**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

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**FORM 10-K**

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

 

**Forthe Year Ended December 31, 2005**

**CommissionFile Number 000-50856**

**NEUROMETRIX, INC.**

(Exact Name of Registrantas Specified in Its Charter)

| **Delaware**                     |   | **04-3308180**       |
|----------------------------------|--------|----------------------|
| (State or Other  Jurisdiction of |   | (I.R.S. Employer     |
| Incorporation or  Organization)  |   | Identification  No.) |

 

**62 Fourth Avenue**

**Waltham, Massachusetts02451**

(Address, Including ZipCode, of Principal Executive Offices)

**(781) 890-9989**

(Registrant’s TelephoneNumber, Including Area Code)

**Securities RegisteredPursuant To Section 12(b) of the Act: None**

**Securities RegisteredPursuant to Section 12(g) of the Act:**

**Common Stock, $0.0001 parvalue per share**

**(Titleof Class)**

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Indicate by check mark if the registrant is awell-known seasoned issuer, as defined in Rule 405 of the Securities Act.   Yes o   No x

Indicate by check mark if the registrant is notrequired to file reports pursuant to Section 13 or 15(d) of the Act.   Yes o   No x

Indicate by check mark whether the registrant: (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or forsuch shorter period that the registrant was required to file such reports); and(2) has been subject to such filing requirements for the past90 days.   Yes x   No o

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K is not contained herein, andwill not be contained, to the best of registrant’s knowledge, in definitiveproxy or information statements incorporated by reference in Part III ofthis Form 10-K or any amendment to this Form 10-K.   o

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer or a non-accelerated filer. Seedefinition of accelerated filer and large accelerated filer in Rule 12b-2of the Exchange Act (check one):   Large accelerated filer  o   Accelerated filer x   Non-accelerated filer o

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

As of June 30, 2005 the aggregate market value ofthe voting stock held by non-affiliates of the registrant was approximately $163,134,000,based on the closing sale price of the common stock as reported on the NASDAQNational Market on June 30, 2005. Forthis computation, the registrant has excluded the market value of alloutstanding shares beneficially owned by any director, executive officer orperson known to the registrant to beneficially own 10% or more of theregistrant’s common stock; such exclusion shall not be deemed to constitute anadmission that any such person is an affiliate of the registrant.

As ofMarch 10, 2006, there were 12,457,108 shares of Common Stock outstanding.

**DOCUMENTSINCORPORATED BY REFERENCE**

Portions of the registrant’sdefinitive proxy statement for the registrant’s 2006 annual meeting ofstockholders, which is expected to be filed pursuant to Regulation 14Awithin 120 days of the registrant’s year ended December 31, 2005, areincorporated by reference into Part III of this Annual Report on Form 10-K.

 

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**NEUROMETRIX, INC.ANNUAL REPORT ON FORM 10-KFOR THE YEAR ENDED DECEMBER 31, 2005**

**TABLEOF CONTENTS**

|                   | ** ** |                                                                                                                    |        | **Page** | ** ** |
|-------------------|------------|--------------------------------------------------------------------------------------------------------------------|--------|----------|------------|
| **PART I**   |       |                                                                                                               |   |     |       |
| Item 1:           |       | Business                                                                                                           |   | 1        |       |
| Item 1A:          |       | Risk  Factors                                                                                                      |   | 26       |       |
| Item 1B:          |       | Unresolved Staff Comments                                                                                          |   | 40       |       |
| Item 2:           |       | Properties                                                                                                         |   | 40       |       |
| Item 3:           |       | Legal  Proceedings                                                                                                 |   | 40       |       |
| Item 4:           |       | Submission of Matters to a Vote of Security Holders                                                                |   | 40       |       |
| **PART II**  |       |                                                                                                               |   |     |       |
| Item 5:           |       | Market for Registrant’s Common Equity, Related  Stockholder Matters and Issuer Purchases of Equity Securities |   | 41       |       |
| Item  6:          |       | Selected  Financial Data                                                                                           |   | 42       |       |
| Item 7:           |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                        |   | 43       |       |
| Item 7A:          |       | Quantitative and Qualitative Disclosures About Market  Risk                                                        |   | 61       |       |
| Item 8:           |       | Financial Statements and Supplementary Data                                                                        |   | 62       |       |
| Item 9:           |       | Disagreements with Accountants on Accounting and  Financial Disclosure                                             |   | 62       |       |
| Item 9A:          |       | Controls and Procedures                                                                                            |   | 62       |       |
| Item  9B:         |       | Other  Information                                                                                                 |   | 63       |       |
| **PART III** |       |                                                                                                               |   |     |       |
| Item 10:          |       | Directors and Executive Officers of the Registrant                                                                 |   | 64       |       |
| Item 11:          |       | Executive Compensation                                                                                             |   | 64       |       |
| Item 12:          |       | Security Ownership of Certain Beneficial Owners and  Management and Related Stockholder Matters                    |   | 64       |       |
| Item 13:          |       | Certain Relationships and Related Transactions                                                                     |   | 64       |       |
| Item 14:          |       | Principal Accountant Fees and Services                                                                             |   | 64       |       |
| **PART IV**       |       |                                                                                                               |   |     |       |
| Item 15:          |       | Exhibits and Financial Statement Schedule                                                                          |   | 64       |       |
| Signatures        |       | 67                                                                                                                 |   |

 

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**PART I**

*The statements contained in this annual report on Form 10-K,including under the section titled “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations” and other sections of thisannual report, include forward-looking statements within the meaning of Section 27Aof the Securities Act of 1933, as amended, and Section 21E of theSecurities Exchange Act of 1934, as amended, including, without limitation,statements regarding our or our management’s expectations, hopes, beliefs,intentions or strategies regarding the future. The words “believe,” “may,” “will,”“estimate,” “continue,” “anticipate,” “intend,” “expect,” “plan” and similarexpressions may identify forward-looking statements, but the absence of thesewords does not mean that a statement is not forward-looking. Theforward-looking statements contained in this annual report are based on ourcurrent expectations and beliefs concerning future developments and theirpotential effects on us. There can be no assurance that future developmentsaffecting us will be those that we have anticipated. These forward-lookingstatements involve a number of risks, uncertainties (some of which are beyondour control) or other assumptions that may cause actual results or performance tobe materially different from those expressed or implied by theseforward-looking statements. These risks and uncertainties include, but are notlimited to, those factors described in the section titled “Risk Factors.”Should one or more of these risks or uncertainties materialize, or should anyof our assumptions prove incorrect, actual results may vary in materialrespects from those projected in these forward-looking statements. We undertakeno obligation to update or revise any forward-looking statements, whether as aresult of new information, future events or otherwise, except as may berequired under applicable securities laws.*

**ITEM 1:**               BUSINESS

**Our Business**

We design, develop and sell proprietary medicaldevices used to diagnose neuropathies. Neuropathies are diseases of theperipheral nerves and parts of the spine that frequently are caused by orassociated with diabetes, low back pain and carpal tunnel syndrome, as well asother clinical disorders. We believe that our neuropathy diagnostic system, theNC-stat System, improves the quality and efficiency of patient care by offeringall physicians the ability to diagnose patients with neuropathies at thepoint-of-service, that is, in the physician’s office at the time the patient isexamined, resulting in earlier and more accurate detection, greater patientcomfort and convenience, and, in many cases, improved clinical and economicoutcomes.

Neuropathies traditionally have been evaluated bysimple clinical examination by the primary care physician, and, in some cases,subsequently diagnosed by a nerve conduction study and needle electromyography,or NCS/nEMG, procedure performed by a neurologist or physician in a relatedspecialty. We estimate that there are approximately 2.0 million traditionalNCS/nEMG procedures currently performed each year in the United States. Webelieve that use of traditional NCS/nEMG procedures is limited by: (1) theneed to obtain a referral to a neurologist for the procedure and the resultingdelay in availability of diagnostic information; (2) the inconvenience anddiscomfort of these procedures for the patient; and (3) the expense to thepatient and third-party payer. We anticipate that the advantages and increasedavailability of the NC-stat System will significantly increase the number ofnerve conduction studies performed. Based on our analysis of current data, weestimate that the potential market size for point-of-service nerve conductionstudies in the diabetes, low back pain and carpal tunnel syndrome markets inthe aggregate could be greater than 9.5 million annual patient tests,estimated to be more than $1.0 billion annually for our disposablebiosensors, in the United States.

Our goal is to become the leading provider ofinnovative, proprietary, high margin medical devices that provide comprehensivesolutions for the diagnosis and treatment of patients with neuropathies. Todate, our primary focus has been on the diagnosis of neuropathies. We alsobelieve that our core technology can be adapted and extended to provideminimally invasive approaches to treating neuropathies. We are in the earlystages of designing a drug delivery system for the minimally invasive treatmentof neuropathies by both primary care and specialist physicians.

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All of our currentproducts have received 510(k) clearance by the United States Food and DrugAdministration, or FDA. The NC-stat System has been on the market since May 1999and is presently used in nearly 3,300 physician’s offices, clinics and otherhealth care facilities. We hold issued utility patents covering a number ofimportant aspects of our NC-stat System. In 2005, we increased our revenuesfrom the prior year by 91%, generating $34.3 million in revenues, comparedwith $17.9 million in 2004. Our gross margin percentage in 2005 was 74.2%,and 88% of our revenues were attributable to sales of the disposable biosensorsthat physicians use to perform tests with our NC-stat System. We recorded netincome of approximately $938,000 in 2005 and incurred net losses ofapproximately $4.3 million in 2004 and $3.7 million in 2003. Sinceour inception, more than 500,000 patients have been tested with the NC-statSystem.

**Disordersof the Peripheral Nerves and Spine**

*The Nervous System*

The nervous system is a collection of interconnectedspecialized cells called neurons, supported by other complementary cells. Thebasic function of the nervous system is to convert physical stimuli into neuralsignals, to process these neural signals, and to generate an appropriate motorresponse. The classic reflex obtained by tapping on the knee and eliciting amild kick is a simple example of this function.

The nervous system is divided into the central nervoussystem, or CNS, and the peripheral nervous system, or PNS. The CNS is comprisedof the neurons in the brain and spine, while the PNS consists of neurons andrelated elements outside the spine and within the extremities, such as thehands or feet. Neurons, which are the primary components of the nervous system,typically have three elements: (1) the dendrites, or input region; (2) thecell body, where the cell nucleus resides; and (3) the axon, or outputregion. The dendrites and the cell body of most neurons reside within the CNS(e.g., in the spine), while the axons may reside within the CNS, the PNS orboth. The axon carries information from one neuron to another or to a muscle.Axons can exceed one meter in length yet represent the same cell. The term “nerve”generally refers to a collection of axons encased within a common sheath. Axonscombine into nerves in the extremities that are considered part of the PNS.

All neurons, andparticularly their axons, are highly susceptible to metabolic or mechanicaldamage and have limited regenerative ability. Disorders of the nervous systemlead to symptoms, which can range from numbness and weakness in the extremitiesif confined to the PNS, to changes in cognition, speech and personality if theCNS is involved.

*Neuropathies*

Disorders of thenerves are broadly described by the term neuropathies. There are two basictypes of neuropathies, those that are focal, or localized in nature, and thosethat are systemic. Focal neuropathies are typically caused by a compression ofone or more specific nerves. Systemic neuropathies are typically caused by a metabolicdisturbance that results in widespread damage to nerves throughout the body.The most common clinical conditions associated with neuropathies include:

·       *Diabetes.*Diabetes is a disease in which the body eitherdoes not produce sufficient quantities of insulin or does not properly useinsulin. Insulin is a hormone that is needed to convert sugar, starches andother food into energy needed for daily body function. Diabetes often resultsin a high level of glucose in the blood, called hyperglycemia. Chronichyperglycemia is associated with complications of diabetes including nerve, eyeand kidney disease. The most common form of diabetes-related nerve disease is asystemic neuropathy called diabetic peripheral neuropathy, or DPN. The symptomsof DPN include impaired sensation or pain in the feet and hands. The AmericanDiabetes Association currently estimates that 60% to 70% of people withdiabetes are affected by DPN, although a majority of these individuals areunaware of their nerve disease 

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because they have nosymptoms. Clinical studies have demonstrated that nerve conduction studies candetect DPN in cases where symptoms are not present. DPN, if left undiagnosedand unmanaged, can result in the development of lower extremity ulcers and, insevere cases, amputation. It is estimated by the American Diabetes Associationthat over 75% of all foot amputations are in patients with diabetic peripheralneuropathy. Other neuropathies may be present in as many as 30% of patientswith diabetes, including carpal tunnel syndrome, radiculopathy and chronicinflammatory demyelinating polyneuropathy, or CIDP.

·       *Low back pain.*Low back pain can have many causes. When lowback pain has a neurological source, it is often focal in nature and associatedwith pain that radiates from the lower back region into the leg, calledsciatica. In some cases, the patient may also experience loss of sensation andweakness in the lower leg. In advanced cases, these symptoms can becomedisabling. The symptoms result from pressure on the nerve roots, the precursorsof the nerve, as they exit the spine. The source of the pressure is usuallypart of an intervertebral disc that is displaced from its normal locationbetween the vertebral bodies. These disorders are often called herniated or ruptureddiscs.

·       *Carpal tunnel syndrome.*Carpal tunnel syndrome, or CTS, iscaused by swelling of the tendons that traverse the wrist alongside the mediannerve. The swollen tendons compress the median nerve, resulting in damage tothe nerve that leads to numbness in the first three fingers of the hand,weakness in the thumb, and occasionally wrist and hand pain. CTS is the mostcommon focal neuropathy.

·       *Other medical conditions associated with neuropathies.*Commonchronic disorders such as obesity; rheumatoid arthritis; and spinal stenosis,or narrowing of the spinal canal; are commonly associated with neuropathies. Inthese complicated cases, it is particularly important for the physician toconfirm or exclude neuropathies in order to develop effective treatmentprograms.

·       *Nerve damage caused by chemotherapy.*A number of widely usedchemotherapeutic agents are toxic to nerves. Unfortunately, by the timepatients report symptoms, significant nerve damage has often already occurred.

**Market Opportunity**

The sensitivity of thenervous system to metabolic and mechanical damage, compounded by its limitedregenerative ability, creates a market opportunity for a medical device thatcan assist in point-of-service diagnoses of neuropathies in a manner that iscost-effective for the patient and third-party payer. We believe the ease ofuse, accuracy and convenience provided by the NC-stat System position it tobecome a standard of care for the assessment of neuropathies at thepoint-of-service. We believe that the availability of point-of-service nerveconduction studies, through the NC-stat System, will result in earlierdetection of neuropathies, leading to earlier therapeutic intervention and, inmany cases, improved clinical and economic outcomes. We believe that use oftraditional NCS/nEMG procedures is limited by the referral process and theresulting delay in availability of diagnostic information, the inconvenienceand discomfort of these methods for the patient, and the expense to the patientand third-party payer. Our policy is to promote and support the utilization ofnerve conduction studies in a manner strictly consistent with prevailingguidelines on the medically appropriate use of this diagnostic procedure. Weestimate that there are approximately 2.0 million traditional NCS/nEMGprocedures currently performed each year in the United States. Although themost common indication for which the NC-stat System has been used historicallyis carpal tunnel syndrome, we have since expanded our marketing efforts to includeDPN and low back pain, as well as other indications. We anticipate that ourfuture growth will be generated mainly from this expanded focus. Based on ouranalysis of current patient data, we estimate that the potential forpoint-of-service nerve conduction studies in the diabetes, low back pain andcarpal tunnel syndrome markets in the aggregate could be greater than 9.5 millionannual patient tests, estimated to be more than 

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$1.0 billionannually for our disposable biosensors, in the United States. However, marketsize is difficult to predict, and we cannot assure you that our estimates willprove to be correct. We believe that additional applications of apoint-of-service product offering such as the NC-stat System, including theclinical assessment of patients with neuropathies caused by or associated withother clinical disorders, could further increase this potential market size.Additionally, although we have not yet quantified the size of the market, webelieve a potential international market opportunity exists for the NC-statSystem.

**Assessmentand Treatment Methods for Neuropathies**

*Traditional Methodsfor Detecting Neuropathies*

Neuropathiestraditionally have been evaluated using clinical and diagnostic methods. Theclinical examination of a patient with a potential neuropathy focuses on thenature, location and duration of the symptoms. The physician will also performa physical examination of the patient to corroborate and qualify the patient’ssymptoms. In many cases, the physician will use simple instruments such as areflex hammer or a tuning fork. Although the clinical examination is essentialto the evaluation of the patient with a potential neuropathy, it has a numberof important disadvantages, including the following:

·       *It is qualitative.  *A clinical examination providesqualitative rather than quantitative information, and results can vary greatlydepending on the physician performing the examination. In this respect, it haslimited use as an objective and repeatable measure of disease.

·       *It is subjective.  *Much of the clinical examinationrelies on the patient experiencing and reporting symptoms or perceptions. As aresult, it depends greatly on the investigative efforts of the physician ininterviewing the patient, is highly variable because of individual differencesin recollection and discomfort thresholds, and requires an alert, cooperativepatient. Because of the subjective nature of the clinical examination, theresults must be interpreted cautiously.

·       *It often does not detect pre-clinical or early stage disease.  *Becausethe clinical examination relies on the patient reporting symptoms or physicalsigns of disease, the physician typically cannot detect early stage diseasewith this evaluation. The progressive nature of neurological damage is suchthat pre-clinical or early detection creates the optimal opportunity forintervention and successful clinical outcomes.

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The limitations ofthe clinical examination in detecting and monitoring neuropathies suggest thatan objective and quantitative diagnostic procedure would be of value for manypatients. The role of an objective diagnostic procedure in a patient at riskfor a neuropathy or experiencing common symptoms of a neuropathy, such asnumbness, unusual sensations, pain and weakness, is shown in the diagram below.

The cause of symptoms in many of these patients willnot be disorders of the nervous system, but rather arthritic pain,musculo-skeletal disturbances, inflammatory conditions, psychiatric disordersand others. The importance of an objective diagnostic procedure in this type ofpatient is to determine if the patient does in fact have a neuropathy, and ifso, of what type and severity. Only with this information can appropriatetherapy be determined.

The principal diagnosticmethod used today to assess patients with or at risk for neuropathies is atraditional nerve conduction study and a needle electromyography, or nEMG.Traditional nerve conduction studies and nEMGs are distinct studies and can beperformed independently, but are collectively described as traditional NCS/nEMGprocedures. In a traditional nerve conduction study, electrodes are placed onthe patient’s skin surface and the physician performing the study electricallystimulates the nerve, evoking a neural impulse that travels along the nerve,thereby enabling the physician to measure a series of nerve conductionparameters. In an nEMG, recording needles are inserted through the skin’ssurface into a muscle and the physician performing the study reviews theelectrical activity of those muscles. From these data, the physician candetermine whether or not the patient has a neuropathy, and if so, itscharacteristics and severity. The traditional nerve conduction study, in somecases combined with an nEMG, is considered by most physicians to be the “goldstandard” in terms of diagnostic accuracy for most neuropathies.

*Limitations ofTraditional Diagnostic Methods*

TraditionalNCS/nEMG procedures have a number of limitations, which have frequentlyresulted in these procedures not being performed until late in the patients’care episodes. These limitations include the following:

·       *Referral process.*Traditional NCS/nEMG procedures typicallyare performed under a referral from a primary care physician or orthopedicsurgeon to a neurologist. This process may lead to loss of control of thepatient’s care by the referring physician, higher expense for the patient andthird-party payer, and the likely delay and inconvenience for the patientassociated with a separate office visit to a new physician.

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·       *Expense.*When the patient visits a new physician under areferral for the purpose of a traditional NCS/nEMG procedure, that physician isless familiar with the patient’s medical history and condition than the primarycare physician. Therefore, these physicians may need to perform more extensivetesting incorporating multiple nerves and muscles. Because of the breadth ofthese studies, the cost per study can exceed $1,000 per patient, which leads togreater expense for the patient and third-party payer.

·       *Equipment.*The equipment used to perform a traditionalNCS/nEMG procedure is expensive and typically ranges in cost from $15,000 to$40,000. For this reason, it is generally only purchased by neurologists andphysicians in related specialties, who expect high utilization to offset thiscost.

·       *Complexity.*Traditional procedures require familiarity withequipment and engineering principles that most physicians do not acquire duringtheir medical training. This fact, combined with high equipment cost, has meantthat only a small number of physicians, such as neurologists and physicians inrelated specialties, perform testing under traditional methods, making thistype of testing not generally widely available.

·       *Discomfort.*The traditional NCS/nEMG procedure is considereduncomfortable or painful by most patients. In particular, the nEMG componentcan be very painful because it involves a physician inserting needles intospecific muscles of the patient, often in close proximity to the site of pain.Patients are sometimes therefore reluctant to undergo these procedures, andneuropathies may go undiagnosed.

*Current Methods forTreating Neuropathies*

Addressing thelimitations of traditional methods for detecting neuropathies is importantbecause of the expanding number of treatments for common neuropathies currentlyin use and under development. We believe earlier and more accurate detection ofneuropathies would allow more patients to benefit from these treatments, whichinclude the following:

·       *Diabetic Peripheral Neuropathy.*Optimal clinical managementof DPN is based on earliest possible detection so as to limit the degree ofnerve damage. At the present time, most people with diabetes are evaluated forDPN with simple clinical procedures that generally do not identify the diseasein its early stages. Although treatment options for DPN are presently limited,there are interventions designed to slow down the progression of nerve degenerationand to minimize the complications of the nerve disease. Current interventionsconsist primarily of increased attention to the individual’s blood glucosethrough monitoring and administration of insulin and other medications, as wellas increased compliance with proper diet and exercise programs. In addition,greater attention to the existence and progression of foot ulcers that areoften triggered by nerve disease has been shown to be valuable in preventingamputation. A number of pharmaceutical companies and researchers areinvestigating and developing drugs specifically designed to treat DPN. Thefollowing table summarizes the leading drug development programs in DPN knownto us, as described, for each company, in current publicly available informationreleased by that company.

| Company Name                                                                | ** ** | **Drug Name**                    | ** ** | **Status**                    |
|-----------------------------------------------------------------------------|------------|----------------------------------|------------|-------------------------------|
| Eli Lilly and Company                                                       |       | ruboxistaurin mesylate (Arxxant) |       | U.S. Phase III clinical trial |
| Sanwa Kagaku  Kenkyusho Co., Ltd., Sankyo Co., Ltd., and NK Curex |       | Fidarestat                       |       | U.S. Phase II clinical  trial |

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| Dainippon  Pharmaceutical Co., Ltd. |   | AS-3201             |   | U.S. Phase III clinical trial                                                                                                             |
|------------------------------------------|--------|---------------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------|
| Johnson &  Johnson              |   | Topiramate          |   | Approved in the United  States as anticonvulsant; Phase II clinical trials being conducted to  determine efficacy in the treatment of DPN |
| Vitaris GmbH                             |   | α-lipoic  acid |   | Approved in Germany;  studies being conducted to determine efficacy in the treatment of DPN                                               |

 

·       *Sciatica.*The widespread incidence of low back pain andintense discomfort associated with the condition makes the detection of truesciatica difficult. However, treatment decisions require a clear delineationbetween those patients that have non-neuropathic back pain, such as musclestrains or spasms, and those that have underlying neuropathies. Mild sciaticamay be treated with non-steroidal anti-inflammatory drugs, or NSAIDs, rest andphysical therapy. More advanced sciatica is often treated with steroidinjections and eventually a minimally invasive or more involved surgicalprocedure may be required.

·       *Carpal Tunnel Syndrome.*Mild CTS is treated conservativelyusing wrist splints, NSAIDs, and physical and occupational therapy. Moderate tosevere CTS is treated by injecting steroids into the carpal tunnel in theimmediate vicinity of the median nerve, or ultimately by a surgical procedurecalled a carpal tunnel release, or CTR. Most physicians and third-party payersrequire confirmation of median nerve damage by a nerve conduction study, likethat performed using the NC-stat System, prior to performing CTR. According tothe Centers for Disease Control and Prevention, or CDC, over 350,000 CTRprocedures were performed in 1997.

**NEUROMetrix Solution**

Recognizing theopportunity created by the limitations of traditional diagnostic methodscoupled with the availability of current and potential new treatments forcertain neuropathies, NEUROMetrix has developed the NC-stat System for theperformance of non-invasive nerve conduction studies at the point-of-service.Our proprietary technology provides physicians with an in-office diagnosticsystem that enables physicians to make rapid and accurate diagnoses that arecost-effective for the patient and third-party payer. We believe that theNC-stat System represents a significant advance in neurological diagnostics andoffers an improvement over traditional diagnostic procedures with the followingbenefits:

·       *Facilitates performance of nerve conduction studies at thepoint-of-service.*The complexity and high capital cost oftraditional diagnostic methods generally has limited their use to neurologistsand physicians in related specialties. We believe the features of the NC-statSystem facilitate the performance of nerve conduction studies within theoffices of a wide range of physicians. By allowing nerve conduction studies tobe performed in the primary care physician’s office, the patient can avoid theexpense and inconvenience of a referral visit to a neurologist. Additionally,the NC-stat System enables primary care physicians to retain greater controlover their patients by eliminating the need to refer them out for a traditionalNCS/nEMG procedure.

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·       *Provides a cost-effective diagnostic tool.*We believe thatthe NC-stat System should reduce the cost to the patient and third-party payerof many nerve conduction studies. This belief is based on our observation thatwhen these procedures are performed by the physician with primary clinicalresponsibility for the patient, the study is more directed so that generallyfewer nerves are tested without compromising the accuracy of the diagnosis. Asthe cost to third-party payers for nerve conduction studies is typically basedon the number of nerves tested, use of the NC-stat System can result in lowercosts to patients and third-party payers. For example, a nerve conduction studyfor DPN using the NC-stat System would typically be performed by testing four nerves,whereas a nerve conduction study for the same indication performed by aneurologist using traditional NCS/nEMG equipment upon referral could involvethe testing of six nerves or more.

·       *Requires minimal capital investment.*We sell the NC-statSystem, with equivalent technical specifications to the more expensivetraditional instruments, for under $5,000, compared with $15,000 to $40,000 forthe cost of traditional NCS/nEMG equipment. We believe the lower capital costof the NC-stat System will aid in the expansion of nerve conduction studiesbeyond neurologist offices.

·       *Simple to operate.*The NC-stat biosensors are designed forease in placement, which allows a wide range of physician office personnel toadminister the technical parts of the study under supervision of a physician.The NC-stat monitor utilizes software algorithms that perform each step of anerve conduction study in a reliable manner, with embedded automationtechnology that addresses and minimizes the technical training requirements forperforming nerve conduction studies, while also ensuring that the enddiagnostic result is accurate and reliable. We believe that, in combination,these features allow accurate and reliable nerve conduction studies to beperformed in 15 to 30 minutes on average.

