Table of Contents

 

 

 

**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON, D. C. 20459**

 

**FORM 10-Q**

 

**(Mark One)**

 
| x                                                                                                                                                                                     | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|---------------------------------------------------------------------------------------------------------------|
| ** **                                                                                                                                                                            |
| **For the quarterly period ended September 30, 2008**                                                                                                                            |
| ** **                                                                                                                                                                            | ** **                                                                                                    |
| **Or**                                                                                                                                                                                |
| ** **                                                                                                                                                                            | ** **                                                                                                    |
| o                                                                                                                                                                                     | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| ** **                                                                                                                                                                            | ** **                                                                                                    |
| **For the transition period from              to           ** |

 

**COMMISSION FILE NUMBER 0-20970**

 

**VISION-SCIENCES, INC.**

(Exact name ofregistrant as specified in its charter)

 

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

 

**(845) 365-0600**

(Registrant’stelephone number, including area code)

 

**None**

(Former name,former address, and

former fiscalyear if changed since last report)

 

Indicate by check mark whether the registrant (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorterperiod that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirement for the past 90 days.

 

Yes x    No o

 

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

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

 

Indicate by check mark whether the registrant is a shell company (asdefined by Rule 12b-2 of the Exchange Act).

 

Yes o  No x

 

Indicate the number of shares outstanding of each of the issuer’sclasses of common stock, as of November 11, 2008

 
| **Common  Stock, par value of $.01** | ** ** | **36,734,632**     |
|--------------------------------------|------------|--------------------|
| (Title of Class)                     |       | (Number of Shares) |

 

 

 

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Table of Contents

 

**VISION-SCIENCES, INC.**

**TABLE OF CONTENTS**

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

 

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**PART I—FINANCIAL INFORMATION**

**Item 1: Financial Statements**

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

**CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                                                               | ** ** | **September 30,** | ** **     | **March 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|----------------|--------------------|------------|
| ** **                                                                                                                                                               | ** ** | **2008**               | ** **     | **2008**           | ** ** |
| ** **                                                                                                                                                               | ** ** | **(unaudited)**        | ** **     | ** **         | ** ** |
| **ASSETS**                                                                                                                                                               |       |                   |           |               |       |
| **Current assets:**                                                                                                                                                      |       |                   |           |               |       |
| Cash and cash equivalents                                                                                                                                                |       | $                      | 604,339        |               | $          | 10,655,033 |   |
| Short term investments                                                                                                                                                   |       | 13,638,207             |           | 8,062,418          |       |
| Accounts receivable, net of allowance for  doubtful accounts of $242,507 and $162,800, respectively                                                                      |       | 1,875,479              |           | 1,092,460          |       |
| Inventories, net                                                                                                                                                         |       | 6,601,913              |           | 4,021,077          |       |
| Prepaid expenses and deposits                                                                                                                                            |       | 342,570                |           | 446,682            |       |
| **Total current assets**                                                                                                                                                 | ** ** | **23,062,508**         | ** **     | **24,277,670**     | ** ** |
|                                                                                                                                                                     |       |                   |           |               |       |
| **Property and equipment, at cost:**                                                                                                                                     |       |                   |           |               |       |
| Machinery and equipment                                                                                                                                                  |       | 5,090,291              |           | 5,073,701          |       |
| Furniture and fixtures                                                                                                                                                   |       | 796,139                |           | 390,586            |       |
| Leasehold improvements                                                                                                                                                   |       | 594,953                |           | 594,953            |       |
|                                                                                                                                                                     |       | 6,481,383              |           | 6,059,240          |       |
| Less—Accumulated depreciation and  amortization                                                                                                                     |       | 4,488,406              |           | 4,282,783          |       |
| **Total property and equipment, net**                                                                                                                                    | ** ** | **1,992,977**          | ** **     | **1,776,457**      | ** ** |
| Other assets, net of accumulated  amortization of $94,639 and $72,200, respectively                                                                                      |       | 26,260                 |           | 363,225            |       |
|                                                                                                                                                                     |       |                   |           |               |       |
| **Total assets**                                                                                                                                                         | ** ** | **$**                  | **25,081,745** | ** **         | **$**      | **26,417,352** | ** ** |
|                                                                                                                                                                     |       |                   |           |               |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                           | ** ** | ** **             | ** **     | ** **         | ** ** |
| **Current liabilities:**                                                                                                                                                 |       |                   |           |               |       |
| Capital lease obligations                                                                                                                                                |       | $                      | 28,996         |               | $          | 56,810 |   |
| Accounts payable                                                                                                                                                         |       | 895,307                |           | 1,768,859          |       |
| Accrued expenses                                                                                                                                                         |       | 2,184,514              |           | 2,439,159          |       |
| Total current liabilities                                                                                                                                                |       | 3,108,817              |           | 4,264,828          |       |
| Capital lease obligations, net of current  portion                                                                                                                       |       | 81,083                 |           | 81,083             |       |
| **Total liabilities**                                                                                                                                                    | ** ** | **3,189,900**          | ** **     | **4,345,911**      | ** ** |
|                                                                                                                                                                     |       |                   |           |               |       |
| Commitments and contingencies                                                                                                                                            |       | —                 |           | —             |       |
|                                                                                                                                                                     |       |                   |           |               |       |
| **Stockholders’ equity:**                                                                                                                                           |       |                   |           |               |       |
| Preferred stock, $.01 par value—                                                                                                                                    |       |                   |           |               |       |
| Authorized—5,000,000 shares issued and  outstanding—none                                                                                                       |       | —                 |           | —             |       |
| Common stock, $.01 par value—                                                                                                                                       |       |                   |           |               |       |
| Authorized—50,000,000 shares issued and  outstanding—36,739,599 shares and 35,647,512 shares at September 30,  2008 and March 31, 2008, respectively |       | 367,396                |           | 356,474            |       |
| Additional paid-in capital                                                                                                                                               |       | 79,903,078             |           | 77,477,690         |       |
| Accumulated deficit                                                                                                                                                      |       | (58,378,629            | )              | (55,762,723        | )          |
| **Total stockholders’ equity**                                                                                                                                      | ** ** | **21,891,845**         | ** **     | **22,071,441**     | ** ** |
| **Total liabilities and stockholders’ equity**                                                                                                                      | ** ** | **$**                  | **25,081,745** | ** **         | **$**      | **26,417,352** | ** ** |

 

Seeaccompanying notes to consolidated financial statements.

 

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

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**(Unaudited)**

 
| ** **                                                | ** ** | **Three Months Ended** | ** **     | **Six Months Ended** | ** ** |
|-----------------------------------------------------------|------------|----------------------------------|----------------|--------------------------------|------------|
| ** **                                                | ** ** | **September 30,**           | ** **     | **September 30,**         | ** ** |
| ** **                                                | ** ** | **2008**                         | ** **     | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                                                | ** ** | ** **                       | ** **     | ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Net sales**                                             | ** ** | **$**                            | **3,052,986**  | ** **                     | **$**      | **3,126,962** | ** ** | **$** | **5,981,920** | ** ** | **$** | **5,557,401** | ** ** |
| Cost of sales                                             |       | 2,739,720                        |           | 2,249,134                      |       | 4,979,522 |   | 3,737,346 |   |
| **Gross profit**                                          | ** ** | **313,266**                      | ** **     | **877,828**                    | ** ** | **1,002,398** | ** ** | **1,820,055** | ** ** |
|                                                      |       |                             |           |                           |       |   |   |   |   |
| Selling, general and administrative  expenses             |       | 2,933,532                        |           | 2,001,680                      |       | 5,852,901 |   | 3,748,968 |   |
| Research and development expense                          |       | 1,513,795                        |           | 1,125,381                      |       | 2,684,887 |   | 1,960,654 |   |
| Intangible assets impairment                              |       | 315,000                          |           | —                         |       | 315,000 |   | — |   |
| Reversal of restructuring charge                          |       | (125,600                         | )              | —                         |       | (97,856 | ) | — |   |
| **Loss from operations**                                  | ** ** | **(4,323,461**                   | **)**          | **(2,249,233**                 | **)**      | **(7,752,534** | **)** | **(3,889,567** | **)** |
|                                                      |       |                             |           |                           |       |   |   |   |   |
| Interest income                                           |       | 72,924                           |           | 288,919                        |       | 152,495 |   | 569,112 |   |
| Interest expense                                          |       | (2,022                           | )              | —                         |       | (15,926 | ) | — |   |
| Other income (expense), net                               |       | 23,769                           |           | 586,846                        |       | 23,769 |   | 585,315 |   |
| Gain on sale of product line, net of direct  costs        |       | 1,755,526                        |           | —                         |       | 4,985,411 |   | — |   |
| Loss in equity investment                                 |       | —                           |           | (130,839                       | )          | — |   | (213,094 | ) |
| **Loss before provision for income taxes**                |       | (2,473,264                       | )              | (1,504,307                     | )          | (2,606,785 | ) | (2,948,234 | ) |
| Provision for (recovery of) income taxes                  |       | (190                             | )              | (180,000                       | )          | 9,121 |   | (180,000 | ) |
| **Net Loss**                                              | ** ** | **$**                            | **(2,473,074** | **)**                          | **$**      | **(1,324,307** | **)** | **$** | **(2,615,906** | **)** | **$** | **(2,768,234** | **)** |
| ** **                                                | ** ** | ** **                       | ** **     | ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Basic and diluted net loss per common share**           |       | $                                | (0.07          | )                              | $          | (0.04 | ) | $ | (0.07 | ) | $ | (0.08 | ) |
| **Shares used in computing net loss****per common share** |       | 36,700,766                       |           | 35,253,759                     |       | 36,012,908 |   | 35,251,179 |   |

 

Seeaccompanying notes to consolidated financial statements.

 

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

**CONSOLIDATED STATEMENT OF STOCKHOLDERS’EQUITY**

**(Unaudited)**

 
| ** **                             | ** ** | **Preferred Stock** | ** ** | **Common Stock** | ** ** | **Additional**     | ** **     | ** **         | ** ** | **Total**   | ** ** |
|----------------------------------------|------------|--------------------------|------------|-----------------------|------------|--------------------|----------------|--------------------|------------|-------------|------------|
| ** **                             | ** ** | **Number**               | ** ** | **$0.01**             | ** ** | **Number**         | ** **     | **$0.01**          | ** ** | **Paid-in** | ** ** | **Accumulated** | ** ** | **Stockholders’** | ** ** |
| ** **                             | ** ** | **of Shares**       | ** ** | **Par Value**    | ** ** | **of Shares** | ** **     | **Par Value** | ** ** | **Capital** | ** ** | **Deficit** | ** ** | **Equity** | ** ** |
| **Balance, March 31, 2008**       | ** ** | **5,000,000**            | ** ** | **$**                 | **—** | ** **         | **35,647,512** | ** **         | **$**      | **356,474** | ** ** | **$** | **77,477,690** | ** ** | **$** | **(55,762,723** | **)** | **$** | **22,071,441** | ** ** |
| ** **                             | ** ** | ** **               | ** ** | ** **            | ** ** | ** **         | ** **     | ** **         | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Exercise of stock options and warrants |       | —                   |       | —                |       | 1,092,087          |           | 10,922             |       | 1,579,718   |       | — |   | 1,590,640 |   |
| Stock based compensation expense       |       | —                   |       | —                |       | —             |           | —             |       | 845,670     |       | — |   | 845,670 |   |
| Net loss                               |       | —                   |       | —                |       | —             |           | —             |       | —      |       | (2,615,906 | ) | (2,615,906 | ) |
| **Balance, September 30, 2008**   | ** ** | **5,000,000**            | ** ** | **$**                 | **—** | ** **         | **36,739,599** | ** **         | **$**      | **367,396** | ** ** | **$** | **79,903,078** | ** ** | **$** | **(58,378,629** | **)** | **$** | **21,891,845** | ** ** |

 

See accompanyingnotes to consolidated financial statements.

 

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

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited)**

 
| ** **                                                                   | ** ** | **Six Months Ended**   | ** **     | **Six Months Ended**   | ** ** |
|------------------------------------------------------------------------------|------------|----------------------------------|----------------|----------------------------------|------------|
| ** **                                                                   | ** ** | **September 30, 2008** | ** **     | **September 30, 2007** | ** ** |
| **Cash flows from operating activities:**                                    |       |                             |           |                             |       |
| **Net loss**                                                                 | ** ** | **$**                            | **(2,615,906** | **)**                            | **$**      | **(2,768,234** | **)** |
| Adjustments to reconcile net loss to net  cash used in operating activities: |       |                             |           |                             |       |
| Depreciation and amortization                                                |       | 205,623                          |           | 87,475                           |       |
| Gain on sale of product line                                                 |       | (4,985,411                       | )              | —                           |       |
| Loss in equity investment                                                    |       | —                           |           | 213,094                          |       |
| Stock-based compensation                                                     |       | 845,670                          |           | 390,834                          |       |
| Income taxes recoverable                                                     |       | —                           |           | (180,000                         | )          |
| Intangible assets impairment                                                 |       | 315,000                          |           | —                           |       |
| Changes in assets and liabilities:                                           |       |                             |           |                             |       |
| Accrued interest receivable                                                  |       | (64,628                          | )              | (338,035                         | )          |
| Accounts receivable                                                          |       | (783,019                         | )              | (356,970                         | )          |
| Inventories                                                                  |       | (2,580,836                       | )              | (400,567                         | )          |
| Prepaid expenses and deposits                                                |       | 104,112                          |           | (370,126                         | )          |
| Other Assets                                                                 |       | 21,965                           |           | (12,029                          | )          |
| Accounts payable                                                             |       | (873,553                         | )              | (38,140                          | )          |
| Accrued expenses                                                             |       | (254,644                         | )              | 196,224                          |       |
| Income taxes payable                                                         |       | —                           |           | (549,000                         | )          |
| **Net cash used in operating activities**                                    | ** ** | **(10,665,627**                  | **)**          | **(4,125,474**                   | **)**      |
| **Cash flows from investing activities:**                                    |       |                             |           |                             |       |
| Purchase of short term investments                                           |       | (15,270,287                      | )              | (21,140,900                      | )          |
| Sale of short term investments                                               |       | 9,759,126                        |           | —                           |       |
| Purchase of property and equipment                                           |       | (422,143                         | )              | (597,270                         | )          |
| Net proceeds from sale of product line                                       |       | 4,985,411                        |           | —                           |       |
| Purchase of equity investment                                                |       | —                           |           | (1,000,000                       | )          |
| Advance payment for acquisition                                              |       | —                           |           | (450,000                         | )          |
| **Net cash used in investing activities**                                    | ** ** | **(947,893**                     | **)**          | **(23,188,170**                  | **)**      |
| **Cash Flows from financing activities:**                                    |       |                             |           |                             |       |
| Payments of acceptances payable to a bank                                    |       | —                           |           | (2,794                           | )          |
| Payments on capital leases                                                   |       | (27,814                          | )              | —                           |       |
| Exercise of stock options                                                    |       | 1,590,640                        |           | 15,716                           |       |
| **Net cash provided by financing activities**                                | ** ** | **1,562,826**                    | ** **     | **12,922**                       | ** ** |
| **Net decrease in cash and cash equivalents**                                |       | (10,050,694                      | )              | (27,300,722                      | )          |
| **Cash and cash equivalents, beginning of  period**                          |       | 10,655,033                       |           | 28,955,497                       |       |
| **Cash and cash equivalents, end of period**                                 | ** ** | **$**                            | **604,339**    | ** **                       | **$**      | **1,654,775** | ** ** |
|                                                                         |       |                             |           |                             |       |
| **Supplemental disclosure of cash flow  information:**                       | ** ** | ** **                       | ** **     | ** **                       | ** ** |
| Cash paid during the period for interest                                     |       | $                                | 15,926         |                             | $          | — |   |
| ** **                                                                   | ** ** | ** **                       | ** **     | ** **                       | ** ** |
| Cash paid during the period for income  taxes                                |       | $                                | 9,121          |                             | $          | — | ** ** |

 

Seeaccompanying notes to consolidated financial statements.

