,727 shares of our common
stock at an exercise price of $1.375 per share (representing 7.5% warrant
coverage, or approximately 0.7% of our outstanding common stock), which was
immediately vested upon issuance. The second five-year warrant (the “Additional
Warrant Shares”) to purchase up to an additional 378,788 shares of our common
stock at an exercise price of $1.65 per share (representing up to an additional
12.5% warrant coverage, or approximately 1.0% of our outstanding common stock)
vests at the time that each Advance is made in an amount equal to (i) the
product of the amount of the Additional Warrant Shares multiplied by (ii) a
ratio, (A) the numerator of which shall be the amount of the new Advance and (B)
the denominator of which shall be $5.0 million.





On the
date of issuance, the fair value of the Initial and Additional Warrant Shares
was approximately $221 thousand and $249 thousand, respectively. We defer costs
associated with securing a line-of-credit or revolving loan agreement over the
applicable term. These costs are amortized as debt cost expense in our condensed
consolidated statement of operations. Accordingly, we recorded the $221 thousand
associated with the Initial Warrant Shares as a deferred debt cost asset with a
corresponding amount as additional paid-in capital. The cost will be amortized
on a straight-line basis over the three-year term of the Loan. In the third
quarter of fiscal 2010, we began amortizing the deferred debt cost resulting in
the recognition of $12 thousand as debt cost expense. Upon an Advance of the
Loan, the fair value of the Additional Warrant Shares will be recalculated and
recognized as debt cost expense over the remaining life of the Loan using the
effective interest method.





16


Results
of Operations





Net sales
by market and by category for the three and nine months ended December 31, 2008
have been reclassified to conform to the current year’s
presentation.





Three
months ended December 31, 2009 compared to the three months ended December
31, 2008 (in thousands, except percentages)





Net
Sales





Net sales
decreased $1.0 million, or 28%, in the third quarter of fiscal 2010 to $2.6
million compared to $3.6 million in the third quarter of fiscal 2009. During the
third quarter of fiscal 2010, our medical segment’s net sales of $1.8 million
decreased by $0.9 million, or 34%, primarily attributable to lower sales in the
ENT and TNE market ($1.3 million) and our industrial segment’s net sales of $0.8
million decreased by $0.1 million, or 9%, primarily attributable to lower sales
of our borescopes ($0.1 million) compared to the same period last
year.





In the
medical segment, we track sales of endoscopes and EndoSheath disposables by
market. We also track sales of peripherals and accessories which can be sold to
more than one market. Sales by segment, market, and by category for the three
months ended December 31, 2009 and 2008 were as follows:




Three
      Months EndedDecember
      31,Market/Category
              
              2009
              
              
              2008
              
              
              Difference
              
              
              PercentageENT
      and TNE
              
              $
              550
              
              
              $
              1,894
              
              
              $
              (1,344
              )
              
              
              -71
              %Urology
              
              
              444
              
              
              
              237
              
              
              
              207
              
              
              
              87
              %Bronchoscopy
              
              
              94
              
              
              
              -
              
              
              
              94
              
              
              
              100
              %SpineView
      milestone (1)
              
              
              225
              
              
              
              -
              
              
              
              225
              
              
              
              100
              %Repairs,
      peripherals, and accessories
              
              
              529
              
              
              
              645
              
              
              
              (116
              )
              
              
              -18
              %Total
      medical sales
              
              
              1,842
              
              
              
              2,776
              
              
              
              (934
              )
              
              
              -34
              %Borescopes
              
              
              610
              
              
              
              664
              
              
              
              (54
              )
              
              
              -8
              %Repairs
              
              
              148
              
              
              
              170
              
              
              
              (22
              )
              
              
              -13
              %Total
      industrial sales
              
              
              758
              
              
              
              834
              
              
              
              (76
              )
              
              
              -9
              %Total
    sales
              
              $
              2,600
              
              
              $
              3,610
              
              
              $
              (1,010
              )
              
              
              -28
              %







(1) See
Note 9. Related Party
Transaction.






Medical
Segment







Medical
Segment – ENT and TNE Markets


Sales to
the ENT and TNE markets include both our ENT and TNE endoscopes and EndoSheath
disposables and were as follows:




Three
      Months EndedDecember
      31,ENT/TNE
      market
              
              2009
              
              
              2008
              
              
              Difference
              
              
              PercentageEndoscopes
              
              $
              541
              
              
              $
              1,768
              
              
              $
              (1,227
              )
              
              
              -69
              %Slide-On
      EndoSheaths
              
              
              9
              
              
              
              126
              
              
              
              (117
              )
              
              
              -93
              %Total
      ENT/TNE market
              
              $
              550
              
              
              $
              1,894
              
              
              $
              (1,344
              )
              