·       *Patient-friendly, non-invasive procedure.*The NC-stat Systemallows for reduced patient discomfort during the nerve conduction study byminimizing the magnitude of the electrical stimulus to the nerve via aproprietary patient-specific calibration procedure. In most cases, thesophisticated signal processing and automation capabilities of the NC-statSystem provide sufficient diagnostic information to eliminate the need for annEMG procedure. This saves the patient the discomfort, stress and risk of thisinvasive procedure.

We believepoint-of-service testing will expand the use of nerve conduction studies toinclude at-risk individuals who may have early-stage neuropathies, a populationthat would be unlikely to be tested under the current inconvenient, expensivereferral system. Because traditional NCS/nEMG procedures are typically notperformed until late in patients’ care episodes, permanent nerve damage mayhave already occurred, which can limit treatment options. We believe that morewidespread use of nerve conduction studies would lead to earlier detection ofneuropathies. Clinical studies published in peer-reviewed medical journals havedemonstrated that nerve conduction studies performed with the NC-stat Systemresult in comparable accuracy to traditional NCS/nEMG procedures, as describedbelow in “—Clinical Studies.”  Byincorporating nerve conduction studies early in patients’ care episodes throughthe use of the NC-stat System, we expect better long-term clinical and economicoutcomes will emerge because of the ability to implement available preventivecare based on accurate early diagnostic results.

**The NC-stat System**

The NC-stat Systemis comprised of: (1) disposable single use NC-stat biosensors that areplaced on the patient’s body; (2) the NC-stat monitor and relatedcomponents; and (3) the NC-stat docking station, an optional device thatenables the physician to transmit data to our onCall Information System. TheonCall Information System formulates the data it receives for each test into adetailed report that is sent to the physician via facsimile or e-mail in threeto four minutes on average and aids in the physician’s 

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diagnosis.The NC-stat System enables the physician to make rapid and accurate diagnosesthat are cost-effective for the patient and third-party payer.

·       *NC-stat biosensors.*The NC-stat biosensors are single use,self-adhesive, nerve-specific, patch-like devices that are placed on the bodyand connected to the NC-stat monitor. Through the use of a specialized gel anda temperature sensor, both of which are contained within the biosensor, NC-statbiosensors convert nerve signals to electronic data that can be received anddisplayed by the NC-stat monitor. Currently we sell eight different types ofbiosensors:

·        Medianmotor;

·        Medianmotor/sensory;

·        Ulnarmotor at wrist;

·        Ulnarmotor/sensory;

·        Combinationulnar motor/sensory at wrist and ulnar at elbow;

·        Peroneal;

·        Tibial;and

·        Sural.

The biosensors are designed to be positioned accordingto common anatomical landmarks with a configuration that facilitates correctplacement. We designed the sensors so that they could be easily and quicklyapplied with minimal training by members of a physician’s office staff. Thebiosensors are encoded with a unique electronic serial number, which allows usto track each biosensor throughout the manufacturing, shipping and end-usestages. The biosensors also are electronically inactivated after use, thuspreventing re-use. This inactivation is essential since prior use of thebiosensor adhesive and specialized gel would significantly degrade the qualityof the measurements. In a typical nerve conduction study, multiple nerves areevaluated and multiple biosensors are used according to general guidelinesestablished by the Center for Medicaid and Medicare Services, or CMS, andphysician associations.

Thetable below provides sample testing protocols for several common clinicalindications.

| Clinical Indication                   | ** ** | **Specific Biosensors Utilized**                    | ** ** | **Total  Number of  Biosensors  Utilized** | ** ** | **Aggregate  Price of  Biosensors  Utilized** |
|---------------------------------------|------------|-----------------------------------------------------|------------|--------------------------------------------|------------|-----------------------------------------------|
| Diabetic peripheral neuropathy        |       | Peroneal (2)  Median   Motor/Sensory (1)  Sural (1) |       | 4                                          |       | $134                                          |
| Low back pain with bilateral sciatica |       | Peroneal (2)  Tibial (2)  Sural (1)                 |       | 5                                          |       | $145                                          |
| Bilateral carpal tunnel syndrome      |       | Median  Motor/Sensory (2)  Ulnar  Motor/Sensory (2) |       | 4                                          |       | $180                                          |

 

·       *NC-stat monitor.*The NC-stat monitor is designed forefficient and easy use by the physician or a member of the physician’s clinicalstaff. The NC-stat monitor can only be operated with our NC-stat 

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biosensors. Thisinstrument, which is lightweight and slightly larger than a cordless telephone,customizes and calibrates the test for each patient, analyzesneurophysiological signals collected from the biosensor and displays thepertinent results on an LCD screen immediately at the conclusion of each nerveconduction study. It also stores data from multiple patients for optionaltransmission to the onCall Information System. We also sell optional relatedcomponents that allow for the testing of long nerve segments, such as thosebetween the elbow and wrist or the knee and foot. The monitor is powered forseveral months by two AA batteries. The NC-stat monitor contains software thatperforms all the control and analysis algorithms necessary to carry out a nerveconduction study. A complete nerve conduction study may be performed with justthe monitor and the biosensors. A third generation neurodiagnostic system iscurrently in development and is expected to be introduced during 2006.

·       *NC-stat docking station and onCall Information System.*TheNC-stat docking station is an optional device that automatically transmits datafrom the NC-stat monitor via any available telephone line, such as those usedby facsimile machines, to the onCall Information System that we maintain. Thedocking station has its own data storage so it does not lose data if thetelephonic connection to the onCall Information System cannot be establishedfor some time or is disrupted during transmission. The data is automaticallyprocessed by the onCall Information System and stored in a central database,and a detailed computer generated report is created for each patient that isthen sent to the physician via facsimile or e-mail in three to four minutes onaverage. The report includes the raw waveform data, comparisons to an age- andheight-adjusted normal range population, study reference table and textsummaries of the study, which facilitate rapid and accurate diagnosis by thephysician examining the patient. Although the study data presented in theonCall report can be generated manually by the physician using the numericalmeasurements displayed by the NC-stat monitor, the report is a convenient andfast adjunct. Whether using the information from the onCall report or the NC-statmonitor display, the actual clinical interpretation of the NC-stat results isalways performed by the physician ordering the study. The onCall InformationSystem can also provide daily, monthly and quarterly reports to customers.These reports provide assistance in correct submission for third-partyreimbursement and assist in tracking overall clinical utilization. The onCallInformation System generally is available 24 hours per day, seven days perweek. Although purchase of the NC-stat docking station and utilization of theonCall Information System are entirely optional, we believe substantially allof our customers use this system in all studies they conduct with the NC-statSystem. We currently have a record of over 1.5 million individual nerve testswithin the onCall information system database. We believe that this informationprovides us with the ability to continually improve our products and provideour customers with a very high level of customer service and value.

**Strategy**

Our goal is to becomethe leading provider of innovative, proprietary, high margin medical devicesthat provide comprehensive solutions for the diagnosis and treatment ofpatients with neuropathies. To achieve this objective, we are pursuing thefollowing business strategies:

·       *Establish the NC-stat System as a Standard of Care.*Ourprimary objective is to establish the NC-stat System as the standard of carefor point-of-service assessment of neuropathies. To accomplish this goal, wededicate significant efforts to the development of marketing and educationalmaterials that encourage the medically appropriate use of the NC-stat System bya broad range of physicians. We also support clinical studies that are designedto demonstrate the clinical accuracy and cost-effectiveness of the NC-statSystem.

·       *Expand Sales and Marketing Efforts.*We currently sell ourproducts through 37 regional managers, three sales representatives and threedistrict sales directors who are our direct employees. We 

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invest significant amountsof time and money in technical, clinical and business practices training forour regional managers. We also have established a sales network with more than75 independent regional sales agencies employing a total of more than 500 salesrepresentatives. Our regional managers utilize sales agencies to identifyselling opportunities and to assist in the ongoing servicing of our customers,in order to enhance and leverage their selling efforts. We intend to hire moredirect regional managers and potentially expand the number of independent salesagencies and representatives generating sales leads for our products, in orderto increase the market penetration of our products.

·       *Focus on Primary Care Market.*We intend to capitalize on thetrend towards the utilization of more sophisticated diagnostic and therapeuticprocedures by primary care physicians. To achieve this goal, we have expendedand are continuing to expend significant resources to establish a physicianoffice distribution channel. This channel focuses on primary care physicians,comprising general internists, family practice physicians, rheumatologists,endocrinologists and diabetologists. By offering our system to primary carephysicians, we are also capitalizing on the trend towards convenient andefficient medical care created by having multiple clinical services providedwithin one facility.

·       *Strengthen Our Presence within Selected Specialty Markets.*Weintend to continue to strengthen our presence within specific physicianspecialty markets that are complementary to our major focus on the primary caremarket. These markets provide both revenue opportunities and additional productvalidation within the marketplace. We believe that the orthopedic, neurology,pain medicine and occupational medicine markets represent the most suitablespecialty markets for expansion.

·       *Continue to Introduce New Products.*We believe that one ofour strengths is our ability to develop and commercialize innovative productsfor neurological applications. We have an ongoing program of makingenhancements and improvements to the NC-stat System, including the introductionof new biosensors. We are also developing a third generation neurodiagnosticsystem. In addition, we are in the early stages of designing a drug deliverysystem for the minimally invasive treatment of neuropathies by both primarycare and specialist physicians. We are also engaged in the development ofproducts for the diagnosis of additional neuropathies. These potential newproducts build upon our mission of enhancing the clinical and businesspractices of our customers. We believe that these potential new products willimprove patient care, allowing us to generate more revenues at attractivemargins from our existing customer base, as well as to attract new customers.

**Market Size**

We estimate thatthere are approximately 2.0 million traditional NCS/nEMG procedures currentlyperformed each year in the United States*.* This estimateis based on (1) data from a CDC report in 1996 regarding NCS/nEMGprocedures ordered or performed during ambulatory patient visits and (2) datafrom a 2001 CMS report regarding Medicare reimbursement under CurrentProcedural Terminology, or CPT, codes for nerve conduction studies andassumptions that Medicare represents 30% of the total existing nerve conductionstudy market and that the average number of CPT codes used per nerve conductionstudy is eight. We anticipate that the advantages and increased availability ofthe NC-stat System will significantly increase the number of nerve conductionstudies performed.

·       *We estimate the potential DPN market for a point-of-service productoffering such as the NC-stat System could be over six million annual patienttests.* The number of individuals with diabetes in the United Stateswas estimated to be 21.0 million, or 7.0% of the population. Among thisgroup, approximately 6.0 million were undiagnosed. According to the CDC,there are about 26 million annual patient visits to office-basedphysicians for diabetes. We anticipate that the increasing focus on earlydetection and prevention of the chronic complications of diabetes will lead toincreased 

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nerve conduction studiesfor DPN. We believe that the estimated 50% rate of annual foot examinations inpatients known to have diabetes is a reasonable estimate for the addressabletesting market in diabetes. If these examinations were replaced by a nerveconduction study, or a nerve conduction study were added to the examination,the diabetes arena would represent an opportunity for over six million annualNC-stat patient tests. The number of Americans with diabetes is projected tomore than double over the next 40 to 50 years. At the present time, thereare no currently marketed pharmaceuticals targeted specifically at DPN, andtherefore nerve conduction studies are performed on a selective basis in orderto address specific clinical issues. If a targeted therapy for DPN weresuccessfully developed and marketed, we believe the rate of testing wouldfurther increase. Based on current clinical trial activity, we anticipate thatdrugs for the treatment of DPN will eventually become available in themarketplace, accelerating the need to detect DPN at its earliest stages toallow for earlier therapeutic intervention and a decrease in the adverseclinical and economic outcomes associated with DPN.

·       *We estimate the potential low back pain market for a point-of-serviceproduct offering such as the NC-stat System could be as great as three millionannual patient tests.* Low back pain is one of the most common medicalconditions in the United States. Over 63 million people reportexperiencing at least one day of serious low back pain in the prior year.Furthermore, back disorders account for over one-quarter of all nonfataloccupational injuries and illnesses that result in days away from work.According to the CDC, there are about nine million annual patient visits tooffice-based physicians specifically for low back symptoms. The CDC furtherestimates that about one-third of office visits are initial visits, at whichtime we believe utilization of the NC-stat System is most likely. We thusanticipate that there may be as many as approximately three million testingopportunities for nerve conduction testing related to low back pain for apoint-of-service product offering such as the NC-stat System. We believe thatthe number of testing opportunities may be even higher, as there are manypatients that visit physicians for symptoms and medical conditions that must bedifferentiated from sciatica, such as leg and foot symptoms, rheumatoidarthritis and diabetes.

·       *We estimate the potential carpal tunnel syndrome market for apoint-of-service product offering such as the NC-stat System could be as greatas 650,000 annual patient tests.* CTS is a significant occupationalissue, as the disorder results in the most days away from work among all majordisabling workplace injuries and illnesses. In a recent health care surveypublished in the Journal of the American Medical Association, approximately 14%of adults reported symptoms characteristic of CTS. It was further estimatedthat 2.5% of adults have true CTS, which could be confirmed by clinicalexamination and nerve conduction studies. This is equivalent to approximatelyfive million individuals in the United States. Over 350,000 surgeries areperformed annually for CTS. The surgical procedure is called a carpal tunnelrelease, or CTR. Most third-party payers require a nerve conduction study priorto authorizing CTR surgery. According to the CDC, there are more than two millionannual visits to office-based physicians for which CTS is the primarydiagnosis. The CDC estimates that about one third of CTS-related office visitsare initial visits, at which time we believe utilization of the NC-stat Systemis most likely. As a result, we estimate that there may be as many as 650,000testing opportunities for the NC-stat System related to CTS. We further believethat this estimate is conservative, as there are many patients that visitphysicians for hand and wrist pain, or medical conditions with a highassociation with CTS such as rheumatoid arthritis, diabetes and obesity. Wealso anticipate that the high costs of CTS-related workers’ compensation claimscould motivate employers to increasingly use a point-of-service product offeringsuch as the NC-stat System to pre-screen and monitor employees for CTS.

Based on the data outlined above, we estimate that thepotential market size for a point-of-service product offering such as theNC-stat System for nerve conduction studies in the diabetes, low back pain andCTS markets in the aggregate could be greater than 9.5 million annualpatient tests in the United States. We 

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estimate that the potential market for NC-stat Systemcould be more than $1.0 billion annually in the United States. However,market size is difficult to predict, and we cannot assure you that ourestimates will prove to be correct. We believe that additional applications ofa point-of-service product offering such as the NC-stat System, including theclinical assessment of patients with neuropathies caused by or associated withother clinical disorders, could further increase this market size.Additionally, although we have not yet quantified the size of the market, webelieve a potential international market opportunity exists for the NC-statSystem.

**Clinical Studies**

The performance ofthe NC-stat System has been substantiated in clinical studies that we havesupported, the results of which have been published in peer-reviewed medicaljournals or presented at major medical conferences.

·       Instudies published in the April 2000 issue of the *Journal of Occupational & EnvironmentalMedicine*, the September 2000 issue of *Neurology and Clinical Neurophysiology*,and the May 2004 issue of the *Journalof Hand Surgery*, the correlation between the results generated bythe NC-stat System and traditional nerve conduction studies in measuring nervefunction of 198 patients was examined. The correlation was equivalent to thatfound between different neurologists performing traditional nerve conductionstudies.

·       Twoabstracts presented at the American Diabetes Association Meeting in June 2004outline the results of a study of 1,000 patients with diabetes. In this study,the NC-stat System was found to detect DPN at the same level and stage as wouldhave been expected from traditional NCS/nEMG procedures.

·       Astudy published in the December 2002 issue of *Spine* evaluated the ability of the NC-stat System to detectneurological impairment in 25 patients with sciatica, confirmed by MRI andclinical examination. The diagnostic accuracy of the NC-stat System wasequivalent to traditional NCS/nEMG procedures as documented in several otherpublished studies.

·       Ina study published in the August 2005 American Journal of Orthopedics, theclinical utility of the NC-stat System was assessed in 72 patients with carpaltunnel syndrome. The NC-stat was found to have a high correlation withtraditional laboratory testing. The NC-stat also measured statisticallysignificant improvement in median nerve function six months following carpaltunnel release surgery.

We continue to support well-designed clinical researchstudies utilizing the NC-stat System that are designed to demonstrate itsclinical accuracy and cost-effectiveness. In addition, several clinical studiesand trials have been performed, and others are underway, in which the NC-statSystem is used to measure changes in nerve function. The NC-stat System wasutilized by Eli Lilly in a clinical trial of Cymbalta for the treatment of painassociated with diabetic peripheral neuropathy. Cymbalta received FDA approvalin the second half of 2004.

**Customers**

We market our productsdirectly to physicians. The NC-stat System provides primary care physicians,who previously were not performing a nerve conduction study at thepoint-of-service or were referring these patients to a neurologist for atraditional NCS/nEMG procedure, with a potential new source of revenues. As of December 31,2005, we had nearly 3,300 active customers. No single customer accounted formore than 10% of our revenues in 2005, 2004 or 2003.

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**Geographic Information**

All of our assets,revenues and expenses for the years ended December 31, 2005, 2004 and 2003were located at or derived from operations in the United States.

**Sales, Marketing and Distribution**

Our sales team is led by our Chief Operating Officer.We presently employ 37 regional sales managers, three sales representatives andthree district sales directors who lead more than 75 independent regional salesagencies employing a total of more than 500 independent sales representatives. Weplan to increase the number of regional sales managers to a total of 46 by theend of the first quarter of 2006. At present, our products are marketed anddistributed solely within the United States. We select our sales agencies andrepresentatives based on their expertise and experience calling on primary careor specialty physicians, their reputation within the targeted physiciancommunity and their sales coverage. Each sales agency is assigned a salesterritory for the NC-stat System and is subject to periodic performancereviews. Our current operating practice is to limit coverage overlap withinmost regions. Through this, we believe we gain a more focused sales approachand more dedicated sales agency organization. Typically, our independent salesrepresentatives identify potential customers for us and assist in monitoringour existing customer accounts, and our regional sales managers complete salesto these customers. Our independent sales agencies do not act as distributorsof our products.

We invest significant efforts in technical, clinicaland business practices training for our regional managers. We work closely withour sales agencies and their sales representatives in order to provide themwith the information and assistance that they need in order to successfullygenerate qualified sales leads for our products. We also require each salesrepresentative to attend periodic sales and product training programs. Theefforts of our regional sales managers and independent sales representativesare enhanced by proprietary software tools that are accessed via a securewebsite, which we refer to as the sales and sales partner portals,respectively. These portals give our sales personnel access to real timecustomer sales and product usage information, various applications to helpidentify and close new business, and marketing materials. The portals alsoprovide customer relationship management functions. Our corporate managementand reimbursement team have access to the same information, as well as portalusage information by all sales personnel.

We market our products directly to physicians. TheNC-stat System provides primary care physicians, who previously were notperforming a nerve conduction study at the point-of-service or were referringthese patients to a neurologist for a traditional NCS/nEMG procedure, with apotential new source of revenues. We believe that this potential revenue streamis an essential marketing advantage of the NC-stat System. We also market ourproducts at various industry conferences in order to accelerate the marketawareness of our products, our customer accrual efforts and market adoption forour products.

We generally invoice products directly to physicianoffices and other customers, typically at list prices. We currently have arelationship with one distributor that directly invoices the physician practiceand we invoice the distributor at list price less a negotiated discount. Weship all products directly to the customer even in cases where we are sellingthrough a distributor. The independent regional sales agencies and their salesrepresentatives are compensated by commissions. Our regional managers arecompensated by a combination of base salary, commissions and goal-based bonuscompensation.

As we launch new products and increase our marketingefforts with respect to existing products, we intend to expand the reach of ourmarketing and sales force. We plan to accomplish this by increasing the numberof direct regional managers and maintaining a broad-based network ofindependent sales agencies and representatives. The establishment anddevelopment of a larger sales force will be expensive and time consuming.Because of the intense competition for their services, we may be unable toenter into agreements with additional qualified independent sales agencies andrepresentatives on commercially 

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reasonable terms or atall. Even if we are able to enter into agreements with additional independentsales agencies, these parties may not commit the necessary resources toeffectively market and sell our products or ultimately be successful in sellingour products. Promotion and sales of medical devices are also highly regulatednot only by the FDA, but also by the Federal Trade Commission, and are subjectto federal and state fraud and abuse enforcement activities.

In March 2005, we entered into an education anddevelopment program agreement with Eli Lilly and Company, an Indianacorporation, pursuant to which the parties agreed to work together to conductand present up to eighty-four educational and development programs regardingDPN across the United States. During the second quarter of 2005, the firstseries of approximately 20 programs were conducted as originally planned. In August 2005,Eli Lilly announced that a Phase III clinical trial evaluating the use ofruboxistaurin, Eli Lilly’s drug candidate, for the treatment of DPN did notmeet its primary endpoints, but Eli Lilly also announced that it was continuingan ongoing, three-year Phase III clinical trial evaluating the use ofruboxistaurin for the treatment of DPN that was scheduled to complete in 2007. SinceEli Lilly’s announcement we have not conducted, or made any plans to conduct,any further programs with Eli Lilly. The agreement with Eli Lilly is scheduledto terminate in September 2006 unless we agree to extend it and we may, ormay not, conduct additional programs prior to the termination of thisagreement.

**Manufacturing and Supply**

We rely on outside contractors for the manufacture andservicing of our products and their components, and we do not currentlymaintain alternative manufacturing sources for the NC-stat monitor, dockingstation or biosensors or any other finished goods products. In outsourcing, wetarget companies that meet FDA, International Organization for Standardization,or ISO, and other quality standards supported by internal policies andprocedures. Supplier performance is maintained and managed through a correctiveaction program ensuring all product requirements are met or exceeded. Webelieve these manufacturing relationships minimize our capital investment,provide us with manufacturing expertise and help control costs.

Following the receipt of products or productcomponents from our third-party manufacturers, we conduct the necessaryinspection and packaging and labeling at our corporate headquarters facility.We may consider manufacturing certain products or product componentsinternally, if and when demand or quality requirements make it appropriate todo so. We currently have no plans to manufacture any products or productcomponents internally.

We seek to obtain products from our manufacturers inorder to maintain sufficient inventory to satisfy our customer obligations. We didnot experience any inventory shortages on any established products in 2005. Weoccasionally experience transient inventory shortages, typically lasting lessthan one month, on new products during the initial production ramp-up phase. Weare currently working with our third-party manufacturers to increasemanufacturing capabilities to meet the demand we expect as we increase oursales efforts. Manufacturers often experience difficulties in scaling-upproduction, including problems with production yields and quality control andassurance. If our third-party manufacturers are unable to manufacture ourproducts to keep up with demand, we would not meet expectations for growth ofour business.

Parlex Polymer FlexibleCircuits, Inc., which was previously known as PolyFlex Circuits, Inc.,a wholly owned subsidiary of the Parlex Corporation, or Parlex, has beenmanufacturing NC-stat biosensors under general purchase orders since early1999. While our relationship with Parlex is good, we do not have a formalsupply agreement in place with them, although we are negotiating such anagreement, and it could cease manufacturing NC-stat biosensors at any time. Ifwe are forced to engage an alternative supplier, we may incur additional expense,higher cost per unit, delays in delivery and quality control problems. Wecannot assure you that a supply agreement will be successfully negotiated, orif negotiated, that it will be on reasonable terms. Parlex was acquired byJohnson Electric, a Hong Kong based manufacturing company, 

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in November 2005.While we do not expect any material changes in Parlex’s operations as a resultof the acquisition, we cannot assure you that Johnson Electric will notimplement changes that may be adverse to our company or remain committed to themanufacturing of our NC-stat biosensors.

Sunburst EMS, Inc.,or Sunburst, has been manufacturing our NC-stat monitors and docking stationssince November 2005. Previously, Advanced Electronics, Inc., or AEI,had been manufacturing our monitors and docking stations since 2002. Sunburstcould cease manufacturing NC-stat monitors and docking stations for us at anytime. We are currently negotiating a supply agreement with Sunburst but we cannotassure you that we will be able to successfully negotiate a supply agreement,or if negotiated, that the supply agreement will be on reasonable terms.  We have identified alternative supplierscapable of manufacturing the NC-stat monitors and docking stations should thisbecome necessary. However, if we are forced to engage an alternative supplier,we may incur additional expense, higher cost per unit, delays in delivery andquality control problems.

We and our third-party manufacturers are registeredwith the FDA and subject to compliance with FDA quality system regulations. Weare also ISO registered and undergo frequent quality system audits by Europeanagencies. Our products are cleared for market within the United States and Canada,and are also approved for distribution in the European Union, although to datewe have sales only in the United States. Our facility and the facilities of ourmanufacturers are subject to periodic unannounced inspections by regulatoryauthorities, and may undergo compliance inspections conducted by the FDA andcorresponding state agencies. We experienced an FDA inspection in May 2003.During its inspection, the FDA issued a Form 483, which is a notice ofinspection observations. Two minor items were identified and the correctiveactions for both were initiated prior to the completion of the audit. Theresponses provided to the FDA were deemed adequate and no further action hasbeen requested. As a registered device manufacturer, we and our manufacturerswill undergo regularly scheduled FDA quality system inspections; however,additional FDA inspections may occur if deemed necessary by the FDA.

**InformationTechnology Infrastructure**

Our information technologyinfrastructure is designed to support the requirements of our onCallInformation System. The onCall Information System employs a high performance,scalable platform consisting of standard hardware, proprietary andoff-the-shelf system software components, database servers, proprietaryapplication servers, a modem bank and desktop applications. The in-boundinfrastructure consists of telephone lines and proprietary communicationsgateway software to collect data from the remote NC-stat Systems. The gatewayassembles the data sent from each remote NC-stat docking station, stores it andqueues it for processing by our proprietary software. The processinginfrastructure consists of proprietary software to process each nerveconduction study. The out-bound infrastructure consists of a proprietary reportserver application and a fax and email server that is an off-the-shelf product.

TheonCall Information System utilizes sophisticated expert system technology toprovide real-time quality control monitoring and reporting of nerve conductionstudy results. The onCall applications include:

·       acommunications gateway for receiving test files and updating the software ofremote NC-stat Systems;

·       arelational database server to store and retrieve nerve conduction studies;

·       anapplication server to analyze and maintain the nerve conduction study data;

·       anapplication server to format and produce nerve conduction reports;

·       afax and email server to send reports to remote users; and

·       aclient application that is designed to monitor quality and service customerrequests.

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The application servers and client applications use acommon set of software components that form the onCall class library.

The onCall InformationSystem is physically secured in our restricted-access computer room at ourfacilities in Waltham, Massachusetts. Our computer facility’s electrical poweris backed up with auxiliary power in the event of a power outage. Automatedbackups of the databases and computer files are maintained both on- andoff-site. We also maintain a lock box at an off-site location that containscopies of the business continuity plan and application server software vital tothe operation of the onCall Information System that would be needed in adisaster recovery situation.