 

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

** **

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

** **

**(Unaudited)**

 

**1.****             Basis of Presentation**

 

Vision-Sciences, Inc. and subsidiaries (thecompany or we) have prepared the consolidated financial statements includedherein accordance with generally accepted accounting principles in the UnitedStates of America, without audit, pursuant to the rules and regulations ofthe Securities and Exchange Commission and include, in the opinion ofmanagement, all adjustments that we consider necessary for a fair presentationof such information.  Certain informationand footnote disclosures normally included in financial statements have beencondensed or omitted pursuant to such rules and regulations. We believe,however, that our disclosures are adequate to make the information presentednot misleading. The results for the interim periods presented are notnecessarily indicative of results to be expected for the full fiscal year. Ourfiscal year-end is on March 31 of each year, and is herein referred to asFY 08 and FY 09 (our current fiscal year), respectively. Q2 09 refers tothe period from July 1, 2008 to September 30, 2008, our currentfiscal quarter, and Q2 08 refers to the period from July 1, 2007 to September 30,2007.  These consolidated financialstatements should be read in conjunction with the consolidated financialstatements and the notes thereto, included in our Annual Report on Form 10-Kfor the fiscal year ended March 31, 2008.

 

***All amounts in the financial notes except for share and per-share dataare reported in ($000’s), unless otherwise indicated.***

 

**2.            Summary ofSignificant Accounting Policies**

 

The accompanying consolidated financial statements reflect theapplication of certain accounting policies described below:

 

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

 

b.     *Basic and Diluted Net Income (Loss) per Common Share:*  Basic net income (loss) per share iscalculated by dividing the net income (loss) by the weighted average number ofcommon shares outstanding. For the periods ended September 30, 2008 and September 30,2007, the diluted net loss per common share is the same as basic net loss percommon share, as the inclusion of other shares of stock issuable pursuant tostock options and warrants would be anti-dilutive.

 

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

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

 

Leasehold improvements are amortized over the shorter of theirestimated useful lives or the lease lives.

 

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

 

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

 
| ** **      | ** ** | **September 30, 2008** | ** ** | ** **                   | ** ** |
|-----------------|------------|----------------------------------|------------|------------------------------|------------|
| ** **      | ** ** | **(unaudited)**                  | ** ** | **March 31, 2008** | ** ** |
| Raw materials   |       | $                                | 5,052      |                         | $          | 2,924 |   |
| Work-in-process |       | 228                              |       | 497                          |       |
| Finished goods  |       | 1,322                            |       | 600                          |       |
| ** **      | ** ** | **$**                            | **6,602**  | ** **                   | **$**      | **4,021** | ** ** |

 

Raw materialsinclude components purchased from independent suppliers. Most purchasedcomponents are available from multiple sources, with the exception of severalkey components which are supplied to us by three key suppliers, with whom wehave long term supply agreements. Our long term agreement with one of these keysuppliers, Pentax, was amended in April 2008 and is now due to expire in February 2009,and will not be renewed. Work-in-process and finished goods inventories consistof materials, labor and manufacturing overhead.

 

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

 

g.     *Foreign Currency Transactions:*  We charge to operations all foreign currencyexchange gains or losses in connection with our purchases of products fromforeign vendors. For the periods ended September 30, 2008 and September 30,2007, these amounts were immaterial.

 

h.     *Cash and Cash Equivalents:*  We classify investments with originalmaturities of ninety days or less, consisting of commercial paper and a moneymarket account at a bank, as cash equivalents. Cash equivalents are stated atamortized cost, which approximates market value.

 

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

 
| ** **                                                   | ** ** | **September 30, 2008** | ** ** | ** **                   | ** ** | ** **          | ** ** |
|--------------------------------------------------------------|------------|----------------------------------|------------|------------------------------|------------|---------------------|------------|
| ** **                                                   | ** ** | **(unaudited)**                  | ** ** | **March 31, 2008** | ** ** |
| ** **                                                   | ** ** | **Fair Value**              | ** ** | **Cost**                     | ** ** | **Fair Value** | ** ** | **Cost** | ** ** |
| **Held to maturity less than one year:**                     |       |                             |       |                         |       |                |       |   |   |
| Government securities                                        |       | $                                | 11,094     |                         | $          | 11,191              |       | $ | 6,563 |   | $ | 6,512 |   |
| Commercial paper                                             |       | 2,355                            |       | 2,447                        |       | 1,534               |       | 1,550 |   |
| **Total short term investments including  accrued interest** | ** ** | **$**                            | **13,449** | ** **                   | **$**      | **13,638**          | ** ** | **$** | **8,097** | ** ** | **$** | **8,062** | ** ** |

 

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

 

Compensation costs associated with stock options include: (i) amortizationrelated to the remaining unvested portion of all stock options outstanding at March 31,2006, based on the fair value determined on the grant date in accordance withthe original provisions of SFAS 123, and (ii) amortization related toall stock option awards granted subsequent to March 31, 2006, based uponthe fair value estimated in accordance with SFAS 123R. The compensationexpense for stock-based compensation awards under SFAS 123R is recognizedover the vesting period of the options, and includes an estimate for forfeitures.

 

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In accordance with SFAS 123R and EITF 96-18, we recordedstock-based compensation expense for Q2 09 and Q2 08, respectively, and for thesix months ended September 30, 2008 (YTD 09) and September 30, 2007(YTD 08) respectively, in the following expense categories:

 
| ** ** | ** ** | **(Unaudited)**                  | ** ** |
|------------|------------|----------------------------------|------------|
| ** ** | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
| ** ** | ** ** | **September 30,**           | ** ** | **September 30,** | ** ** |
| ** ** | ** ** | **2008**                         | ** ** | **2007** | ** ** | **2008** | ** ** | **2007** | ** ** |
| COGS       |       | $                                | 58         |   | $ | 17 |   | $ | 71 |   | $ | 30 |   |
| SG&A   |       | 261                              |       | 163 |   | 378 |   | 295 |   |
| R&D    |       | 358                              |       | 40 |   | 397 |   | 66 |   |
| **Total**  | ** ** | **$**                            | **677**    | ** ** | **$** | **220** | ** ** | **$** | **846** | ** ** | **$** | **391** | ** ** |

 

The total compensation expense for the three months ending September 30,2008 include a one-time adjustment of $299, of which $176 represents expensefor fiscal year (FY) 07 and FY 08, representing stock based compensation expense for non-employeesconsultants that should have been calculated and recognized according to EITF 96-18for the period between September 2006 and June 2008. During Q2 09, wediscovered that we had accounted for our non-employees consultants compensationexpenses according to SFAS 123R instead of according to EITF 96-18. Theadjustment impacted COGS by $23, SG&A by $22 and R&D by $254. We reviewedthe impact of these adjustments on the results of operations for FY 07 ($75),FY 08 ($101) and Q1 09 ($123), and found it to be immaterial.

 

At September 30, 2008, total unamortized stock-based compensationwas approximately $3,694. We will expense that amount over periods endingthrough June 30, 2013. We do not expect to realize any tax benefits fromfuture disqualifying dispositions, if any, since we currently have a fullvaluation allowance against our deferred tax asset.

 

In the six months ended September 30, 2008, we granted options topurchase a total of 1,480,958 shares of our common stock to employees,non-employee consultants and directors. The fair value of these optionsmeasured at the option grant date was approximately $3,988, determined usingthe Black-Scholes option-pricing model. This amount is reduced by an estimatedforfeiture rate and is being recorded as an expense over the vesting period. Weused the following assumptions in the Black-Scholes option-pricing model inthat period:

 
| ** **                             | ** ** | **September 30, 2008** | ** ** |
|----------------------------------------|------------|----------------------------------|------------|
| Risk-free interest rate                |       | 3.07                             | %          |
| Expected dividend yield                |       | —                           |       |
| Expected life                          |       | 6.25 years                       |       |
| Expected volatility                    |       | 78                               | %          |
| Weighted average value grant per share |       | $                                | 2.74       |   |
|                                        |            |                                  |            |  |

 

We grant options with vesting periods ranging from immediate to sixyears. We use the simplified method of calculating the expected option term,which averages an award’s weighted average vesting period and its contractualterm. The contractual term of our options is ten years. The risk-free rate isbased upon the daily treasury yield curve for a period approximately equal tothe expected option term. We used historical data to estimate the expectedprice volatility and forfeiture rate. The expected dividend yield is 0%, basedon our history of not paying dividends.

 

k.     *Recently Issued Accounting Standards:*

 

On April 1, 2008, we adopted theprovisions of Financial Accounting Standards Board (FASB) Statement No. 159,*The Fair Value Option for Financial Assetsand Financial Liabilities.* This Statement allows companies the optionto measure eligible financial instruments at fair value. Such election, whichmay be applied on an instrument by instrument basis, is typically irrevocableonce elected. We have elected not to apply the fair value option to any of ourfinancial instruments, except for those expressly required by U.S. GAAP.

 

On April 2008, the FASB issued FASB StaffPosition (FSP) FAS 142-3*, Determinationof the Useful Life of Intangible Assets*. FSP FAS 142-3 amendsthe factors that should be considered in developing renewal or extensionassumptions used to determine the useful life of a recognized intangible assetunder FASB Statement No. 142, *Goodwilland Other Intangible Assets*. FSP FAS 142-3 is effective forfiscal years beginning after December 15, 2008 and early adoption isprohibited. We are currently evaluating the impact of the pending adoption ofFSP FAS 142-3 on our 

 

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consolidatedfinancial statements.

 

In March 2008, the FASB issued SFAS No. 161,Disclosures about Derivative Instruments and Hedging Activities, an amendmentto FASB Statement No. 133 (SFAS 161), which requires additionaldisclosures about the objectives of using derivative instruments, the method bywhich the derivative instruments and related hedged items are accounted forunder FASB Statement No. 133 and its related interpretations, and theeffect of derivative instruments and related hedged items on financialposition, financial performance, and cash flows. SFAS 161 also requiresdisclosure of the fair values of derivative instruments and their gains andlosses in a tabular format. SFAS 161 is effective for financial statementsissued for fiscal years and interim periods beginning after November 15,2008 (which for our company would be on April 1, 2009, our 2010 FiscalYear), with early adoption encouraged. We are currently assessing the impactthat the adoption of SFAS 161 will have on our financial statementdisclosures.

 

In December 2007, the FASB issuedStatement No. 141(R), *BusinessCombinations—A Replacement of FASB Statement No. 141.* Thisstatement significantly changes the principles and requirements for how anacquisition is recognized and measured in a company’s financial statementsincluding the identifiable assets acquired and the liabilities assumed. Thisstatement also provides guidance for recognizing and measuring goodwillacquired in a business combination and required disclosures to enable users ofthe financial statements to evaluate the nature and financial effects of thebusiness combination. This statement is effective prospectively, except forcertain retrospective adjustments to deferred income tax balances, for thecompany beginning on January 1, 2009. We have not yet determined theimpact, if any, the adoption of this statement will have on our financialposition.

 

In December 2007, the FASB issuedStatement No. 160, *NoncontrollingInterests in Consolidated Financial Statements*, *an amendment of ARB No. 51.* Thisstatement significantly changes the financial accounting and reporting ofnoncontrolling (or minority) interests of a subsidiary in consolidatedfinancial statements. For us it would be effective prospectively beginning on January 1,2009. We have not yet determined the impact, if any, the adoption of thisStatement will have on our financial position.

 

**3.****             Stock Option Plans**

 

Our first stock option plan (the 1990 Plan) allowed us to grant keyemployees and non-employee consultants incentive and non-statutory stockoptions at the fair value of the stock on the date of grant. Options becameexercisable at varying dates ranging up to five years from the date of grant.Under the 1990 Plan, our Board of Directors (our Board) had authorized theissuance of options for the purchase of up to 4,375,000 shares of common stock.This plan expired in 2001 and was replaced with the 2000 Plan. The terms of the2000 Plan are substantially the same as the 1990 Plan. Under the 2000 Plan, ourBoard and stockholders authorized the issuance of options for the purchase ofup to 4,500,000 shares of common stock, of which 31,655 shares remain availablefor future grants.

 

In August 2007, our stockholders approved our 2007 Stock IncentivePlan (the 2007 Plan). Under the 2007 Plan, we are authorized to issue optionsfor the purchase of up to 4,000,000 shares of common stock. The terms of the2007 Plan are substantially the same as the 2000 Plan. As of September 30,2008, there remain 1,033,500 shares available for future grants. In the 2007Plan, we grant options to both employees and non-employee consultants, withvesting periods ranging from immediate to six years. For options granted underthe 2007 plan, we have chosen to employ the simplified method of calculatingthe option term, which averages an award’s weighted average vesting period andits contractual term. The contractual term of our options is ten years.

 

On September 30, 2008, the total unamortized stock-basedcompensation for the 1990, 2000 and 2007 plans is approximately $3,694, whichwill be expensed through the period ending June 30, 2013. We do not expectto realize any tax benefits from future disqualifying dispositions, if any,since we currently have a full valuation allowance against our deferred taxassets.