              
              -71
              %




Net sales
to the ENT and TNE markets decreased $1.3 million, or 71%, in the third quarter
of fiscal 2010 to $0.6 million compared to $1.9 million in the third quarter of
fiscal 2009. The decrease in net sales was primarily attributable to lower sales
to Medtronic of our fiberscopes and videoscopes ($0.8 million) and digital
processing units, a component of our videoscope product line ($0.2
million).
 17







Medical
Segment – Urology Market





Sales to
the urology market include urology endoscopes and EndoSheath disposables and
were as follows:







Three
      Months EndedDecember
      31,Urology
      market
              
              2009
              
              
              2008
              
              
              Difference
              
              
              PercentageEndoscopes
              
              $
              163
              
              
              $
              36
              
              
              $
              127
              
              
              
              353
              %Slide-On
      EndoSheaths
              
              
              281
              
              
              
              201
              
              
              
              80
              
              
              
              40
              %Total urology market
              
              $
              444
              
              
              $
              237
              
              
              $
              207
              
              
              
              87
              %


Net sales
to the urology market increased $0.2 million, or 87%, in the third quarter of
fiscal 2010 to $0.4 million compared to $0.2 million in the third quarter of
fiscal 2009. The increase in net sales was primarily attributable to higher
sales of our fiberscopes ($0.1 million) and EndoSheath disposables ($0.1
million).





Medical
Segment – Bronchoscopy Market





Sales to
the bronchoscopy market include bronchoscopy endoscopes and EndoSheath
disposables and were as follows:




Three
      Months EndedDecember
      31,Bronchoscopy
      market
              
              2009
              
              
              2008
              
              
              Difference
              
              
              PercentageEndoscopes
              
              $
              74
              
              
              $
              -
              
              
              $
              74
              
              
              
              100
              %Slide-On
      EndoSheaths
              
              
              20
              
              
              
              -
              
              
              
              20
              
              
              
              100
              %Total bronchoscopy
      market
              
              $
              94
              
              
              $
              -
              
              
              $
              94
              
              
              
              100
              %







In the
first quarter of fiscal 2010, we launched our video bronchoscope (an endoscope
that allows detailed viewing of the lungs) and EndoSheath technology for
bronchoscopy to pulmonologists, oncologists, thoracic surgeons, and other
pulmonology-related physicians.




Medical
Segment – SpineView Milestone
  In the
third quarter of fiscal 2010, pursuant to the terms of the Development and
Supply agreement between us and SpineView, Inc., we recorded $0.2 million in
connection with the milestone achievement for delivery of the first working
prototype of the SpineView spinoscope. The milestone revenue related to
non-recurring engineering costs for the development of the spinoscope
prototype.
  Medical
Segment – Repairs, Peripherals, and Accessories







Net sales
of repairs, peripherals, and accessories decreased $0.1 million, or 18%, in the
third quarter of fiscal 2010 to $0.5 million compared to $0.6 million in the
third quarter of fiscal 2009. The decrease was primarily attributable to lower
sales volume of peripherals and accessories for our ENT endoscopes ($0.1
million).




Industrial
Segment







Net sales
of industrial products of $0.8 million decreased $0.1 million, or 9%, in the
third quarter of fiscal 2010 compared to the same period last year. The decrease
was primarily attributable to lower sales of our borescopes ($0.1 million). This
segment’s products are mature, and therefore, we expect future sales to remain
relatively flat.







18


Gross
Profit




Gross
profit, measured as net sales less cost of sales, was as follows:




Three
      Months EndedDecember
      31,Gross
      profit
              
              2009
              
              
              2008
              
              
              Difference
              
              
              PercentageMedical
              
              $
              8
              
              
              $
              431
              
              
              $
              (423
              )
              
              
              -98
              %As
      percentage of sales
              
              
              0
              %
              
              
              16
              %
              
              
              -16
              %Industrial
              
              
              342
              
              
              
              334
              
              
              
              8
              
              
              
              2
              %As
      percentage of sales
              
              
              45
              %
              
              
              40
              %
              
              
              5
              %Total
      gross profit
              
              $
              350
              
              
              $
              765
              
              
              $
              (415
              )
              
              
              -54
              %As
      percentage of sales
              
              
              13
              %
              
              
              21
              %
              
              
              -8
              %




Gross
profit decreased $0.4 million, or 54%, in the third quarter of fiscal 2010 to
$0.4 million, or 13% of net sales, compared to $0.8 million, or 21% of net
sales, in the third quarter of fiscal 2009. In the medical segment, gross profit
decreased $0.4 million, or 98%, in the third quarter of fiscal 2010 compared to
the same period last year. The decrease was primarily due to unfavorable
overhead absorption as result of the lower sales volume ($0.3 million). In the
industrial segment, gross profit increased by a marginal 2% in the third quarter
of fiscal 2010 to $0.3 million compared to the same period last year. The
increase was primarily attributable to manufacturing efficiencies.