**ProductsUnder Development and Research and Development**

Our research anddevelopment efforts are focused in the near term on further enhancing ourexisting products and developing the third generation neurodiagnostic systemand new NC-stat biosensors, as well as designing a drug delivery system for theminimally invasive treatment of neuropathies by both primary care andspecialist physicians. Our research and development staff consists of 20people, including five who hold Ph.D. degrees. Our research and developmentgroup has extensive experience in neurophysiology, biomedical instrumentation,signal processing, biomedical sensors and information systems. Theseindividuals work closely with our marketing group, our clinical support group(led by a board-certified neurologist), our scientific advisors and our customersto design products that are intended to improve clinical and economic outcomes.

*Devices for theTreatment of Neuropathy*

In pursuit of ourobjective to develop medical devices that provide comprehensive solutions forthe diagnosis and treatment of patients with neuropathies, we are seeking toexpand our product base beyond the diagnostic and into the treatment arena. Webelieve that our core technology can be adapted and extended to provideminimally invasive approaches to treating neuropathies. In particular, webelieve that neuropathies that are focal, or localized, in nature can be safelyand effectively treated if drugs can be delivered near the disease site withoutdamaging the nerve in the process. Some of these types of treatments areperformed today, but they are performed manually by a limited number ofphysicians. Our product development program includes the design of a productthat we believe will reduce the risk involved in providing these treatments. Weare in the early stages of designing this product to enable a broad base ofphysicians to provide this type of minimally invasive neuropathy therapy at thepoint-of-service.

*NC-stat System*

We have an ongoing program of making enhancements andimprovements to the NC-stat System. We are developing new NC-stat biosensorsand associated software for the medically appropriate testing of additionalnerves. We also are developing our third generation neurodiagnostic system withan improved user interface, along with new features for the onCall InformationSystem, that will allow our customers to perform more complex analyses ofdiagnostic data. In addition, we continually seek ways to reduce themanufacturing costs and improve the performance of the NC-stat biosensors.

NEUROMetrix®, NC-stat® andonCallTM are trademarks of ours.

During 2005, 2004 and2003, we spent $3.8 million, $3.3 million and $2.4 million, respectively, onresearch and development.

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**CustomerService and Clinical Support**

Our customer service groupconsists of six representatives. These representatives are available bytelephone 12 hours per day, five days per week (plus limited coverage onSaturday) to address a wide range of technical questions from customers on theuse of the NC-stat System, respond to customer requests for product and clinicalmaterials that have been released by our marketing department, take orders, andprovide customers with order status information. Our customer servicerepresentatives receive specialized ongoing product and clinical training. Wealso maintain a clinical support group consisting of four individuals. Ourclinical support group is available to address questions from our customersrelating to test results and use of our products. This group is led by aboard-certified neurologist, who is a full-time employee.

**Competition**

We consider the primary competition for our productsto be traditional NCS/nEMG procedures. Our success depends in large part onconvincing physicians to adopt the NC-stat System in order to perform nerveconduction studies at the point-of-service.

There are a number of companies that sell traditionalNCS/nEMG equipment, typically to neurologists. These companies include ViasysHealthcare Inc., Cadwell Laboratories, Inc and Xltec, Inc. ViasysHealthcare has substantially greater financial resources than we do, and theyhave established reputations as worldwide distribution channels for medicalinstruments to neurologists and other physicians. We do not know if thesecompanies are engaged in research and development efforts to develop products toperform point-of-service nerve conduction studies that would be competitivewith the NC-stat System. We are aware of one company, Neumed Inc., thatmarkets a nerve conduction study system to the point-of-service market.

We believe that amongsystems marketed for performance of nerve conduction studies today, only theNC-stat System provides both the level of diagnostic accuracy, the level ofautomation and the ease of use required for successful penetration of thepoint-of-service market. We also believe that the reporting and data repositoryfunctions provided by the onCall Information System, although entirelyoptional, provide our customers who use this service with significant addedclinical and economic value that is not matched by other currently marketedproducts. We further believe that the expanding database of nerve conductionstudy data captured by the onCall Information System facilitates our ability toimprove the performance of the NC-stat System. We believe that the size of ourdatabase and ongoing improvements provide us with a significant competitiveadvantage.

**Intellectual Property**

We rely on a combinationof patents, trademarks, copyrights, trade secrets and other intellectualproperty laws, nondisclosure agreements and other measures to protect ourproprietary technology, intellectual property rights and know-how. We holdissued utility patents covering a number of important aspects of our NC-statSystem. We believe that in order to have a competitive advantage, we mustdevelop and maintain the proprietary aspects of our technologies. Currently, werequire our employees, consultants and advisors to execute confidentialityagreements in connection with their employment, consulting or advisoryrelationships with us, where appropriate. We also require our employees,consultants and advisors who we expect to work on our products to agree todisclose and assign to us all inventions conceived during the work day,developed using our property or which relate to our business. Despite anymeasures taken to protect our intellectual property, unauthorized parties mayattempt to copy aspects of our products or to obtain and use information thatwe regard as proprietary.

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*Patents*

As of December 31,2005, we had 12 issued U.S. patents, three issued foreign patents and23 pending patent applications, including 16 U.S. applications, oneinternational (PCT application and six foreign national applications. We alsohold an exclusive license to two issued U.S. patents, one issued foreign patent(Europe) and one pending foreign national patent application. The issued andpending patents that we own and license cover, among other things:

·       Nerveconduction biosensors and related methods;

·       Nerveconduction hardware;

·       Algorithmsfor performing and analyzing nerve conduction studies; and

·       NC-statSystem industrial design.

Our issued design patents begin to expire in 2015, andour issued utility patents begin to expire in 2017. In particular, seven of ourissued U.S. utility patents covering important aspects of our current productswill expire on the same date in 2017. Although the patent protection formaterial aspects of our products covered by the claims of the patents will belost at that time, we have additional patents and patent applications directedto other novel inventions that will have patent terms extending beyond 2017.

In general terms, a utility patent protects the way anarticle is used or works, while a design patent protects the way an articlelooks. More particularly, utility patents are provided for a new, nonobviousand useful process, machine, article of manufacture, composition of matter orimprovement of any of the foregoing. Design patents are provided for a new,nonobvious and useful ornamental design of an article of manufacture. In adesign patent application, the subject matter which is claimed is the designembodied in or applied to an article of manufacture, or a portion thereof, andnot the article itself. Both design and utility patents may be obtained on anarticle if invention resides both in its utility and ornamental appearance.

The medical device industry is characterized by theexistence of a large number of patents and frequent litigation based onallegations of patent infringement. Patent litigation can involve complexfactual and legal questions, and its outcome is uncertain. Any claim relatingto infringement of patents that is successfully asserted against us may requireus to pay substantial damages. Even if we were to prevail, any litigation couldbe costly and time-consuming and would divert the attention of our managementand key personnel from our business operations. Our success will also depend inpart on our not infringing patents issued to others, including our competitorsand potential competitors. If our products are found to infringe the patents ofothers, our development, manufacture and sale of these potential products couldbe severely restricted or prohibited. In addition, our competitors mayindependently develop similar technologies. Because of the importance of ourpatent portfolio to our business, we may lose market share to our competitorsif we fail to protect our intellectual property rights.

As the number of entrants into our market increases,the possibility of a patent infringement claim against us grows. Although wehave not received notice of any claims, and are not aware that our productsinfringe other parties’ patents and proprietary rights, our products andmethods may be covered by U.S. patents held by our competitors. In addition,our competitors may assert that future products we may market infringe theirpatents.

A patent infringement suitbrought against us may force us or any strategic partners or licensees to stopor delay developing, manufacturing or selling potential products that areclaimed to infringe a third party’s intellectual property, unless that partygrants us rights to use its intellectual property. In such cases, we may berequired to obtain licenses to patents or proprietary rights of others in orderto continue to commercialize our products. However, we may not be able toobtain any licenses required under any patents or proprietary rights of thirdparties on acceptable terms, or at all. Even if we were able to obtain 

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rightsto the third party’s intellectual property, these rights may be non-exclusive,thereby giving our competitors access to the same intellectual property.Ultimately, we may be unable to commercialize some of our potential products ormay have to cease some of our business operations as a result of patent infringementclaims, which could severely harm our business.

*Trademarks*

We hold domestic andcertain foreign trademark registrations for the marks NEUROMETRIX and NC-STAT.The U.S. registration for NEUROMETRIX is on the Supplemental Register. Inaddition, we also have two other pending U.S. trademark applications for themark NEUROMETRIX. We also have a U.S. trademark application pending for themark onCall.

**Third-Party Reimbursement**

We anticipate that sales volumes and prices of ourproducts will continue to be dependent in large part on the availability ofreimbursement for our customers from third-party payers and on policies issuedby governmental agencies. Third-party payers include governmental programs suchas Medicare and Medicaid, private insurance plans, and workers’ compensationplans. These organizations may deny coverage and refuse reimbursement for adiagnostic procedure or specific product such as the NC-stat System if theydetermine that the diagnostic test or product was not medically appropriate ornecessary. The third-party payers may also place limitations on the types ofphysicians that can perform specific types of diagnostic procedures. Also,third-party payers are increasingly challenging the prices charged for medicalproducts and services. In international markets, reimbursement and healthcarepayment systems vary significantly by country, and many countries haveinstituted payment ceilings on specific product lines and procedures. We cannotassure you that procedures using our products will be considered medicallyreasonable and necessary for a specific indication, that our products will beconsidered cost-effective by third-party payers, that procedures performedusing our products will be reimbursed as separate procedures under existing CPTcodes, that an adequate level of reimbursement will be available or that thethird-party payers’ coverage and reimbursement policies will not adverselyaffect our ability to sell our products profitably.

A key component in the reimbursement decision by mostprivate insurers and CMS, which administers Medicare, is the assignment of aCPT code. This code is used in the submission of claims to insurers forreimbursement for medical services. CPT codes are assigned, maintained andrevised by the CPT Editorial Panel administered by the American MedicalAssociation, or AMA. According to present Medicare guidelines, nerve conductionstudies may be performed by medical doctors, or M.D.s, and doctors ofosteopathic medicine, or D.O.s, and are reimbursable under the three CPT codes:95900, 95903, and 95904. We believe that the nerve conduction measurementsperformed by the NC-stat System meet the requirements stipulated in the codedescriptions published by the AMA and that these codes are currently used byphysicians performing nerve conduction studies with the NC-stat System. If theCPT codes that apply to the procedures performed using our products arechanged, reimbursement for performances of these procedures may be adverselyaffected.

In the United States, some insured individuals arereceiving their medical care through managed care programs, which monitor andoften require pre-approval of the services that a member will receive. Somemanaged care programs are paying their providers on a per capita basis, which putsthe providers at financial risk for the services provided to their patients bypaying these providers a predetermined payment per member per month, andconsequently, may limit the willingness of these providers to use our products.

We believe that the overall escalating cost of medicalproducts and services has led to, and will continue to lead to, increasedpressures on the healthcare industry to reduce the costs of products andservices. We cannot assure you that third-party reimbursement and coverage willbe available or adequate, 

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or that futurelegislation, regulation, or reimbursement policies of third-party payers willnot adversely affect the demand for our products or our ability to sell theseproducts on a profitable basis. The unavailability or inadequacy of third-partypayer coverage or reimbursement could have a material adverse effect on ourbusiness, operating results and financial condition.

In addition, we believethere may be pressure applied on payer organizations by specialists, such as neurologists,who perform traditional nerve conduction studies and view the NC-stat System ascompetitive with their business.

**FDAand Other Governmental Regulation**

*FDA Regulation*

Our products aremedical devices subject to extensive regulation by the FDA under the U.S. Food,Drug, and Cosmetic Act, as well as other regulatory bodies. FDA regulationsgovern, among other things, the following activities that we or our contractmanufacturers perform and will continue to perform to ensure that medicaldevices distributed domestically or exported internationally are safe andeffective for their intended use:

·       product design anddevelopment;

·       product testing;

·       product manufacturing;

·       product labeling;

·       product safety;

·       product storage;

·       pre-market clearance orapproval;

·       recordkeeping;

·       advertising and promotion;

·       production

·       postmarketsurveillance and reporting; and

·       product sales anddistribution.

The FDA classifiesmedical devices into one of three classes on the basis of the controls deemednecessary to reasonably ensure their safety and effectiveness:

·       Class I, requiringgeneral controls, including labeling, device listing, reporting and, for someproducts, adherence to good manufacturing practices through the FDA’s qualitysystem regulations and pre-market notification;

·       Class II, requiringgeneral controls and special controls, which may include performance standardsand post-market surveillance; and

·       Class III, requiringgeneral controls and pre-market approval.

Before being introducedinto the market, our products must obtain market clearance through either the510(k) pre-market notification process, the *de novo* review process or the pre-market approval process.

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*510(k) Pre-MarketNotification Process*

To obtain 510(k) clearance, we must submit apre-market notification demonstrating that the proposed device is substantiallyequivalent in intended use, safety and effectiveness to a legally marketed Class Ior II medical device or to a Class III device marketed prior to May 28,1976 for which the FDA has not yet required the submission of a pre-marketapproval application. In some cases, we may be required to perform clinicaltrials to support a claim of substantial equivalence. It generally takes fromthree to twelve months from the date of submission to obtain 510(k) clearance,but it may take longer.

After a medical devicereceives 510(k) clearance, any modification that could significantlyaffect its safety or effectiveness, or that would constitute a significantchange in its intended use, requires a new 510(k) clearance or couldrequire *de novo* classification orpre-market approval. The FDA allows each company to make this determination,but the FDA can review the decision. If the FDA disagrees with a company’sdecision not to seek FDA authorization, the FDA may retroactively require thecompany to seek 510(k) clearance, *denovo* classification or pre-market approval. The FDA also can requirethe company to cease marketing and/or recall the medical device in questionuntil 510(k) clearance, *de novo*classification or pre-market approval is obtained or take other action.

*De Novo ReviewProcess*

If a previouslyunclassified medical device does not qualify for the 510(k) pre-marketnotification process because there is no predicate device to which it issubstantially equivalent, and if the device may be adequately regulated throughgeneral controls or special controls, the device may be eligible for *de novo* classification through what iscalled the *de novo* reviewprocess. In order to use the *de novo*review process, a company must receive a letter from the FDA stating that,because the device has been found not substantially equivalent to a legallymarketed Class I or II medical device or to a Class III devicemarketed prior to May 28, 1976 for which the FDA has not yet required thesubmission of a pre-market approval application, it has been placed into Class III.After receiving this letter, the company, within 30 days, must submit tothe FDA a request for *de novo*classification into Class I or II. The FDA then has 60 days in whichto approve or deny the *de novo*classification request. If the FDA grants *denovo* classification, the device will be placed into either Class Ior Class II, and allowed to be marketed. If a product is classified into Class Ior II through the *de novo* reviewprocess, then that device may serve as a predicate device for subsequent 510(k) pre-marketnotifications.

*Pre-Market ApprovalProcess*

If a medical device doesnot qualify for the 510(k) pre-market notification process and is noteligible for clearance through the *de novo*reviewprocess, a company must file a pre-market approval application. Thepre-market approval process generally requires more extensive pre-filingtesting than is required in the 510(k) pre-market notification process andis more costly, lengthy and uncertain. The pre-market approval process can takeone to three years or longer. The pre-market approval process requires thecompany to prove the safety and effectiveness of the device to the FDA’s satisfactionthrough extensive submissions, including pre-clinical and clinical trial data,and information about the device, its design, manufacture, labeling andcomponents. Before granting pre-market approval, the FDA generally alsoperforms an on-site inspection of manufacturing facilities for the product toensure compliance with the FDA’s quality system regulations. After anypre-market approval, a new pre-market approval application or applicationsupplement may be required in the event of modifications to the device, itslabeling, intended use or indication, or its manufacturing process.

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*Clinical Studies*

A clinical study is almostalways required to support a pre-market approval application and is sometimesrequired to obtain 510(k) clearance. Before conducting clinical trials, amanufacturer generally must submit to the FDA an application for aninvestigational device exemption, or IDE. The IDE application must be supportedby appropriate data, such as animal and laboratory testing results, showing thatit is safe to test the device in humans and that the testing protocol isscientifically sound. If a medical device is considered a “non-significant”risk, an IDE application to the FDA is not required. Instead, only approvalfrom the Institutional Review Board overseeing the clinical trial is required.The IDE application must be approved in advance by the FDA for a specifiednumber of patients, unless the product is deemed a non-significant risk deviceand eligible for more abbreviated investigational device exemptionrequirements. Clinical trials for a significant risk device may begin once theinvestigational device exemption application is approved by the FDA and theappropriate institutional review boards at the clinical study sites. Allclinical studies must be conducted in accordance with FDA regulations andfederal regulations concerning human subject protection and healthcare privacy.Failure to comply with these requirements can prevent the clinical trialsponsor from using the study data, and could result in regulatory enforcementor liability. Even if all regulatory standards are met, the results of ourclinical testing may not support or may not be sufficient to obtain clearanceor approval for our product.

*NC-stat System*

The NC-stat System has receivedfive 510(k) clearances as a Class II medical device, the first ofwhich was received in 1998, and the most recent (K041320) in August 2004.The NC-stat System has the following intended use:

*The NEUROMetrixNC-stat is intended to measure neuromuscular signals that are useful indiagnosing and evaluating systemic and entrapment neuropathies.*

We believe that thisintended use is consistent with the manner in which the NC-stat System ismarketed and used by our customers. Since we received our most recent 510(k) clearancefor the NC-stat System in August 2004, we have enhanced the NC-stat Systemby making changes to the software it employs. We do not believe that thesechanges require new 510(k) clearances. We further believe that theaddition of new indications and enhancements to the NC-stat System in thefuture either will not require new FDA authorization or will be able to becleared using the 510(k) pre-market notification process. However, the FDAcould disagree, and could require us to halt selling and/or recall the productuntil we obtain 510(k) clearance or pre-market approval.

*Post-MarketRegulation*

After a device isplaced on the market, numerous regulatory requirements apply. These include:

·       quality system regulations,which require manufacturers to follow design, testing, control, documentationand other quality assurance procedures during the manufacturing process;

·       labeling regulations, whichprohibit the promotion of products for unapproved or “off-label” uses andimpose other restrictions on labeling; and

·       medical device reportingregulations, which require that manufacturers, which term includes companiessuch as us that create the specifications for the regulated products, report tothe FDA if their device may have caused or contributed to a death or seriousinjury or malfunctioned in a way that would likely cause or contribute to adeath or serious injury if it were to recur.

Also, we are subject to unannounced inspections by theFDA, and these inspections may include the manufacturing facilities of ourcontractor manufacturers.

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Failure to complywith applicable regulatory requirements can result in enforcement action by theFDA, which may include any of the following sanctions:

·       warning letters, fines,injunctions, consent decrees and civil penalties;

·       repair, replacement,refund, recall or seizure of our products;

·       operating restrictions,suspension or shutdown of production;

·       refusing our request for510(k) clearance or pre-market approval of new products, new intendeduses, or modifications to existing products;

·       withdrawing 510(k) clearanceor pre-market approvals that already have been granted; and

·       criminal prosecution.

*InternationalRegulations*

International sales of medical devices are subject toforeign governmental regulations, which vary substantially from country tocountry. The time required to obtain approval by a foreign country may belonger or shorter than that required for FDA approval, and the requirements maydiffer.

The primary regulatoryenvironment in Europe is that of the European Union, which consists of 25countries encompassing most of the major countries in Europe. Other countries,such as Switzerland, have voluntarily adopted laws and regulations that mirrorthose of the European Union with respect to medical devices. The European Unionhas adopted numerous directives and standards regulating the design,manufacture, clinical trials, labeling, and adverse event reporting for medicaldevices. Devices that comply with the requirements of a relevant directive areentitled to bear CE conformity marking, indicating that the device conformswith the essential requirements of the applicable directives and, accordingly,can be commercially distributed throughout Europe. The method of assessingconformity varies depending on the class of the product, but may involveself-assessment by the manufacturer, a third-party assessment by a NotifiedBody, which is a third-party organization appointed by a member of the EuropeanUnion, or some combination thereof. This third-party assessment may consist ofan audit of the manufacturer’s quality system and specific testing of themanufacturer’s product. An assessment by a Notified Body in one country withinthe European Union generally is required in order for a manufacturer to distributethe product commercially throughout the European Union. In 2000, we werecertified by TUV Product Service, a Notified Body, under the European UnionMedical Device Directive allowing the CE conformity marking to be applied tothe NC-stat System. We had a successful renewal audit in 2005.

*U.S. Anti-Kickbackand False Claims Laws*

In the United States,there are federal and state anti-kickback laws that prohibit the offer,payment, solicitation or receipt of kickbacks, bribes or other remuneration intended,among other things, to induce the purchase or recommendation of healthcareproducts and services. Violations of these laws can lead to severe civil andcriminal penalties, including exclusion from participation in federalhealthcare programs. These laws are potentially applicable to manufacturers ofmedical devices, such as us, and to hospitals, physicians and other potentialpurchasers of medical devices. Other provisions of state and federal lawprovide civil and criminal penalties for presenting, or causing to bepresented, to third-party payers for reimbursement, claims that are false orfraudulent, or which are for items or services that were not provided asclaimed. Under the federal civil False Claims Act, in addition to actionsinitiated by federal law enforcement authorities, the statute authorized “quitam” actions to be brought on behalf of the federal government by a privateparty in certain circumstances and, if successful, that private party can sharein any monetary recovery. Although we believe we have and will continue tostructure our business relationships with purchasers of our products to complywith these and other applicable laws, it is possible 

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thatsome of our business practices could be subject to scrutiny and challenge by federalor state enforcement officials or others under these laws. This type ofchallenge could have a material adverse effect on our business, financialcondition and results of operations.

*Health InsurancePortability and Accountability Act of 1996 and Related Laws*

Federal and state lawsprotect the confidentiality of certain patient health information, includingpatient records, and restrict the use and disclosure of that protectedinformation. In particular, the U.S. Department of Health and Human Servicespromulgated patient privacy rules under HIPAA. These privacy rules protectmedical records and other personal health information by limiting their use anddisclosure, giving individuals the right to access, amend and seek accountingof their protected health information and limiting most use and disclosures ofhealth information to the minimum amount reasonably necessary to accomplish theintended purpose. We believe that, as a medical device manufacturer, we are notdirectly subject to the HIPAA privacy rules. In addition, we only receivepatient data in our onCall Information System on an anonymous basis, with allpatient specific information de-identified. Nevertheless, we seek to complywith a number of the HIPPA privacy rules. We believe that we are not inviolation of federal or state health information privacy or confidentialitystatutes or regulations. However, if we are found to have violated any of theselaws, we could be subject to civil or criminal penalties. Additionally, changesin these laws could adversely affect our business.

**Employees**

As of December 31, 2005, we had a total of 100employees. Of the total employees, 21 were in research and development, 53 insales and marketing and 26 in general and administrative services. Twoemployees hold both M.D. and Ph.D. degrees, five additional employees holdPh.D. degrees and one additional employee holds an M.D. degree.

Our employees are notrepresented by a labor union and are not subject to a collective bargainingagreement. We have never experienced a work stoppage. We believe our relationswith our employees are good.

**Available Information**

Access to our Annual Report on Form 10-K,Quarterly Reports on Form 10-Q, Current Reports on Form 8-Kand amendments to these reports filed with or furnished to the Securities andExchange Commission, or SEC, may be obtained through the Investor Relationssection of our website at www.neurometrix.com/investor as soon as reasonablypractical after we electronically file or furnish these reports. We do not chargefor access to and viewing of these reports. Information on our InvestorRelations page and on our website is not part of this Annual Report on Form 10-Kor any of our other securities filings unless specifically incorporated hereinby reference. In addition, the public may read and copy any materials that wefile with the SEC at the SEC’s Public Reference Room at 100 F Street, NE,Washington, D.C. 20549. The public may obtain information on the operation ofthe Public Reference Room by calling the SEC at 1-800-SEC-0330.Also, our filings with the Securities and Exchange Commission may be accessedthrough the Securities and Exchange Commission’s Electronic Data Gathering,Analysis and Retrieval system at www.sec.gov. All statements made in any of oursecurities filings, including all forward-looking statements or information,are made as of the date of the document in which the statement is included, andwe do not assume or undertake any obligation to update any of those statementsor documents unless we are required to do so by law.

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**ITEM 1A.**        Risk Factors

*You should carefully consider the following risks andall other information contained in this annual report on Form 10-Kand our other public filings before making any investment decisions withrespect to our common stock. If any of the following risks occurs, ourbusiness, prospects, reputation, results of operations or financial conditioncould be harmed. In that case, the trading price of our common stock coulddecline, and our stockholders could lose all or part of their investment. Thisannual report also contains forward-looking statements that involve risks anduncertainties. Our actual results could differ materially from thoseanticipated in the forward-looking statements as a result of specific factors,including the risks described below and elsewhere in this annual report.*

**We have incurredsignificant operating losses since inception and cannot assure you that we willsustain profitability.**

Since our inception in1996, we have incurred losses every quarter with the exception of the third andfourth quarters of 2005. We began commercial sales of our products in May 1999and we have yet to demonstrate that we can consistently generate sufficientsales of our products to sustain profitability. The extent of our futureoperating income or losses is highly uncertain, and we may not be able tosustain profitability. We have incurred significant net losses since ourinception, including net losses of approximately $8.7 million in 2001,$4.8 million in 2002, $3.7 million in 2003 and $4.3 million for in2004. In 2005 we recorded net income of $938,200. At December 31, 2005, wehad an accumulated deficit of approximately $56.5 million. We cannot assure youthat we will be able to sustain the profitability achieved in 2005.

**If physicians orother healthcare providers are unable to obtain sufficient reimbursement fromthird-party healthcare payers for procedures performed using the NC-statSystem, the adoption of the NC-stat System and our future product sales will beseverely harmed.**

Widespread adoption of theNC-stat System by the medical community is unlikely to occur if physicians donot receive sufficient reimbursement from third-party payers for performingnerve conduction studies using the NC-stat System or if certain changes are imposedon the professional requirements for performing nerve conduction studies and wemay be required to expend substantial resources to address potentialreimbursement issues with third-party payers. If physicians are unable to obtain adequatereimbursement for procedures performed using the NC-stat System, we may beunable to sell the NC-stat System and our business would suffer significantly.Additionally, even if these procedures are reimbursed by third-party payers,adverse changes in payers’ policies toward reimbursement for the procedureswould harm our ability to market and sell the NC-stat System. Third-partypayers include those governmental programs such as Medicare and Medicaid,workers’ compensation programs, private health insurers and other organizations.These third-party payers may deny coverage if they determine that a procedurewas not reasonable or necessary, for example, if its use was not consideredmedically appropriate, or was experimental, or was performed for an unapprovedindication. In addition, some health care systems are moving towards managedcare arrangements in which they contract to provide comprehensive healthcarefor a fixed cost per person, irrespective of the amount of care actuallyprovided. These providers, in an effort to control healthcare costs, areincreasingly challenging the prices charged for medical products and servicesand, in some instances, have pressured medical suppliers to lower their prices.If we are pressured to lower our prices, our revenues may decline and ourprofitability could be harmed. CMS guidelines set the reimbursement rates forprocedures covered by Medicare. Future regulatory action by CMS or othergovernmental agencies or negative clinical results may diminish reimbursementpayments to physicians for performing procedures using the NC-stat System.Medicaid reimbursement differs from state to state, and some state Medicaidprograms may not reimburse physicians for performing procedures using theNC-stat System in an adequate amount, if at all. Additionally, some privatepayers do not follow the CMS and Medicaid guidelines and may reimburse for 

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only a portion of these procedures or not at all. Weare unable to predict what changes will be made in the reimbursement methodsused by private or governmental third-party payers. Additionally, we may berequired to expend substantial resources to address potential reimbursementissues with third party payers.