 

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A summary of the stock option activity for employees and non-employeeconsultants under the 1990, 2000 and 2007 plans for the six months period endedSeptember 30, 2008 is as follows:

 
| ** **                              | ** ** | ** **         | ** ** | ** **           | ** ** | ** **                | ** ** | **Weighted Average** | ** ** |
|-----------------------------------------|------------|--------------------|------------|----------------------|------------|---------------------------|------------|---------------------------|------------|
| ** **                              | ** ** | **Number**         | ** ** | **Exercise**         | ** ** | **Weighted Average** | ** ** | **Remaining**             | ** ** |
| ** **                              | ** ** | **of Shares** | ** ** | **Price Range** | ** ** | **Exercise Price**   | ** ** | **Contractual Life** | ** ** |
| **Outstanding March 31, 2008**     |       | 6,130,369          |       | $0.79-$4.30          |       | $                         | 1.49       |                      | 6.25 years |   |
| Granted                                 |       | 1,426,958          |       | 3.62-5.10            |       | 3.91                      |       |                      |       |
| Exercised                               |       | (892,408           | )          | 0 .79-4.00           |       | 1.61                      |       |                      |       |
| Canceled                                |       | (10,000            | )          | 2.05-3.20            |       | 2.91                      |       |                      |       |
| **Outstanding September 30, 2008** |       | 6,654,919          |       | $0.79-$5.10          |       | $                         | 1.98       |                      | 7.43 years |   |
| **Exercisable September 30, 2008** |       | 3,232,315          |       | $0.79-$4.30          |       | $                         | 1.41       |                      | 5.60 years |   |

 

In August 1993, we adopted the 1993 Director Option Plan (the 1993Plan) under which we may grant up to 200,000 non-statutory stock options tonon-employee directors of the company at the fair value of the stock on thedate of grant. Options become exercisable over a four-year period from the dateof grant. We reserved 200,000 shares of common stock for the exercise of stockoptions under the 1993 Plan. We no longer grant options under this plan.

 

In July 2003, we adopted, and our stockholders approved, a 2003Director Option Plan (the 2003 Plan). The terms of the 2003 Plan were similarto the 1993 Plan, and included automatic grants of 4,000 shares to each outsidemember of our Board on the date of the annual meeting of stockholders, so longas such outside director does not hold at that time any outstanding options topurchase common stock under the 1993 Plan, which options are not fullyexercisable. Options granted under the 2003 Plan are fully vested on the dateof grant.

 

During our recent Annual Stockholders Meeting held on August 28,2008, our stockholders approved our Board’s recommendation of new compensationfor our outside directors (the Amended 2003 Plan). The Amended 2003 Planincreased the annual automatic grant to 10,000 options per director per year,and increased the maximum number of options available under the Amended 2003Plan from 200,000 to 450,000. During this Annual Shareholders meeting, 10,000 optionswere granted to each our five outside directors. If the number of outsidedirectors remains unchanged, we would be required to grant options to purchasean aggregate of 50,000 shares in each of August 2009 and August 2010.As of September 30, 2008, there remain 352,000 shares available for futuregrants under the Amended 2003 Plan.

 

A summary of the director option plans activity is as follows:

 
| ** **                              | ** ** | **Number**         | ** ** | **Exercise**         | ** ** | **Weighted Average** | ** ** |
|-----------------------------------------|------------|--------------------|------------|----------------------|------------|---------------------------|------------|
| ** **                              | ** ** | **of Shares** | ** ** | **Price Range** | ** ** | **Exercise Price**   | ** ** |
| **Outstanding March 31, 2008**     |       | 104,000            |       | $1.00-$2.10          |       | $                         | 1.39       |   |
| Granted                                 |       | 54,000             |       | 4.09-4.88            |       | 4.15                      |       |
| Exercised                               |       | —             |       | —               |       | —                    |       |
| Canceled                                |       | (20,000            | )          | 1.50-1.50            |       | 1.50                      |       |
| **Outstanding September 30, 2008** |       | 138,000            |       | $1.00-$4.88          |       | $                         | 2.47       |   |
| **Exercisable September 30, 2008** |       | 138,000            |       | $1.00-$4.88          |       | $                         | 2.47       |   |

 

**4.Segment Information**

 

As of October 1,2007, we operate in three reportable segments: ***medical, industrial, and health services***.

 

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

 

***Our industrialsegment,*** through our wholly-owned subsidiary,Machida, Inc., designs, manufactures and sells borescopes to a variety ofusers, primarily in the aircraft engine-manufacturing and aircraftengine-maintenance industries. A borescope is an instrument that uses opticalfibers for the visual inspection of narrow cavities.

 

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***Our health servicessegment*** is our wholly-owned subsidiary BEST DMSInc., (BEST-DMS) which was established in October 2007. BEST-DMS is aservice-based segment, providing the Bedside Endoscopic Swallowing Test (BEST)to nursing homes, rehabilitation centers, and assisted living facilities.(Please refer to Note 6. Subsequent Events, below).

 

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

 

Our segmentsare described in the following tables:

 
| **Three Months Ended**                   | ** ** | ** **  | ** ** | ** **     | ** ** | ** ** | ** ** | ** **      | ** ** | ** ** | ** ** |
|----------------------------------------------------|------------|-------------|------------|----------------|------------|------------|------------|-----------------|------------|------------|------------|
| **September 30, 2008 (Q2 09)** | ** ** | **Medical** | ** ** | **Industrial** | ** ** | **Health** | ** ** | **Adjustments** | ** ** | **Total**  | ** ** |
| **Sales to external customers**                    | ** ** | **$**       | **2,141**  | ** **     | **$**      | **644**    | ** ** | **$**           | **268**    | ** ** | **$**      | **—** | ** ** | **$** | **3,053** | ** ** |
| Gross Profit                                       |       | (107        | )          | 332            |       | 88         |       | —          |       | 313        |       |
| Operating income (loss)                            |       | (3,833      | )          | 95             |       | (586       | )          | —          |       | (4,324     | )          |
| Other income (expense), net                        |       | 95          |       | —         |       | —     |       | —          |       | 95         |       |
| Depreciation and amortization                      |       | 82          |       | 8              |       | 16         |       | —          |       | 106        |       |
| Stock-based compensation                           |       | 677         |       | —         |       | —     |       | —          |       | 677        |       |
| Expenditures for fixed assets                      |       | 5           |       | —         |       | 4          |       | —          |       | 9          |       |
| Total Assets                                       |       | 26,152      |       | 2,761          |       | 251        |       | (4,082          | )*         | 25,082     |       |
| ** **                                         | ** ** | ** **  | ** ** | ** **     | ** ** | ** ** | ** ** | ** **      | ** ** | ** ** | ** ** |
| **2007 (Q2 08)**                                   |       |        |       |           |       |       |       |            |       |       |       |
| **Sales to external customers**                    | ** ** | **$**       | **2,545**  | ** **     | **$**      | **582**    | ** ** | **$**           | **—** | ** ** | **$**      | **—** | ** ** | **$** | **3,127** | ** ** |
| Gross Profit                                       |       | 430         |       | 448            |       | —     |       | —          |       | 878        |       |
| Operating income (loss)                            |       | (2,253      | )          | 4              |       | —     |       | —          |       | (2,249     | )          |
| Interest income (expense), net                     |       | 287         |       | 2              |       | —     |       | —          |       | 289        |       |
| Depreciation and amortization                      |       | 37          |       | 10             |       | —     |       | —          |       | 47         |       |
| Stock-based compensation                           |       | 256         |       | 3              |       | —     |       | —          |       | 259        |       |
| Expenditures for fixed assets                      |       | 215         |       | 1              |       | —     |       | —          |       | 216        |       |
| **Total assets**                                   | ** ** | **28,794**  | ** ** | **1,454**      | ** ** | **—** | ** ** | **—**      | ** ** | **30,248** | ** ** |

 
| **Six Months Ended**                  | ** ** | ** **  | ** ** | ** **     | ** ** | ** ** | ** ** | ** **      | ** ** | ** ** | ** ** |
|---------------------------------------|------------|-------------|------------|----------------|------------|------------|------------|-----------------|------------|------------|------------|
| **September 30, 2008 (YTD  09)** | ** ** | **Medical** | ** ** | **Industrial** | ** ** | **Health** | ** ** | **Adjustments** | ** ** | **Total**  | ** ** |
| **Sales to external customers**       | ** ** | **$**       | **4,141**  | ** **     | **$**      | **1,340**  | ** ** | **$**           | **501**    | ** ** | **$**      | **—** | ** ** | **$** | **5,982** | ** ** |
| Gross Profit                          |       | 371         |       | 503            |       | 128        |       | —          |       | 1,002      |       |
| Operating income (loss)               |       | (7,032      | )          | 53             |       | (774       | )          | —          |       | (7,753     | )          |
| Other income (expense), net           |       | 160         |       | —         |       | —     |       | —          |       | 160        |       |
| Depreciation and amortization         |       | 163         |       | 17             |       | 25         |       | —          |       | 205        |       |
| Stock-based compensation              |       | 846         |       | —         |       | —     |       | —          |       | 846        |       |
| Expenditures for fixed assets         |       | 398         |       | —         |       | 24         |       | —          |       | 422        |       |
| **Total assets**                      | ** ** | **26,152**  | ** ** | **2,761**      | ** ** | **251**    | ** ** | **(4,082**      | **)***     | **25,082** | ** ** |
| ** **                            | ** ** | ** **  | ** ** | ** **     | ** ** | ** ** | ** ** | ** **      | ** ** | ** ** | ** ** |
| **2007 (YTD 08)**                     |       |        |       |           |       |       |       |            |       |       |       |
| **Sales to external customers**       | ** ** | **$**       | **4,377**  | ** **     | **$**      | **1,180**  | ** ** | **$**           | **—** | ** ** | **$**      | **—** | ** ** | **$** | **5,557** | ** ** |
| Gross Profit                          |       | 1,191       |       | 629            |       | —     |       | —          |       | 1,820      |       |
| Operating income (loss)               |       | (3,907      | )          | 17             |       | —     |       | —          |       | (3,890     | )          |
| Interest income (expense), net        |       | 566         |       | 3              |       | —     |       | —          |       | 569        |       |
| Depreciation and amortization         |       | 68          |       | 19             |       | —     |       | —          |       | 87         |       |
| Stock-based compensation              |       | 385         |       | 6              |       | —     |       | —          |       | 391        |       |
| Loss in equity investments            |       | 213         |       | —         |       | —     |       | —          |       | 213        |       |
| Expenditures for fixed assets         |       | 596         |       | 1              |       | —     |       | —          |       | 597        |       |
| **Total assets**                      | ** ** | **28,794**  | ** ** | **1,454**      | ** ** | **—** | ** ** | **—**      | ** ** | **30,248** | ** ** |

 

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*Adjustments include thefollowing elimination entries:

 
| BEST-DMS purchase    |       | $     | 450       | ** ** |
|---------------------------|------------|-------|-----------|------------|
| Intercompany eliminations |       | 2667  |      |
| Investment in subs        |       | 965   |      |
| **Total**                 | ** ** | **$** | **4,082** | ** ** |

 

**5.****             Acquisitions**

 

**(i)  BEST DMS Inc.**

 

On October 1, 2007, we purchased the assets of Best DysphagiaManagement, Inc., a Florida based speech pathology company, whichspecializes in providing what is referred to as the Bedside EndoscopicSwallowing Test (BEST) to nursing homes, rehabilitation centers and assistedliving settings via our new wholly-owned subsidiary (BEST- DMS). The purchaseprice was $1,500, which was comprised of (a) $450 (the Initial PurchasePrice), paid at the closing, and (b) earn out payments payable over fouryears, in an aggregate amount not to exceed $1,050, based on certain milestones being met.  The Initial PurchasePrice of $450 has been allocated as follows: $135 to fixed assets and $315 tointangible assets. This acquisition was intended to allow us access to newmarkets, including the geriatric market, nursing homes and rehabilitationcenters.  The operating results ofBEST-DMS are included in the operating results as of the acquisition date, andproforma numbers are not presented since this acquisition was immaterial inamount. (For more information, please refer to Note 6. Subsequent Events,below).

 

**(ii)  Minos Medical, Inc.**

 

In April 2007, we executed a definitive investment agreement underwhich we acquired a strategic interest in Minos Medical, Inc. (Minos).Minos is a privately held California-based development-stage medical devicecompany concentrating in the emerging field of N.O.T.E.S. (Natural OrificeTrans-luminal Endoscopic Surgery). N.O.T.E.S. is a new frontier in surgery,focusing on using natural orifices to enter the body to facilitate surgicalprocedures that require no incisions. We invested $1,000 in cash and agreed toexpend $165 in development costs in collaboration with Minos, in order toexploit certain surgical procedures. Our investment amounted to 30% of theoutstanding shares of Minos, and we accounted for this transaction on ourbalance sheet as an equity investment.

 

During FY 08, we recorded our share of equity losses totaling $350, andat March 31, 2008, we wrote off our remaining investment balance of $650due to liquidity issues at Minos. The $165 in development costs was neverincurred. In September 2008, a new investor proposed to invest up to$2,000 in Minos, at a pre-money valuation of $8,000, conditioned on the companywaiving certain rights. Minos repurchased our interest in Minos via a one yearinterest-bearing convertible note (the Note). The Note will automatically convert into a new class of junior preferredMinos common stock at our original purchase price if the Note is not repaid in12 months. No value has been attributable to this note since collectability isuncertain.  In addition, Minos waived ouragreement to invest $165 in development costs as described above. In exchange,we agreed to terminate our shareholder and registration rights agreements, andgave up our board seat, but retained a board observer right.

 

**6.****             Subsequent Events**

 

Since we acquired the assets of Best Dysphasia Management Services, Inc.in October 2007, our management and financial resources were divertedtowards managing and growing the unprofitable health services segment. At therequest of our Board of Directors, we evaluated BEST-DMS for possible sale ordisposal. This evaluation was a result of our desire to focus our attention andfinancial resources on our core business in the medical segment, where we arecurrently launching the videoscope family of products.

 

This evaluation resulted in the sale of the BEST-DMS assets toGhiglieri Winchester Inc., the successor to Best Dysphasia Management Services, Inc.This transaction was signed on November 7, 2008, closed on November 10,2008 and was effective October 28, 2008. We therefore recorded animpairment of $315 for intangible assets. The final proceeds of the asset sale will be recorded in our thirdfiscal quarter, and the health services segment will be discontinued.

 

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

 

**ExecutiveSummary**

 

This Quarterly Report on Form 10-Q contains forward-lookingstatements within the meaning of The Private Securities Litigation Reform Actof 1995, which are subject to various risks and uncertainties that could causeour actual results to differ materially from those expressed or implied in suchstatements. These factors include, but are not limited to: pricing pressures,including cost-containment measures which could adversely affect the price of,or demand for our products; availability of parts on acceptable terms; ourability to design new products and the success of such new products; changes ineconomic conditions that may adversely affect the level of demand for ourproducts; changes in foreign exchange markets; and changes in financial marketsand changes in the competitive environment. Other examples of forward-lookingstatements include statements about expectations about future financialresults, future products and future sales of new and existing products, futureexpenditures, and capital resources to meet anticipated requirements.Generally, words such as expect, believe, anticipate, may, will, plan, intend,estimate, could, and other similar expressions are intended to identifyforward-looking statements. The forward-looking statements are based on ourfuture plans, strategies, projections and predictions and involve risks anduncertainties, and our actual results may differ significantly from thosediscussed in the forward-looking statements. Factors that might cause such adifference could include the availability of capital resources, theavailability of third-party reimbursement, government regulation, theavailability of raw material components, our dependence on certain keydistributors and customers, competition, technological difficulties, generaleconomic conditions and other risks detailed in our most recent Annual Reporton Form 10-K and any subsequent periodic filings we make with theSecurities and Exchange Commission. We do not undertake an obligation to updateour forward-looking statements to reflect future events or circumstances.