Operating
Expenses





Total
operating expenses decreased $0.3 million, or 8%, in the third quarter of fiscal
2010 to $3.6 million compared to $3.9 million in the third quarter of fiscal
2009. Selling, general, and administrative (“SG&A”) expenses increased $0.5
million, or 20%, and research and development (“R&D”) expenses decreased
$0.8 million, or 55%, compared to the same period last year.





Operating
expenses, by segment, were as follows:




Three
      Months EndedDecember
      31,Operating
      expenses
              
              2009
              
              
              2008
              
              
              Difference
              
              
              PercentageSG&AMedical
              
              $
              2,673
              
              
              $
              2,201
              
              
              $
              472
              
              
              
              21
              %Industrial
              
              
              246
              
              
              
              226
              
              
              
              20
              
              
              
              9
              %Total
      SG&A
              
              
              2,919
              
              
              
              2,427
              
              
              
              492
              
              
              
              20
              %R&D
      Medical
              
              
              659
              
              
              
              1,478
              
              
              
              (819
              )
              
              
              -55
              %Total operating
      expenses
              
              $
              3,578
              
              
              $
              3,905
              
              
              $
              (327
              )
              
              
              -8
              %






SG&A
Expenses – Medical Segment





SG&A
expenses in the medical segment increased $0.5 million, or 21%, in the third
quarter of fiscal 2010 primarily attributable to one-time termination costs for
the former Chief Executive Officer (“CEO”) ($0.5 million).





SG&A
Expenses – Industrial Segment





SG&A
expenses in the industrial segment increased by 9% in the third quarter of
fiscal 2010 to $0.2 million primarily due to higher corporate allocations as a
result of the one-time termination costs associated with the former
CEO.





R&D
Expenses





R&D
expenses decreased $0.8 million, or 55%, in the third quarter of fiscal 2010
primarily attributable to reduced spending for our videoscope product line as
this latest product innovation moved from the development stage into production
($0.3 million), lower stock-based compensation ($0.2 million), and the
reclassification of labor and materials associated with the development of the
working spinoscope prototype to cost of goods sold ($0.2 million).





19


Other
Income





Other
income was as follows:




Three
      Months EndedDecember
      31,Other
      (expense) income
              
              2009
              
              
              2008
              
              
              Difference
              
              
              PercentageInterest
      income
              
              $
              14
              
              
              $
              85
              
              
              $
              (71
              )
              
              
              -84
              %Interest
      expense
              
              
              (6
              )
              
              
              -
              
              
              
              (6
              )
              
              
              100
              %Debt
      cost expense
              
              
              (12
              )
              
              
              -
              
              
              
              (12
              )
              
              
              100
              %Other,
      net
              
              
              -
              
              
              
              12
              
              
              
              (12
              )
              
              
              -100
              %Total
      other (expense) income
              
              $
              (4
              )
              
              $
              97
              
              
              $
              (101
              )
              
              
              -104
              %







Interest
Income





Interest
income decreased $71 thousand, or 84%, in the third quarter of fiscal 2010
primarily attributable to lower cash and short-term investments
balances.





Interest
Expense





Interest
expense increased $6 thousand, or 100%, in the third quarter of fiscal 2010
primarily attributable to the availability fee associated with the $5.0 million
revolving loan with the Lender.





Debt
Cost Expense





In the
third quarter of fiscal 2010, we recorded debt cost expense of $12 thousand
associated with the issuance of the Initial Warrant Shares.





Other,
Net





In the
third quarter of fiscal 2009, we recorded other income of $12 thousand related
to the collection of accounts receivable balances that were previously written
off as bad debt.




Net
Loss





Net loss
was as follows:





Three
      Months EndedDecember
      31,Net
      loss
              
              2009
              
              
              2008
              
              
              DifferenceLoss
      before provision for income taxes
              
              $
              (3,232
              )
              
              $
              (3,043
              )
              
              $
              (189
              )Provision
      for income taxes
              
              
              2
              
              
              
              10
              
              
              
              (8
              )Net
      loss from continuing operations
              
              
              (3,234
              )
              
              
              (3,053
              )
              
              
              (181
              )Net
      loss from discontinued operations
              
              
              -
              
              
              
              (10
              )
              
              
              10Net
      loss
              
              $
              (3,234
              )
              
              $
              (3,063
              )
              
              $
              (171
              )






Loss
Before Provision for Income Taxes





Loss
before provision for income taxes increased $0.2 million in the third quarter of
fiscal 2010 to $3.2 million primarily attributable to the lower gross profit of
$0.4 million, which was partially offset by reduced operating expenses of $0.3
million.





Provision
for Income Taxes





We
recorded a provision for state income taxes of $2 thousand and $10 thousand in
the third quarter of fiscal 2010 and 2009, respectively.





Net
Loss from Continuing Operations





Net loss
from continuing operations increased $0.2 million in the third quarter of fiscal
2010 to $3.2 million primarily attributable to the lower gross profit, which was
partially offset by reduced operating expenses.