**Wemay be unable to expand the market for the NC-stat System, which would limitour ability to increase our revenues.**

We believe that thedrawbacks of traditional nerve conduction studies, including those related tothe referral process, and the limited treatment options for DPN, have limitedthe number of nerve conduction studies that are performed. For our futuregrowth, we are relying, in part, on increased use of nerve conduction studies.A number of factors could limit the increased use of nerve conduction studiesand the NC-stat System, including:

·       third-partypayers challenging, or the threat of third-party payers challenging, thenecessity of increased levels of nerve conduction studies;

·       third-partypayers reducing or eliminating reimbursement for procedures performed byphysicians using the NC-stat System;

·       unfavorableexperiences by physicians using the NC-stat System;

·       physicians’reluctance to alter their existing practices; and

·       thefailure of other companies’ existing drug development programs to produce aneffective treatment for DPN, which may limit the perceived need and the actual useof the NC-stat System in connection with this disease, and thereby limit ordelay our growth in the DPN market, which we have estimated to be our largestpotential market for our NC-stat System.

If we are unable to expandthe market for the NC-stat System, our ability to increase our revenues will belimited and our business prospects will be adversely affected.

**Wemay not be able to accurately predict the size of the market for our NC-statSystem.**

We may not be able toaccurately predict the size of the market for products used to diagnoseneuropathies, such as our NC-stat System. Neuropathies traditionally have beendiagnosed by an NCS/nEMG procedure, performed by a neurologist or physician ina related specialty. We estimate that there are approximately 2.0 milliontraditional NCS/nEMG procedures performed each year in the United States;however, we anticipate that the advantages and increased availability of theNC-stat System will significantly increase the number of nerve conductionstudies performed. Based on our analysis of current data, we estimate that thepotential market size for the NC-stat System in the diabetes, low back pain andcarpal tunnel syndrome markets in the aggregate could be greater than 9.5million annual patient tests. This represents a significant increase in thesize of the market for nerve conduction studies and is based upon a number ofassumptions and estimates, which themselves may not be accurate. For example,we have assumed that all initial office visits for low back pain may representan opportunity for use of the NC-stat System, and we have estimated that anannual testing rate of 50% for all individuals diagnosed with diabetesrepresents the potential addressable market in diabetes. Market size isdifficult to predict, and we cannot assure you that our assumptions orestimates will prove to be correct. The industry and market data in this annualreport on Form 10-K on which we have based our assumptions andestimates of future market size, may be inaccurate or incomplete, and we havenot independently verified those data. If our estimate of the size of themarket for our NC-stat System is incorrect, our potential revenue growth may belimited.

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**If weare unable to successfully sell the NC-stat System to primary care physicians,our ability to increase our revenues will be limited.**

We are focusing our salesand marketing efforts for the NC-stat System on primary care physicians. Asthese physicians traditionally have not been targeted by companies sellingequipment used to perform nerve conduction studies, we may face difficulties inselling our products to them. Particularly, we may be unable to convince thesephysicians that the NC-stat System provides an effective alternative or usefulsupplement to existing testing methods. In addition, these physicians may bereluctant to make the capital investment to purchase the NC-stat System andalter their existing practices. If we are unable to successfully sell theNC-stat System to primary care physicians, our ability to increase our revenueswill be severely limited.

**Weare dependent on two single source manufacturers to produce all of our currentproducts, and any change in our relationship with either of these manufacturerscould prevent us from delivering products to our customers in a timely mannerand may adversely impact our future revenues or costs.**

We rely on two third-partymanufacturers to manufacture all of our current products. In the event thateither of our manufacturers ceases to manufacture sufficient quantities of ourproducts in a timely manner and on terms acceptable to us, we would be forcedto locate an alternate manufacturer. Additionally, if either of ourmanufacturers experiences a failure in its production process, is unable toobtain sufficient quantities of the components necessary to manufacture ourproducts or otherwise fails to meet our quality requirements, we may be forcedto delay the manufacture and sale of our products or locate an alternativemanufacturer. We may be unable to locate suitable alternative manufacturers forour products, particularly our NC-stat biosensors, for which the manufacturingprocess is relatively specialized, on terms acceptable to us, or at all.Currently, we rely on a single manufacturer, Parlex, for the manufacture of theNC-stat biosensors, and a single manufacturer, Sunburst, for the manufacture ofour NC-stat monitors and docking stations. We order all of our products fromParlex on a purchase order basis. Because we do not have a supply agreement inplace with Parlex, Parlex may cease manufacturing our products or increase theprice it charges us for our products at any time. Johnson Electric, a Hong Kongbased manufacturing company, acquired Parlex, in November 2005. We cannotassure you that the acquisition will not have a material adverse impact on ourrelationship with Parlex or that Johnson Electric will remain committed to themanufacturing of our biosensors. The manufacturing of the NC-stat monitors anddevices was transitioned from AEI to Sunburst in November 2005 as a resultof a decision by AEI to shut down its operations.  We cannot assure you that the transition willproceed smoothly or that Sunburst will be able to manufacture NC-stat monitorsand docking stations with the same level of quality and on the same deliveryschedule as AEI. We do occasionally experience transient inventory shortages,typically lasting less than one month, on new products during the initialproduction ramp-up phase. If any of the changes in our relationships with thesemanufacturers as described above occurs, our ability to supply our customerswill be severely limited until we are able to engage an alternate manufactureror, if applicable, resolve any quality issues with our existing manufacturer.This situation could prevent us from delivering products to our customers in atimely manner, lead to decreased sales or increased costs, or harm ourreputation with our customers.

**Ifour manufacturers are unable to supply us with an adequate supply of productsas we expand our markets, we could lose customers, our growth could be limitedand our business could be harmed.**

In order for ussuccessfully to expand our business within the United States andinternationally, our contract manufacturers must be able to provide us with theproducts that comprise the NC-stat System in substantial quantities, incompliance with regulatory requirements, in accordance with agreed uponspecifications, at acceptable cost and on a timely basis. Our anticipatedgrowth may strain the ability of our manufacturers to deliver an increasinglylarge supply of products and obtain materials and components in sufficientquantities. Manufacturers often experience difficulties in scaling upproduction, including 

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problemswith production yields and quality control and assurance. If we are unable toobtain sufficient quantities of high quality products to meet customer demandon a timely basis, we could lose customers, our growth may be limited and ourbusiness could be harmed.

**Wecurrently rely entirely on sales of the products that comprise the NC-statSystem to generate revenues, and any factors that negatively impact our salesof these products could significantly reduce our ability to generate revenues.**

We introduced theNC-stat System to the market in May 1999. We derive all of our revenuesfrom sales of the products that comprise the NC-stat System, and we expect thatsales of these products will continue to constitute the substantial majority ofour sales for the foreseeable future. Accordingly, our ability to generaterevenues is entirely reliant on our ability to market and sell the productsthat comprise the NC-stat System, particularly the disposable biosensors, salesof which accounted for approximately 87.7%, 87.6% and 85.8% of our totalrevenues in 2005, 2004 and 2003, respectively. Our sales of these products maybe negatively impacted by many factors, including:

·       changesin reimbursement rates or policies relating to our products by third-partypayers;

·       thefailure of the market to accept our products;

·       manufacturingproblems;

·       claimsthat our products infringe on patent rights or other intellectual propertyrights owned by other parties;

·       adverseregulatory or legal actions relating to our products;

·       competitivepricing and related factors; and

·       resultsof clinical studies relating to our products or our competitors’ products.

If any of these eventsoccurs, our ability to generate revenues could be significantly reduced.

**Thepatent rights we rely upon to protect the intellectual property underlying ourproducts may not be adequate, which could enable third parties to use ourtechnology and would harm our ability to compete in the market.**

Our success willdepend in part on our ability to develop or acquire commercially valuablepatent rights and to protect these rights adequately. Our patent position isgenerally uncertain and involves complex legal and factual questions. The risksand uncertainties that we face with respect to our patents and other relatedrights include the following:

·       thepending patent applications we have filed or to which we have exclusive rightsmay not result in issued patents or may take longer than we expect to result inissued patents;

·       theclaims of any patents that are issued may not provide meaningful protection;

·       wemay not be able to develop additional proprietary technologies that arepatentable;

·       otherparties may challenge patents, patent claims or patent applications licensed orissued to us; and

·       othercompanies may design around technologies we have patented, licensed ordeveloped.

We also may not be able toprotect our patent rights effectively in some foreign countries. For a varietyof reasons, we may decide not to file for patent protection. Our patent rightsunderlying our products may not be adequate, and our competitors or customersmay design around our proprietary technologies or independently develop similaror alternative technologies or products that are equal or 

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superiorto our technology and products without infringing on any of our patent rights.In addition, the patents licensed or issued to us may not provide a competitiveadvantage. If any of these events were to occur, our ability to compete in themarket would be harmed.

**Otherrights and measures we have taken to protect our intellectual property may notbe adequate, which would harm our ability to compete in the market.**

In addition topatents, we rely on a combination of trade secrets, copyright and trademarklaws, confidentiality, nondisclosure and assignment of invention agreements andother contractual provisions and technical measures to protect our intellectualproperty rights. In particular, we have sought no patent protection for thetechnology and algorithms we use in our onCall Information System, and we relyon trade secrets to protect this information. While we currently requireemployees, consultants and other third parties to enter into confidentiality,non-disclosure or assignment of invention agreements or a combination thereofwhere appropriate, any of the following could still occur:

·       theagreements may be breached;

·       wemay have inadequate remedies for any breach;

·       tradesecrets and other proprietary information could be disclosed to ourcompetitors; or

·       othersmay independently develop substantially equivalent proprietary information andtechniques or otherwise gain access to our trade secrets or disclose suchtechnologies.

If, for any of the abovereasons, our intellectual property is disclosed or misappropriated, it wouldharm our ability to protect our rights and our competitive position.

**Wemay need to initiate lawsuits to protect or enforce our patents and otherintellectual property rights, which could be expensive and, if we lose, couldcause us to lose some of our intellectual property rights, which would harm ourability to compete in the market.**

We rely on patentsto protect a portion of our intellectual property and our competitive position.Patent law relating to the scope of claims in the technology fields in which weoperate is still evolving and, consequently, patent positions in the medicaldevice industry are generally uncertain. In order to protect or enforce ourpatent rights, we may initiate patent litigation against third parties, such asinfringement suits or interference proceedings. Litigation may be necessary to:

·       assertclaims of infringement;

·       enforceour patents;

·       protectour trade secrets or know-how; or

·       determinethe enforceability, scope and validity of the proprietary rights of others.

Any lawsuits that weinitiate could be expensive, take significant time and divert management’sattention from other business concerns. Litigation also puts our patents atrisk of being invalidated or interpreted narrowly and our patent applicationsat risk of not issuing. Additionally, we may provoke third parties to assertclaims against us. We may not prevail in any lawsuits that we initiate and thedamages or other remedies awarded, if any, may not be commercially valuable.The occurrence of any of these events could harm our business, our ability tocompete in the market or our reputation.

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**Claimsthat our products infringe on the proprietary rights of others could adverselyaffect our ability to sell our products and increase our costs.**

Substantial litigationover intellectual property rights exists in the medical device industry. Weexpect that our products could be increasingly subject to third-partyinfringement claims as the number of competitors grows and the functionality ofproducts and technology in different industry segments overlap. Third partiesmay currently have, or may eventually be issued, patents on which our productsor technologies may infringe. Any of these third parties might make a claim ofinfringement against us. Any litigation regardless of its impact would likelyresult in the expenditure of significant financial resources and the diversionof management’s time and resources. In addition, litigation in which we areaccused of infringement may cause negative publicity, adversely impactprospective customers, cause product shipment delays or require us to developnon-infringing technology, make substantial payments to third parties, or enterinto royalty or license agreements, which may not be available on acceptableterms, or at all. If a successful claim of infringement were made against usand we could not develop non-infringing technology or license the infringed orsimilar technology on a timely and cost-effective basis, our revenues maydecrease substantially and we could be exposed to significant liability.

**Weare subject to extensive regulation by the U.S. Food and Drug Administration,which could restrict the sales and marketing of the NC-stat System and couldcause us to incur significant costs.**

We sell medical devices that are subject to extensiveregulation in the United States by the FDA for manufacturing, labeling, sale,promotion, distribution and shipping. Before a new medical device, or a new useof or claim for an existing product, can be marketed in the United States, itmust first receive either 510(k) clearance, grant of a *de novo* classification or pre-marketingapproval from the FDA, unless an exemption applies. We may be required toobtain a new 510(k) clearance or *denovo* classification or pre-market approval for significantpost-market modifications to our products. Each of these processes can beexpensive and lengthy. The FDA’s process for obtaining 510(k) clearanceusually takes from three to twelve months, but it can last longer. The processfor obtaining de novo classification involves a level of scrutiny similar tothe 510(k) clearance process. The process for obtaining pre-marketapproval is much more costly and uncertain and it generally takes from one tothree years, or longer, from the time the application is filed with the FDA.

Medical devices maybe marketed only for the indications for which they are approved or cleared. Wehave obtained 510(k) clearance for the current clinical applications forwhich we market our products. However, our clearances can be revoked if safetyor effectiveness problems develop. Further, we may not be able to obtainadditional 510(k) clearances or premarket approvals for new products orfor modifications to, or additional indications for, our existing products in atimely fashion, or at all. Delays in obtaining future clearances wouldadversely affect our ability to introduce new or enhanced products in a timelymanner, which in turn would harm our revenue and future profitability. We havemade modifications to our devices in the past and may make additionalmodifications in the future that we believe do not or will not requireadditional clearances or approvals. If the FDA disagrees, and requires newclearances or approvals for the modifications, we may be required to recall andto stop marketing the modified devices. We also are subject to numerouspost-marketing regulatory requirements, including quality system regulations,which relate to the manufacturing of our products, labeling regulations andmedical device reporting regulations. Our failure or either contractmanufacturer’s failure to comply with applicable regulatory requirements couldresult in enforcement action by the FDA, which may include any of the followingsanctions:

·       warningletters, fines, injunctions, consent decrees and civil penalties;

·       requiringrepair, replacement, refunds, recall or seizure of our products;

·       imposingoperating restrictions, suspension or shutdown of production;

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·       refusingour requests for 510(k) clearance or pre-market approval of new products,new intended uses, or modifications to existing products;

·       withdrawing510(k) clearance or pre-market approvals that have already been granted;and

·       criminalprosecution.

If any of these eventswere to occur, they could harm our reputation, our ability to generate revenuesand our profitability.

**If weor our contract manufacturers fail to comply with the FDA’s quality systemregulations, the manufacturing and distribution of our products could beinterrupted, and our product sales and operating results could suffer.**

We and our contractmanufacturers are required to comply with the FDA’s quality system regulations,which is a complex regulatory scheme that covers the procedures anddocumentation of the design, testing, production, control, quality assurance,labeling, packaging, sterilization, storage and shipping of our devices. TheFDA enforces its quality system regulations through periodic unannouncedinspections. We cannot assure you that our facilities or our contractmanufacturers’ facilities would pass any future quality system inspection. If ouror any of our contract manufacturers’ facilities fails a quality systeminspection, the manufacturing or distribution of our products could beinterrupted and our operations disrupted. Failure to take adequate and timelycorrective action in response to an adverse quality system inspection couldforce a suspension or shutdown of our packaging and labeling operations, themanufacturing operations of our contract manufacturers or a recall of ourproducts. If any of these events occurs, we may not be able to provide ourcustomers with the quantity of products they require on a timely basis, ourreputation could be harmed, and we could lose customers and suffer reducedrevenues and increased costs.

**Ourproducts are subject to recalls even after receiving FDA clearance or approval,which would harm our reputation, business and financial results.**

We are subject to themedical device reporting regulations, which require us to report to the FDA ifour products cause or contribute to a death or serious injury, or malfunctionin a way that would likely cause or contribute to a death or serious injury.The FDA and similar governmental bodies in other countries have the authorityto require the recall of our products if we or our contract manufacturers failto comply with relevant regulations pertaining to manufacturing practices,labeling, advertising or promotional activities, or if new information is obtainedconcerning the safety or efficacy of our products. A government-mandated orvoluntary recall by us could occur as a result of manufacturing defects,labeling deficiencies, packaging defects or other failures to comply withapplicable regulations. Any recall would divert management attention andfinancial resources and harm our reputation with customers. A recall involvingthe NC-stat System would be particularly harmful to our business and financialresults because the products that comprise the NC-stat System are currently ouronly products.

**Weare subject to federal and state laws prohibiting “kickbacks” and false orfraudulent claims, which, if violated, could subject us to substantialpenalties. Additionally, any challenge to or investigation into our practicesunder these laws could cause adverse publicity and be costly to respond to, andthus could harm our business.**

A federal law commonlyknown as the Medicare/Medicaid anti-kickback law, and several similar statelaws, prohibit payments that are intended to induce physicians or others eitherto refer patients or to acquire or arrange for or recommend the acquisition ofhealthcare products or services. These laws constrain our sales, marketing andother promotional activities by limiting the kinds of financial arrangements,including sales programs, we may have with hospitals, physicians or otherpotential purchasers of medical devices. Other federal and state laws generallyprohibit individuals or entities from 

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knowinglypresenting, or causing to be presented, claims for payment from Medicare,Medicaid or other third-party payers that are false or fraudulent, or for itemsor services that were not provided as claimed. Because we may provide somecoding and billing information to purchasers of our products, and because wecannot assure that the government will regard any billing errors that may bemade as inadvertent, these laws are potentially applicable to us. Anti-kickbackand false claims laws prescribe civil and criminal penalties for noncompliance,which can be substantial. Even an unsuccessful challenge or investigation intoour practices could cause adverse publicity, and be costly to respond to, andthus could harm our business and results of operations.

**If weare found to have violated laws protecting the confidentiality of patienthealth information, we could be subject to civil or criminal penalties, whichcould increase our liabilities and harm our reputation or our business.**

There are a number offederal and state laws protecting the confidentiality of certain patient healthinformation, including patient records, and restricting the use and disclosureof that protected information. In particular, the U.S. Department of Health andHuman Services promulgated patient privacy rules under the HealthInsurance Portability and Accountability Act of 1996, or HIPAA. These privacy rules protectmedical records and other personal health information by limiting their use anddisclosure, giving individuals the right to access, amend and seek accountingof their own health information and limiting most use and disclosures of healthinformation to the minimum amount reasonably necessary to accomplish theintended purpose. Although we do not believe that we are subject to the HIPAA rules becausewe receive patient data in our onCall Information System on an anonymous basis,the exact scope of these rules has not been clearly established. If we arefound to be in violation of the privacy rules under HIPAA, we could besubject to civil or criminal penalties, which could increase our liabilitiesand harm our reputation or our business.

**Theuse of the NC-stat System could result in product liability claims that couldbe expensive, damage our reputation and harm our business.**

Our business exposes us toan inherent risk of potential product liability claims related to themanufacturing, marketing and sale of medical devices. The medical deviceindustry historically has been litigious, and we face financial exposure toproduct liability claims if the use of our products were to cause or contributeto injury or death. In particular, the NC-stat System may be susceptible toclaims of injury because it involves the electric stimulation of a patient’snerves. Although we maintain product liability insurance for our products, thecoverage limits of these policies may not be adequate to cover future claims.As sales of our products increase, we may be unable to maintain sufficientproduct liability insurance on acceptable terms or at reasonable costs, andthis insurance may not provide us with adequate coverage against potentialliabilities. A successful claim brought against us in excess of, or outside of,our insurance coverage could have a material adverse effect on our financialcondition and results of operations. A product liability claim, regardless ofits merit or eventual outcome, could result in substantial costs to us, a substantialdiversion of management attention and adverse publicity. A product liabilityclaim could also harm our reputation and result in a decline in revenues and anincrease in expenses.

**Ourproducts are complex in design, and defects may not be discovered prior toshipment to customers, which could result in warranty obligations or productliability claims, reducing our revenues and increasing our costs andliabilities.**

We depend upon third parties for the manufacture ofour products. Our products, particularly our NC-stat biosensors, require asignificant degree of technical expertise to produce. If our manufacturers failto produce our products to specification, or if the manufacturers use defectivematerials or workmanship in the manufacturing process, the reliability andperformance of our products will be compromised.

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If our productscontain defects that cannot be repaired quickly, easily and inexpensively, wemay experience:

·       lossof customer orders and delay in order fulfillment;

·       damageto our brand reputation;

·       increasedcost of our warranty program due to product repair or replacement;

·       inabilityto attract new customers;

·       diversionof resources from our manufacturing and research and development departmentsinto our service department; and

·       legalaction.

The occurrence of any oneor more of the foregoing could harm our reputation and materially reduce ourrevenues and increase our costs and liabilities.

**If welose any of our officers or key employees, our management and technicalexpertise could be weakened significantly.**

Our success largelydepends on the skills, experience and efforts of our officers, including ShaiN. Gozani, M.D., Ph.D., our founder and President and Chief Executive Officer;Gary L. Gregory, our Chief Operating Officer; Guy Daniello, our Senior VicePresident of Information Technology; Michael Williams, Ph.D., our Senior VicePresident of Engineering; W. Bradford Smith, Chief Financial Officer; and ourother key employees. We maintain a $5.0 million key person life insurancepolicy on Dr. Gozani, for which the Company is the beneficiary, but do notmaintain key person life insurance policies covering any of our otheremployees. The loss of any of our officers or key employees could weaken ourmanagement and technical expertise significantly and harm our business.

**If weare unable to recruit, hire and retain skilled and experienced personnel, ourability to manage and expand our business will be harmed, which would impairour future revenues and profitability.**

We are a small companywith only 100 employees as of December 31, 2005, and our ability to retainour skilled labor force and our success in attracting and hiring new skilledemployees will be a critical factor in determining our future performance. Wemay not be able to meet our future hiring needs or retain existing personnel.We will face challenges and risks in hiring, training, managing and retainingengineering and sales and marketing employees, as well as independent regionalsales agencies and sales representatives, most of whom are geographicallydispersed and must be trained in the use and benefits of our products. Failureto attract and retain personnel, particularly technical and sales and marketingpersonnel, would materially harm our ability to compete effectively and growour business.

**If wedo not effectively manage our growth, our business resources may becomestrained, we may not be able to deliver the NC-stat System in a timely mannerand our results of operations may be adversely affected.**

We have recentlysignificantly increased our sales force and our total headcount. This growth,as well as any other growth that we may experience in the future, will providechallenges to our organization and may strain our management and operations. Wemay misjudge the amount of time or resources that will be required toeffectively manage any anticipated or unanticipated growth in our business orwe may not be able to attract, hire and retain sufficient personnel to meet ourneeds. If we cannot scale our business appropriately, maintain control overexpenses or otherwise adapt to anticipated and unanticipated growth, ourbusiness resources may become strained, we may not be able to deliver theNC-stat System in a timely manner and our results of operations may beadversely affected.

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**If weare unable to successfully expand, develop and retain our sales force andmaintain our independent sales agent network, our revenues may decline, ourfuture revenue growth may be limited and our expenses may increase.**

As of December 31,2005, we employed 31 regional sales managers, three sales representatives andtwo district sales directors and utilize a network of over 500 independentsales agents. We are highly dependent on our regional sales managers andindependent sales agents to generate our revenues. We have recentlysignificantly increased our sales force and expect to add approximately 15additional regional sales managers and several sales representative and salesdirectors during the first quarter of 2006. Our ability to build and develop astrong sales force will be affected by a number of factors, including:

·       ourability to attract, integrate and motivate sales personnel;

·       ourability to effectively train our sales force;

·       theability of our sales force to sell an increased number of products;

·       thelength of time it takes new sales personnel to become productive;

·       thecompetition we face from other companies in hiring and retaining salespersonnel;

·       ourability to effectively manage a multi-location sales organization;

·       ourability to enter into agreements with prospective members of our sales force oncommercially reasonable terms; and

·       ourability to get our independent sales agencies, who may sell products ofmultiple companies, to commit the necessary resources to effectively market andsell our products.

If we are unable tosuccessfully build, develop and retain a strong sales force, our revenues maydecline, our revenue growth may be limited and our expenses may increase.

**Failureto develop products other than the NC-stat System and enhance the NC-statSystem could have an adverse effect on our business prospects.**

All of our currentrevenues are derived from selling the NC-stat System. Our future business andfinancial success will depend, in part, on our ability to continue to introducenew products and upgraded products into the marketplace. Developing newproducts and upgrades to existing and future products imposes burdens on ourresearch and development department and our management. This process is costly,and we cannot assure you that we will be able to successfully develop new productsor enhance the NC-stat System or any future products. In addition, as wedevelop the market for point-of-service nerve conduction studies, futurecompetitors may develop desirable product features earlier than we do, whichcould make our competitors’ products less expensive or more effective than ourproducts and could render our products obsolete or unmarketable. If our productdevelopment efforts are unsuccessful, we will have incurred significant costswithout recognizing the expected benefits and our business prospects maysuffer.

**Wecurrently compete, and may in the future need to compete, against other medicaldevice companies with potentially greater resources, more establisheddistribution channels and other competitive advantages, and the success ofthese competitors may harm our ability to generate revenues.**

We currently do,and in the future may need to, compete directly and indirectly with a number ofother companies that enjoy significant competitive advantages over us.Currently, in the point-of-service market, we indirectly compete with companiesthat sell traditional NCS/nEMG equipment. In this market, these companies areindirect competitors because the equipment they sell traditionally has beenused by neurologists, who rely upon and seek to obtain referrals from primarycare physicians to perform the same types of tests that may be performed byprimary care physicians using the NC-stat System. Additionally, in 

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sellingthe NC-stat System to neurologists, which is not a market we historically havefocused on, we compete directly with the companies that sell traditionalNCS/nEMG equipment. There are a number of companies that sell traditionalNCS/nEMG equipment including Viasys Healthcare Inc., Cadwell Laboratories, Inc.and Xltec, Inc. Additionally, we are aware of one company, Neumed Inc.,that markets a nerve conduction study system to the point-of-service market. Ofthese companies, Viasys Healthcare, in particular, enjoy significantcompetitive advantages, including:

·       greaterresources for product development, sales and marketing;

·       moreestablished distribution networks;

·       greatername recognition;

·       moreestablished relationships with health care professionals, customers andthird-party payers; and

·       additionallines of products and the ability to offer rebates or bundle products to offerdiscounts or incentives.