 

**Registered Trademarks, Trademarks and ServiceMarks**

 

Vision-Sciences, Inc. and its subsidiaries own the registered trademarksVision Sciences®, Slide-On® and EndoSheath®.

 

Our fiscal year-end is on March 31 of each year, and is referredto herein as FY 08 and FY 09 (our current fiscal year), respectively.  Q2 09 refers to the period from July 1,2008 to September 30, 2008 and Q2 08 refers to the period from July 1,2007 to September 30, 2007.

 

We design, develop, manufacture and market products for endoscopy - thescience of using an instrument, known as an endoscope - to provide minimallyinvasive access to areas not readily visible to the human eye.

 

We were incorporated in Delaware in 1987 under the name MachidaIncorporated (Machida). Since that time, we acquired by merger CyberexCorporation (October 1988), Vascu-Care, Inc. (March 1989), andwe acquired Opielab, Inc. through a share exchange (September 1990).In December 1990, we changed our name to Vision-Sciences, Inc. andMachida became a wholly owned subsidiary. Another of our subsidiaries, VisionSciences Ltd., an Israeli corporation, has been inactive since the fiscalyear ended March 31, 2002.

 

Vision-Sciences primarily operates in the medical segment, whileMachida primarily operates in the industrial segment. In October, 2007 wepurchased the assets of BEST Dysphagia Management Services, Inc., aFlorida based speech pathology company, which specializes in providing what isreferred to as the Bedside Endoscopic Swallowing Test (BEST) to nursing homes,rehabilitation centers and assisted living, facilities, via our newwholly-owned subsidiary BEST DMS Inc. (BEST-DMS). BEST-DMS is our healthservices segment. (For more information, please refer to Item 1, Note 6.Subsequent Events, above).

 

Our principal executive offices are currently located at40 Ramland Road South, Orangeburg, New York 10962. Our telephone number is(845) 365-0600. Our corporate website is *www.visionsciences.com*.Through a link on the Investor Relations section of our website, we makeavailable all our filings as soon as reasonably practicable after they areelectronically filed with or furnished to the Securities and ExchangeCommission (SEC).  All such filings areavailable free of charge.

 

As of October 1, 2008, we operated in three reportable segments: ***medical, industrial, and healthservices***

 

***Our medical segment***designs, manufactures and sells our advanced line of endoscopy products for avariety of specialties, including our state-of-the-art flexible endoscopes, andour Slide-On EndoSheath technology (Sheath or EndoSheath disposable).

 

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Our longstanding primary line of high-quality fiber-based flexibleendoscopes is now augmented with our first generation CCD (charge coupleddevice) based flexible digital video endoscope systems, which were announcedand cleared for sale by the Food & Drug Administration (FDA) in Q3 andQ4 of FY 08. We expect this new high-performance imaging technology platform toredefine our place in the minimally invasive device market. These flexiblevideo endoscopes are unlike conventional endoscopes, and when utilized with theEndoSheath technology, offer a multitude of benefits and advantages to thehealthcare practice.

 

EndoSheath endoscopy, the differentiating term we give to proceduresperformed with our unique technology, consists of a reusable flexible endoscopecombined with a single-use, sterile, protective disposable sheath, which isplaced on to the insertion tube (patient contact area) of the endoscope. Theuse of the EndoSheath technology gives healthcare providers clinical andeconomic advantages, as it allows them to avoid the elaborate high leveldisinfection and sterilization routines required of conventional endoscopes.This design of “always ready” equipment, which allows for a rapid and lesscaustic cleaning process, provides a multitude of benefits such as: lesscapital inventory investment, less service and maintenance costs of capitalequipment, less staff exposure to toxic chemicals, increased patient schedulingflexibility, improved staff productivity and a more practical implementation ofoffice-based endoscopy.

 

We believe EndoSheath technology allows for unprecedented practiceefficiency in a wide array of healthcare settings, from private practices tobusy academic hospitals. In addition, each EndoSheath disposable is a steriledevice, providing patients with a contaminant-free insertion tube for eachprocedure and reducing the risk of cross-contamination from the reuse ofconventional flexible endoscopes, which are difficult to clean and disinfectand cannot be sterilized.

 

We target four main areas for our fiber and video scopes and ourEndoSheath technology: ENT (ear, nose and throat), urology, gastroenterology(GI) and pulmonology. Within the ENT area, we manufacture ENT endoscopes andsell these scopes exclusively to Medtronic. In March 2007 we completed the sale to Medtronic of our ENTEndoSheath product line, which Medtronic now manufactures and distributes alongwith our ENT endoscopes. Our TNE (trans-nasal esophagoscopy) scopes andEndoSheaths sold only to ENT physicians are manufactured by us but marketed anddistributed by Medtronic.  Within theurology area, we manufacture, market and sell our cystoscopes and EndoSheathsto urologists and other uro-gyn related physicians.  Within the GI area, we manufacture, marketand sell our TNE scopes and EndoSheaths to GI physicians and primary care andother physicians with a GI focus as part of their practice.  We will manufacture, market and sell our soonto be introduced bronchoscopes and EndoSheaths to pulmonologists, oncologists,thoracic surgeons and other pulmonology related physicians.

 

***Our industrialsegment,*** through our wholly-owned subsidiary,Machida, Inc., designs, manufactures and sells borescopes to a variety ofusers, primarily in the aircraft engine manufacturing and aircraft enginemaintenance industries. A borescope is an instrument using optical fibers forthe visual inspection of narrow cavities. Our borescopes are used to inspect aircraft engines, casting parts andground turbines, among other items. Machida’s quality line of borescopesincludes a number of advanced standard features normally found only in customdesigned instruments.

 

***Our health servicessegment,*** through our wholly-owned subsidiaryBEST-DMS, is a service-based segment, providing the Bedside EndoscopicSwallowing Test to nursing homes, rehabilitation centers and assisted livingsettings.  (For more information, pleaserefer to Item 1, Note 6. Subsequent Events, above).

 

***Research and Development***

 

During our previous fiscal quarter we released our new family offlexible videoscopes, with a miniature digital camera mounted on the distal, orfar, end of the insertion tube. This videoscope line includes the ENT-5000(ear, nose and throat) videoscope, the TNE-5000 (trans-nasal esophagoscopy)videoscopes and our urology video-based flexible cystoscope, the CST-5000. Weexpect to release our video-based bronchoscope for the pulmonology area beforethe end of this fiscal year.

 

We continue to develop our next generation of improved family ofmedical and industrial fiberscopes, which will no longer have any Pentax parts.We anticipate that we will be able to have completed the development and theFDA approval process for our new line of fiberscopes by the end of this fiscalyear.

 

We are also working on improving our manufacturing processes, which webelieve will result in lower costs to produce our endoscopes and EndoSheaths.We are also at various stages of exploration of opportunities in, anddevelopment of products for use in the medical fields of ENT, urology,gynecology, pulmonology and gastroenterology, among others.

 

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***The MINOS Medical Inc.Investment***

 

In April 2007, we acquired a strategic interest in Minos. Minos isa privately held California-based development-stage medical device companyconcentrating in the emerging field of N.O.T.E.S. (Natural OrificeTrans-luminal Endoscopic Surgery). N.O.T.E.S. is a new frontier in surgery,focusing on using natural orifices to enter the body to facilitate surgicalprocedures that require no incisions. We invested $1,000 in cash and agreed toexpend $165 in development costs in collaboration with Minos, in order toexploit certain surgical procedures. Our investment amounted to 30% of theoutstanding shares of Minos, and we accounted for this transaction on ourbalance sheet as an equity investment.

 

During FY 08, we wrote off our entire investment balance of $1,000 dueto liquidity issues at Minos. The $165 in development costs was never incurred.In September 2008, a new investor proposed to invest up to $2,000 inMinos, at a pre-money valuation of $8,000, conditioned on our waiver of certainrights. Minos repurchased our interest in Minos via a one year interest-bearingconvertible note (the Note).  The Notewill automatically convert into a new class of junior preferred 

 

Minos common stock at our original purchase price if the Note is notrepaid in 12 months. In addition, Minos waived our additional investment of$165 in development costs as described above. In exchange, we agreed toterminate our shareholder and registration rights agreements, and gave up ourboard seat, but retained a board observer right.

 

***Other Developments***

 

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

 

On June 19, 2008 we entered into a Development and SupplyAgreement (the SpineView Agreement), pursuant to which we are to develop andsupply a CCD-based video endoscope to SpineView for use with SpineView’sproducts. SpineView is engaged in the development and manufacture of miniature,minimally invasive, disposable spine surgery devices that include reusableendoscopes for visualization and image guidance.

 

SpineView agreed to pay us $225 for certain non-recurring engineeringcosts, and to reimburse us for up to $40 of our out-of-pocket costs. After thecompletion of certain milestones and delivery of a prototype, SpineView hasagreed to place an initial firm order with us for 50 video endoscopes at apurchase price of $27 per unit (the Initial Order), for a total of $1,350.Following delivery of the Initial Order, SpineView shall submit a forecast forthe following 12 months, of which the first six months will be considereda firm order at a price of $23.5 per video endoscope. Payment for certain ofthese items is subject to the closing of certain of SpineView’s fundraisingactivities. We are also to be the exclusive supplier to SpineView ofvisualization means for use with certain future SpineView products.

 

The initial term of the SpineView Agreement is for four years from thedate of delivery of the Initial Order and will automatically renew forsuccessive one year periods, unless either party gives the other notice of itsintention not to renew.

 

Mr. Lewis C. Pell, the chairman of our board of directors (ourBoard), is the chairman of the SpineView board of directors and an investor inSpineView. Mr. Ron Hadani, our president and chief executive officer and amember of our Board, and Mr. Katsumi Oneda, a member of our Board, arealso investors in SpineView.

 

Our policy with respect to transactions in which any of our directorsor officers may have an interest, requires that such transaction be on terms noless favorable to us than could be obtained from unaffiliated third parties andbe approved by a majority of the uninterested, outside members of the Board.

 

At a Board meeting held on May 29, 2008, the Board reviewed theterms of the final draft of the SpineView Agreement, outside of the presence ofMr. Pell, Mr. Oneda and Mr. Hadani. The remaining (uninterested)members of our Board determined that the SpineView Agreement was fair, properlynegotiated, and would be at least as favorable to us as could have beenobtained from unaffiliated third parties, and accordingly, after discussion, itwas approved.

 

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

 

In March of 2007, we completed the sale to Medtronic of certainassets with respect to our ENT EndoSheath business. As part of the transaction,we granted Medtronic an exclusive, royalty-free worldwide license to certain ofour intellectual property, for use in making and selling EndoSheath productssolely within the field of ENT (otolaryngology).  Additionally, as part of the transaction andunder a separate transition agreement, we transferred our ENT production linesfor the EndoSheath ENT products from our Natick, MA facility to a Medtronicfacility in Jacksonville, FL. Medtronic now distributes, markets and sells ourENT endoscope products worldwide, on a co-branded basis, through Medtronic’sdedicated sales force.

 

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

 

·                  $27,000 waspaid at the closing;

 

·                  $3,000 waspaid in the quarter ending June 30, 2008, representing the portion of thepurchase price that was held back at closing for potential indemnificationclaims and to ensure that we complied with our obligations under the agreementwith Medtronic;

 

·                  $4,000relating to the transition agreement was paid in several installments, based onagreed upon milestones.

 

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

 

**Medtronic Transaction Payments**

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

 

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

 

·                  Upon receiptat the closing of $27,000, we recognized a net gain of $26,097 from thetransaction. This gain reflects the initial payment of $27,000 received at theclosing less the net book value of the assets sold to Medtronic. The effect ofthis was to reduce our basis in the assets sold to Medtronic to zero;

 

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

 

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

 

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

 

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

 

***Critical Accounting Policies and Estimates***

 

Thisdiscussion and analysis of our financial condition and results of operations isbased upon our Consolidated Financial Statements, which have been prepared inaccordance with generally accepted accounting principles (GAAP) in the UnitedStates of America (see the Notes to the Consolidated Financial Statementsincluded elsewhere herein). Certain of our accounting policies require theapplication of judgment in selecting the appropriate assumptions forcalculating financial estimates. By their nature these judgments are subject toan inherent degree of uncertainty. We periodically evaluate the judgments andestimates used for our critical accounting policies to ensure that suchjudgments and estimates are reasonable for our interim and year-end reportingrequirements. These judgments and estimates are based upon our historicalexperience, 

 

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current trends and informationavailable from other sources, as appropriate. If different conditions resultfrom those assumptions used in our judgment, the results could be materiallydifferent from our estimates. Our critical accounting policies include thefollowing:

 

*Revenue Recognition*

 

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

 

*Options Issued*

 

Effective April 1, 2006 we began accounting for compensationexpense related to stock options in accordance with SFAS No. 123 (Revised2004) *Share-Based Payment*(SFAS 123R). Prior to April 1, 2006, the Company accounted for stockoptions according to Accounting Principles Board (APB) Opinion 25, *Accounting for Stock Issued to Employees.* We account for equityinstruments issued to non-employees in accordance with the provisions ofSFAS No. 123R and Emerging Issues Task Force Abstract No. 96-18,*Accounting for Equity Instruments that areIssued to Other than**Employeesfor Acquiring, or in Conjunction with Selling, Goods or Services*(EITF 96-18).

 

In accordance with SFAS 123R and EITF 96-18, we recorded $677 and$220 of stock-based compensation expense for Q2 09 and for Q2 08,respectively, in the following expense categories:

 
| ** ** | ** ** | **(Unaudited)**                  | ** ** |
|------------|------------|----------------------------------|------------|
| ** ** | ** ** | **Three Months Ended** | ** ** |
| ** ** | ** ** | **September 30,**           | ** ** |
| ** ** | ** ** | **2008**                         | ** ** | **2007** | ** ** |
| COGS       |       | $                                | 58         |   | $ | 17 |   |
| SG&A   |       | 261                              |       | 163 |   |
| R&D    |       | 358                              |       | 40 |   |
| Total      |       | $                                | 677        |   | $ | 220 |   |

 

The total of $677 for the three months ending September 30, 2008includes a one-time adjustment of $299, of which $176 represents expense for FY07 and FY 08, representing stock based compensation expense for non-employeesconsultants that should have been calculated and recognized according to EITF96-18 between September 2006 and June 2008. During Q2 09, wediscovered that we have accounted for our non-employees consultantscompensation expenses according to FAS 123R instead of according to EITF 96-18.The adjustment impacted COGS by $23, SG&A by $22 and R&D by $254. Wereviewed the impact of these adjustments on the results of operations for FY 07($75), FY 08 ($101) and Q1 09 ($123), and found it to be immaterial.