20


Net Loss from Discontinued
Operations





Operating
results for discontinued operations were as follows:




Three
      Months EndedDecember
      31,Description
              
              2009
              
              
              2008Net
      sales
              
              $
              -
              
              
              $
              82Gross
      margin
              
              
              -
              
              
              
              18
              %Net
      loss from discontinued operations
              
              
              -
              
              
              
              (10
              )


Net
Loss





Net loss
increased $0.2 million in the third quarter of fiscal 2010 to $3.2 million
primarily attributable to the lower gross profit, which was partially offset by
reduced operating expenses.





Nine
months ended December 31, 2009 compared to the nine months ended December
31, 2008 (in thousands, except percentages)





Net
Sales





Net sales
decreased $0.3 million, or 3%, in the first nine months of fiscal 2010 to $8.8
million compared to $9.1 million in the first nine months of fiscal 2009. During
the first nine months of fiscal 2010, our medical segment’s net sales of $6.7
million decreased by $0.2 million, or 3%, primarily attributable to lower sales
in the ENT and TNE market ($1.1 million), partially offset by sales of our video
bronchoscopes ($0.4 million) and our industrial segment’s net sales of $2.1
million decreased by $0.1 million, or 3%, primarily attributable to lower
repairs sales ($0.1 million) compared to the same period last year.





Sales by
segment, market, and by category for the nine months ended December 31, 2009 and
2008 were as follows:




Nine
      Months EndedDecember
      31,Market/Category
              
              2009
              
              
              2008
              
              
              Difference
              
              
              PercentageENT
      and TNE
              
              $
              2,744
              
              
              $
              3,880
              
              
              $
              (1,136
              )
              
              
              -29
              %Urology
              
              
              1,702
              
              
              
              1,543
              
              
              
              159
              
              
              
              10
              %Bronchoscopy
              
              
              426
              
              
              
              -
              
              
              
              426
              
              
              
              100
              %SpineView
      milestone (1)
              
              
              225
              
              
              
              -
              
              
              
              225
              
              
              
              100
              %Repairs,
      peripherals, and accessories
              
              
              1,598
              
              
              
              1,494
              
              
              
              104
              
              
              
              7
              %Total
      medical sales
              
              
              6,695
              
              
              
              6,917
              
              
              
              (222
              )
              
              
              -3
              %Borescopes
              
              
              1,581
              
              
              
              1,569
              
              
              
              12
              
              
              
              1
              %Repairs
              
              
              531
              
              
              
              605
              
              
              
              (74
              )
              
              
              -12
              %Total
      industrial sales
              
              
              2,112
              
              
              
              2,174
              
              
              
              (62
              )
              
              
              -3
              %Total
    sales
              
              $
              8,807
              
              
              $
              9,091
              
              
              $
              (284
              )
              
              
              -3
              %








(1)
See Note 9. Related Party
Transaction.





21


Medical
Segment






Medical
Segment – ENT and TNE Markets


Sales to
the ENT and TNE markets were as follows:




Nine
      Months EndedDecember
      31,ENT/TNE
      market
              
              2009
              
              
              2008
              
              
              Difference
              
              
              PercentageEndoscopes
              
              $
              2,673
              
              
              $
              3,724
              
              
              $
              (1,051
              )
              
              
              -28
              %Slide-On
      EndoSheaths
              
              
              71
              
              
              
              156
              
              
              
              (85
              )
              
              
              -54
              %Total
      ENT/TNE market
              
              $
              2,744
              
              
              $
              3,880
              
              
              $
              (1,136
              )
              
              
              -29
              %




Net sales
to the ENT and TNE markets decreased $1.1 million, or 29%, in the first nine
months of fiscal 2010 to $2.7 million primarily attributable to lower sales to
Medtronic  of our fiberscopes ($0.8 million) and digital processing
units, a component of our videoscope product line ($0.3 million).
  Medical
Segment – Urology Market




Sales to
the urology market were as follows:







Nine
      Months EndedDecember
      31,Urology
      market
              
              2009
              
              
              2008
              
              
              Difference
              
              
              PercentageEndoscopes
              
              $
              711
              
              
              $
              883
              
              
              $
              (172
              )
              
              
              -19
              %Slide-On
      EndoSheaths
              
              
              991
              
              
              
              660
              
              
              
              331
              
              
              
              50
              %Total urology market
              
              $
              1,702
              
              
              $
              1,543
              
              
              $
              159
              
              
              
              10
              %


Net sales
to the urology market increased $0.2 million, or 10%, in the first nine months
of fiscal 2010 to $1.7 million compared to $1.5 million in the first nine months
of fiscal 2009. The first nine months of fiscal 2009 benefited from initial
orders for videoscopes from our then independent sales reps and international
distributors ($0.3 million), which was not repeated in the current fiscal year.
Higher sales of our EndoSheath disposables offset the decrease in net sales of
urology endoscopes ($0.3 million).