As we develop the marketfor point-of-service nerve conduction studies, we may be faced with competitionfrom these companies or others that decide and are able to enter this market.Some or all of our future competitors in the point-of-service market may enjoycompetitive advantages such as those described above. If we are unable tocompete effectively against existing and future competitors, our sales willdecline and our business will be harmed.

**Weare dependent upon the computer and communications infrastructure employed andutilized by our onCall Information System, and any failures or disruptions inthis infrastructure could impact our revenues and profit margins or harm ourreputation.**

We are dependent upon thecomputer and communications infrastructure employed and utilized by our onCallInformation System. Our computer and communications infrastructure consists ofstandard hardware, off-the-shelf system software components, database servers,proprietary application servers, a modem bank and desktop applications. Ourfuture success in selling the NC-stat System will depend, in part, upon themaintenance and growth of this infrastructure. Any failures or outages of this infrastructureas a result of a computer virus, intentional disruption of our systems by athird party, manufacturing failure, telephone system failure, fire, storm,flood, power loss or other similar events, could prevent or delay the operationof our onCall Information System, which could result in increased costs toeliminate these problems and address related security concerns and harm ourreputation with our customers. In addition, if our infrastructure fails toaccommodate growth in customer transactions, customer satisfaction could beimpaired, we could lose customers, our ability to add customers could beimpaired or our costs could be increased, any of which would harm our business.

**Iffuture clinical studies or other articles are published, or physicianassociations or other organizations announce positions, that are unfavorable tothe NC-stat System, our sales efforts and revenues may be negatively affected.**

Future clinical studies orother articles regarding our existing products or any competing products may bepublished that either support a claim, or are perceived to support a claim,that a competitor’s product is more accurate or effective than our products orthat our products are not as accurate or effective as we claim or previousclinical studies have concluded. Additionally, physician associations or otherorganizations that may be viewed as authoritative or have an economic interestin nerve conduction studies and in related electrodiagnostic procedures couldendorse products or methods that compete with the NC-stat System or otherwiseannounce positions that are unfavorable to the NC-stat System. Any of theseevents may negatively affect our sales efforts and result in decreasedrevenues.

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**Ourfuture capital needs are uncertain and we may need to raise additional funds inthe future, and these funds may not be available on acceptable terms or at all.**

We believe that ourcurrent cash and cash equivalents together with our short-term and long-terminvestments and the cash to be generated from expected product sales will besufficient to meet our projected operating requirements for at least the next12 months. However, we may seek additional funds from public and private stockofferings, borrowings under credit lines or other sources. Our capitalrequirements will depend on many factors, including:

·       therevenues generated by sales of the NC-stat System and any other products thatwe develop;

·       thecosts associated with expanding our sales and marketing efforts;

·       theexpenses we incur in manufacturing and selling our products;

·       thecosts of developing new products or technologies and enhancements to existingproducts;

·       thecost of obtaining and maintaining FDA approval or clearance of our products andproducts in development;

·       costsassociated with any expansion;

·       thecosts associated with capital expenditures; and

·       thenumber and timing of any acquisitions or other strategic transactions.

As a result of thesefactors, we may need to raise additional funds, and these funds may not beavailable on favorable terms, or at all. Furthermore, if we issue equity ordebt securities to raise additional funds, our existing stockholders mayexperience dilution, and the new equity or debt securities may have rights,preferences and privileges senior to those of our existing stockholders. Inaddition, if we raise additional funds through collaboration, licensing orother similar arrangements, it may be necessary to relinquish valuable rightsto our potential products or proprietary technologies, or grant licenses onterms that are not favorable to us. If we cannot raise funds on acceptableterms, we may not be able to develop or enhance our products, execute ourbusiness plan, take advantage of future opportunities, or respond tocompetitive pressures or unanticipated customer requirements. If any of theseevents occurs, our ability to achieve our development and commercializationgoals would be adversely affected.

**If wechoose to acquire or invest in new businesses, products or technologies,instead of developing them ourselves, these acquisitions or investments coulddisrupt our business and could result in the use of significant amounts ofequity, cash or a combination of both.**

From time to timewe may seek to acquire or invest in businesses, products or technologies,instead of developing them ourselves. Acquisitions and investments involvenumerous risks, including:

·       theinability to complete the acquisition or investment;

·       disruptionof our ongoing businesses and diversion of management attention;

·       difficultiesin integrating the acquired entities, products or technologies;

·       difficultiesin operating the acquired business profitably;

·       theinability to achieve anticipated synergies, cost savings or growth;

·       potentialloss of key employees, particularly those of the acquired business;

·       difficultiesin transitioning and maintaining key customer, distributor and supplierrelationships;

·       risksassociated with entering markets in which we have no or limited priorexperience; and

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·       unanticipatedcosts.

In addition, anyfuture acquisitions or investments may result in one or more of the following:

·       issuancesof dilutive equity securities, which may be sold at a discount to market price;

·       theuse of significant amounts of cash;

·       theincurrence of debt;

·       theassumption of significant liabilities;

·       increasedoperating costs or reduced earnings;

·       financingobtained on unfavorable terms;

·       largeone-time expenses; and

·       thecreation of certain intangible assets, including goodwill, the write-down ofwhich may result in significant charges to earnings.

Any of these factors couldmaterially harm our stock price, our business or our operating results.

**If weexpand, or attempt to expand, into foreign markets, we will be affected by newbusiness risks that may adversely impact our financial condition or results ofoperations.**

If we expand, orattempt to expand, into foreign markets, we will be subject to new businessrisks, including:

·       failureto fulfill foreign regulatory requirements to market the NC-stat System orother future products;

·       availabilityof, and changes in, reimbursement within prevailing foreign health care paymentsystems;

·       adaptingto the differing business practices and laws in foreign countries;

·       difficultiesin managing foreign relationships and operations, including any relationshipsthat we establish with foreign distributors or sales or marketing agents;

·       limitedprotection for intellectual property rights in some countries;

·       difficultyin collecting accounts receivable and longer collection periods;

·       costsof enforcing contractual obligations in foreign jurisdictions;

·       recessionsin economies outside of the United States;

·       politicalinstability and unexpected changes in diplomatic and trade relationships;

·       currencyexchange rate fluctuations; and

·       potentiallyadverse tax consequences.

If we are successful inintroducing our products into foreign markets, we will be affected by theseadditional business risks, which may adversely impact our financial conditionor results of operations. In addition, expansion into foreign markets imposesadditional burdens on our executive and administrative personnel, research andsales departments, and general managerial resources. Our efforts to introduceour products into foreign markets may not be successful, in which case we mayhave expended significant resources without realizing the expected benefit.Ultimately, the investment required for expansion into foreign markets couldexceed the revenues generated from this expansion.

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**Ouroperating results may fluctuate due to various factors and, as a result,period-to-period comparisons of our results of operations will not necessarilybe meaningful.**

Factors relating toour business make our future operating results uncertain and may cause them tofluctuate from period to period. These factors include:

·       changesin the availability of third-party reimbursement in the United States or othercountries;

·       thetiming of new product announcements and introductions by us or our competitors;

·       marketacceptance of new or enhanced versions of our products;

·       changesin manufacturing costs or other expenses;

·       competitivepricing pressures;

·       thegain or loss of significant distribution outlets or customers;

·       increasedresearch and development expenses;

·       thetiming of any future acquisitions; or

·       generaleconomic conditions.

Because our operatingresults may fluctuate from quarter to quarter, it may be difficult for us orour investors to predict our future performance by viewing our historicaloperating results.

**Anti-takeoverprovisions in our organizational documents and Delaware law may discourage orprevent a change of control, even if an acquisition would be beneficial to ourstockholders, which could affect our stock price adversely and prevent attemptsby our stockholders to replace or remove our current management.**

Our certificate ofincorporation and bylaws contain provisions that could delay or prevent achange of control of our company or changes in our board of directors that ourstockholders might consider favorable. Some of these provisions:

·       authorizethe issuance of preferred stock which can be created and issued by the board ofdirectors without prior stockholder approval, with rights senior to those ofour common stock;

·       providefor a classified board of directors, with each director serving a staggeredthree-year term;

·       prohibitour stockholders from filling board vacancies, calling special stockholdermeetings, or taking action by written consent;

·       providefor the removal of a director only with cause and by the affirmative vote ofthe holders of 75% or more of the shares then entitled to vote at an electionof our directors; and

·       requireadvance written notice of stockholder proposals and director nominations.

In addition, we aresubject to the provisions of Section 203 of the Delaware GeneralCorporation Law, which may prohibit certain business combinations withstockholders owning 15% or more of our outstanding voting stock. These andother provisions in our certificate of incorporation, bylaws and Delaware lawcould make it more difficult for stockholders or potential acquirers to obtaincontrol of our board of directors or initiate actions that are opposed by ourthen-current board of directors, including a merger, tender offer, or proxycontest involving our company. Any delay or prevention of a change of controltransaction or changes in our board of directors could cause the market priceof our common stock to decline.

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**We do not intend to pay cash dividends.**

We have never declared orpaid cash dividends on our capital stock. We currently intend to retain allavailable funds and any future earnings for use in the operation and expansionof our business and do not anticipate paying any cash dividends in theforeseeable future. In addition, the terms of any future debt or creditfacility may preclude us from paying any dividends. As a result, capitalappreciation, if any, of our common stock will be our stockholders sole sourceof potential gain for the foreseeable future.

**ITEM 1B:**      UNRESOLVEDSTAFF COMMENTS

We have not receivedwritten comments from the Securities and Exchange Commission regarding ourperiodic or current reports under the Securities and Exchange Act of 1934, asamended, 180 days or more before December 31, 2005 that remain unresolved.

**ITEM 2:**               PROPERTIES

Our headquarters islocated in a 30,000 square foot facility in Waltham, Massachusetts, which weoccupy under an office lease expiring in March 2009. We believe that ourexisting facility is adequate for our current needs.

**ITEM 3:**               LEGALPROCEEDINGS

We are not currently partyto any material legal proceedings. However, we may from time to time become aparty to various legal proceedings arising in the ordinary course of ourbusiness.

**ITEM 4:**               SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters were submitted to a vote of our securityholders during the fourth quarter of the year ended December 31, 2005,through the solicitation of proxies or otherwise.

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**PART II**

**ITEM5:**               MARKET FORREGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OFEQUITY SECURITIES

Ourcommon stock is quoted on the NASDAQ National Market under the symbol “NURO”.The price range per share reflected in the table below is the high and lowclosing sales prices of our common stock as reported by NASDAQ for the periodsindicated. Our stock first started trading on July 22, 2004.

| ** **     | ** ** | **Years ended December 31,** | ** ** |
|----------------|------------|---------------------------------------------|------------|
| ** **     | ** ** | **2005**                                    | ** ** | **2004** | ** ** |
| ** **     | ** ** | **High**                                    | ** ** | **Low** | ** ** | **High** | ** ** | **Low** | ** ** |
| First quarter  |       | $                                           | 11.65      |   | $ | 9.28 |   | N/A |   | N/A |   |
| Second quarter |       | $                                           | 20.03      |   | $ | 9.05 |   | N/A |   | N/A |   |
| Third quarter  |       | $                                           | 30.20      |   | $ | 19.57 |   | $ | 11.05 |   | $ | 7.39 |   |
| Fourth quarter |       | $                                           | 37.23      |   | $ | 26.91 |   | $ | 11.75 |   | $ | 8.20 |   |

 

On March 10, 2006,there were approximately 162 stockholders of record of our common stock.This number does not include stockholders for whom shares were held in a “nominee”or “street” name. On March 10, 2006, the last reported sale price pershare of our common stock on the NASDAQ National Market was $33.95.

We have never declared orpaid any cash dividends on our common stock. We currently intend to retainfuture earnings, if any, to finance the expansion and growth of our businessand do not expect to pay any cash dividends in the foreseeable future. Paymentof future cash dividends, if any, will be at the discretion of our board ofdirectors after taking into account various factors, including our financialcondition, operating results, current and anticipated cash needs and plans forexpansion.

On July 21, 2004, theSecurities and Exchange Commission declared effective our registrationstatement on Form S-1 (File No. 333-115440), relating tothe initial public offering of our common stock. We expect to continue to usethe net proceeds from the initial public offering for general corporatepurposes, including to expand our selling and marketing and servicesorganizations, develop new distribution channels, expand our research anddevelopment efforts, improve our operational and financial systems and forother working capital purposes. We may also use a portion of the net proceedsto acquire or invest in complementary businesses, products or technologies. Wehave no specific understandings, commitments or agreements with respect to anysuch acquisition or investment. Except as set forth below, we have notallocated any portion of the net proceeds for any specific purpose. Theaggregate price of the offering amount registered on our behalf was$27.6 million. In connection with the offering, we paid approximately$1.9 million in underwriting discounts and commissions to the underwritersand incurred an estimated $1.7 million in other offering expenses. None ofthe underwriting discounts and commissions or offering expenses were incurredor paid to directors or officers of ours or their associates or to personsowning 10 percent or more of our common stock or to any affiliates ofours. After deducting the underwriting discounts and commissions and offeringexpenses, we received net proceeds from the offering of approximately $24.0 million.From July 21, 2004, the effective date of the registration statement, to December 31,2005 we have used (i) $3.1 million of the net proceeds to repay infull the outstanding balance under our secured line of credit with LighthouseCapital Partners, (ii) an estimated $4.4 million of the net proceeds tofund cash spending of our research and development activities, (iii) anestimated $6.8 million of the net proceeds to fund the expansion of oursales and marketing efforts and (iv) an estimated $517,100 for the purchaseof capital equipment. The remainder of the net proceeds have been invested inmarketable, investment grade, interest-bearing securities pending their use.Our use of the proceeds from our initial public offering does not represent amaterial change from the description provided in our prospectus.

See Part III, Item 12for information regarding securities authorized for issuance under equitycompensation plans.

41

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**ITEM 6:**               SELECTEDFINANCIAL DATA

The data set forth below should be read in conjunctionwith Item 7, “Management’s Discussion and Analysis of Financial Condition andResults of Operations”, Item 7A, “Quantitative and Qualitative DisclosuresAbout Market Risk” and our financial statements and related notes appearingelsewhere in this Annual Report on Form 10-K.

 

| ** **                                                                            | ** ** | **Years Ended December 31,**                                            | ** ** |
|---------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------|------------|
| ** **                                                                            | ** ** | **2005**                                                                               | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                                                            | ** ** | **(In thousands, except share and per share data)** | ** ** |
| ** **                                                                            | ** ** | ** **                                                                             | ** ** |
| **Statement of Operations Data:**                                                     |       |                                                                                   |       |   |   |   |   |   |   |   |   |
| Revenues                                                                              |       | $                                                                                      | 34,298     |   | $ | 17,920 |   | $ | 9,168 |   | $ | 4,225 |   | $ | 3,464 |   |
| Cost of revenues                                                                      |       | 8,858                                                                                  |       | 4,853 |   | 2,707 |   | 1,370 |   | 1,424 |   |
| Gross margin                                                                          |       | 25,440                                                                                 |       | 13,067 |   | 6,461 |   | 2,855 |   | 2,040 |   |
| Operating expenses:                                                                   |       |                                                                                   |       |   |   |   |   |   |   |   |   |
| Research and development(1)                                                           |       | 3,821                                                                                  |       | 3,268 |   | 2,397 |   | 2,146 |   | 2,561 |   |
| Sales and marketing(1)                                                                |       | 14,150                                                                                 |       | 8,488 |   | 4,768 |   | 2,870 |   | 5,304 |   |
| General and administrative(1)                                                         |       | 7,333                                                                                  |       | 4,844 |   | 2,850 |   | 2,673 |   | 3,228 |   |
| Total operating expenses                                                              |       | 25,304                                                                                 |       | 16,601 |   | 10,015 |   | 7,689 |   | 11,093 |   |
| Income (loss) from operations                                                         |       | 136                                                                                    |       | (3,534 | ) | (3,554 | ) | (4,834 | ) | (9,053 | ) |
| Interest income (expense), net                                                        |       | 837                                                                                    |       | (750 | ) | (113 | ) | 41 |   | 336 |   |
| Income (loss) before income taxes                                                     |       | 973                                                                                    |       | (4,284 | ) | (3,667 | ) | (4,793 | ) | (8,717 | ) |
| Income tax provision                                                                  |       | 35                                                                                     |       | — |   | — |   | — |   | — |   |
| Net income (loss)                                                                     |       | 938                                                                                    |       | (4,284 | ) | (3,667 | ) | (4,793 | ) | (8,717 | ) |
| Accretion of dividend on redeemable convertible  preferred stock                      |       | —                                                                                 |       | (1,386 | ) | (2,009 | ) | (1,893 | ) | (1,757 | ) |
| Deemed dividend on redeemable convertible preferred  stock                            |       | —                                                                                 |       | (788 | ) | — |   | (6,873 | ) | — |   |
| Beneficial conversion feature associated with  redeemable convertible preferred stock |       | —                                                                                 |       | (7,051 | ) | — |   | — |   | — |   |
| Net income (loss) attributable to common stockholders                                 |       | $                                                                                      | 938        |   | $ | (13,509 | ) | $ | (5,676 | ) | $ | (13,559 | ) | $ | (10,474 | ) |
| Net income (loss) per  common share:                                                  |       |                                                                                   |       |   |   |   |   |   |   |   |   |
| Basic                                                                                 |       | $                                                                                      | 0.08       |   | $ | (2.35 | ) | $ | (5.46 | ) | $ | (13.17 | ) | $ | (10.47 | ) |
| Diluted                                                                               |       | $                                                                                      | 0.07       |   | $ | (2.35 | ) | $ | (5.46 | ) | $ | (13.17 | ) | $ | (10.47 | ) |
| Weighted average common  shares outstanding                                           |       |                                                                                   |       |   |   |   |   |   |   |   |   |
| Basic                                                                                 |       | 12,152,139                                                                             |       | 5,747,579 |   | 1,038,817 |   | 1,029,210 |   | 1,000,323 |   |
| Diluted                                                                               |       | 12,986,365                                                                             |       | 5,747,579 |   | 1,038,817 |   | 1,029,210 |   | 1,000,323 |   |

----

(1)          Non-cashstock-based compensation expense is included in these amounts as follows:

| Research and development                 |   | $   | 77     |   | $      | 249   |   | $  | 35     |   | $      | 7  |   | $ | 8  |   |
|------------------------------------------|--------|-----|--------|--------|--------|-------|--------|----|--------|--------|--------|----|--------|---|----|--------|
| Sales and marketing                      |   | 168 |   | 356    |   | 37    |   | 6  |   | 15     |   |
| General and administrative               |   | 161 |   | 423    |   | 25    |   | 37 |   | 33     |   |
| Total non-cash  stock-based compensation |   | $   | 406    |   | $      | 1,029 |   | $  | 96     |   | $      | 50 |   | $ | 56 |   |

 

42

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| ** **                                          | ** ** | **As of December 31,** | ** ** |
|-----------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                          | ** ** | **2005**                              | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                          | ** ** | ** **                            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **(unaudited)** | ** ** |
| ** **                                          | ** ** | **(in thousands)**               | ** ** |
| **Balance  Sheet Data:**                            |       |                                  |       |   |   |   |   |   |   |   |   |   |   |
| Cash and cash equivalents                           |       | $                                     | 8,170      |   | $ | 1,936 |   | $ | 1,623 |   | $ | 2,701 |   |   | $ | 5,396 |   |   |
| Short-term investments                              |       | 24,082                                |       | 18,575 |   | — |   | — |   |   | — |   |   |
| Working capital                                     |       | 34,683                                |       | 22,500 |   | 2,754 |   | 3,724 |   |   | 6,380 |   |   |
| Long-term investments                               |       | —                                |       | 9,497 |   | — |   | — |   |   | — |   |   |
| Total assets                                        |       | 42,897                                |       | 37,953 |   | 7,218 |   | 7,053 |   |   | 9,899 |   |   |
| Long-term debt and other long-term liabilities      |       | 131                                   |       | 189 |   | 2,232 |   | 124 |   |   | 331 |   |   |
| Warrants for redeemable convertible preferred stock |       | —                                |       | — |   | 450 |   | — |   |   | — |   |   |
| Redeemable convertible preferred stock              |       | —                                |       | — |   | 47,694 |   | 45,684 |   |   | 34,995 |   |   |
| Accumulated deficit                                 |       | (56,540                               | )          | (57,478 | ) | (44,901 | ) | (39,860 | ) |   | (26,321 | ) |   |
| Total  stockholders’ equity/(deficit)          |       | 36,248                                |       | 34,056 |   | (45,502 | ) | (39,928 | ) |   | (26,431 | ) |   |
|                                                     |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

*You should read the following discussion of ourfinancial condition and results of operations in conjunction with our selectedfinancial data, our financial statements and the accompanying notes to thosefinancial statements included elsewhere in this Annual Report on Form 10-K.This discussion contains forward-looking statements that involve risks anduncertainties. As a result of many factors, such as those set forth under thesection titled “Risk Factors” and elsewhere in this Annual Report onForm 10-K, our actual results may differ materially from thoseanticipated in these forward-looking statements.*

**Overview**

NeuroMetrix was founded in June 1996. We design,develop and sell proprietary medical devices used to diagnose neuropathies. Ourproprietary technology provides physicians with an in-office diagnostic system,the NC-stat System, that enables physicians to make rapid and accuratediagnoses of neuropathies, including carpal tunnel syndrome, low back and legpain and diabetic peripheral neuropathy. The NC-stat System is comprised of:(1) disposable single use NC-stat biosensors that are placed on thepatient’s body; (2) the NC-stat monitor and related components; and(3) the NC-stat docking station, an optional device that enables thephysician’s office to transmit data to our onCall Information System. Eachcomponent of the NC-stat System is also sold separately. The sensitivity of thenervous system to metabolic and mechanical damage, compounded by its limitedregenerative ability, creates a market opportunity for a medical device thatcan assist in point-of-service diagnoses of neuropathies in a manner that iscost-effective for the patient and third-party payer. We believe the ease ofuse, accuracy and convenience provided by the NC-stat System position it tobecome a standard of care for the assessment of neuropathies at thepoint-of-service.

 

43

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From our inception until May 1999, we had devotedsubstantially all of our efforts to designing and developing the NC-stat Systemand other potential products, raising capital and recruiting personnel. Webelieve that one of our strengths is our ability to develop and commercializeinnovative products for neurological applications. In May 1999, we shippedour first NC-stat System. At that time we sold one type of biosensor for thetesting of the median motor nerve. In 2000, we introduced an additional biosensorfor the testing of the ulnar motor nerve. In 2002, we introduced oursecond-generation NC-stat System, as well as two additional biosensors. In2003, we added to our product line two biosensors with higher functionalitythat have the ability to test both motor and sensory nerves. In 2004, weintroduced two new NC-stat biosensors as well as components for the NC-statmonitor to utilize these new biosensors. The first new biosensor is used totest the ulnar nerve at the elbow and the second to test the sural nerve. In2005, our revenues grew 91.4% to $34.3 million from $17.9 million in 2004, ofwhich 87.7% was attributable to sales of NC-stat biosensors in 2005. Our grossmargin percentage in 2005 was 74.2%.

We derive our revenues from the sale of NC-statbiosensors, monitors and docking stations directly to end users, which aregenerally physician practice groups. Our NC-stat biosensors are disposableproducts that are used once and inactivated after use. The NC-stat monitor isan electronic instrument that is used with the NC-stat biosensors to performnerve conduction studies for the purpose of diagnosing neuropathies. TheNC-stat monitor displays the pertinent results of nerve conduction studies onan LCD screen immediately at the conclusion of each study. The NC-stat dockingstation is an optional device that is used to transmit to the onCallInformation System data generated by the nerve conduction study performed withthe NC-stat monitor. The onCall Information System formulates the data itreceives for each test into a detailed report that is provided to the customerthrough facsimile or e-mail.

Diagnostic device revenues include revenues derivedfrom the sale of our NC-stat monitors and NC-stat docking stations. Biosensorrevenues include revenues derived from the sale of various types of disposablebiosensors used to perform nerve conduction studies with the NC-stat monitor.Our revenue recognition policy is to recognize revenue from our monitors andbiosensors upon shipment if the fee is fixed and determinable, persuasiveevidence of an arrangement exists, collection of the resulting receivable isreasonably assured and product returns are reasonably estimable. Revenues fromour docking station are deferred and recognized over the shorter of the estimatedcustomer relationship period or the estimated useful life of the product,currently three years.

Reimbursement from third-party payers is an importantelement of success for medical products companies. Generally, we believe thatthe nerve conduction studies performed by our customers with the NC-stat Systemhave been satisfactorily covered by third-party payers. As our presence in themarket expands and the use of the NC-stat System increases, we haveexperienced and are likely to continue to experience an increased focus fromthird-party payers regarding the reimbursement of nerve conduction studiesperformed using the NC-stat System and an increased focus from third-partypayers regarding the professional requirements for performing nerve conduction studiesin general. Widespread adoption of the NC-stat System by the medical communityis unlikely to occur if physicians do not receive satisfactory reimbursementfrom third-party payers for procedures performed with the NC-stat System. Oneof the primary challenges we face in our business is successfully expanding themarket for nerve conduction studies. A successful market expansion will dependupon, in part, our targeting of primary care and specialty physicians whotraditionally have not been targeted by companies selling equipment used toperform nerve conduction studies and our ability to alter physicians’ practicesrelating to the diagnosis of neuropathies. In order to successfully implementthis growth strategy, we have increased our sales force to 31 regional salesmanagers, three sales representatives and two district sales directors as of December 31,2005 and plan to add approximately 15 additional regional sales managers andseveral additional sales representatives and sales directors during the firstquarter of 2006. We also will participate in various industry conferences inorder to accelerate the market awareness and adoption of our products. Theseefforts, as well as the overall expansion of our business, will providechallenges to our organization and 

44

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may increase the burden onour management and operations. We plan to monitor our business as it grows andappropriately acquire and allocate resources to address these issues, with agoal of sustaining profitable growth.

We incurred losses every year from the inception ofthe Company in 1996 through 2004 and recorded our first year of profitabilityin 2005. We incurred net losses of approximately $8.7 million in 2001,$4.8 million in 2002, $3.7 million in 2003 and $4.3 million in2004 and recorded net income of $938,000 in 2005. We do not know whether wewill be able to sustain the profitability achieved in 2005. As of December 31,2005, we had an accumulated deficit of approximately $56.5 million.Historically, we have primarily financed our operations through the public andprivate placement of equity securities and through debt facilities. As of December 31,2005, we had received net proceeds of $43.5 million from the issuance ofredeemable convertible preferred stock and $24.0 million in net proceedsfrom our initial public offering (“IPO”). Upon completion of the IPO, all thenoutstanding shares of preferred stock converted into shares of our commonstock.