 

In accordance with SFAS 123R and EITF 96-18, the company recorded $846and $391 of stock-based compensation expense in the statement of operations forthe six month period ended September 30, 2008 and for the six month periodended September 30, 2007, in the following expense categories:

 

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| ** ** | ** ** | **(Unaudited)**                | ** ** |
|------------|------------|--------------------------------|------------|
| ** ** | ** ** | **Six Months Ended** | ** ** |
| ** ** | ** ** | **September 30,**         | ** ** |
| ** ** | ** ** | **2008**                       | ** ** | **2007** | ** ** |
| COGS       |       | $                              | 71         |   | $ | 30 |   |
| SG&A   |       | 378                            |       | 295 |   |
| R&D    |       | 397                            |       | 66 |   |
| Total      |       | $                              | 846        |   | $ | 391 |   |

 

The total of$846 for the six months ended September 30, 2008 includes a one-time adjustmentof $299, representing stock based compensation expense for non-employeesconsultants that should have been calculated and recognized according to EITF96-18 between September 2006 and June 2008. During Q2 09, we discovered that wehave accounted for our non-employees consultants compensation expensesaccording to FAS 123R instead of according to EITF 96-18. The adjustmentimpacted COGS by $23, SG&A by $22 and R&D by $254.  We reviewed the impact of these adjustmentson the results of operations for FY 07 ($75), FY 08 ($101) and Q1 09 ($123),and found it to be immaterial.

 

At September30, 2008, the total value of unamortized stock based compensation wasapproximately $3,694. We will expense that amount over periods ending throughJune 30, 2013. We do not expect to realize any tax benefits from futuredisqualifying dispositions, if any, since we currently have a full valuationallowance on our deferred tax assets.

 

In the sixmonths ended September 30, 2008, we granted options to purchase a total of1,480,958 shares of our common stock. A total 1,403,500 of these options weregranted from the 2007 Plan and 54,000 of these options were granted from our2003 Plan. The fair value of these options measured at the option grant datewas approximately $3,988, determined using the Black-Scholes option-pricingmodel. This amount is reduced by an estimated forfeiture rate and is beingrecorded as an expense over the vesting period. Our assumptions used in theBlack-Scholes option-pricing model in the period were as follows:

 
| ** **                             | ** ** | **September 30, 2008** | ** ** |
|----------------------------------------|------------|----------------------------------|------------|
| Risk-free interest rate                |       | 3.07                             | %          |
| Expected dividend yield                |       | —                           |       |
| Expected life                          |       | 6.25 years                       |       |
| Expected volatility                    |       | 78                               | %          |
| Weighted average value grant per share |       | $                                | 2.74       |   |
|                                        |            |                                  |            |  |

 

We account for options issued to directors, non-employees, consultantsand employees in accordance with the provisions of SFAS 123R and EITF96-18. We grant options with vesting periods ranging from immediate to sixyears. We use the simplified method of calculating the expected option term,which averages an award’s weighted average vesting period and its contractualterm. The contractual term of our options is ten years. The risk-free rate isbased upon the daily treasury yield curve for a period approximately equal tothe expected option term. We used historical data to estimate the expectedprice volatility and forfeiture rate. The expected dividend yield is 0%, basedon our history of not paying dividends.

 

*Income Taxes*

 

We account for income taxes under the liability method, and deferredtax assets or liabilities are computed based on the differences between thefinancial statement and income tax basis of assets and liabilities as measuredby the enacted tax rates. We have recorded a valuation allowance equal to ournet deferred tax asset due to the uncertainty of realizing the benefit of thisasset.

 

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**Resultsof Operations**

 

***Net Sales***

 

***Three months ended September 30, 2008(Q1 09) compared to the three months ended September 30, 2007 (Q1 08)***

 

Net sales for Q2 09 were $3,053, a decrease of $74, or 2%, compared tosales of $3,127 for Q2 08. During Q2 09 net sales of the medical segmentdecreased by $404, or 16%, from $2,545 to $2,141, and net sales of theindustrial segment increased by $62, or 11%, from $582 to $644. Sales of ournew health services segment contributed $268 to our Q2 09 sales.

 

Sales by segment and category in Q2 09 and Q2 08 were as follows:

 
| ** **                           | ** ** | ** **     | ** ** | ** **     | ** ** | **Increase/**  | ** ** | ** **     | ** ** |
|--------------------------------------|------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|
| **Segment:**                         | ** ** | **Q2 09** | ** ** | **Q2 08** | ** ** | **(Decrease)** | ** ** | **Percentage** | ** ** |
| *Medical*                            |       |           |       |           |       |           |       |           |       |
| Scopes                               |       | $              | 1,626      |           | $          | 1,068          |       | $              | 558        |   | 52 | % |
| EndoSheaths                          |       | 273            |       | 1,213          |       | (940           | )          | (77            | )%         |
| Repairs, Peripherals and Accessories |       | 242            |       | 264            |       | (22            | )          | (8             | )%         |
| Total Medical                        |       | $              | 2,141      |           | $          | 2,545          |       | $              | (404       | ) | (16 | )% |
|                                 |       |           |       |           |       |           |       |           |       |
| *Industrial*                         |       |           |       |           |       |           |       |           |       |
| Borescopes and Accessories           |       | $              | 446        |           | $          | 244            |       | $              | 202        |   | 83 | % |
| Repairs                              |       | 198            |       | 338            |       | (140           | )          | (41            | )%         |
| Total Industrial                     |       | $              | 644        |           | $          | 582            |       | $              | 62         |   | 11 | % |
|                                 |       |           |       |           |       |           |       |           |       |
| *Health Services*                    |       |           |       |           |       |           |       |           |       |
| Total Health Services                |       | $              | 268        |           | $          | —         |       | $              | 268        |   | 100 | % |
|                                 |       |           |       |           |       |           |       |           |       |
| **Total Sales**                      | ** ** | **$**          | **3,053**  | ** **     | **$**      | **3,127**      | ** ** | **$**          | **(74**    | **)** | **(2** | **)%** |

 

*Medical Sales—Scope Products*

 

Net sales to the medical scope market include products used for ENT(including TNE), urology and other markets were as follows:

 
| **Medical Scope Market** | ** ** | **Q2 09** | ** ** | **Q2 08** | ** ** | **Increase** | ** ** | **Percentage** | ** ** |
|------------------------------------|------------|----------------|------------|----------------|------------|--------------|------------|----------------|------------|
| ENT and TNE                        |       | $              | 1,266      |           | $          | 950          |       | $              | 316        |   | 33 | % |
| Urology and Other                  |       | 360            |       | 118            |       | 242          |       | 205            | %          |
| **Total Scopes**                   | ** ** | **$**          | **1,626**  | ** **     | **$**      | **1,068**    | ** ** | **$**          | **558**    | ** ** | **52** | **%** |

 

Overall endoscope sales increased by $558, or 52%, from $1,068 to$1,626, mainly due to more than doubling our sales to the urology market. Salesto our urology and other markets increased by $242, or 205%, from $118 in Q2 08to $360 in Q2 09. In Q2 09, our ENT scope sales increased by $316, or 33%, from$950 to $1,266, compared to Q2 08. The increase in our scope sales this quarterhas partially benefited from the introduction of our videoscope family ofproducts, which sells at higher price points than our fiberscope line.

 

Our ENT scopes are marketed and distributed globally by Medtronic’s ENTdivision, or MENT. As a result of our exclusive ENT distribution agreement withMENT, the success of our ENT endoscope lines depends substantially upon thesuccess of the marketing and sales activities of MENT, over which we havelimited control.

 

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*Medical Sales—EndoSheath Products*

 

Net sales of EndoSheaths include products used for our ENT/TNE, urologyand other markets as follows:

 
| ** **            | ** ** | ** **     | ** ** | ** **     | ** ** | **Increase/**  | ** ** | ** **     | ** ** |
|-----------------------|------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|
| **Products**          | ** ** | **Q2 09** | ** ** | **Q2 08** | ** ** | **(Decrease)** | ** ** | **Percentage** | ** ** |
| ENT and TNE           |       | $              | 25         |           | $          | 1,098          |       | $              | (1,073     | ) | (98 | )% |
| Urology and Other     |       | 248            |       | 115            |       | 133            |       | 116            | %          |
| **Total EndoSheaths** | ** ** | **$**          | **273**    | ** **     | **$**      | **1,213**      | ** ** | **$**          | **(940**   | **)** | **(77** | **)%** |

 

Sales of our ENT and TNE EndoSheaths decreased by $1,073, or 98%in Q2 09, compared to Q2 08, as MENT stopped purchasing sheaths from us in December 2007,because it now manufactures the ENT EndoSheaths as part of its purchase of thisproduct line.

 

The increase in sales of urology and other EndoSheaths of $133, or116%, from $115 in Q2 08 to $248 in Q2 09 is a result of additional scope salesand re-orders from existing users.

 

*Medical Sales—Repairs, Peripherals and Accessories*

 

Revenue from repairs together with sales of peripherals and accessoriesdecreased in Q2 09 by $22, or 8%, from $264 to $242, as compared to Q2 08.

 

*Industrial Segment*

 

Net sales of the industrial segment increased $62, or 11%, from $582 inQ2 08 to $644 in Q2 09. Although sales grew this quarter as compared to thesame quarter last year, future sales in this segment may be negatively impactedby the slowdown in purchases from the airline industry.

 

***Six months ended September 30,2008 (YTD 09) compared to the six months ended September 30, 2007 (YTD 08)***

 

Net sales for the six months ended September 30, 2008, were $5,982,an increase of $425, or 8%, compared to the six month period ended September 30,2007. During YTD 09, net sales of medical segment decreased by $236, or 5%, to$4,141 and net sales of the industrial segment increased $160, or 14% to$1,340.  YTD 09 sales of our healthservices segment were $501.

 

Sales by segment and category were as follows:

 
| ** **                           | ** ** | ** **      | ** ** | ** **      | ** ** | **Increase/**  | ** ** | ** **     | ** ** |
|--------------------------------------|------------|-----------------|------------|-----------------|------------|----------------|------------|----------------|------------|
| **Segment:**                         | ** ** | **YTD 09** | ** ** | **YTD 08** | ** ** | **(Decrease)** | ** ** | **Percentage** | ** ** |
| *Medical*                            |       |            |       |            |       |           |       |           |       |
| Scopes                               |       | $               | 2,803      |            | $          | 1,745          |       | $              | 1,058      |   | 61 | % |
| EndoSheaths                          |       | 489             |       | 2,059           |       | (1,570         | )          | (76            | )%         |
| Repairs, Peripherals and Accessories |       | 849             |       | 573             |       | 276            |       | 48             | %          |
| Total Medical                        |       | $               | 4,141      |            | $          | 4,377          |       | $              | (236       | ) | (5 | )% |
|                                 |       |            |       |            |       |           |       |           |       |
| *Industrial*                         |       |            |       |            |       |           |       |           |       |
| Borescopes and Accessories           |       | $               | 905        |            | $          | 727            |       | $              | 178        |   | 24 | % |
| Repairs, Peripherals and Accessories |       | 435             |       | 453             |       | (18            | )          | (4             | )%         |
| Total Industrial                     |       | $               | 1,340      |            | $          | 1,180          |       | $              | 160        |   | 14 | % |
|                                 |       |            |       |            |       |           |       |           |       |
| *Health Services*                    |       |            |       |            |       |           |       |           |       |
| Total Health Services                |       | $               | 501        |            | $          | —         |       | $              | 501        |   | 100 | % |
|                                 |       |            |       |            |       |           |       |           |       |
| **Total Sales**                      | ** ** | **$**           | **5,982**  | ** **      | **$**      | **5,557**      | ** ** | **$**          | **425**    | ** ** | **8** | **%** |

 

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*MedicalSales-Scope Products*

 

Net sales tothe medical scope market include products for ENT/TNE, urology and other marketsas follows:

 
| **Medical Scope Market** | ** ** | **YTD 09** | ** ** | **YTD 08** | ** ** | **Increase/  (Decrease)** | ** ** | **Percentage** | ** ** |
|------------------------------------|------------|-----------------|------------|-----------------|------------|---------------------------|------------|----------------|------------|
| ENT and TNE                        |       | $               | 1,956      |            | $          | 1,526                     |       | $              | 430        |   | 28 | % |
| Urology and Other                  |       | 847             |       | 219             |       | 628                       |       | 287            | %          |
| **Total Scopes**                   | ** ** | **$**           | **2,803**  | ** **      | **$**      | **1,745**                 | ** ** | **$**          | **1,058**  | ** ** | **61** | **%** |

 

The primaryreasons for the increase in revenues of scope products to the medical marketswere: (i) an increase in orders from our exclusive distributor of the ENTproducts, Medtronic, which as of Q2 09, started sales of our videoscope ENTproducts worldwide and (ii) our investment in a dedicated independentsales force and our focus on the urology market has resulted in an increase inrevenues to that market.  As a result ofthe sale of certain assets of our ENT sheath business to Medtronic, the successof our ENT product lines is substantially dependent upon Medtronic’s success inthe marketing and sales over which we have limited control.

 

*MedicalSales-EndoSheath Product*

 

Net sales ofEndoSheaths include products used for the ENT/TNE, urology and other markets asfollows:

 
| ** **            | ** ** | ** **      | ** ** | ** **      | ** ** | **Increase/**  | ** ** | ** **     | ** ** |
|-----------------------|------------|-----------------|------------|-----------------|------------|----------------|------------|----------------|------------|
| **Products**          | ** ** | **YTD 09** | ** ** | **YTD 08** | ** ** | **(Decrease)** | ** ** | **Percentage** | ** ** |
| ENT and TNE           |       | $               | 30         |            | $          | 1,822          |       | $              | (1,792     | ) | (98 | )% |
| Urology and Other     |       | 459             |       | 237             |       | 222            |       | 94             | %          |
| **Total EndoSheaths** | ** ** | **$**           | **489**    | ** **      | **$**      | **2,059**      | ** ** | **$**          | **(1,570** | **)** | **(76** | **)%** |

 

Sales of our ENT and TNE EndoSheaths decreased by $1,792 in YTD09, compared to YTD 08, as Medtronic ceased its purchases from us as of December 2007as a result of purchasing our ENT EndoSheath product line.  Medtronic now manufactures and sells the ENTEndoSheaths as part of this transaction.

 

The increase in sales of urology and other EndoSheaths of $222, or 94%,from $237 in YTD 08 to $459 in YTD 09 is a result of additional scope sales andre-orders from existing users.

 

***Gross Profit***

 

***Three months ended September 30, 2008(Q2 09) compared to the three months ended September 30, 2007 (Q2 08)***

 

Gross profit of $313 in Q2 09 decreased by $565 compared to grossprofit of $878 in Q2 08. For the current quarter, gross profit was ($107), $332and $88 for the medical, industrial and health services segments,respectively.  Our gross profit as apercentage of net sales was 10% in Q2 09, vs. 28% in Q2 08. The decrease ingross profit is mainly attributable to startup costs of our videoscope line ofproducts.