Medical
Segment – Bronchoscopy Market





Sales to
the bronchoscopy market were as follows:




Nine
      Months EndedDecember
      31,Bronchoscopy
      market
              
              2009
              
              
              2008
              
              
              Difference
              
              
              PercentageEndoscopes
              
              $
              387
              
              
              $
              -
              
              
              $
              387
              
              
              
              100
              %Slide-On
      EndoSheaths
              
              
              39
              
              
              
              -
              
              
              
              39
              
              
              
              100
              %Total bronchoscopy
      market
              
              $
              426
              
              
              $
              -
              
              
              $
              426
              
              
              
              100
              %







In the
first quarter of fiscal 2010, we launched our video bronchoscope (an endoscope
that allows detailed viewing of the lungs) and EndoSheath technology for
bronchoscopy to pulmonologists, oncologists, thoracic surgeons and other
pulmonology-related physicians.




Medical
Segment – SpineView Milestone
  In the
third quarter of fiscal 2010, we recorded $0.2 million in connection with the
milestone achievement for delivery of the first working prototype of the
SpineView spinoscope. The milestone revenue related to non-recurring engineering
costs for the development of the spinoscope prototype.
  Medical
Segment – Repairs, Peripherals, and Accessories







Net sales
of repairs, peripherals, and accessories increased $0.1 million, or 7%, in the
first months of fiscal 2010 to $1.6 million compared to $1.5 million in the
first nine months of fiscal 2009. The increase was primarily attributable to
higher sales volume of peripherals and accessories for our ENT endoscopes ($0.1
million).


22
 Industrial
Segment







Net sales
of industrial products decreased $0.1 million, or 3%, in the first nine months
of fiscal 2010 to $2.1 million primarily attributable to lower repairs revenue
($0.1 million). This segment’s products are mature, and therefore, we expect
future sales to remain relatively flat.




Gross
Profit




Gross
profit was as follows:




Nine
      Months EndedDecember
      31,Gross
      profit
              
              2009
              
              
              2008
              
              
              Difference
              
              
              PercentageMedical
              
              $
              552
              
              
              $
              802
              
              
              $
              (250
              )
              
              
              -31
              %As
      percentage of sales
              
              
              8
              %
              
              
              12
              %
              
              
              -4
              %Industrial
              
              
              1,051
              
              
              
              837
              
              
              
              214
              
              
              
              26
              %As
      percentage of sales
              
              
              50
              %
              
              
              39
              %
              
              
              11
              %Total
      gross profit
              
              $
              1,603
              
              
              $
              1,639
              
              
              $
              (36
              )
              
              
              -2
              %As
      percentage of sales
              
              
              18
              %
              
              
              18
              %
              
              
              0
              %




Gross
profit remained relatively flat at $1.6 million, or 18% of net sales, for the
first nine months of fiscal 2010 compared to the first nine months of fiscal
2009. In the medical segment, gross profit decreased $0.3 million, or 31%, in
the first nine months of fiscal 2010 compared to the same period last year
primarily attributable to a higher inventory reserve recorded ($0.3 million). In
the industrial segment, gross profit increased $0.2 million, or 26%, in the
first nine months of fiscal 2010 to $1.1 million compared to the same period
last year. The increase was primarily attributable to favorable overhead
absorption ($0.4 million).





Operating
Expenses





Total
operating expenses decreased $1.3 million, or 11%, in the first nine months of
fiscal 2010 to $10.5 million compared to $11.8 million in the first nine months
of fiscal 2009. SG&A expenses increased $0.4 million, or 5%, and R&D
expenses decreased $1.8 million, or 44%, compared to the same period last
year.





Operating
expenses, by segment, were as follows:




Nine
      Months EndedDecember
      31,Operating
      expenses
              
              2009
              
              
              2008
              
              
              Difference
              
              
              PercentageSG&AMedical
              
              $
              7,404
              
              
              $
              7,017
              
              
              $
              387
              
              
              
              6
              %Industrial
              
              
              704
              
              
              
              676
              
              
              
              28
              
              
              
              4
              %Total
      SG&A
              
              
              8,108
              
              
              
              7,693
              
              
              
              415
              
              
              
              5
              %R&D
      Medical
              
              
              2,342
              
              
              
              4,163
              
              
              
              (1,821
              )
              
              
              -44
              %Sub-total operating
      expenses
              
              
              10,450
              
              
              
              11,856
              
              
              
              (1,406
              )
              
              
              -12
              %Restructing
      charge reversal
              
              
              -
              
              
              
              (98
              )
              
              
              98
              
              
              
              100
              %Total operating
      expenses
              
              $
              10,450
              
              
              $
              11,758
              
              
              $
              (1,308
              )
              
              
              -11
              %







SG&A
Expenses – Medical Segment:





SG&A
expenses in the medical segment increased $0.4 million, or 5%, in the first nine
months of fiscal 2010 primarily attributable to one-time termination costs for
the former CEO ($0.5 million).