Our financial objective isto grow our business through the sale of the NC-stat System and additionalproducts that may be commercialized for the diagnosis and treatment ofneuropathies and to achieve sustainable profitability. Our efforts in 2006 willcontinue to focus primarily on expanding our sales and marketing for theNC-stat System and continuing our ongoing program of making enhancements andimprovements to the NC-stat System, with the goal of increasing our marketpenetration. During 2005 we continued efforts on improvements to ourbiosensors, on the development of new biosensors, on the development ofproducts to diagnose additional neuropathies, and on the development of a thirdgeneration neurodiagnostic system. We are also in the early stages of designinga drug delivery system for the minimally invasive treatment of neuropathies byboth primary care and specialist physicians. We believe that the accomplishmentof these goals will have a positive impact on our progress toward the objectiveof growing the business and achieving sustainable profitability.

**Results of Operations**

Thefollowing table presents certain statement of operations information stated asa percentage of total revenues:

| ** **                         | ** ** | **Years Ended December 31,** | ** ** |
|------------------------------------|------------|---------------------------------------------|------------|
| ** **                         | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenues:                          |       |                                        |       |   |   |   |   |
| Diagnostic device                  |       | 12.3                                        | %          | 12.4 | % | 14.2 | % |
| Biosensor                          |       | 87.7                                        |       | 87.6 |   | 85.8 |   |
| Total revenues                     |       | 100.0                                       |       | 100.0 |   | 100.0 |   |
| Cost of revenues                   |       | 25.8                                        |       | 27.1 |   | 29.5 |   |
| Gross margin                       |       | 74.2                                        |       | 72.9 |   | 70.5 |   |
| Operating expenses:                |       |                                        |       |   |   |   |   |
| Research and development           |       | 11.1                                        |       | 18.2 |   | 26.1 |   |
| Sales and marketing                |       | 41.3                                        |       | 47.4 |   | 52.0 |   |
| General and administrative         |       | 21.4                                        |       | 27.0 |   | 31.1 |   |
| Total operating expenses           |       | 73.8                                        |       | 92.6 |   | 109.2 |   |
| Income (loss)  from operations     |       | 0.4                                         |       | (19.7 | ) | (38.8 | ) |
| Interest income (expense), net     |       | 2.4                                         |       | (4.2 | ) | (1.2 | ) |
| Income (loss)  before income taxes |       | 2.8                                         |       | (23.9 | ) | (40.0 | ) |
| Income tax provision               |       | 0.1                                         |       | — |   | — |   |
| Net income (loss)                  |       | 2.7                                         | %          | (23.9 | )% | (40.0 | )% |

 

45

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**Comparisonof Years Ended December 31, 2005 and December 31, 2004**

*Revenues*

Thefollowing tables present a breakdown of our customers, biosensor units used andrevenues:

| ** **            | ** ** | **Year Ended  December 31,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|-----------------------|------------|----------------------------------------|------------|------------|------------|------------|------------|
| ** **            | ** ** | **2005**                               | ** ** | **2004**   | ** ** | **Change** | ** ** | **% Change** | ** ** |
| Customers             |       | 3,282                                  |       | 2,207      |       | 1,075      |       |   | 48.7 | % |   |
| Biosensor units  used |       | 704,800                                |       | 357,400    |       | 347,400    |       |   | 97.2 |   |   |
|                  |       | **(in thousands)**                     |       |       |       |       |       |
| Revenues:             |       |                                   |       |       |       |       |       |   |   |   |   |
| Diagnostic device     |       | $                                      | 4,221.3    |       | $          | 2,219.5    |       | $ | 2,001.8 |   |   | 90.2 |   |   |
| Biosensor             |       | 30,076.8                               |       | 15,700.6   |       | 14,376.2   |       |   | 91.6 |   |   |
| Total revenues        |       | $                                      | 34,298.1   |       | $          | 17,920.1   |       | $ | 16,378.0 |   |   | 91.4 |   |   |

 

Diagnostic device revenues were $4.2 million and $2.2million for the years ended December 31, 2005 and December 31, 2004,respectively, an increase of $2.0 million, or 90.2%. Of this increase,approximately $1.4 million is attributable to a greater number of units sold,primarily as a result of an increase in the number of regional sales managersand expanded clinical uses for the NC-stat System. In addition, approximately$627,600 of this increase is attributable to an increase in the list price ofour NC-stat monitors and docking stations from $3,500 to $4,000 effective January 1,2005, which resulted in a higher average selling price during 2005 as comparedto 2004. Diagnostic device revenues accounted for 12.3% and 12.4% of our totalrevenues for the years ended December 31, 2005 and December 31, 2004,respectively.

Biosensor revenues were $30.1 million and $15.7million for the years ended December 31, 2005 and December 31, 2004,respectively, an increase of $14.4 million, or 91.6%. The increase wasprimarily due to an increased customer base for our biosensors, increasedfrequency of testing by our customers and the introduction of new biosensors,including the sural biosensor in the fourth quarter of 2004. Biosensor revenuesaccounted for 87.7% and 87.6% of our total revenues for the years ended December 31,2005 and December 31, 2004, respectively.

Our customers used 704,800 biosensor units in the yearended December 31, 2005, compared to 357,400 units for 2004, an increaseof 347,400 units, or 97.2%. This increase in biosensor usage is primarily theresult of the increase in the customer base, increased usage by customers andthe introduction of new biosensors, including the sural biosensor in the fourthquarter of 2004. The sural biosensor is an important additional biosensor forour customers’ use of the NC-stat System for low back pain and DPN and webelieve that its introduction is contributing to the growth in biosensor usagefor these clinical indications.

Our total revenues were $34.3 million and $17.9million for the years ended December 31, 2005 and December 31, 2004,respectively, an increase of $16.4 million, or 91.4%. During the 12-monthperiod ending December 31, 2005, a total of 3,282 customers used ourNC-stat System compared to 2,207 customers for the same period ending December 31,2004. This represents a 48.7% year-over-year increase in the number ofcustomers that used our NC-stat System.

We expect revenues tocontinue to increase in 2006 as a result of the recent expansion of our salesforce, which grew from 22 regional sales managers as of December 31, 2004to 31 regional sales managers, three sales representatives and two districtsales directors at December 31, 2005, an increase in the number of activecustomer accounts and increased usage per customer account. However, ourrevenues could be negatively impacted by a variety of factors, including thelevel of demand for nerve conduction studies, 

46

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potentialfor changes in third-party reimbursement for nerve conduction studies, theoverall economy and competitive factors.

*Costs and expenses*

Thefollowing table presents our costs and expenses and net loss:

| ** **                                                                                   | ** ** | **Years Ended December 31,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|----------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|------------|------------|------------|------------|
| ** **                                                                                   | ** ** | **2005**                                    | ** ** | **2004**   | ** ** | **Change** | ** ** | **% Change** | ** ** |
| ** **                                                                                   | ** ** | **(in thousands)**                     | ** ** | ** ** | ** ** |
| Cost of revenues:                                                                            |       |                                        |       |       |       |       |       |   |   |   |   |
| Diagnostic device                                                                            |       | $                                           | 1,059.7    |       | $          | 728.7      |       | $ | 331.0 |   |   | 45.4 | % |   |
| Biosensor                                                                                    |       | 7,798.4                                     |       | 4,124.6    |       | 3,673.7    |       |   | 89.1 |   |   |
| Total cost of revenues                                                                       |       | 8,858.1                                     |       | 4,853.3    |       | 4,004.8    |       |   | 82.5 |   |   |
| Gross margin:                                                                                |       |                                        |       |       |       |       |       |   |   |   |   |
| Diagnostic device                                                                            |       | 3,161.6                                     |       | 1,490.8    |       | 1,670.8    |       |   | 112.1 |   |   |
| Biosensor                                                                                    |       | 22,278.5                                    |       | 11,576.0   |       | 10,702.5   |       |   | 92.5 |   |   |
| Total gross margin                                                                           |       | 25,440.0                                    |       | 13,066.8   |       | 12,373.3   |       |   | 94.7 |   |   |
| Gross Margin %:                                                                              |       |                                        |       |       |       |       |       |   |   |   |   |
| Diagnostic device                                                                            |       | 74.9                                        | %          | 67.2       | %          |       |       |   |   |   |   |
| Biosensor                                                                                    |       | 74.1                                        |       | 73.7       |       |       |       |   |   |   |   |
| Total gross margin                                                                           |       | 74.2                                        |       | 72.9       |       |       |       |   |   |   |   |
| Operating  expenses:                                                                         |       |                                        |       |       |       |       |       |   |   |   |   |
| Research and development(1)                                                                  |       | $                                           | 3,820.6    |       | $          | 3,268.4    |       | $ | 552.3 |   |   | 16.9 |   |   |
| Sales and marketing(1)                                                                       |       | 14,150.2                                    |       | 8,488.0    |       | 5,662.1    |       |   | 66.7 |   |   |
| General and administrative(1)                                                                |       | 7,332.8                                     |       | 4,844.4    |       | 2,488.4    |       |   | 51.4 |   |   |
| Total operating expenses                                                                     |       | 25,303.6                                    |       | 16,600.8   |       | 8,702.8    |       |   | 52.4 |   |   |
| Income (loss)  from operations                                                               |       | 136.5                                       |       | (3,534.0   | )          | 3,670.5    |       |   | -103.9 |   |   |
| Interest income                                                                              |       | 838.8                                       |       | 214.1      |       | 624.7      |       |   | 291.8 |   |   |
| Interest expense                                                                             |       | (2.0                                        | )          | (964.1     | )          | 962.0      |       |   | -99.8 |   |   |
| Income (loss)  before income taxes                                                           |       | 973.3                                       |       | (4,284.0   | )          | 5,257.2    |       |   | -122.7 |   |   |
| Income tax  provision                                                                        |       | 35.0                                        |       | —     |       | 35.0       |       |   | N/A |   |   |
| Net income (loss)                                                                            |       | 938.3                                       |       | (4,284.0   | )          | 5,222.2    |       |   | -121.9 |   |   |
| Accretion of  dividend on preferred stock                                                    |       | —                                      |       | (1,386.3   | )          | 1,386.3    |       |   | -100.0 |   |   |
| Deemed dividend  and beneficial conversion feature on redeemable convertible preferred stock |       | —                                      |       | (7,838.7   | )          | 7,838.7    |       |   | -100.0 |   |   |
| Net income (loss)  available to common stockholders                                          |       | $                                           | 938.3      |       | $          | (13,509.0  | )          | $ | 14,447.2 |   |   | -106.9 |   |   |

----

(1)          Includesnon-cash stock-based compensation of:

| Research and development                 |   | $     | 77.4   |   | $      | 249.1   |   |
|------------------------------------------|--------|-------|--------|--------|--------|---------|--------|
| Sales and marketing                      |   | 167.7 |   | 356.4  |   |
| General and administrative               |   | 161.3 |   | 423.0  |   |
| Total non-cash  stock-based compensation |   | $     | 406.3  |   | $      | 1,028.6 |   |

 

*Gross Margin*

Diagnostic device gross margin percentage was 74.9%and 67.2% for the years ended December 31, 2005 and December 31,2004, respectively. The increase in the gross margin percentage in 2005compared to 2004 is primarily attributable to an increase in the list price ofour NC-stat System from $3,500 to $4,000 effective January 1, 2005.

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Biosensor gross margin percentage increased slightlyto 74.1% for the year ended December 31, 2005 from 73.7% for the yearended December 31, 2004. The increase in biosensor gross margin percentageis primarily due to manufacturing cost reductions realized for several of ourbiosensors, offset in part by a change in the mix of biosensors resulting fromthe introduction of new biosensors in the second half of 2004 which havemodestly lower gross margins.

Our overall gross margin percentage was 74.2% for theyear ended December 31, 2005 compared to 72.9% for 2004.

Our biosensors are manufactured by the Parlex PolymerFlexible Circuits division of Parlex Corporation. Johnson Electric, a Hong Kongbased manufacturing company, acquired Parlex in November 2005. We expectto establish a second manufacturing line in an existing Parlex facility during2006. We cannot assure you that this new manufacturing site will be capable ofproducing biosensors of the same quality or that they will be capable ofdelivering biosensors to us in a timely manner. Furthermore, we cannot assureyou that the acquisition of Parlex by Johnson Electric will not result inadverse changes in our relationship with Parlex.

The manufacturing ofNC-stat monitors and docking stations was transitioned from AEI to Sunburst in November 2005as a result of a decision by AEI to shut down its operations. Several AEIemployees who were involved in the manufacturing of our devices have been hiredby Sunburst and we did not experience any interruptions during this transition.Sunburst has the required ISO certifications for manufacturing our monitors anddocking stations and is qualified in the manufacturing of such devices based onour assessment of their operations. However, we cannot assure you that Sunburstwill be able to manufacture the NC-stat monitors and docking stations with thesame level of quality and on the same timely delivery schedule as AEI.

*Research andDevelopment*

Our research and development, or R&D, expensesinclude expenses from the research, product development, clinical, regulatoryand quality assurance departments.

R&D expenses increased $552,300, or 16.9%, to $3.8million for the year ended December 31, 2005 from $3.3 million for theyear ended December 31, 2004. As a percentage of revenues, R&Dexpenses were 11.1% and 18.2% for the years ended December 31, 2005 and2004, respectively. This increase was primarily due to a $434,200 increase inemployee compensation and benefit costs and a $54,400 increase in recruitingcosts. These increases resulted from the hiring of additional employees in ourR&D department, particularly in product development to support our effortson the development of a third generation neurodiagnostic system, newbiosensors, improvements to existing biosensors, products to diagnoseadditional neuropathies and a drug delivery system for the minimally invasivetreatment of neuropathies.  Alsocontributing to the change was an increase of $283,600 in outside consultingcosts primarily related to efforts expended on the development of a thirdgeneration neurodiagnostic system and on new biosensors and improvements toexisting biosensors.  These increaseswere partially offset by a decrease in stock-based compensation expense of$171,800 related to employee stock options

We expect our spending onR&D will increase during 2006 due to additional consulting services and thehiring of several additional employees to support product development effortsas well as increased clinical study costs. In addition, we expect R&Dexpenses will also increase in 2006 due to the adoption of the provisions ofStatement of Financial Accounting Standards No. 123(R), “Share-BasedPayment” (“SFAS No. 123(R)”). We expect R&D expenses, as a percentageof total revenues, to continue to decrease slightly due to an expected increasein revenue. This percentage may vary, however, depending primarily on ourrevenues for 2006.

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*Sales and Marketing*

Our sales and marketing expenses include expenses fromthe marketing, field sales, sales administration and reimbursement departments.

Sales and marketing expenses increased $5.7 million,or 66.7%, to $14.2 million for year ended December 31, 2005 from $8.5million for the year ended December 31, 2004. As a percentage of revenues,sales and marketing expenses were 41.3% and 47.4% for the years ended December 31,2005 and 2004, respectively. The change in expenses was primarily due to anincrease of $3.7 million in employee compensation and benefit costs, includingsales commissions paid to our regional sales managers. This increase is due tothe expansion of the sales force and higher revenues in 2005 as compared to2004.  Also contributing to the change inexpenses was an increase of $1.5 million in sales commissions paid to ourindependent sales agencies, which were related to our higher revenues in 2005,and increases of $351,400 in travel expenses and $73,300 in recruiting costsdue to the expansion of the sales force. The change in expenses was alsopartially due to an increase of $192,800 in costs for trade shows, advertisingand promotional materials as we have increased our presence at tradeshows anddeveloped new promotional materials. These increases were offset in part by adecrease in stock-based compensation expense of $188,700 related to employeestock options.

We have increased oursales force to 31 regional sales managers, three sales representatives and twodistrict sales directors as of the end of 2005 and expect to add approximately15 additional regional sales managers and several sales representatives andsales directors during the first quarter of 2006. In addition, we expect salesand marketing expenses will also increase in 2006 due to the adoption of theprovisions of SFAS No. 123(R). For 2006, we expect sales and marketingexpenses, as a percentage of total revenues, to decrease slightly from thelevel experienced in 2005. This percentage may vary, however, dependingprimarily on our revenues for 2006.

*General andAdministrative*

Our general and administrative expenses includeexpenses from the executive, finance, administrative, customer service andinformation technology departments.

General and administrative expenses increased $2.5million, or 51.4%, to $7.3 million for year ended December 31, 2005 from$4.8 million for the year ended December 31, 2004. As a percentage ofrevenues, general and administrative expenses were 21.4% and 27.0% for theyears ended December 31, 2005 and 2004, respectively. The increase inexpenses was primarily due to (a) an increase in employee compensation andbenefit costs of $885,500 due to the expansion of staff and increases inemployee compensation; (b) an increase of $663,700 in professional feesfor legal services and for accounting and audit services primarily as a resultof the increased regulatory requirements associated with being apublicly-traded company including the provisions of the Sarbanes-Oxley Act of2002, and the rules promulgated thereunder, regarding internal controlover financial reporting (“Sarbanes-Oxley 404”) which began to apply to us asof December 31, 2005; (c) an increase of $344,100 in our insurancecosts, primarily relating to increases in director and officer insurancepremiums as a result of the transition to a publicly-traded company; (d) anincrease of $177,600 in credit card and bank transaction fees related tocustomer sales; (e) an increase of $148,000 in franchise taxes andother fees; and (f) an increase in recruiting costs of $94,300 associatedwith new hires. The increases are offset in part by a decrease of $261,800 instock-based compensation expense related to employee stock options.

We expect our general andadministrative expenses to increase during 2006 as a result of our expectedgrowth and the expected hiring of additional general and administrative staffto support this growth. In addition, we expect general and administrativeexpenses will also increase in 2006 due to the adoption of the provisions ofSFAS No. 123(R). Total general and administrative expenses, as apercentage of total revenues, are expected to decrease in 2006, in spite of theanticipated need to hire additional staff. This 

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percentagemay vary, however, depending primarily on our revenues for 2006. We expect tobe able to leverage certain existing resources such that the growth in generaland administrative expenses is anticipated to be less than the growth in ourrevenues. Furthermore, while we experienced an increase in professional fees in2005 largely due to the effect of the first year of compliance withSarbanes-Oxley 404, we do not expect the costs associated with Sarbanes-Oxley404 to increase in 2006.

*Interest Income*

Interest income was$838,800 and $214,100 during the years ended December 31, 2005 and 2004,respectively, representing an increase of $624,700. Interest income was earnedfrom investments in cash equivalents, short-term investments and long-terminvestments. Interest income increased during the year ended December 31,2005 compared to the year ended December 31, 2004 due to the investment ofthe proceeds from the IPO, which was completed in the third quarter of 2004,the investment of the proceeds from the sale of preferred stock in March 2004and increased yields on invested funds in 2005.

*Interest Expense*

Interest expense was$2,000 and $964,100 during the years ended December 31, 2005 and 2004,respectively, representing a decrease of $962,000. The decrease in interest expensewas due to the payment in the third quarter of 2004 of an outstanding debtbalance of $3.0 million under our line of credit with Lighthouse CapitalPartners by using a portion of the proceeds received from the IPO.

*Deemed Dividend andBeneficial Conversion Feature on Redeemable Convertible Preferred Stock*

In 2004, we recorded a$787,900 deemed dividend as a result of the March 2004 Series E-1redeemable convertible preferred stock financing. The deemed dividend resultedfrom an adjustment to the conversion ratios pursuant to the anti-dilutionprotection provisions associated with the Series D redeemable convertiblepreferred stock. We also recorded a charge of $7.1 million for a beneficialconversion feature associated with the Series E-1 redeemable convertiblepreferred stock issued in March 2004. There was no deemed dividend orbeneficial conversion charge in 2005. All issued and outstanding shares ofpreferred stock were converted into shares of common stock in connection withthe initial public offering.

**Comparisonof Years Ended December 31, 2004 and December 31, 2003**

*Revenues*

Thefollowing table presents a breakdown of our customers, biosensor units used andrevenues:

| ** **            | ** ** | **Years Ended December 31,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|-----------------------|------------|---------------------------------------------|------------|------------|------------|------------|------------|
| ** **            | ** ** | **2004**                                    | ** ** | **2003**   | ** ** | **Change** | ** ** | **% Change** | ** ** |
| Customers             |       | 2,207                                       |       | 1,736      |       | 471        |       |   | 27.1 | % |   |
| Biosensor units  used |       | 357,400                                     |       | 203,000    |       | 154,400    |       |   | 76.1 |   |   |
| ** **            | ** ** | **(in  thousands)**                         | ** ** | ** ** | ** ** |
| Revenues:             |       |                                        |       |       |       |       |       |   |   |   |   |
| Diagnostic device     |       | $                                           | 2,219.5    |       | $          | 1,302.3    |       | $ | 917.2 |   |   | 70.4 |   |   |
| Biosensor             |       | 15,700.6                                    |       | 7,865.3    |       | 7,835.3    |       |   | 99.6 |   |   |
| Total revenues        |       | $                                           | 17,920.1   |       | $          | 9,167.6    |       | $ | 8,752.5 |   |   | 95.5 |   |   |

 

Diagnostic device revenues were $2.2 million and$1.3 million for the years ended December 31, 2004 and December 31,2003, respectively, representing a year-over-year increase of $917,200, or70.4%. Of this increase, approximately $518,600 is attributable to a greaternumber of units sold, primarily as a result of 

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an increase in the numberof our regional sales managers and expanded clinical uses for the NC-statSystem, and $398,600 is attributable to an increase in the list price of ourNC-stat monitors and docking stations. Diagnostic device revenues accounted for12.4% and 14.2% of our total revenues for the years ended December 31,2004 and December 31, 2003, respectively.

Biosensor revenues were $15.7 million and$7.9 million for the years ended December 31, 2004 and December 31,2003, respectively, representing a year-over-year increase of$7.8 million, or 99.6%. The increase was primarily due to an increasedcustomer base for our biosensors, increased frequency of testing by ourcustomers, and the introduction in May 2003 of higher functionalitybiosensors that test both motor and sensory nerve conduction. These higherfunctionality biosensors have an average selling price 60-80% higher thanmotor-only biosensors. Biosensor revenues accounted for 87.6% and 85.8% of ourtotal revenues for the years ended December 31, 2004 and December 31,2003, respectively.

Our customers used 357,400 biosensor units in the yearended December 31, 2004, compared to 203,000 units for the same period in2003, an increase of 154,400 units, or 76.1%.

Our total revenues were$17.9 million and $9.2 million for the years ended December 31,2004 and December 31, 2003 respectively, representing a year-over-yearincrease of $8.8 million, or 95.5%. During the 12-month periodending December 31, 2004, a total of 2,207 customers used our NC-statSystem compared to 1,736 customers for the same period ending December 31,2003. This represents a 27.1% year-over-year increase in the number of customersthat used our NC-stat System.

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*Costs and expenses*

Thefollowing table presents our costs and expenses and net loss:

| ** **                                                 | ** ** | **Years Ended December 31,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|------------------------------------------------------------|------------|---------------------------------------------|------------|------------|------------|------------|------------|
| ** **                                                 | ** ** | **2004**                                    | ** ** | **2003**   | ** ** | **Change** | ** ** | **% Change** | ** ** |
| ** **                                                 | ** ** | **(in thousands)**                     | ** ** | ** ** | ** ** |
| Cost of revenues:                                          |       |                                        |       |       |       |       |       |   |   |   |   |
| Diagnostic device                                          |       | $                                           | 728.7      |       | $          | 658.1      |       | $ | 70.6 |   |   | 10.7 | % |   |
| Biosensor                                                  |       | 4,124.6                                     |       | 2,048.4    |       | 2,076.2    |       |   | 101.4 |   |   |
| Total cost of revenues                                     |       | 4,853.3                                     |       | 2,706.5    |       | 2,146.8    |       |   | 79.3 |   |   |
| Gross margin:                                              |       |                                        |       |       |       |       |       |   |   |   |   |
| Diagnostic device                                          |       | 1,490.8                                     |       | 644.2      |       | 846.6      |       |   | 131.4 |   |   |
| Biosensor                                                  |       | 11,576.0                                    |       | 5,816.8    |       | 5,759.2    |       |   | 99.0 |   |   |
| Total gross margin                                         |       | 13,066.8                                    |       | 6,461.0    |       | 6,605.8    |       |   | 102.2 |   |   |
| Gross margin %:                                            |       |                                        |       |       |       |       |       |   |   |   |   |
| Diagnostic device                                          |       | 67.2                                        | %          | 49.5       | %          |       |       |   |   |   |   |
| Biosensor                                                  |       | 73.7                                        |       | 74.0       |       |       |       |   |   |   |   |
| Total gross margin %                                       |       | 72.9                                        |       | 70.5       |       |       |       |   |   |   |   |
| Operating expenses:                                        |       |                                        |       |       |       |       |       |   |   |   |   |
| Research and development(1)                                |       | $                                           | 3,268.4    |       | $          | 2,396.8    |       | $ | 871.6 |   |   | 36.4 |   |   |
| Sales and marketing(1)                                     |       | 8,488.0                                     |       | 4,767.6    |       | 3,720.4    |       |   | 78.0 |   |   |
| General and administrative(1)                              |       | 4,844.4                                     |       | 2,850.5    |       | 1,993.9    |       |   | 70.0 |   |   |
| Total operating expenses                                   |       | 16,600.8                                    |       | 10,014.9   |       | 6,585.9    |       |   | 65.8 |   |   |
| Loss from  operations                                      |       | (3,534.0                                    | )          | (3,553.8   | )          | 19.8       |       |   | -0.6 |   |   |
| Interest income                                            |       | 214.1                                       |       | 23.5       |       | 190.6      |       |   | 811.1 |   |   |
| Interest expense                                           |       | (964.1                                      | )          | (136.3     | )          | (827.8     | )          |   | 607.3 |   |   |
| Net loss                                                   |       | (4,284.0                                    | )          | (3,666.7   | )          | (617.3     | )          |   | 16.8 |   |   |
| Accretion on  redeemable convertible preferred stock       |       | (1,386.3                                    | )          | (2,009.5   | )          | 623.2      |       |   | -31.0 |   |   |
| Deemed dividend  on redeemable convertible preferred stock |       | (7,838.7                                    | )          | —     |       | (7,838.7   | )          |   | — |   |   |
| Net loss available to  common stockholders                 |       | $                                           | (13,509.0  | )          | $          | (5,676.2   | )          | $ | (7,832.8 | ) |   | -138.0 |   |   |

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(1)          Includesnon-cash stock-based compensation of:

| Research and development                 |   | $     | 249.1   |   | $      | 35.1 |   |
|------------------------------------------|--------|-------|---------|--------|--------|------|--------|
| Sales and marketing                      |   | 356.4 |    | 36.8   |   |
| General and administrative               |   | 423.0 |    | 24.5   |   |
| Total non-cash  stock-based compensation |   | $     | 1,028.6 |   | $      | 96.4 |   |

 

*Gross Margin*

Diagnostic device gross margin percentage was 67.2%and 49.5% for the years ended December 31, 2004 and December 31,2003, respectively. The increase in the gross margin percentage for the year of2004 compared to 2003 is attributable partially to an increase in the list priceof our NC-stat neurodiagnostic system, and partially to a decrease in the costof our diagnostic devices commencing in mid-2003 resulting from a changein our third-party manufacturer.