 

***Six months ended September 30,2008 (YTD 09) compared to the six months ended September 30, 2007 (YTD 08)***

 

Gross profit of $1002 in YTD 09 decreased by $818 compared to grossprofit of $1,820 in YTD 08.  For YTD 09gross profit was $371, $503 and $128 for the medical, industrial and healthservices segment, respectively.  Ourgross profit as a percentage of net sales was 17% in YTD 09, vs. 33% in YTD08.  The decrease in gross profit ismainly attributable to startup costs of our videoscope line of products.

 

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***Operating Expenses***

*** ***

***Three months ended September 30, 2008(Q2 09) compared to the three months ended September 30, 2007 (Q2 08)***

*** ***

*Selling,General and Administrative Expenses*

* *

Selling,general and administrative (SG&A) expenses in Q2 09 were $2,934, anincrease of $932, or 47%, compared to SG&A expenses of $2,002 in Q2 08.This increase in SG&A expenses is primarily from increases of $468 in salesand marketing expenses due to more trade shows attended, use of consultants,travel and accounting fees, as well as $359 in SG&A expenses in Q2 09 fromthe health services segment which we did not have in Q2 08. The increased levelof expense reflects our commitment to establish our infrastructure to supportour projected future growth.

 

*Researchand Development Expenses*

* *

Researchand development (R&D) expenses in Q2 09 were $1,514, an increase of $389,or 35%, as compared to expenses of $1,125 in Q2 08. This increase resultedprimarily from additional spending for materials, a feasibility study on apotential new product and on additional personnel developing our new lines ofvideoscope and EndoSheath products.

 

*IntangibleAssets Impairment*

* *

Sincewe acquired the assets of Best Dysphasia Management Services, Inc. inOctober 2007, our management and financial resources were diverted towardsmanaging and growing the unprofitable health services segment. At the requestof our Board of Directors, we evaluated BEST-DMS for possible sale or disposal.This evaluation was a result of our desire to focus our attention and financialresources on our core business in the medical segment, where we are currentlylaunching the videoscope family of products.

 

Thisevaluation resulted in the sale of BEST-DMS assets to Ghiglieri WinchesterInc., the successor to Best Dysphasia Management Services, Inc. Thistransaction was signed on November 7, 2008, closed on November 10,2008 and was effective October 28, 2008. We therefore recorded an impairmentof $315 for intangible assets.  The finalproceeds of the asset sale will be recorded in our third quarter, and thehealth services segment will be discontinued. (Please refer to Note 6. Subsequent Events, above).

 

*RestructuringCharge*

 

DuringFY 08 Our Board of Directors decided to consolidate our Natick, MA (Natick)facility and our 40 Ramland Road, Orangeburg, NY facility under one roof, in anew location at One Ramland Road, Orangeburg, NY.

 

InQ4 08, based on SFAS 146, we recognized a liability of $660 for costsassociated with closing down our Natick facility and moving the production ofour EndoSheath products to our One Ramland Road facility. In Q1 09 and Q2 09,we measured this exit activity at fair market value and have updated therestructuring charge by adding an additional $28 and $70, respectively, for atotal of $758.

 

Becauseof a disagreement with the landlord of our new facility at One Ramland Roadregarding increased costs to the company of renovations relating to ourpotential move, there is a delay with the landlord’s renovation of thelocation, a process initially expected to be completed by December 2008.We are working expeditiously to resolve this disagreement.

 

Wealso re-evaluated our plans to close down our Natick facility, and decided thatin order to protect our EndoSheath business we would stay in Natick. We thereforeextended our Natick lease through December 2008.   In order to reduce costs, however, wereduced our Natick staff by approximately 50%. These staff reduction will be effective November 17, 2008. We arecurrently negotiating with the Natick facility landlord to extend our leasebeyond December 2008.

 

Totalprojected expenses for severance and other employee benefits is $358.Accordingly, we have reduced our restructuring charge by $400, from $758 to$358. Out of the $400 reduction, $165 was accrued for Paid Time Off (PTO) forthe remaining employees and $235 was allocated back to SG&A and COGS in ourEndoSheath product line. Overall, we reversed $126 of the restructuring chargein Q2 09.

 

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***Six months ended September 30, 2008 (YTD 09) compared to thesix months ended September 30, 2007 (YTD 08)***

*** ***

*Selling,General and Administrative Expenses*

* *

Selling,general and administrative (SG&A) expenses in YTD 09 were $5,853, anincrease of $2,104, or 56%, compared to SG&A expenses of $3,749 in YTD 08.This increase in SG&A primarily resulted from increases of $1,415 in salesand marketing expenses due to more trade shows attended, travel, consulting,samples and administrative expenses due to legal, accounting fees, investorrelations and computer expenses, as well as $587 in SG&A expenses in YTD 09from the health services segment which we did not have in YTD 08. The increasedlevel of expense reflects our commitment to establish our infrastructure tosupport our projected future accelerated growth.

 

*Researchand Development Expenses*

* *

Researchand development (R&D) expenses in YTD 09 were $2,685, an increase of $724,or 37%, as compared to expenses of $1,961 in YTD 08. This increase resultedprimarily from additional spending for materials, a feasibility study on apotential new product and on additional personnel developing our new lines ofvideoscope and EndoSheath products.

 

*IntangibleAssets Impairment*

* *

Sincewe acquired the assets of Best Dysphasia Management Services, Inc. inOctober 2007, our scarce management and financial resources were divertedtowards managing and growing the unprofitable health services segment. On therequest of our Board of Directors, we evaluated BEST-DMS for possible sale ordisposal. This evaluation was a result of our desire to focus our attention andfinancial resources on our core business in the medical segment, where we arecurrently launching the videoscope family of products.

 

Thisevaluation resulted in the sale of BEST-DMS assets to Ghiglieri WinchesterInc., the successor to Best Dysphasia Management Services, Inc. Thistransaction was signed on November 7, 2008, closed on November 10,2008 and was effective October 28, 2008. We therefore recorded animpairment of $315 for intangible assets. The final proceeds of the asset sale will be recorded in our thirdquarter, and the health services segment will be discontinued.  (Please refer to Note 6. Subsequent Events,above).

 

*RestructuringCharge*

 

DuringFY 08 Our Board of Directors decided to consolidate our Natick facility and our40 Ramland Road, Orangeburg, NY facility under one roof, in a new location atOne Ramland Road, Orangeburg, NY.

 

InQ4 08, based on SFAS 146, we recognized a liability of $660 for costsassociated with closing down our Natick facility and moving the production ofour EndoSheath products to our One Ramland Road facility. In Q1 09 and Q2 09,we measured this exit activity at fair market value and have updated therestructuring charge by adding an additional $28 and $70, respectively, for atotal of $758.

 

Becauseof a disagreement with the landlord of our new facility at One Ramland Roadregarding increased costs to the company of renovations relating to ourpotential move, there is a delay with the landlord’s renovation of thelocation, a process initially expected to be completed by December 2008.We are working expeditiously to resolve this disagreement.

 

Wealso re-evaluated our plans to close down our Natick facility, and decided thatin order to protect our EndoSheath business we would stay in Natick.  We therefore extended our Natick leasethrough December 2008.   In order toreduce costs, however, we reduced our Natick staff by approximately 50%.  These staff reduction will be effectiveNovember 17, 2008. We are currently negotiating with the Natick facilitylandlord to extend our lease beyond December 2008.

 

Totalprojected expenses for severance and other employee benefits is $358.Accordingly, we have reduced our restructuring charge by $400, from $758 to$358. Out of the $400 reduction, $165 was accrued for Paid Time Off (PTO) forthe remaining employees and $235 was allocated back to SG&A and COGS in ourEndoSheath product line. Overall, we reversed $98 of the restructuring chargein YTD 09.

 

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*** ***

***Loss from Operations***

*** ***

***Three months ended September 30, 2008(Q2 09) compared to the three months ended September 30, 2007 (Q2 08)***

*** ***

Loss from operations bysegment was as follows:

 
| **Segment**      | ** ** | **Q2 09** | ** ** | **Q2 08** | ** ** | **Increase/  (Decrease)** | ** ** |
|------------------|------------|----------------|------------|----------------|------------|---------------------------|------------|
| Medical          |       | $              | (3,833     | )              | $          | (2,253                    | )          | $ | (1,580 | ) |
| Industrial       |       | 95             |       | 4              |       | 91                        |       |
| Health  Services |       | (586           | )          | —         |       | (586                      | )          |
| **Total**        | ** ** | **$**          | **(4,324** | **)**          | **$**      | **(2,249**                | **)**      | **$** | **(2,075** | **)** |

 

Inthe medical segment, the increased loss from operations is primarily due to(i) an increase in our COGS, mainly due to startup costs of production forour new videoscope line of products and (ii) increases in our SG&A andR&D expenses, as discussed above. Our total loss from operations had anadditional expense of $586 from our health services segment.

 

***Six months ended September 30, 2008 (YTD 09) compared to thesix months ended September 30, 2007 (YTD 08)***

*** ***

Operating income (loss) bysegment was as follows:

 
| **Segment**      | ** ** | **YTD 09** | ** ** | **YTD 08** | ** ** | **Increase/   (Decrease)** | ** ** |
|------------------|------------|-----------------|------------|-----------------|------------|---------------------------------|------------|
| Medical          |       | $               | (7,032     | )               | $          | (3,907                          | )          | $ | (3,125 | ) |
| Industrial       |       | 53              |       | 17              |       | 36                              |       |
| Health  Services |       | (774            | )          | —          |       | (774                            | )          |
| **Total**        | ** ** | **$**           | **(7,753** | **)**           | **$**      | **(3,890**                      | **)**      | **$** | **(3,863** | **)** |

 

Inthe medical segment, the increased loss from operations is primarily due to(i) an increase in our COGS, mainly due to startup costs of production forour new videoscope line of products and (ii) increases in our SG&A andR&D expenses, as discussed above. Our total loss from operations had an additional expense of $774 for ourhealth services segment.

 

***Liquidity and Capital Resources***

*** ***

AtSeptember 30, 2008 our principal source of liquidity was working capitalof approximately $19,954, including $14,243 in cash and short term investments.

 

Duringthe first 6 months of FY 09 we purchased $15,270 and sold $9,759 of short terminvestments for a net investment of $5,511. Net cash used in operatingactivities of $10,666 included (i) an increase of $2,581 in inventory,mainly for parts and sub assemblies related to the new videoscope productionand for fiberscopes, (ii) an increase of $783 in accounts receivable,mainly due to higher sales volume during the end of the quarter and(iii) a decrease in accounts payable and accrued expenses of $1,128. Inaddition, we recorded $4,985 in net proceeds from the sale of our ENT EndoSheathproduct line to Medtronic.

 

Ourcash and cash equivalents decreased by approximately $10,051 in YTD 09 ascompared to a decrease of $27,301 in YTD 08. The decrease is due to thepurchase of short term investments.

 

Weexpect that our current balance of cash and short term investments will besufficient to fund our operations for at least the next twelve months.

 

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InJanuary 2008, we entered into a $10,000 revolving line of credit agreementwith Merrill Lynch Bank USA (the Bank), pursuant to the terms of a MerrillLynch Loan Management Account Agreement (the Loan Agreement). The LoanAgreement permits us to borrow funds from the Bank from time-to-time at fixed,variable or term rates. The current rate for our borrowing is set at LIBOR plus1.75%. Any outstanding amounts for variable rate borrowings may be repaid atour option at any time without penalty or premium. If we repay a fixed advanceor term advance prior to its scheduled repayment date, we may be required topay a breakage fee to the Bank. The amount of advances available under the LoanAgreement varies from time to time and is based on the value of, and securedby, the securities we maintain with Merrill Lynch, Pierce, Fenner &Smith Incorporated. Under the Loan Agreement, the Bank has the right to demandrepayment, in whole or in part, at any time, of any outstanding amounts. As ofSeptember 30, 2008, we have not requested any advances under the LoanAgreement.

 

Wehave incurred losses since our inception, and losses are expected to continueat least through FY 10. We have funded the losses principally with proceedsfrom operations, proceeds from public and private equity financings, andpayments from Medtronic.

 

DuringFY 09, we expect total spending for property and equipment to be approximately$2,500, including approximately $1,600 for renovation of our new facility inOrangeburg, NY, subject to resolution of our disagreement with the landlord.

 

Weconduct our operations in certain leased facilities. These leases expire onvarious dates through August 31, 2013. In addition, we have operatingleases for certain office equipment. At September 30, 2008, the minimumlease and rent commitments are as follows:

 
| **Fiscal Year** | ** ** | ** ** | ** ** |
|----------------------|------------|------------|------------|
| 2009                 |       | $          | 550        |   |
| 2010                 |       | 786        |       |
| 2011                 |       | 593        |       |
| 2012                 |       | 476        |       |
| 2013                 |       | 269        |       |
| ** **           | ** ** | **$**      | **2,674**  | ** ** |

 

*Notes to the lease commitments table:*

* *

(i)    SFAS 146 indicates that costs associatedwith the termination of a lease contract before the end of its term shall berecognized when the entity terminates the contract or moves out and does notuse the facility.

 

(ii)   The above table includes a new lease for ourcurrent premises in Natick, which started on March 1, 2008 and will expirein December 2008. We are now negotiating to extend this lease.

 

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

 

***Recently Issued Accounting Standards***

*** ***

OnApril 1, 2008, we adopted the provisions of Financial Accounting StandardsBoard (FASB) Statement No. 159, *TheFair Value Option for Financial Assets and Financial Liabilities.*This Statement allows companies the option to measure eligible financialinstruments at fair value. Such election, which may be applied on an instrumentby instrument basis, is typically irrevocable once elected. We have elected notto apply the fair value option to any of our financial instruments except forthose expressly required by U.S. GAAP.

 

On April 2008, the FASB issued FASB StaffPosition (FSP) FAS 142-3*, Determinationof the Useful Life of Intangible Assets*. FSP FAS 142-3 amendsthe factors that should be considered in developing renewal or extensionassumptions used to determine the useful life of a recognized intangible assetunder FASB Statement No. 142, *Goodwilland Other Intangible Assets*. FSP FAS 142-3 is effective forfiscal years beginning after December 15, 2008 and early adoption isprohibited. We are currently evaluating the impact of the pending adoption ofFSP FAS 142-3 on our consolidated financial statements.

 

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InMarch 2008, the FASB issued SFAS No. 161, Disclosures aboutDerivative Instruments and Hedging Activities, an amendment of FASB StatementNo. 133 (SFAS 161), which requires additional disclosures about theobjectives of using derivative instruments, the method by which the derivativeinstruments and related hedged items are accounted for under FASB Statement No. 133and its related interpretations, and the effect of derivative instruments andrelated hedged items on financial position, financial performance, and cashflows. SFAS 161 also requires disclosure of the fair values of derivativeinstruments and their gains and losses in a tabular format. SFAS 161 iseffective for financial statements issued for fiscal years and interim periodsbeginning after November 15, 2008 (which for our company would be onApril 1, 2009, our FY 2010), with early adoption encouraged. We are currentlyassessing the impact that the adoption of SFAS 161 will have on itsfinancial statement disclosures.