SG&A
Expenses – Industrial Segment





SG&A
expenses in the industrial segment increased by 4% in the first nine months of
fiscal 2010 to $0.7 million primarily due to higher corporate allocations as a
result of the one-time termination costs associated with the former
CEO.





23


R&D
Expenses





R&D
expenses decreased $1.8 million, or 44%, in the first nine months of fiscal 2010
primarily attributable to reduced spending for our videoscope product line as
this latest product innovation moved from the development stage into production
($0.6 million), lower stock-based compensation ($0.5 million), reduced
consulting expenses ($0.2 million), and the reclassification of labor and
materials associated with the development of the working spinoscope prototype to
cost of goods sold ($0.2 million).





Restructuring
Charge Reversal





In the first nine months of fiscal
2009, we recorded a net adjustment of $98 thousand reducing our restructuring
reserve for severance and other termination costs related to the staff reduction
and relocation of our Natick, MA facility.





Other
Income (Expense)





Other
income (expense) was as follows:




Nine
      Months EndedDecember
      31,Other
      (expense) income
              
              2009
              
              
              2008
              
              
              Difference
              
              
              PercentageInterest
      income
              
              $
              85
              
              
              $
              237
              
              
              $
              (152
              )
              
              
              -64
              %Interest
      expense
              
              
              (52
              )
              
              
              (16
              )
              
              
              (36
              )
              
              
              225
              %Debt
      cost expense
              
              
              (12
              )
              
              
              -
              
              
              
              (12
              )
              
              
              100
              %Gain
      on sale of product line, net of direct costs
              
              
              -
              
              
              
              4,985
              
              
              
              (4,985
              )
              
              
              -100
              %Other,
      net
              
              
              (28
              )
              
              
              36
              
              
              
              (64
              )
              
              
              -178
              %Total
      other (expense) income
              
              $
              (7
              )
              
              $
              5,242
              
              
              $
              (5,249
              )
              
              
              -100
              %







Interest
Income





Interest
income decreased $152 thousand, or 64%, in the first nine months of fiscal 2010
primarily attributable to lower cash and short-term investments
balances.





Interest
Expense





Interest
expense increased $36 thousand, or 225%, in the first nine months of fiscal 2010
primarily attributable to the amortization of interest for our short-term
investments in corporate bonds. We carry these investments at amortized cost in
our condensed consolidated balance sheet.





Debt
Cost Expense





In the
first nine months of fiscal 2010, we recorded debt cost expense of $12 thousand
associated with the issuance of the Initial Warrant Shares.





Gain
on Sale of Product Line, Net of Direct Costs





In the
first nine months of fiscal 2009, we received $5.0 million from Medtronic, of
which $3.0 million was related to the asset purchase agreement and $2.0 million
was in connection with achieving certain milestones related to the transition of
the ENT EndoSheath disposables production from our Natick facility to
Medtronic’s facility in Jacksonville, FL.





Other,
Net





In the
first nine months of fiscal 2010, we recorded a loss on investments of $28
thousand. In the first nine months of fiscal 2009, we recorded other income of
$36 thousand related to the collection of accounts receivable balances that were
previously written off as bad debt.





24


Net
Loss





Net loss
was as follows:





Nine
      Months EndedDecember
      31,Net
      loss
              
              2009
              
              
              2008
              
              
              DifferenceLoss
      before provision for income taxes
              
              $
              (8,854
              )
              
              $
              (4,877
              )
              
              $
              (3,977
              )Provision
      for income taxes
              
              
              18
              
              
              
              19
              
              
              
              (1
              )Net
      loss from continuing operations
              
              
              (8,872
              )
              
              
              (4,896
              )
              
              
              (3,976
              )Net
      loss from discontinued operations
              
              
              -
              
              
              
              (783
              )
              
              
              783Net
      loss
              
              $
              (8,872
              )
              
              $
              (5,679
              )
              
              $
              (3,193
              )






Loss
Before Provision for Income Taxes





Loss
before provision for income taxes increased $4.0 million in the first nine
months of fiscal 2010 to $8.9 million compared to $4.9 million in the first nine
months of fiscal 2009. The higher loss was primarily attributable to the net
gain on sale of product line of $5.0 million recognized in the first nine months
of fiscal 2009, partially offset by reduced R&D expenses of $1.8 million in
the first nine months of fiscal 2010.





Provision
for Income Taxes





Provision
for income taxes decreased $1 thousand in the first nine months of fiscal 2010
to $18 thousand compared to $19 thousand in the first nine months of fiscal
2009.





Net
Loss from Continuing Operations





Net loss
from continuing operations increased $4.0 million in the first nine months of
fiscal 2010 to $8.9 million compared to $4.9 million in the first nine months of
fiscal 2009. The higher loss was primarily attributable to the net gain on sale
of product line recognized in the first nine months of fiscal 2009, partially
offset by reduced R&D expenses in the first nine months of fiscal
2010.