Biosensor gross margin percentage decreased to 73.7%for the year ended December 31, 2004 from 74.0% for the same period in2003. The small decrease in biosensor gross margin percentage is primarily dueto a less favorable mix towards higher sales volume of lower margin biosensorsduring the year of 2004 when compared to 2003.

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Our overall gross marginpercentage was 72.9% for the year ended December 31, 2004 compared to70.5% for 2003.

*Research andDevelopment*

R&D expenses increased$871,600, or 36.4%, to $3.3 million for the year ended December 31,2004 from $2.4 million for the same period in 2003. As a percentage ofrevenues, R&D expenses were 18.2% and 26.1% for the years ended December 31,2004 and December 31, 2003, respectively. The increase in expenses was dueto an increase of $564,400 in employee compensation and benefit costs primarilyfrom the hiring of additional employees in our R&D department, an increasein stock-based compensation of $214,000 and an increase of $87,400 in outsideconsulting costs.

*Sales and Marketing*

Sales and marketingexpenses increased $3.7 million, or 78.0%, to $8.5 million for theyear ended December 31, 2004 from $4.8 million for the year ended2003. As a percentage of revenues, sales and marketing expenses were 47.4% and52.0% for the years ended December 31, 2004 and December 31, 2003,respectively. The increase in expenses was primarily due to an increase of$1.1 million in sales commissions paid to our independent regional salesagencies and an increase of $792,900 in sales commissions paid to our directsales force, which were directly related to our higher revenues in 2004, andincreases of $741,900, $440,700 and $133,000 in employee compensation andbenefit costs, travel expenses and recruiting costs, respectively, whichresulted from the addition of seventeen employees in our sales and marketingdepartment. The increase was also partially due to an increase of $189,000 inoutside consulting service expense. Sales and marketing expense also increaseddue to an increase in non-cash stock based compensation of $319,600 in 2004compared to 2003. These increases were partially offset by a reduction of$113,900 in costs for advertising, promotional materials and trade shows. Thisreduction was due to the fact that we performed a significant portion ofadvertising design work in-house during 2004, which resulted in lower costs ascompared to the previous year when this design work was contracted to vendors.Also, during 2003 we incurred advertising and promotion costs related to theintroduction of our new motor/sensory biosensors.

*General andAdministrative*

General and administrativeexpenses increased $2.0 million, or 70.0%, to $4.8 million for theyear ended December 31, 2004 from $2.8 million for the year ended December 31,2003. As a percentage of revenues, general and administrative expenses were27.0% and 31.1% for the years ended December 31, 2004 and December 31,2003, respectively. The increase in expenses was primarily due to an increaseof $349,000 in employee compensation and benefit costs resulting partially fromthe hiring of four additional employees, an increase of $397,000 in non-cashstock-based compensation related to employee stock options, an increase of$325,400 in outside consulting services expense partially used to assist in thepreparation for and the IPO process, an increase of credit card and banktransaction fees of $97,400 and an increase of $68,100 to bad debt write-offsduring the year of 2004. Also contributing to the increase in general andadministrative expenses were increases of $362,300 in our insurance costs,$327,300 increase in our legal and accounting costs and an increase of $25,200in financial printing costs and filing fees, all related to fulfilling therequirements of a publicly traded company. Partially offsetting these increasesin general and administrative expenses was a decrease in recruiting costs of$31,900 resulting from an executive search in 2003 that did not recur in 2004.

*Interest Income*

Interest income was$214,100 and $23,500 during the years ended December 31, 2004 and December 31,2003, respectively. Interest income was earned from investments in cashequivalents, short-

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terminvestments and long-term investments. All cash invested is designated as heldto maturity, however, the investments held are liquid and marketable. Interestincome increased during the year ended December 31, 2004 compared to thesame period in 2003 due primarily to the investment of the net proceeds fromour IPO in the third quarter of 2004 and the net proceeds from our sale of Series E-1redeemable convertible preferred stock in March 2004.

*Interest Expense*

Interest expense was$964,100 and $136,300 during the years ended December 31, 2004 and 2003,respectively, representing an increase of $827,700. The increase in interestexpense was primarily due to full repayment of our borrowings under a creditline entered into in May 2003 with Lighthouse Capital Partners whichtriggered an additional payment equal to 11% of the original principal amountof the line of credit.

*Deemed Dividend andBeneficial Conversion Feature on Redeemable Convertible Preferred Stock*

In the first quarter of2004, we recorded a $787,900 deemed dividend as a result of the March 2004Series E-1 redeemable convertible preferred stock financing. Thedeemed dividend resulted from an adjustment to the conversion ratios as aresult of anti-dilution protection associated with the Series D redeemableconvertible preferred stock. We also recorded a charge of $7.1 million fora beneficial conversion feature embedded within the Series E-1redeemable convertible preferred stock issued in March 2004. There was nodeemed dividend or beneficial conversion charge in 2003.

**Liquidity and Capital Resources**

Ourprincipal source of liquidity is our current cash and cash equivalents, andshort-term and long-term held-to-maturity investments. As of December 31,2005, weighted average maturity of our cash equivalents and short-termheld-to-maturity investments was 107 days. Our ability to generate cashfrom operations is dependent upon our ability to generate revenue from sales ofour diagnostic devices and consumable biosensors, as well as our ability tomanage our operating costs and net assets. A decrease in demand for ourproducts or unanticipated increases in our operating costs would likely have anadverse effect on our liquidity and cash generated from operations. Thefollowing sets forth information relating to our liquidity:

| ** **                                                                           | ** ** | **December 31,**   | ** ** | ** ** | ** ** | ** ** | ** ** |
|--------------------------------------------------------------------------------------|------------|-------------------------|------------|------------|------------|------------|------------|
| ** **                                                                           | ** ** | **2005**                | ** ** | **2004**   | ** ** | **Change** | ** ** | **% Change** | ** ** |
| ** **                                                                           | ** ** | **(in thousands)** | ** ** | ** ** | ** ** |
| Cash and cash  equivalents                                                           |       | $                       | 8,170      |       | $          | 1,936      |       | $ | 6,234 |   |   | 322.0 | % |   |
| Short-term  held-to-maturity investments                                             |       | 24,082                  |       | 18,575     |       | 5,507      |       |   | 29.6 |   |   |
| Long-term  held-to-maturity investments                                              |       | —                  |       | 9,497      |       | (9,497     | )          |   | -100.0 |   |   |
| Total cash, cash  equivalents, short-term and long-term held-to-maturity investments |       | $                       | 32,252     |       | $          | 30,008     |       | $ | 2,244 |   |   | 7.5 | % |   |

 

During 2005, our cash and cash equivalents andshort-term and long-term held-to-maturity investments increased $2.2 million,primarily due to positive cash flow from operations of $1.9 million and$812,200 of proceeds from the exercise of stock options and the issuance ofcommon stock through our employee stock purchase plan, offset in part bycapital expenditures of $475,100.

In March 2004, we sold 7,050,771 shares of our Series E-1redeemable convertible preferred stock to existing preferred stockholders fornet proceeds of $10.6 million. These shares converted into1.8 million shares of common stock upon the closing of our initial publicoffering. These shares contained a beneficial conversion feature, as theestimated fair value of our common stock at the date of the sale was in excessof the conversion price associated with Series E-1 redeemableconvertible preferred stock share price. The 

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total value of thebeneficial conversion feature of approximately $7.1 million was recognizedin the form of a preferred stock dividend in the first quarter of 2004. Inaddition, we recognized a deemed dividend of approximately $787,900 in thefirst quarter of 2004 as a result of an adjustment in the conversion rate ofthe Series D redeemable convertible preferred stock associated withanti-dilution provisions in connection with the March 2004 Series E-1redeemable convertible preferred stock sale.

On July 27, 2004, we closed the initial publicoffering of our common stock selling 3,000,000 shares at $8.00 per share. On August 19,2004 we sold a 450,000 common share over-allotment to our underwriters at $8.00per share. Our initial public offering, including the over-allotment shares,provided net proceeds of approximately $24.0 million. We repaid approximately$2.9 million of secured debt which was outstanding at the beginning of thequarter in July 2004 by using a portion of the proceeds received from ourinitial public offering.

Inmanaging our working capital, two of the financial measurements that we monitorare days’ sales outstanding, or DSO, and inventory turnover rate, which arepresented in the table below for the years ended December 31, 2005 and December 31,2004:

| ** **                                | ** ** | **Years Ended  December 31,** | ** ** |
|-------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                | ** ** | **2005**                                | ** ** | **2004** | ** ** |
| Days’ sales  outstanding (days)      |       |                                    | 40         |   |   |   | 50 |   |   |
| Inventory turnover rate  (times per year) |       |                                    | 4.5        |   |   |   | 4.1 |   |   |

 

Our payment terms extended to our customers generallyrequire payment within 30 days from invoice date. At December 31, 2005,our DSO was 40 days, a decrease of 10 days as compared to December 31,2004. This decrease in DSO resulted from increasing revenues and a decrease inthe percentage of accounts receivable balances more than 60 days past due. Thisdecrease in the percentage of accounts receivable balances more than 60 dayspast due was primarily due to more aggressive management of collections and thesignificant revenue growth in the year ended December 31, 2005 relative tothe more modest increase in our accounts receivable balances during the yearended December 31, 2005. We continue to focus our efforts on reducing ouraccounts receivable balances over 60 days past due. Accounts payable arenormally paid within 30 to 40 days from receipt of a vendor’s invoice.

Our inventory turnover for the year ended December 31,2005 was 4.5 times, compared with 4.1 times for the year ended December 31,2005. The increase in the inventory turnover rate for the year ended December 31,2005 as compared to the year ended December 31, 2004 was primarily due tothe effective management of inventory levels of biosensors. We monitor ourinventories closely, especially as it pertains to the mix of differentbiosensors sold, and the sales volumes of new biosensors launched in 2004. Weexpect to increase our inventory levels through the first quarter of 2006 witha target of maintaining at least three months worth of inventory in ourfacility in Waltham, MA. This may have the effect of decreasing our inventoryturnover rate.

Thefollowing sets forth information relating to the sources and uses of our cash.

| ** **                                           | ** ** | **Years Ended December 31,** | ** ** |
|------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                           | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                           | ** ** | **(in thousands)**                     | ** ** |
| Net cash provided  by (used in) operating activities |       | $                                           | 1,908      |   | $ | (2,652 | ) | $ | (3,873 | ) |
| Net cash provided  by (used in) investing activities |       | $                                           | 3,514      |   | $ | (28,706 | ) | $ | (204 | ) |
| Net cash provided by  financing activities           |       | $                                           | 812        |   | $ | 31,671 |   | $ | 2,999 |   |

 

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Cash provided by operating activities wasapproximately $1.9 million in the 2005, compared with cash used in operatingactivities of $2.7 million in 2004. In 2005, we recorded $938,000 in net income.In addition, we had $1.5 million in depreciation, amortization and othernon-cash items. We had a net use of cash totaling approximately $550,000 forour investment in working capital. The primary drivers of our investment inworking capital were as follows:  Ouraccounts receivable increased $1.8 million, excluding the change in theallowance for doubtful accounts, due to growth in revenues offset by the morerapid collection of amounts due from our customers as evidenced by the decreasein DSO from 50 in 2004 to 40 in 2005. Our inventories increased $1.4 milliondue to the growth in our business and due to a strategic decision to increaseinventory levels from two months to three months of purchases.  Accounts payable, representing amounts due toour vendors, increased approximately $800,000, principally due to increases inamounts due to our third-party manufacturers as a result of the growth in ourbusiness and the increase in our inventory levels. Accrued expenses increased$1.2 million, primarily due to increases in commissions and bonuses owed tosales representatives and third party distributors as a result of the increasein our revenues. Deferred revenue, net of deferred costs, increased $589,000due to the increase in the number of new NC-stat docking stations sold tocustomers.

Cash used in operations in 2004 was driven by the netloss of $4.3 million and a net investment of $363,700 in working capital,offset in part by $2.0 million of non-cash items.

Cash provided by investing activities was $3.5 millionin 2005, compared with cash used in investing activities of $28.7 million in2004. In 2005, there were net maturities of investments in the amount ofapproximately $3.6 million, which was primarily reinvested in cash equivalents.In 2004, $31.0 million of proceeds from equity financings was invested in short-termand long-term held-to-maturity investments. In 2005 and 2004 cash was used forthe purchase of fixed assets in the amount of $475,100 and $545,200,respectively, primarily representing production tooling equipment for newproducts, especially the third generation neurodiagnostic systems indevelopment, computer equipment and leasehold improvements in 2005 andproduction tooling and computer equipment in 2004.

In connection with our property lease entered into atthe beginning of January, 2001, we are required to maintain, for the benefit ofthe lessor, an irrevocable standby letter of credit stating the lessor as thebeneficiary. The original amount of the letter of credit was $1,860,000. DuringSeptember 2005, in accordance with the terms of the lease agreement, theamount required under the letter of credit was reduced to $1,430,000. Theletter of credit is secured by a certificate of deposit in an amount equal to102% of the letter of credit. The lease expires in March 2009. Thecertificate of deposit is renewable in 30-day increments. This amount isclassified as restricted cash in the balance sheet. The restricted cash balanceas of December 31, 2005 has been reduced by approximately $438,600 fromthe balance as of December 31, 2004 to approximately $1,458,600.

Cash provided by financing activities was $812,200 and$31.7 million in 2005 and 2004, respectively. Cash provided by financingactivities in 2005 represents the proceeds from the exercise of stock optionsand the issuance of shares under our employee stock purchase plan. The cashfrom financing activities in 2004 primarily represented the net proceeds of$24.0 million realized from our initial public offering, including the netproceeds from the over-allotment shares, as well as net proceeds of $10.6million received from the issuance of preferred stock in a private placement,offset by payments on long-term debt of $3.0 million.

During 2006, we will be continuing to expend funds inconnection with our efforts to expand our sales and marketing for the NC-statSystem, although more modestly than the expansion in the last several quarters,and continue our ongoing program of making enhancements and improvements to theNC-stat System, including the development of new and/or improved biosensors,products for the diagnosis of additional neuropathies, and the development of athird generation neurodiagnostic system. In connection with the developmentefforts on a third generation neurodiagnostic system, we expect to continue toincur 

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additional capitalexpenditures in the first quarter of 2006 for production tooling costs. We alsoplan to expend funds on the design of a drug delivery system, which is in itsearly stages of development, for the minimally invasive delivery of therapeuticagents to treat neuropathies by both primary care and specialist physicians. Wealso expect to incur capital expenditures for computer hardware and software tosupport the growth in our business and the additional requirements of ourcustomer base. We believe that the combination of funds available from cash andcash equivalents and funds available from our short-term investments will beadequate to finance our ongoing operations for at least 24 months, includingthe expenditures described above.

As of December 31, 2005, we have federal andstate net operating loss carryforwards available to offset future taxableincome of $35.5 million and $28.8 million, respectively, and federaland state research and development credits of $563,000 and $126,000, respectively,which may be available to reduce future taxable income and the related taxesthereon. The net operating loss and research and development creditcarryforwards expire at various dates beginning in 2011 for federal and 2006for state. Ownership changes in our company, as defined in the Internal RevenueCode, are expected to have a modest limitation on the amount of net operatingloss and research and development credit carryforwards that can be utilizedannually to offset future taxable income and taxes, based on an analysis of theprovisions of Section 382 of the Internal Revenue Code. Subsequent changesin our ownership could further affect the limitation in future years.

To date, inflation has nothad a material impact on our financial operations.

*Off-Balance SheetArrangements, Contractual Obligations and Contingent Liabilities andCommitments*

As of December 31, 2005, we did not have anyoff-balance sheet financing arrangements.

Thefollowing table summarizes our principal contractual obligations as of December 31,2005 and the effects such obligations are expected to have on our liquidity andcash flows in future periods.

| ** **                       | ** ** | **Payments due in** | ** ** |
|----------------------------------|------------|-------------------------------|------------|
| **Contractual Obligations** | ** ** | ** **                    | ** ** | **Total** | ** ** | **2006** | ** ** | **2007 and 2008** | ** ** | **2009 and 2010** | ** ** | **After 2010** | ** ** |
| Operating lease  obligations     |       | $                             | 3,022,500  |   | $ | 930,000 |   |   | $ | 1,860,000 |   |   |   | $ | 232,500 |   |   |   | $ | — |   |   |
| Purchase order  obligations      |       | 2,656,900                     |       | 2,656,900 |   |   | — |   |   |   | — |   |   |   | — |   |   |
| License agreement  obligations   |       | 85,000                        |       | 85,000 |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Total contractual  obligations   |       | $                             | 5,764,400  |   | $ | 3,671,900 |   |   | $ | 1,860,000 |   |   |   | $ | 232,500 |   |   |   | $ | — |   |   |
|                                  |            |                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

In addition to the above-listed items, we entered intotwo separate license agreements. The first license agreement is with theMassachusetts Institute of Technology, or M.I.T. We have obtained a right touse certain technology through the term of the M.I.T.’s patent rights on suchtechnology, which is exclusive for a period of 15 years from the date ofthe license agreement. In exchange, we issued shares of common stock to M.I.T.and are required to pay royalties of 2.15% of net sales of productsincorporating the licensed technology. In addition, we are required to payroyalties ranging from 25% to 50% of payments received from sublicensees,depending on the degree to which the licensor’s technology was incorporatedinto the products sublicensed by us. In addition, we are obligated to payM.I.T. annual license maintenance fees. On or before December 31, 2002, wehave paid M.I.T. annual license maintenance fees totaling $50,000 in theaggregate. For each year after 2003, we are obligated to pay M.I.T. annuallicense maintenance fees of $75,000 if minimum sales requirements are not met.All annual license maintenance fees that we pay can be used to offset futureroyalties payable under the agreement. We have the right to terminate thislicense agreement at any time upon six months’ notice. Through the year ended December 31,2005, we have not incorporated this licensed technology into our products.

The second licenseagreement is with an unrelated third party. We obtained the right to usecertain proprietary technology of this third party. This technology is used inthe manufacture of our NC-stat 

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biosensors.The term of this agreement is perpetual, subject to rights of termination. Inexchange, we were required to pay the licensor $50,000 every year for the firstthree years of the agreement. In subsequent years, we are required to pay$10,000 per year as long as we continue to use the licensed technology. We paid$10,000 during the year ended December 31, 2005. We have the right toterminate this license agreement upon written notice not later than30 days prior to any anniversary date.

**Critical Accounting Policies**

Our financial statementsare based on the selection and application of generally accepted accountingprinciples, which require us to make estimates and assumptions about futureevents that affect the amounts reported in our financial statements and theaccompanying notes. Future events and their effects cannot be determined withcertainty. Therefore, the determination of estimates requires the exercise ofjudgment. Actual results could differ from those estimates, and any suchdifferences may be material to our financial statements. We believe that thepolicies set forth below may involve a higher degree of judgment and complexityin their application than our other accounting policies and represent thecritical accounting policies used in the preparation of our financialstatements. If different assumptions or conditions were to prevail, the resultscould be materially different from our reported results. Our significantaccounting policies are presented within Note 2 to our FinancialStatements.

*Revenue Recognition*

Our revenue recognition policy is to recognizerevenues from our monitor and biosensors upon shipment if the fee is fixed anddeterminable, persuasive evidence of an arrangement exists, collection of theresulting receivables is reasonably assured and product returns are reasonablyestimable. Revenues from our docking station and access to the onCall InformationSystem are considered one unit of accounting and are deferred and recognizedover the shorter of the estimated customer relationship period or the estimateduseful life of the product, currently three years. We record revenue on a netbasis for product sales made to distributors, based upon the amount billed tothe distributors, when the distributor accepts the responsibility for invoicingthe customer and the responsibility for the risk of collections and productreturns from the customer.

When multiple elements are contained in a singlearrangement, the Company allocates revenue between the elements based on theirrelative fair value, provided that each element meets the criteria fortreatment as a separate unit of accounting. An element is considered a separateunit of accounting if it has value to the customer on a stand-alone basis,there is objective, reliable evidence of the fair value of the undelivered elementsand delivery or performance of the undelivered elements is considered probableand substantially in the control of the Company. Fair value is determined basedupon the price charged when the element is sold separately.

Revenue recognition involves judgments, includingassessments of expected returns, allowance for doubtful accounts and expectedcustomer relationship periods. We analyze various factors, including a reviewof specific transactions, our historical returns, average customer relationshipperiods, customer usage, customer balances and market and economic conditions.Changes in judgments or estimates on these factors could materially impact thetiming and amount of revenues and costs recognized. Should market or economicconditions deteriorate, our actual return or bad debt experience could exceedour estimate.

Certain product sales aremade with a thirty-day right of return. Since we can reasonably estimate futurereturns, we recognize revenues associated with product sales that contain aright of return upon shipment and at the same time reduce revenue by the amountof estimated returns under the provisions of SFAS No. 48, “RevenueRecognition When Right of Return Exists.”

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*Warranty Costs*

We accrue for device andbiosensor warranty costs at the time of sale. While we engage in extensiveproduct quality programs and processes, our warranty obligation is affected byproduct failure rates, user error, variability in physiology and anatomy ofcustomers’ patients, material usage and delivery costs. Should actual productfailure and user error rates, material usage or delivery costs differ from ourestimates, the amount of actual warranty costs could materially differ from ourestimates. Warranty costs are based on the cost of repairing or replacingmonitors and docking stations and based on the replacement cost of biosensors.

*Asset Valuation*

Asset valuation includesassessing the recorded value of certain assets, including accounts receivable,inventories and fixed assets. We use a variety of factors to assess valuation,depending upon the asset. Accounts receivable are evaluated based upon ourhistorical experience, the age of the receivable and current market andeconomic conditions. Should current market and economic conditions deteriorate,our actual bad debt experience could exceed our estimate. The realizable value ofinventories is based upon the types and levels of inventory held, forecasteddemand, pricing, competition and changes in technology. Should current marketand economic conditions deteriorate, our actual recovery could be less than ourestimate.

*Accounting forIncome Taxes*

As part of the process ofpreparing our financial statements, we are required to estimate our incometaxes in each of the jurisdictions in which we operate. This process involvesestimating our actual current tax exposure, including assessing the risksassociated with tax audits, together with assessing temporary differencesresulting from the different treatment of items for tax and accountingpurposes. These differences, together with cumulative net operating losses,result in deferred tax assets and liabilities, which are included within ourbalance sheet. We assess the likelihood that our deferred tax assets will berecovered from future taxable income and, to the extent we believe thatrecovery is not more likely than not, establish a valuation allowance. Theprimary factor used in the determination of the valuation allowance is ourhistorical profitability. In the event that actual results differ from theseestimates, our provision for income taxes could be materially impacted.

**New Accounting Pronouncements**

In November 2005, the Financial Accounting StandardsBoard (“FASB’’) issued FASB Staff Position (“FSP”) FAS 115-1/124-1, “TheMeaning of Other-Than-Temporary Impairment and Its Application to CertainInvestments.” The guidance in this FSP addresses the determination of when aninvestment is considered impaired, whether that impairment isother-than-temporary and the measurement of an impairment loss. The FSP alsoincludes accounting considerations subsequent to the recognition of another-then-temporary impairment and requires certain disclosures aboutunrealized losses that have not been recognized as other-than-temporaryimpairments. The guidance in this FSP applies to reporting periods beginningafter December 15, 2005. The adoption of this FSP did not have a materialimpact on the Company’s financial position or results of operations.

In May 2005, the FASB issued SFAS No 154, “AccountingChanges and Error Corrections—a replacement of APB Opinion No. 20 and FASBStatement No. 3” (“SFAS No. 154”). SFAS No. 154 changes therequirements for the accounting and reporting of a change in accounting principle.SFAS No. 154 applies to all voluntary changes in accounting principles. Italso applies to changes required by an accounting pronouncement in the unusualinstance that the pronouncement does not contain specific transition provisions.When a pronouncement includes specific transition provisions, those provisionswill 

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continue to be followed. SFASNo. 154 is effective for accounting changes and corrections of errors madein fiscal years beginning after December 15, 2005. Earlier application ispermitted for accounting changes and corrections of errors occurring in fiscalyears beginning after June 1, 2005. The adoption of SFAS No. 154 isnot expected to have a material impact on our financial position or results ofoperations.

In December 2004, the FASB issued SFAS No. 123(R),which is a revision of SFAS No. 123, “Accounting for Stock-BasedCompensation,”**and supersedesAccounting Principles Board (“APB”) Opinion No. 25, “Accounting for StockIssued to Employees”**and SFAS No. 148“Accounting for Stock-Based Compensation—Transition and Disclosure.” Thisstatement requires that the cost resulting from all share-based paymenttransactions be recognized in the financial statements. This statementestablishes fair value as the measurement objective in accounting forshare-based payment arrangements and requires all entities to apply a fairvalue based measurement method in accounting for share-based paymenttransactions with employees except for equity instruments held by employeeshare ownership plans. As a result, beginning January 1, 2006, we adoptedSFAS No. 123(R) using the modified prospective method and have begunreflecting the stock-based compensation expense determined under fair valuebased methods in the income statement rather than as pro forma disclosure inthe notes to the financial statements. The Company uses the Black-Scholesoption pricing model for determining the fair value of its stock options andamortizes its stock-based compensation expense using the straight-line method. Theadoption of SFAS No. 123(R) will have a material impact on ourresults of operations.

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**CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS**

The statements containedin this annual report on Form 10-K, including under the sectiontitled “Management’s Discussion and Analysis of Financial Condition and Resultsof Operations” and other sections of this annual report, includeforward-looking statements within the meaning of Section 27A of theSecurities Act of 1933, as amended, and Section 21E of the SecuritiesExchange Act of 1934, as amended, including, without limitation, statementsregarding our or our management’s expectations, hopes, beliefs, intentions orstrategies regarding the future. The words “believe,” “may,” “will,” “estimate,”“continue,” “anticipate,” “intend,” “expect,” “plan” and similar expressionsmay identify forward-looking statements, but the absence of these words doesnot mean that a statement is not forward-looking. The forward-lookingstatements contained in this annual report are based on our currentexpectations and beliefs concerning future developments and their potentialeffects on us. There can be no assurance that future developments affecting uswill be those that we have anticipated. These forward-looking statementsinvolve a number of risks, uncertainties (some of which are beyond our control)or other assumptions that may cause actual results or performance to bematerially different from those expressed or implied by these forward-lookingstatements. These risks and uncertainties include, but are not limited to,those factors described in the section titled “Risk Factors.” Should one ormore of these risks or uncertainties materialize, or should any of ourassumptions prove incorrect, actual results may vary in material respects fromthose projected in these forward-looking statements. We undertake no obligationto update or revise any forward-looking statements, whether as a result of newinformation, future events or otherwise, except as may be required underapplicable securities laws.