 

InDecember 2007, the FASB issued Statement No. 141(R), *Business Combinations—a replacement of FASB StatementNo. 141.* This statement significantly changes the principlesand requirements for how an acquisition is recognized and measured in acompany’s financial statements including the identifiable assets acquired andthe liabilities assumed. This statement also provides guidance for recognizingand measuring goodwill acquired in a business combination and requireddisclosures to enable users of the financial statements to evaluate the natureand financial effects of the business combination. This statement is effectiveprospectively, except for certain retrospective adjustments to deferred incometax balances, for the company beginning on January 1, 2009. We have notyet determined the impact, if any, the adoption of this Statement will have onour financial position.

 

InDecember 2007, the FASB issued Statement No. 160, *Noncontrolling Interests in Consolidated FinancialStatements*, *an amendment of ARBNo. 51.* This Statement significantly changes the financialaccounting and reporting of noncontrolling (or minority) interests of asubsidiary in consolidated financial statements. For our company it would beeffective prospectively beginning on January 1, 2009. We have not yetdetermined the impact, if any, the adoption of this statement will have on thefinancial position of the company.

 

**Item 3.  Quantitativeand Qualitative Disclosures About Market Risk**

** **

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

 

**Item 4.  Controlsand Procedures**

** **

See Item 4T of thisPart I

 

**Item 4T.  Controlsand Procedures**

** **

DisclosureControls and Procedures

 

Wemaintain disclosure controls and procedures that are designed to ensure thatinformation required to be disclosed in our Exchange Act reports are recorded,processed, summarized and reported within the time periods specified in theSEC’s rules and forms, and that such information is accumulated andcommunicated to our management, including our Chief Executive Officer and ChiefFinancial Officer, as appropriate, to allow timely decisions regarding requireddisclosure based on the definition of “disclosure controls and procedures” inRule 13a-15(e). In designing and evaluating the disclosure controls andprocedures, management recognizes that any controls and procedures, no matterhow well designed and operated, can provide only reasonable assurance ofachieving the desired control objectives, and management necessarily isrequired to apply its judgment in evaluating the cost-benefit relationship ofpossible controls and procedures.

 

Wehave evaluated, under the supervision and with the participation of our seniormanagement, including our Chief Executive Officer and Chief Financial Officer,the effectiveness of the design and operation of our disclosure controls andprocedures as of September 30, 2008. Based upon the foregoing, our ChiefExecutive Officer and Chief Financial Officer concluded that our disclosurecontrols and procedures were not effective as of September 30, 2008 due toa lack of adequate resources within the accounting and finance department. Theeffect of the lack of resources has resulted in certain reviews of financialinformation not being performed on a timely basis or at all, leading toadjustments being made after the books and records were closed and reducedresources to complete the company’s review and preparation of an annual reportand Quarterly Reports on Form 10-Q to be filed within the prescribedtimeframe.  To address these lack ofresources, in  March 2008 weretained a new controller, and since then have added two additional senioraccountants and retained an outside certified public accounting firm on aconsulting basis for Sarbanes Oxley compliance. In September 2008 we hireda new CFO and retained our former CFO as an accounting and finance consultant

 

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Changesin Internal Controls Over Financial Reporting

 

Therehave been no changes in our internal controls over financial reporting duringthe quarter ended September 30, 2008 that have materially affected, or arereasonably likely to materially affect our internal controls over financialreporting.

 

**PART II—OTHERINFORMATION**

** **

**Item 1.  LegalProceedings**

** **

None

 

**Item 1A.  RiskFactors**

** **

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

 

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

*** ***

Wehave incurred substantial operating losses since our inception (our net incomein FY 07 resulted from the sale of our ENT EndoSheath product line toMedtronic) and there can be no assurance that we will achieve a profitablelevel of operations in the future. We anticipate a negative cash flow during FY09, because of additional spending for research and development, increasing ourglobal network of independent sales representatives and distributors andinvesting in a small direct sales force, for the urology market, generalbusiness operations and capital expenditures. As of September 30, 2008, wehad cash and cash equivalents including short term investments totaling$14.2 million. Although we do not anticipate the need for additionalfinancing in FY 09, management may seek new financing, if terms are favorable.However, there can be no assurance that such financing will be available onterms acceptable to us, if at all.

 

***Our stock price is volatile, and you maynot be able to sell your shares for a profit***

*** ***

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

 

·                  actualor anticipated variations in quarterly operating results;

 

·                  conditionsor trends in the medical device market;

 

·     announcements by us or our competitors ofsignificant customer wins or loses, gains or losses of distributors,technological innovations, new products or services;

 

·                  addition or departures of key personnel;

 

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

 

·                  adverse litigation;

 

·                  unfavorable legislative or regulatorydecisions;

 

·                  variations in interest rates; and

 

·                  general market conditions.

 

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

 

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

*** ***

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

 

·                  the growth of the market for medical devicesand supplies;

 

·                  our ability to simultaneously develop a newline of fiber-based scopes and expand our videoscope family;

 

·                  increase customer awareness and acceptance ofour products;

 

·                  continued enhancement of our research anddevelopment capabilities;

 

·                  competition from other manufacturers of thesedevices; and

 

·                  competition from other companies that offerthese products, many of which are beyond our control.

 

We may not be able to implement our growth strategy successfully ormanage our expansion effectively.

 

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

 

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

*** ***

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

 

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

*** ***

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

 

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

 

Therecan be no assurance that the required regulatory clearances will be obtained,and those obtained may include significant limitations on the uses of theproduct in question. In addition, changes in existing regulations or theadoption of new regulations could make regulatory compliance by us moredifficult in the future. The failure to obtain the required regulatoryclearances or to comply with applicable regulations may result in fines,delays, suspensions of clearances, seizures,

 

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recalls of products,operating restrictions or criminal prosecutions, and could have a materialadverse effect on our operations.

 

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

 

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

 

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

 

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

 

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

*** ***

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

 

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

 

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

 

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***We currently purchase certaincritical components from several single source manufacturers under varioussupply agreements, and if we are unable or unwilling to obtain components,meeting our specifications in quantities that meet our production needs, ourbusiness will be materially and adversely affected***

 

Inour medical and industrial segments, we purchase certain critical componentsfor the majority of our fiberscopes, and our newly developed videoscopes, fromseveral single source manufacturers. For example, some critical parts for ourexisting line of fiberscopes are purchased solely from a key supplier, Pentax,which is a competitor of ours. These components are being purchased pursuant toa supply agreement now due to expire in February 2009.

 

Asa result of the approaching expiration of our supply agreement with Pentax inFebruary 2008, we are designing a new line of fiberscopes that do not useany parts manufactured by Pentax. We anticipate that we will have completed theredesign and FDA approval process for our new line of fiberscopes by the end ofFY 09. However, there are no assurances that we will be able to complete thisprocess within such timeframe.  If we arenot able to complete the redesign of the fiberscopes within this timeframe, ourresults of operations would be materially and adversely impacted until wecomplete the redesign. Furthermore, as with the fiberscopes produced withPentax parts, certain critical components of our redesigned fiberscopes and ournewly designed videoscopes are available only from one or two suppliers. Aninterruption of supply from one of these suppliers or our inability to obtain asufficient quantity of such critical components on favorable terms couldmaterially adversely affect our business.

 

Inaddition, the success of our new videoscopes will depend in part on our abilityto manufacture these videoscopes in sufficient quantities to meet customerdemand. The failure or inability of one of these key suppliers to meet ourproduction and quality needs could have a material adverse effect on the salesof our new videoscopes, their acceptance into the marketplace and our long termprospects.

 

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

 

***We depend on a small group ofindependent sales representatives and distributors for all of our revenues, anda loss of these sales representatives and distributors may have a materialadverse effect on our business. Although we intend to expand this group andinvest in a small direct sales force, there is no assurance that we will beable to obtain or manage them***

 

Inour medical and industrial segments, we depend on independent salesrepresentatives and distributors of medical devices, supplies, and industrialequipment, respectively, for all of our product sales. In particular, in Q2 09Medtronic accounted for 47% of our sales and 67% of our medical segment sales.We expect that in any given period a relatively small and changing number ofindependent sales representatives or distributors will continue to account forall of our product sales revenues. We do not have long term contracts with ourindependent sales representatives and distributors, but rather typically sellto them on a unit-by-unit basis. We expect this relatively small group, whichmay change from year to year, to generate all of our product sales revenue. Wealso plan to build a small direct sales force. We cannot assure you that anydistributor will continue to purchase our products at the same levels as inprior years, will purchase our new products (such as our videoscopes) or that suchrelationship will continue on favorable terms, if at all.

 

Thereis no assurance that we will succeed in expanding our distribution network inthe short term. As we expand our distribution network, our inability toeffectively manage this larger group may adversely impact our reputation amongend users of our products, interfere with our ability to service existingcustomers and reduce our revenues from product sales.

 

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

 

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

 

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

 

·                  fail to adequately promote our products; or

 

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·                  fail to provide proper service to ourend-users.

 

Failureto adequately manage our distribution network, or the non-compliance of thisnetwork with their obligations under agreements with us could harm our corporateimage among end users of our products and disrupt our sales, resulting in afailure to meet our sales goals. Although we do not have significantly largeoverseas sales, foreign governments have increased their anti-bribery effortsin the healthcare sector to reduce improper payments received by hospitaladministrators and doctors in connection with the purchase of pharmaceuticalproducts and medical devices. To our knowledge, none of our independent salesrepresentatives or distributors engages in corrupt practices. However, ourindependent sales representatives or distributors may violate these laws orotherwise engage in illegal practices with respect to their sales or marketingof our products which would adversely affect our corporate image and business.

 

***Competition in our industry is intense, andmany of our competitors have greater resources than we do***

 

Theflexible endoscopes and related products currently sold and under developmentby us face competition primarily from medical products companies such asOlympus Group, Pentax Imaging Company, KarlStorz GmbH & Co., Stryker Corp, and Gyrus Group PLC. Inaddition, any company that is able to significantly redesign conventionalflexible endoscopes to simplify the cleaning process, or significantly improvethe current methods of cleaning flexible endoscopes, would provide competitionfor our products.

 

Theprincipal competitors for our industrial products are Olympus, GeneralElectric—Inspection Technology and Karl Storz GmbH & Co.Many of our competitors and potential competitors have far greater financialresources, research and development personnel, and manufacturing and marketingcapabilities than we have. Our competitors could utilize their greaterfinancial resources to acquire other companies to gain enhanced namerecognition and market share, as well as to acquire new technologies orproducts that could effectively compete with our product lines. In addition, itis possible that other large health care companies may enter the flexibleendoscope market in the future.

 

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

 

·                  product performance design;

 

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

 

·                  quality of customer support;

 

·                  product pricing;

 

·                  product safety;

 

·                  sales, marketing, and distributioncapabilities;

 

·                  success and timing of new product developmentand introductions; and

 

·                  intellectual property protection.

 

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

 

Wecurrently market and sell our existing videoscopes and fiberscopes for our ENTbusiness through a single distributor, Medtronic, and our other endoscopes andEndoSheaths through other outside distributors and independent salesrepresentatives.  We currently expect tobuild a small internal sales force. We have limited experience in managing alarge sales force for all non-ENT markets and distributor network. We cannotassure you that we will be able to build an internal sales force, maintain aneffective independent sales force or successfully develop our relationshipswith third-party, outside distributors. If we fail to do any one of those, oursales could fail to grow or could even decline, and our ability to grow ourbusiness could be adversely affected. The expansion of our sales force anddistribution network is also likely to require a significant investment offinancial resources and management efforts, and the benefits, if any, which wegain from such expansion, may not be sufficient to generate an adequate returnon our investment.

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

***We may not succeed in sustaining a marketfor our new videoscopes***

 

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

 

·                  successfully promote product awareness of ourvideoscopes;

 

·                  competitively price our videoscopes andadd-on components;

 

·                  develop new applications to expand our familyof videoscopes;

 

·                  select effective distributors; and

 

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

 

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

 

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

 

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

 

·                  our product or technology development will besuccessfully completed;

 

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

 

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

 

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

 

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

 

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

 

***Our operating results could be negativelyimpacted if we are unable to capitalize on research and development spending***

 

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

 

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

 

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

 

·                  changes in customer, geographic, or productmix;

 

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

 

·                  our ability to reduce production costs;

 

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

 

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·                  increases in material or labor costs;

 

·                  changes in shipment volume;

 

·                  loss of cost savings due to changes in componentpricing including the affect of foreign exchange rates for components purchasedoverseas;

 

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

 

·                  changes in distribution channels; and

 

·                  increased warranty costs.

 

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

 

Weproduce highly complex videoscope products that incorporate leading-edgetechnology, including both hardware and software. Software typically containsbugs that can unexpectedly interfere with expected operations. There can be noassurance that our Quality Assurance testing programs will be adequate todetect all defects, either ones in individual products or ones that couldaffect numerous shipments, which might interfere with customer satisfaction,reduce sales opportunities, or affect gross margins. In the past, we have hadto replace certain components and provide remediation in response to thediscovery of defects or bugs in products that we had shipped. Although the costof such remediation has not been material in the past, there can be noassurance that such a remediation, depending on the product involved, would nothave a material impact. An inability to cure a product defect could result inthe failure of a product line, temporary or permanent withdrawal from a productor market, damage to our reputation, inventory costs or product reengineeringexpenses, any of which could have a material impact on our revenue, margins,and net income.

 

***Our costs could substantially increase ifwe experience a significant number of warranty claims***

 

Weprovide 12-month product warranties against technical defects of ourfiberscopes and videoscopes and we offer a lifetime warranty for the LED lightsource on our videoscopes. Our product warranty requires us to repair defectsarising from product design and production process, and if necessary, replacedefective components. Historically, we have received a limited number ofwarranty claims for our fiberscopes, but we introduced a new line ofvideoscopes. The costs associated with our warranty claims have historicallybeen relatively low. Thus, we generally do not accrue a significant liabilitycontingency for potential warranty claims. As we only recently developed ourvideoscope line, we do not currently have historical data on potential warrantyclaims.

 

Ourvideoscope product is technologically superior to our fiberscope product, andwas designed, built and tested against substantially higher benchmarks than ourcurrent fiberscope product line. Although we have insufficient historicalwarranty data to estimate the expected warranty claims from our videoscopeproduct line, we expect that these warranty claims will be less than ourhistorical warranty claims for the fiberscope product line. As ofSeptember 30, 2008, our warranty reserve was at 3.2% of our medical scoperevenue, reflecting our expected future liability from fiberscopes andvideoscopes warranty claims, based on our historical fiberscope warranty claims.