Net Loss from Discontinued
Operations





Operating
results for discontinued operations were as follows:




Nine
      Months EndedDecember
      31,Description
              
              2009
              
              
              2008Net
      sales
              
              $
              -
              
              
              $
              583Gross
      margin
              
              
              -
              
              
              
              20
              %Net
      loss from discontinued operations
              
              
              -
              
              
              
              (783
              )







Net
Loss





Net loss
increased $3.2 million in the first nine months of fiscal 2010 to $8.9 million
compared to $5.7 million in the first nine months of fiscal 2009. The higher
loss was primarily attributable to the net gain on sale of product line
recognized in the first nine months of fiscal 2009, partially offset by reduced
R&D expenses in the first nine months of fiscal 2010.





Liquidity
and Capital Resources





At
December 31, 2009, our principal source of liquidity was working capital of
approximately $6.8 million, including $2.5 million in cash and short-term
investments. Our cash and cash equivalents decreased $1.6 million during the
first nine months of fiscal 2010 as compared to $9.1 million in the first nine
months of fiscal 2009. The lower decrease was primarily attributable to lower
net cash used in operating activities ($7.0 million).





In the
first nine months of fiscal 2010, we used $6.7 million of net cash in our
operating activities compared to $13.7 million in the first nine months of
fiscal 2009. The lower cash used in operations was primarily attributable to
favorable changes in inventories ($2.9 million), accounts receivable ($1.8
million), and accrued expenses ($0.8 million).





25


In the
first nine months of fiscal 2010, we provided $5.1 million of net cash from our
investing activities compared to $3.1 million in the first nine months of fiscal
2009. The increase was primarily attributable to lower purchases of short-term
investments ($13.0 million), partially offset by reduced proceeds yielded from
sales and maturities of our short-term investments ($5.7 million).





In the
first nine months of fiscal 2010, we provided $12 thousand of net cash from our
financing activities compared to $1.5 million in the first nine months of fiscal
2009. The decrease was primarily attributable to lower proceeds from the
exercise of stock options ($1.5 million).





We have
incurred losses since our inception, and losses are expected to continue through
at least fiscal years 2010 and 2011. We have funded the losses principally with
proceeds from operations, proceeds from public and private equity financings,
payments from Medtronic related to the sale of certain assets related to our ENT
EndoSheath technology business, and the sale of other assets. We believe that
our cash, short-term investments, and capital available under the $5.0 million
revolving loan agreement with the Lender will be sufficient to fund our working
capital, capital expenditures, and future operating losses until December 31,
2010. However, if our performance expectations fall short (including regaining
sales or profits generated from Medtronic) or our expenses exceed expectations,
we will need to either secure additional financing or reduce expenses or a
combination thereof, and in such instance, the failure to do so would have a
material adverse impact on our financial condition. There can be no assurance
that any contemplated external financing will be available on terms acceptable
to us, if at all.





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





Subsequent
Event





On
February 11, 2010, we announced that Medtronic will no longer serve as the
distributor for our ENT endoscopes. Medtronic and we have agreed to a transition
period through April 1, 2010 during which time we will continue to support the
Medtronic sales force and Medtronic will assist us in transitioning Medtronic’s
customer service needs directly to us, among other items. After April 1, 2010,
we will sell our ENT endoscopes through our direct sales force in the U.S. and
through distributors internationally.





Item 3.  Quantitative
and Qualitative Disclosures About Market Risk





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





Item 4.  Controls
and Procedures





Disclosure
Controls and Procedures





We have
evaluated, under the supervision and with the participation of our senior
management, including our Interim Chief Executive Officer (“Interim CEO”) and
Chief Financial Officer (“CFO”), the effectiveness of the design and operation
of our disclosure controls and procedures as of December 31, 2009. Based upon
the foregoing, our Interim CEO and CFO concluded that our disclosure controls
and procedures were effective as of December 31, 2009.





Changes
      in Internal Controls Over Financial
Reporting





There
have been no changes in our internal controls over financial reporting during
the three months ended December 31, 2009 that have materially affected, or are
reasonably likely to materially affect our internal controls over financial
reporting.





26




PART
II—OTHER INFORMATION





Item 1.  Legal
Proceedings




None




Item 1A.  Risk
Factors




There
have been no material changes from the information discussed in Part I, Item 1A.
Risk Factors, on page 22 of our Annual Report on Form 10-K for the year ended
March 31, 2009, except for the
information discussed below. You should carefully consider the risks and
uncertainties we discussed in our Form 10-K and the risks described below in
this quarterly report before deciding to invest in, or retain, shares of our
common stock. These are not the only risks and uncertainties that we face.
Additional risks and uncertainties that we do not currently know about or that
we currently believe are immaterial, or that we have not predicted, may also
harm our business operations or adversely affect us. If any of these risks or
uncertainties actually occurs, our business, financial condition, operating
results, or liquidity could be materially harmed.





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





We have
incurred substantial operating losses since our inception and there can be no
assurance that we will achieve a profitable level of operations in the future.
We anticipate a negative cash flow during fiscal years 2010 and 2011, because of
spending for research and development, increasing our global network of
independent sales representatives and distributors, investing in a direct sales
force for the North American market, general business operations, and capital
expenditures. As of December 31, 2009, we had cash and cash equivalents,
including short-term investments, totaling approximately $2.5 million. We expect
that our current balance of cash, short-term investments, and capital available
under the $5.0 million revolving loan agreement with the Lender will be
sufficient to fund our operations until December 31, 2010.  However,
if our performance expectations fall short (including regaining sales or profits
generated from Medtronic) or our expenses increase, we will need to either
secure additional financing or reduce expenses or a combination thereof, and in
such instance, the failure to do so would have a material adverse impact on our
financial condition.  There can be no assurance that any contemplated
external financing will be available on terms acceptable to us, if at
all.





Our
failure to maintain our relationships with our key distributors on acceptable
terms would have a material adverse effect on our results of operations and
financial condition





We have
no assurance that any distributor will continue to purchase our products at the
same levels as in prior years, will purchase our new products (such as our
videoscopes), or that such relationship will continue on favorable terms, if at
all. For our ENT sales to the ENT market, we have depended on a single,
worldwide distributor, Medtronic. In the first nine months of fiscal 2010,
Medtronic accounted for 43% of our total sales and 56% of our medical segment’s
sales. Our exclusive distribution agreement with Medtronic expired and on
February 11, 2010, we announced that Medtronic will no longer serve as the
distributor of our ENT endoscopes.  Medtronic and we have agreed to a
transition period through April 1, 2010 during which time we will continue to
support the Medtronic sales force and Medtronic will assist us in transitioning
Medtronic’s customer service needs directly to us, among other items. After
April 1, 2010, we will sell our ENT endoscopes through our direct sales force in
the U.S. and through distributors internationally. We believe that through our
direct sales force and other distributors, we will be able to replace ENT
endoscope sales lost due to the end of our distribution arrangement with
Medtronic. There can be no assurance, however, that we will be able to generate
ENT endoscope sales or profits at the same levels as generated through
Medtronic. Unless and until we regain such sales or profits derived from such
sales, the end of our distribution arrangement with Medtronic will have a
material adverse effect on our business and financial condition. For our
industrial segment sales, we rely on a worldwide network of independent
distributors. There is no assurance that we will succeed in expanding our
distribution network in the short-term.





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




N/A




Item 3.  Defaults
Upon Senior Securities




N/A




Item 4.  Submission
of Matters to a Vote of Stockholders




N/A





Item 5.  Other
Information





N/A




27


Item 6.  Exhibits





Exhibits10.47
            
            Separation
      and Release Agreement between Ron Hadani and the Company, dated November
      9, 2009.31.1
            
            Certifications
      of Interim Chief Executive Officer pursuant to Section 302 of the
      Sarbanes-Oxley Act of 2002.31.2
            
            Certifications
      of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley
      Act of 2002.32
            
            Certification
      of Interim Chief Executive Officer and Chief Financial Officer pursuant to
      Section 906 of the Sarbanes Oxley Act of
  2002.








28


SIGNATURES




Pursuant
to the requirements of the Securities Exchange Act of 1934, the Registrant has
duly caused this report to be signed on its behalf by the undersigned thereunto
duly authorized.




VISION-SCIENCES, INC.Date:
      February 11, 2010
            /s/
      Warren Bielke
              Warren
      Bielke
              Interim
      Chief Executive Officer (Duly Authorized Officer)Date:
      February 11, 2010
            /s/
      Katherine L. Wolf
              Katherine
      L. Wolf
              Chief
      Financial Officer
              (Principal
      Financial Officer and
              Principal
      Accounting Officer)







29




VISION-SCIENCES, INC.





EXHIBIT
INDEX








Exhibit
            Description of
      Exhibit





10.44(1)
            Loan
      Agreement between Lewis C. Pell and the Company, dated November 9,
      2009.


10.45(1)
            Common
      Stock Warrants of the Company issued to Lewis C. Pell, dated November 9,
      2009.


10.46(1)
            Employment
      Agreement between Warren Bielke and the Company, dated November 9,
      2009.


10.47
            Separation
      and Release Agreement between Ron Hadani and the Company, dated November
      9, 2009.


31.1
            Certifications
      of Interim Chief Executive Officer pursuant to Section 302 of the
      Sarbanes-Oxley Act of 2002.


31.2
            Certifications
      of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley
      Act of 2002.


32
            Certification
      of Interim Chief Executive Officer and Chief Financial Officer pursuant to
      Section 906 of the Sarbanes-Oxley Act of
2002.





(1)
            Incorporated
      by reference to the Quarterly Report on Form 10-Q filed for the quarter
      ended September 30, 2009.