 

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

 

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

 

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

 

Thedevelopment, manufacture, and sale of our products involve a significant riskof product liability claims. We maintain product liability insurance andbelieve that our level of coverage is adequate, given our past sales levels,our anticipated sales

 

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levels for FY 09, and ourclaims experience. We are now evaluating the adequacy of our coverage due toour annual renewal of all our insurance policies.  No product liability claims have been broughtagainst us to date. However, there can be no assurance that product liabilityinsurance will continue to be available to us on acceptable terms, or thatproduct liability claims in excess of our insurance coverage, if any, will notbe successfully asserted against us in the future.

 

***We sell our products in numerous internationalmarkets***

 

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

 

·                  foreign certification and regulatoryrequirements;

 

·                  maintenance of agreements with competentdistributors;

 

·                  import and export controls;

 

·                  currency exchange fluctuation; and

 

·                  political and economic instability.

 

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

 

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

 

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

 

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

 

Currentlywe use several subcontractors in Israel to develop and produce some of ourproducts. Political, economic and military conditions in Israel may directlyaffect our operations, and we could be adversely affected by hostilitiesinvolving Israel, the interruption or curtailment of trade between Israel andits trading partners or a significant downturn in the economic or financialcondition of Israel. Israel frequently has been subject to terrorist activity,with varying levels of severity, and the United States Department of State hasissued an advisory regarding travel to Israel. According to the U.S. Departmentof State’s website, the violence in Iraq and the clashes between Palestiniansand Israelis have the potential to produce demonstrations and unrest throughoutthe region. Also, although it has not yet occurred, the political and securitysituation in Israel may result in certain parties with whom we have contractsclaiming that they are not obligated to perform their commitments pursuant toforce majeure provisions of those contracts.

 

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

 

***Currency exchange rate fluctuations couldadversely affect our operating results***

 

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

 

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

 

***We are exposed to credit risk of some ofour customers***

 

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

 

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

 

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

 

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

 

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

 

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

 

***We may attempt to acquire newproducts or technologies, and if we are unable to successfully complete theseacquisitions or to integrate acquired businesses, products, technologies oremployees, we may fail to realize expected benefits or harm our existingbusiness.***

 

Our success will depend, in part, on our ability toexpand our product offerings and grow our business in response to changingtechnologies, customer demands and competitive pressures. In somecircumstances, we may determine to do so through the acquisition ofcomplementary businesses, products or technologies rather than through internaldevelopment. The identification of suitable acquisition candidates can bedifficult, time consuming and costly, and we may not be able to successfullycomplete identified acquisitions. Furthermore, even if we successfully completean acquisition, we may not be able to successfully integrate newly acquiredorganizations, products or technologies into our operations, and the process ofintegration could be expensive, time consuming and may strain our resources.Consequently, we may not achieve anticipated benefits of the acquisitions,which could harm our existing business. In addition, future acquisitions couldresult in potentially dilutive issuances of equity securities or the incurrenceof debt, contingent liabilities or expenses, or other charges such asin-process research and development, any of which could harm our business andaffect our financial results or cause a reduction in the price of our commonstock.

 

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**Item 2.  UnregisteredSales 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 OFSTOCKHOLDERS**

 

Weheld our 2008 Annual General Meeting of Shareholders on August 28, 2008.Our stockholders took the following actions at the Annual Meeting:

 

1.     The stockholders elected Messrs. Ron Hadani and Katsumi Oneda asClass I directors to serve for a three year term. Holders of 29,217,467shares of common stock voted for and holders of 1,104,012 shares of commonstock withheld votes for Mr. Hadani. Holders of 30,196,014 shares of common stock voted for and holders of125,465 shares of common stock withheld votes for Mr. Oneda.  In addition to Messrs. Hadani and Oneda,Messrs. Anderson, Anstey, Bielke, Pell and Wallace will continue to serveon the Board of Directors.

 

2.     The stockholders ratified the selection of BDO Seidman, LLP as thecompany’s independent auditors for the current fiscal year. Holders of32,260,327 shares of common stock voted for, holders of 6,375 shares of commonstock voted against and holders of 54,776 shares of common stock abstained.

 

3.     The stockholders approved the amendment to the 2003 Directors’ StockOption Plan to increase the number of options to be automatically granted tooutside directors and the amount of options available for issuance.  Holders of 21,447,567shares of common stockvoted for, holders of 1,345,007 shares of common stock voted against andholders of 11,350 shares of common stock abstained.

 

**Item 5.  OtherInformation**

 

N/A.

 

**Item 6.  Exhibits**

 

**Seeexhibits below.**

 
| **Exhibits** | ** ** | ** **                                                                                                                                                                          |
|--------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.41        |       | Consulting Agreement  between NYC Advisors, LLC and the Company, effective October 1, 2008.                                                                                         |
| 31.1         |       | Certification of Chief  Executive Officer pursuant to Rule 13a-15(e)/15d-15(e), promulgated  under the Securities Exchange Act of 1934, as amended.                            |
| 31.2         |       | Certification of Chief  Financial Officer pursuant to Rule 13a-15(e)/15d-15(e), promulgated  under the Securities Exchange Act of 1934, as amended.                            |
| 32           |       | Certification of Chief  Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. §1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |

 

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**SIGNATURES**

 

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

 
|                          | VISION-SCIENCES, INC.                                                                                                          |
|-------------------------------|-------------------------------------------------------------------------------------------------------------------------------------|
|                          |                                                                                                                                |
| Date: November 14, 2008       | /s/ RON HADANI                                                                                                                      |
|                          | Ron Hadani                                                                                                                          |
|                          | *President,  CEO (Duly Authorized Officer)*                                                                                         |
|                          |                                                                                                                                |
| Date: November 14,  2008 | /s/ KATHERINE L. WOLF                                                                                                               |
|                          | Katherine L. Wolf                                                                                                                   |
|                          | *EVP,  Corporate Development & Chief Financial Officer   (Principal Financial Officer and   Principal Accounting Officer)* |

 

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**VISION-SCIENCES, INC.**

 

**EXHIBIT INDEX**

 
| **Exhibit No.** | ** ** | **Description** |
|----------------------|------------|-----------------|
| 3.                   | 1(1)       |            | Amended and Restated  Certificate of Incorporation of the Company, as amended to date |
|                 |       |            |   |
| 3.                   | 2(2)       |            | By-laws, as amended to  date |
|                 |       |            |   |
| *10.                 | 1(3)       |            | 1990 Stock Option Plan, as  amended |
|                 |       |            |   |
| *10.                 | 2(19)      |            | 2003 Director Option Plan,  as amended |
|                 |       |            |   |
| *10.                 | 3(4)       |            | 2000 Stock Incentive Plan |
|                 |       |            |   |
| 10.                  | 3.1(14)    |            | 2007 Stock Incentive Plan |
|                 |       |            |   |
| *10.                 | 4(2)       |            | Vision-Sciences, Inc.  401(k) Plan, as amended |
|                 |       |            |   |
| *10.                 | 5(2)       |            | Form of  Vision-Sciences, Inc. Invention, Non-Disclosure and Non-Competition  Agreement for employees |
|                 |       |            |   |
| *10.                 | 6(17)      |            | Letter Agreement between  the Company and Ron Hadani dated January 24, 2003 |
|                 |       |            |   |
| 10.                  | 9(2)       |            | Registration Rights  Agreement dated as of February 28, 1992 among the Registrant and the  persons listed therein |
|                 |       |            |   |
| 10.                  | 10(1)      |            | Piggyback Registration  Rights Agreement, dated January 2, 2001, between the Company and the  individuals and entities listed therein |
|                 |       |            |   |
| 10.                  | 11(9)      |            | Supply Agreement dated  March 16, 1992 between the Registrant and Pentax Corporation (formerly  known as Asahi Optical Co., Ltd.) and amendment dated  October 1, 2002 |
|                 |       |            |   |
| 10.                  | 12(15)     |            | Termination Agreement  between Pentax Corporation and Vision-Sciences, Inc. dated  February 12, 2008 |
|                 |       |            |   |
| 10.                  | 14(6)      |            | License Agreement between  Vision-Sciences, Inc. and Advanced Polymers, Inc. dated  June 10, 1993 |
|                 |       |            |   |
| 10.                  | 15(7)      |            | Amendment to License  Agreement between Vision-Sciences, Inc. and Advanced Polymers, Inc.  dated April 5, 1994 |
|                 |       |            |   |
| 10.                  | 16(8)      |            | Amendment to License  Agreement between Vision-Sciences, Inc. and Advanced Polymers, Inc.  dated April 5, 1995 |
|                 |       |            |   |
| 10.                  | 17(8)      |            | Amendment to License  Agreement between Vision-Sciences, Inc. and Advanced Polymers, Inc.  dated April 5, 1996 |
|                 |       |            |   |
| **10.                | 19(5)      |            | License Agreement dated as  of August 6, 1998 between Vision-Sciences, Inc. and Pentax  Corporation (formerly Asahi Optical Co., Ltd.) |
|                 |       |            |   |
| 10.                  | 21(4)      |            | Agreement of Lease between  30 Ramland Road LLC and Vision-Sciences, Inc. dated as of  March 23, 2000 |
|                 |       |            |   |
| 10.                  | 26(10)     |            | Exclusive Distribution  Agreement between the Company and Medtronic Xomed, Inc. dated  August 6, 2003 |
|                 |       |            |   |
| 10.                  | 31(11)     |            | Asset Purchase Agreement  dated as of January 16, 2007 by and between Medtronic Xomed, Inc.  and the Company |
|                 |       |            |   |
| 10.                  | 32(11)     |            | Amended and Restated  Exclusive Distribution Agreement dated as of March 26, 2007 by and  between the Company and Medtronic Xomed, Inc. |
|                 |       |            |   |
| 10.                  | 33(11)     |            | License Agreement dated as  of March 26, 2007 by and between the Company and Medtronic  Xomed, Inc. |
|                 |       |            |   |
| *10.                 | 34(17)     |            | Amendment dated  April 4, 2007 to Employment Letter Agreement of Yoav Cohen |
|                 |       |            |   |
| *10.                 | 35(17)     |            | Amendment dated  April 4, 2007 to Employment Letter Agreement of Ron Hadani |
|                 |       |            |   |
| 10.                  | 36(12)     |            | Merrill Lynch Loan  Management Account Agreement (the “Agreement”) between  Vision-Sciences, Inc. and Merrill Lynch Bank USA (“Bank”) and  accompanying Commitment Letter from the Bank |
|                 |       |            |   |
| 10.                  | 37(13)     |            | Lease Agreement dated as  of May 1, 2008 between Ramland Realty Associates LLC and Vision  Sciences, Inc. |

 

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Table of Contents

 
| **Exhibit No.** | ** ** | **Description** |
|----------------------|------------|-----------------|
| 10.                  | 38(17)     |            | Third Amendment to Lease  between 30 Ramland Road, LLC dated as December 26, 2006 LLC  and Vision Sciences, Inc. |
|                 |       |            |   |
| 10.                  | 39(16)     |            | Development and Supply  Agreement between Vision-Sciences, Inc. and SpineView, Inc. dated  June 19, 2008 |
|                 |       |            |   |
| 10.                  | 40(18)     |            | Employment Letter between  Katherine Wolf and the Company, effective September 16, 2008 |
|                 |       |            |   |
| 10.                  | 41         |            | Consulting Agreement  between NYC Advisors, LLC and the Company, effective October 1, 2008. |
|                 |       |            |   |
| 21.                  | 1(17)      |            | Subsidiaries of the  Company |
|                 |       |            |   |
| 31.                  | 1          |            | Certification of Chief  Executive Officer pursuant to Rule 13a-14(a) and  Rule 15d-14(a), promulgated under the Securities Exchange Act of 1934,  as amended. |
|                 |       |            |   |
| 31.                  | 2          |            | Certification of Chief  Financial Officer pursuant to Rule 13a-14(a) and  Rule 15d-14(a), promulgated under the Securities Exchange Act of 1934,  as amended. |
|                 |       |            |   |
| 32                   |       |            | Certification of Chief  Executive Officer and Chief Financial Officer pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |

 

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| *      | Management contract or  compensatory plan or arrangement filed as an exhibit to this  Form pursuant to Items 15(a) and 15(b) of Form 10-K.       |
|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                      |
| **     | Confidential treatment  granted as to certain portions, which portions have been deleted and filed  separately with the Securities and Exchange Commission.               |
|   |                                                                                                                                                                      |
| (1)    | Incorporated by reference  to the Annual Report on Form 10-K for the fiscal year ended  March 31, 2001.                                                         |
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| (2)    | Incorporated by reference  to the Registration Statement on Form S-1 (File No. 33-53490).                                                                       |
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| (3)    | Incorporated by reference  to the Annual Report on Form 10-K for the fiscal year ended  March 31, 1994.                                                         |
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| (4)    | Incorporated by reference  to the Annual Report on Form 10-K for the fiscal year ended  March 31, 2000.                                                         |
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| (5)    | Incorporated by reference  to the Current Report on Form 8-K dated August 20, 1998.                                                                             |
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| (6)    | Incorporated by reference  to the Quarterly Report on Form 10-Q for the quarter ended June 30,  1993.                                                           |
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| (7)    | Incorporated by reference  to the Quarterly Report on Form 10-Q/A for the quarter ended June 30,  1994.                                                         |
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| (8)    | Incorporated by reference  to the Annual Report on Form 10-K for the fiscal year ended  March 31, 1996.                                                         |
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| (9)    | Incorporated by reference  to the Quarterly Report on Form 10-Q/A for the quarter ended  December 31, 2002.                                                     |
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| (10)   | Incorporated by reference  to the Quarterly Report on Form 10-Q for the quarter ended  September 30, 2003.                                                      |
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| (11)   | Incorporated by reference  to the Proxy Statement dated March 6, 2007 filed with the Securities and  Exchange Commission on March 7, 2007 on Schedule 14A. |
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| (12)   | Incorporated by reference  to the Current Report on Form 8-K filed on January 24, 2008.                                                                         |
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| (13)   | Incorporated by reference  to the Current Report on Form 8-K filed on May 5, 2008.                                                                              |
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| (14)   | Incorporated by reference  to the Proxy Statement dated July 30, 2007 filed with the Securities and  Exchange Commission on July 27, 2007 on Schedule 14A. |
|   |                                                                                                                                                                      |
| (15)   | Incorporated by reference  to the current report on Form 8-K filed on February 15, 2008.                                                                        |
|   |                                                                                                                                                                      |
| (16)   | Incorporated by reference  to the current report on Form 8-K filed on June 23, 2008.                                                                            |
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| (17)   | Incorporated by reference  to the Annual Report on Form 10-K for the fiscal year ended  March 31, 2008.                                                         |
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| (18)   | Incorporated by reference  to the current report on Form 8-K filed on September 16, 2008.                                                                       |
|   |                                                                                                                                                                      |
| (19)   | Incorporated by reference  Registration Statement on Form S-8, filed on October 10, 2008                                                                                  |

 

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