**Item 7A.**                Quantitativeand Qualitative Disclosures about Market Risk

We do not use derivativefinancial instruments in our investment portfolio and have no foreign exchangecontracts. Our financial instruments consist of cash, cash equivalents,short-term investments, accounts receivable, accounts payable and accruedexpenses. We consider investments that, when purchased, have a remainingmaturity of 90 days or less to be cash equivalents. The primary objectivesof our investment strategy are to preserve principal, maintain proper liquidityto meet operating needs, and maximize yields. To minimize our exposure to anadverse shift in interest rates, we invest mainly in cash equivalents,short-term investments and long-term investments with a maturity of18 months or less and maintain an average maturity of twelve months orless. We do not believe that a 10% change in interest rate percentages wouldhave a material impact on the fair value of our investment portfolio or ourinterest income.

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**Item 8.**                        FinancialStatements and Supplementary Data

Theinformation required by this item may be found on pages F-1 throughF-26 of this Form 10-K with the exception of quarterlyfinancial information which is presented below:

| ** **                                                                  | ** ** | **Year Ended December 31, 2005** | ** ** |
|-----------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                  | ** ** | **First  Quarter**                                   | ** ** | **Second  Quarter** | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter** | ** ** | **Total** | ** ** |
| Revenues                                                                    |       | $                                                    | 6,789,764  |   | $ | 8,067,506 |   | $ | 9,109,436 |   | $ | 10,331,427 |   | $ | 34,298,133 |   |
| Gross margin                                                                |       | $                                                    | 4,972,039  |   | $ | 5,977,442 |   | $ | 6,791,595 |   | $ | 7,698,963 |   | $ | 25,440,039 |   |
| Net income (loss)  attributable to common shareholders                      |       | $                                                    | (596,314   | ) | $ | (40,144 | ) | $ | 769,265 |   | $ | 805,451 |   | $ | 938,258 |   |
| Net income (loss)  per common share                                         |       |                                                 |       |   |   |   |   |   |   |   |   |
| Basic                                                                       |       | $                                                    | (0.05      | ) | $ | (0.00 | ) | $ | 0.06 |   | $ | 0.07 |   | $ | 0.08 |   |
| Diluted                                                                     |       | $                                                    | (0.05      | ) | $ | (0.00 | ) | $ | 0.06 |   | $ | 0.06 |   | $ | 0.07 |   |
| Weighted average  shares used to compute net income (loss) per common share |       |                                                 |       |   |   |   |   |   |   |   |   |
| Basic                                                                       |       | 12,043,103                                           |       | 12,085,448 |   | 12,187,835 |   | 12,289,075 |   | 12,152,139 |   |
| Diluted                                                                     |       | 12,043,103                                           |       | 12,085,448 |   | 13,103,158 |   | 13,181,140 |   | 12,986,365 |   |

 

| ** **                                                                           | ** ** | **Year Ended December 31, 2004** | ** ** |
|--------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                           | ** ** | **First  Quarter**                                   | ** ** | **Second  Quarter** | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter** | ** ** | **Total** | ** ** |
| Revenues                                                                             |       | $                                                    | 3,030,267  |   | $ | 4,296,015 |   | $ | 4,819,318 |   | $ | 5,774,489 |   | $ | 17,920,089 |   |
| Gross margin                                                                         |       | $                                                    | 2,203,060  |   | $ | 3,125,592 |   | $ | 3,529,075 |   | $ | 4,209,036 |   | $ | 13,066,763 |   |
| Net loss  attributable to common shareholders                                        |       | $                                                    | (9,153,072 | ) | $ | (1,956,932 | ) | $ | (1,563,769 | ) | $ | (835,173 | ) | $ | (13,508,946 | ) |
| Net loss per  common share (basic and diluted)                                       |       | $                                                    | (8.78      | ) | $ | (1.85 | ) | $ | (0.18 | ) | $ | (0.07 | ) | $ | (2.35 | ) |
| Weighted average shares  used to compute basic and diluted net loss per common share |       | 1,042,990                                            |       | 1,055,993 |   | 8,819,558 |   | 12,025,223 |   | 5,747,579 |   |

 

**Item 9.**                        Disagreementswith Accountants on Accounting and Financial Disclosure

There have been no changesor disagreements with accountants on accounting of financial disclosure mattersin the last fiscal year.

**Item 9A.**                Controlsand Procedures

**(a)**          Evaluationof disclosure controls and procedures.

Our management carried outan evaluation, with the participation of our Chief Executive Officer and ourChief Financial Officer, of the effectiveness of our disclosure controls andprocedures (as defined in Rules 13a-15(e) or 15d-15(e) underthe Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of December 31,2005. Based upon that evaluation, our Chief Executive Officer and our ChiefFinancial Officer concluded that they believe that our disclosure controls andprocedures are effective to ensure that information required to be disclosed byus in reports that we file or submit under the Exchange Act, is recorded,processed, summarized and reported, within the time periods specified in theSecurities and Exchange Commission’s rules and forms. In designing andevaluating our disclosure controls and procedures, we and our managementrecognize that any controls and procedures, no matter how well designed andoperated, can provide only reasonable assurance of achieving the desiredcontrol objectives, 

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and ourmanagement necessarily was required to apply its judgment in evaluating andimplementing possible controls and procedures. We continue to review anddocument our disclosure controls and procedures, including our internalcontrols over financial reporting, and may from time to time make changes aimedat enhancing their effectiveness and to ensure that our systems evolve with ourbusiness.

**(b)**          Changesin internal control over financial reporting.

There was no change in ourinternal control over financial reporting that occurred during the fiscalquarter ended December 31, 2005 that has materially affected, or isreasonably likely to materially affect, our internal control over financialreporting.

**(c)**           Management’sAnnual Report on Internal Control Over Financial Reporting.

Our management is responsible for establishing andmaintaining adequate internal control over financial reporting, as such term isdefined in Exchange Act Rule 13a-15(f), for our company. Under thesupervision and with the participation of our management, including our ChiefExecutive Officer and our Chief Financial Officer, we conducted an evaluationof the effectiveness of our internal control over financial reporting based onthe framework in *Internal Control—IntegratedFramework*issued by the Committee of Sponsoring Organizations of theTreadway Commission (“COSO”). Based on our evaluation under the framework in *Internal Control—Integrated Framework*issuedby the COSO, our management concluded that our internal control over financialreporting was effective as of December 31, 2005.

Our management’sassessment of the effectiveness of our internal control over financialreporting as of December 31, 2005 has been audited byPricewaterhouseCoopers LLP, an independent registered public accounting firm,as stated in their report which is included on page F-2 of this Form 10-K.

**Item 9B.**               OtherInformation

None.

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**PART III**

**Item 10.**                 Directorsand Executive Officers of the Registrant

The response to this itemis contained in our Proxy Statement relating to our 2006 Annual Meeting ofStockholders (the “Proxy Statement”) and is incorporated herein by reference.

**Item 11.**                 ExecutiveCompensation

The response to this itemis incorporated herein by reference from the discussion responsive thereto inthe Proxy Statement.

**Item 12.**                 SecurityOwnership of Certain Beneficial Owners and Management and Related ShareholderMatters

The response to this itemis incorporated herein by reference from the discussion responsive thereto inthe Proxy Statement

**Item 13.**                 CertainRelationships and Related Transactions

The response to this itemis incorporated herein by reference from the discussion responsive thereto inthe Proxy Statement.

**Item 14.**                 PrincipalAccountant Fees and Services

The response to this itemis incorporated herein by reference from the discussion responsive thereto inthe Proxy Statement.

**PART IV**

**Item 15.**                 Exhibitsand Financial Statement Schedule

**(a)   1.  ***Financial Statements*

The consolidatedfinancial statements are listed in the accompanying index to financialstatements on page F-1.

**2.**   *Financial Statement Schedule*

The Schedule on page S-1 is filed as partof this report.

**3.**   *Exhibit Index:*

|        | **Exhibit   Number** | ** ** | ** ** | **Description**                                                                                      |
|--------|----------------------|------------|------------|------------------------------------------------------------------------------------------------------|
|   | 3.1             |       |       | Form of Second  Amended and Restated By-laws of NeuroMetrix, Inc.(1)                       |
|   | 3.2             |       |       | Form of Third  Amended and Restated Certificate of Incorporation of  NeuroMetrix, Inc.(1)  |
|   | 4.1             |       |       | Specimen certificate for  shares of common stock(1)                                                  |
|   | 10.1            |       |       | Lease Agreement dated  October 18, 2000 between Fourth Avenue LLC and NeuroMetrix, Inc.(1) |
|   | 10.2            |       |       | Amended and Restated  1996 Stock Option/Restricted Stock Plan(1)                                     |
|   | 10.3            |       |       | Amended and Restated 1998  Equity Incentive Plan(1)                                                  |
|   | 10.4            |       |       | First Amendment to  Amended and Restated 1998 Equity Incentive Plan(1)                               |
|   | 10.5            |       |       | 2004 Stock Option and  Incentive Plan(1)                                                             |
|   | 10.6            |       |       | 2004 Employee Stock  Purchase Plan(1)                                                                |
|        |                      |            |            |                                                                                                      |  |  |

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|        | 10.7                         |   |   | Form of  Indemnification Agreement between NeuroMetrix, Inc. and each of its  directors(1)                                                                                          |
|--------|-----------------------------------|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | 10.8                         |   |   | Employment  Agreement, dated June 21, 2004, by and between NeuroMetrix, Inc. and  Shai N. Gozani, M.D., Ph.D.(1)                                                          |
|   | 10.9                         |   |   | Letter Agreement,  dated June 19, 2002, by and between NeuroMetrix, Inc. and Gary L.  Gregory(1)                                                                               |
|   | 10.10                             |   |   | NeuroMetrix, Inc.  Stock Option Agreements (1998 Plan) dated as of July 1, 2002 and  April 8, 2004 by and between NeuroMetrix, Inc. and Gary L.  Gregory(1)          |
|   | 10.11                             |   |   | NeuroMetrix, Inc.  Confidentiality and Non-Compete Agreement, dated as of June 28, 2002, by  and between Gary L. Gregory and NeuroMetrix, Inc.(1)                         |
|   | 10.12                             |   |   | NeuroMetrix, Inc.  Confidentiality & Non-Compete Agreement dated as of June 21,  2004, by and between Shai N. Gozani, M.D., Ph.D. and  NeuroMetrix, Inc.(1) |
|   | 10.13                             |   |   | NeuroMetrix, Inc.  Non-Statutory Stock Option Agreement (1998 Plan) dated as of June 21,  2004, by and between Shai N. Gozani M.D., Ph.D., and  NeuroMetrix, Inc.(1) |
|   | 10.14                             |   |   | Second Amendment  to Amended and Restated 1998 Equity Incentive Plan(1)                                                                                                                       |
|   | 10.15                             |   |   | NeuroMetrix, Inc.  Non-Statutory Stock Option Agreement (1998 Plan) dated as of June 21,  2004 by and between Gary Gregory and NeuroMetrix, Inc.(1)                            |
|   | 10.16                             |   |   | Indemnification  Agreement dated June 21, 2004, by and between Shai N. Gozani, M.D.,  Ph.D., and NeuroMetrix, Inc.(1)                                                               |
|   | 10.17                             |   |   | NeuroMetrix, Inc.  Confidentiality & Non-Compete Agreement, dated as of May 1,  2000, by and between Michael Williams and NeuroMetrix, Inc.(1)                        |
|   | 10.18                             |   |   | NeuroMetrix, Inc.  Confidentiality & Non-Compete Agreement, dated as of  October 13, 1998, by and between Guy Daniello and  NeuroMetrix Inc.(1)                       |
|   | 10.19                             |   |   | Form of  Incentive Stock Option Agreement, under the NeuroMetrix, Inc. 2004 Stock  Option And Incentive Plan(2)                                                                     |
|   | 10.20                             |   |   | Form of  Non-Qualified Stock Option Agreement For Company Employees, under the  NeuroMetrix, Inc. 2004 Stock Option And Incentive Plan(2)                                           |
|   | 10.21                             |   |   | Form of  Non-Qualified Stock Option Agreement For Non-Employee Directors, under the  NeuroMetrix, Inc. 2004 Stock Option And Incentive Plan(2)                                      |
|   | 10.22                             |   |   | Letter Agreement,  dated February 7, 2005, by and between NeuroMetrix, Inc. and  W. Bradford Smith(3)                                                                          |
|   | 10.23                             |   |   | Form of  Incentive Stock Option Agreement, under the NeuroMetrix, Inc. 2004 Stock  Option and Incentive Plan, by and between NeuroMetrix, Inc. and  W. Bradford Smith(3)  |
|   | 10.24                             |   |   | NeuroMetrix, Inc.  Confidentiality & Non-Compete Agreement, dated as of  February 7, 2005, by and between W. Bradford Smith and  NeuroMetrix, Inc.(3)            |
|   | 10.25                             |   |   | Executive Officer  Compensation Arrangements (2004 Bonuses and 2005 Salaries and Bonus Targets)(5)                                                                                            |
|   | *10.26                            |   |   | Director  Compensation Arrangements                                                                                                                                                           |
|   | *23.1                   |   |   | Consent of  PricewaterhouseCoopers LLP                                                                                                                                                        |
|   | *31.1                   |   |   | Certification of  Principal Executive Officer pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002                                                                                 |
|   | *31.2                   |   |   | Certification of  Principal Financial Officer pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002                                                                                 |
|   | *32      |   |   | Certification of  Principal Executive Officer and Principal Financial Officer pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002                                                 |

 

65

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----

*                    Filedherewith.

(1)          Incorporated herein byreference to NeuroMetrix, Inc.’s Registration Statement on From S-1(Registration No. 333-115440).

(2)          Incorporated herein byreference to NeuroMetrix, Inc.’s Quarterly Report on Form 10-Qfiled on November 15, 2004 (File No. 000-50856).

(3)          Incorporated herein byreference to NeuroMetrix, Inc.’s Current Report on Form 8-Kfiled on February 11, 2005 (File No. 000-50856).

(4)          Incorporated herein byreference to NeuroMetrix, Inc.’s Current Report on Form 8-Kfiled on March 16, 2005 (File No. 000-50856).

(5)          Incorporated herein byreference to NeuroMetrix, Inc.’s Quarterly Report on Form 10-Qfiled on May 11, 2005 (File No. 000-50856).

66

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**SIGNATURES**

Pursuantto the requirements of Section 13 and 15(d) of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned, thereunto duly authorized.

|                            | NEUROMETRIX, INC. |
|----------------------------|-------------------|
|                       | By:               | /s/  SHAI N. GOZANI, M.D. PH.D. |
|                       |              | Shai N. Gozani,  M.D. Ph.D. |
|                       |              | Chairman,  President and Chief Executive Officer |
| Date: March 16,  2006 |              |   |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the registrant on March 16,2006 in the capacities indicated below.

| ** **                                  | **Name** | ** **                                            | ** ** |  | **Title** | ** ** |
|---------------------------------------------|----------|-------------------------------------------------------|------------|--|-----------|------------|
| /s/  SHAI  N. GOZANI, M.D., PH.D. |     | Chairman,  President and Chief Executive Officer      |
| Shai  N. Gozani, M.D., Ph. D.               |     | (Principal Executive Officer)                         |
| /s/  W.  BRADFORD SMITH           |     | Chief Financial  Officer (Principal Financial Officer |
| W.  Bradford Smith                          |     | and Principal Accounting Officer)                     |
| /s/  DAVID  E. GOODMAN, M.D.      |     | Director                                              |
| David  E. Goodman, M.D.                     |     |                                                  |
| /s/  ALLEN  J. HINKLE, M.D.       |     | Director                                              |
| Allen  J. Hinkle M.D.                       |     |                                                  |
| /s/  CHARLES  R. LAMANTIA         |     | Director                                              |
| Charles  R. LaMantia                        |     |                                                  |
| /s/  JONATHAN  T. LORD, M.D.      |     | Director                                              |
| Jonathan  T. Lord M.D.                      |     |                                                  |
| /s/  W.  MARK LORTZ               |     | Director                                              |
| W. Mark Lortz                               |     |                                                  |

 

 

67

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**INDEX TO FINANCIAL STATEMENTS**

**NeuroMetrix, Inc.**

**Yearsended December 31, 2005, 2004 and 2003**

|                                                                                                                     | ** ** | **Page** | ** ** |
|---------------------------------------------------------------------------------------------------------------------|------------|----------|------------|
| **Report of Independent Registered Public Accounting  Firm**                                                        |       | F-2      |       |
| **Financial  Statements**                                                                                           |       |     |       |
| Balance Sheets                                                                                                      |       | F-4      |       |
| Statements of Operations                                                                                            |       | F-5      |       |
| Statements of Changes in Redeemable Convertible  Preferred Stock and Changes in Stockholders’ (Deficit)/Equity |       | F-6      |       |
| Statements of Cash Flows                                                                                            |       | F-8      |       |
| Notes to Financial Statements                                                                                       |       | F-9      |       |
| **Schedule II—Valuation and Qualifying Accounts**                                                              |       | S-1      |       |

 

F-1

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**Report of Independent Registered Public AccountingFirm**

To the Board of Directors and Shareholders ofNeuroMetrix, Inc.:

We have completed anintegrated audit of NeuroMetrix, Inc.’s 2005 financial statements and ofits internal control over financial reporting as of December 31, 2005 andaudits of its 2004 and 2003 financial statements in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, arepresented below.

***Financial statementsand financial statement schedule***

In our opinion, the financial statements listed in theindex appearing under Item 15 (a) (1) present fairly, in all materialrespects, the financial position of NeuroMetrix, Inc. at December 31,2005 and 2004, and the results of its operations and its cash flows for each ofthe three years in the period ended December 31, 2005 in conformity withaccounting principles generally accepted in the United States of America. Inaddition, in our opinion, the financial statement schedule listed under Item 15(a) (2) presents fairly, in all material respects, the informationset forth therein when read in conjunction with the related financialstatements. These financial statements and financial statement schedule are theresponsibility of the Company’s management. Our responsibility is to express anopinion on these financial statements and financial statement schedule based onour audits. We conducted our audits of these statements in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit of financial statements includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financialstatements, assessing the accounting principles used and significant estimatesmade by management, and evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

***Internal control over financial reporting***

Also, in our opinion, management’s assessment,included in “Management’s Annual Report on Internal Control Over FinancialReporting” appearing under Item 9A, that the Company maintained effectiveinternal control over financial reporting as of December 31, 2005 based oncriteria established in *Internal Control—Integrated Framework* issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO), is fairly stated, in allmaterial respects, based on those criteria. Furthermore, in our opinion, theCompany maintained, in all material respects, effective internal control overfinancial reporting as of December 31, 2005, based on criteria establishedin *Internal Control— Integrated Framework*issued by the COSO. The Company’s management is responsible for maintainingeffective internal control over financial reporting and for its assessment ofthe effectiveness of internal control over financial reporting. Ourresponsibility is to express opinions on management’s assessment and onthe effectiveness of the Company’s internal control over financial reportingbased on our audit. We conducted our audit of internal control over financialreporting in accordance with the standards of the Public Company AccountingOversight Board (United States). Those standards require that we plan andperform the audit to obtain reasonable assurance about whether effectiveinternal control over financial reporting was maintained in all materialrespects. An audit of internal control over financial reporting includesobtaining an understanding of internal control over financial reporting,evaluating management’s assessment, testing and evaluating the design and operatingeffectiveness of internal control, and performing such other procedures as weconsider necessary in the circumstances. We believe that our audit provides areasonable basis for our opinions.

F-2

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A company’s internal control over financial reportingis a process designed to provide reasonable assurance regarding the reliabilityof financial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles. A company’sinternal control over financial reporting includes those policies andprocedures that (i) pertain to the maintenance of records that, inreasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (ii) provide reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with generally accepted accountingprinciples, and that receipts and expenditures of the company are being madeonly in accordance with authorizations of management and directors of thecompany; and (iii) provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

Because of its inherentlimitations, internal control over financial reporting may not prevent ordetect misstatements. Also, projections of any evaluation of effectiveness tofuture periods are subject to the risk that controls may become inadequatebecause of changes in conditions, or that the degree of compliance with thepolicies or procedures may deteriorate.

/s/ PricewaterhouseCoopersLLP

Boston, MassachusettsMarch 16, 2006

F-3

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**NeuroMetrix, Inc.**

**Balance Sheets**

| ** **                                                                                                                                                         | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                         | ** ** | **2005**              | ** ** | **2004** | ** ** |
| **Assets**                                                                                                                                                         |       |                  |       |   |   |
| Current assets:                                                                                                                                                    |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                                                          |       | $                     | 8,170,037  |   | $ | 1,936,241 |   |
| Short-term held-to-maturity investments                                                                                                                            |       | 24,081,946            |       | 18,574,593 |   |
| Accounts receivable, net of allowance for doubtful  accounts of $400,000 and $300,000 at December 31, 2005 and 2004,  respectively                            |       | 4,543,339             |       | 3,126,565 |   |
| Inventories, net                                                                                                                                                   |       | 2,683,409             |       | 1,284,261 |   |
| Prepaid expenses and other current assets                                                                                                                          |       | 614,169               |       | 672,970 |   |
| Current portion of deferred costs                                                                                                                                  |       | 223,009               |       | 140,719 |   |
| Total current assets                                                                                                                                               |       | 40,315,909            |       | 25,735,349 |   |
| Restricted cash                                                                                                                                                    |       | 1,458,598             |       | 1,897,200 |   |
| Long-term  held-to-maturity investments                                                                                                                            |       | —                |       | 9,497,158 |   |
| Fixed assets, net                                                                                                                                                  |       | 875,551               |       | 679,359 |   |
| Deferred costs                                                                                                                                                     |       | 247,013               |       | 143,462 |   |
| Total assets                                                                                                                                                       |       | $                     | 42,897,071 |   | $ | 37,952,528 |   |
| **Liabilities  and Stockholders’ Equity**                                                                                                                     |       |                  |       |   |   |
| Current liabilities:                                                                                                                                               |       |                  |       |   |   |
| Accounts payable                                                                                                                                                   |       | $                     | 1,698,583  |   | $ | 899,291 |   |
| Accrued compensation                                                                                                                                               |       | 1,959,621             |       | 1,343,206 |   |
| Accrued expenses                                                                                                                                                   |       | 1,213,928             |       | 593,420 |   |
| Current portion of deferred revenue                                                                                                                                |       | 760,613               |       | 399,468 |   |
| Total current liabilities                                                                                                                                          |       | 5,632,745             |       | 3,235,385 |   |
| Deferred revenue                                                                                                                                                   |       | 885,354               |       | 471,734 |   |
| Other long-term  liabilities                                                                                                                                       |       | 130,909               |       | 189,091 |   |
| Total liabilities                                                                                                                                                  |       | 6,649,008             |       | 3,896,210 |   |
| Commitments and  contingencies (Note 11)                                                                                                                           |       |                  |       |   |   |
| Stockholders’  equity                                                                                                                                         |       |                  |       |   |   |
| Preferred stock, $0.001 par value, 5,000,000 shares  authorized, none outstanding                                                                                  |       | —                |       | — |   |
| Common stock, $0.0001 par value; 50,000,000  authorized; 12,375,276 and 12,034,650 shares issued and outstanding at  December 31, 2005 and 2004, respectively |       | 1,238                 |       | 1,203 |   |
| Additional paid-in capital                                                                                                                                         |       | 93,212,368            |       | 92,278,379 |   |
| Deferred compensation                                                                                                                                              |       | (425,623              | )          | (745,086 | ) |
| Accumulated deficit                                                                                                                                                |       | (56,539,920           | )          | (57,478,178 | ) |
| Total stockholders’ equity                                                                                                                                    |       | 36,248,063            |       | 34,056,318 |   |
| Total liabilities and  stockholders’ equity                                                                                                                   |       | $                     | 42,897,071 |   | $ | 37,952,528 |   |

 

The accompanying notes are an integral part of these financial statements.

F-4

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**NeuroMetrix, Inc.**

**Statements ofOperations**

| ** **                                                                            | ** ** | **Years Ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                            | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenues:                                                                             |       |                                        |       |   |   |   |   |
| Diagnostic device                                                                     |       | $                                           | 4,221,311  |   | $ | 2,219,489 |   | $ | 1,302,306 |   |
| Biosensor                                                                             |       | 30,076,822                                  |       | 15,700,600 |   | 7,865,251 |   |
| Total revenues                                                                        |       | 34,298,133                                  |       | 17,920,089 |   | 9,167,557 |   |
| Cost of revenues                                                                      |       | 8,858,094                                   |       | 4,853,326 |   | 2,706,539 |   |
| Gross margin                                                                          |       | 25,440,039                                  |       | 13,066,763 |   | 6,461,018 |   |
| Operating expenses:                                                                   |       |                                        |       |   |   |   |   |
| Research and development(1)                                                           |       | 3,820,624                                   |       | 3,268,363 |   | 2,396,772 |   |
| Sales and marketing(1)                                                                |       | 14,150,157                                  |       | 8,488,047 |   | 4,767,640 |   |
| General and administrative(1)                                                         |       | 7,332,783                                   |       | 4,844,378 |   | 2,850,455 |   |
| Total operating expenses                                                              |       | 25,303,564                                  |       | 16,600,788 |   | 10,014,867 |   |
| Income (loss) from operations                                                         |       | 136,475                                     |       | (3,534,025 | ) | (3,553,849 | ) |
| Interest income                                                                       |       | 838,825                                     |       | 214,092 |   | 23,481 |   |
| Interest expense                                                                      |       | (2,042                                      | )          | (964,056 | ) | (136,340 | ) |
| Income (loss)  before income taxes                                                    |       | 973,258                                     |       | (4,283,989 | ) | (3,666,708 | ) |
| Income tax provision                                                                  |       | 35,000                                      |       | — |   | — |   |
| Net income (loss)                                                                     |       | 938,258                                     |       | (4,283,989 | ) | (3,666,708 | ) |
| Accretion of redeemable convertible preferred stock                                   |       | —                                      |       | (1,386,301 | ) | (2,009,450 | ) |
| Deemed dividend on redeemable convertible preferred  stock                            |       | —                                      |       | (787,885 | ) | — |   |
| Beneficial conversion feature associated with  redeemable convertible preferred stock |       | —                                      |       | (7,050,771 | ) | — |   |
| Net income (loss) attributable to common  stockholders                                |       | $                                           | 938,258    |   | $ | (13,508,946 | ) | $ | (5,676,158 | ) |
| Net income (loss)  per common share                                                   |       |                                        |       |   |   |   |   |
| Basic                                                                                 |       | $                                           | 0.08       |   | $ | (2.35 | ) | $ | (5.46 | ) |
| Diluted                                                                               |       | $                                           | 0.07       |   | $ | (2.35 | ) | $ | (5.46 | ) |
| Weighted average  shares used to compute net income (loss) per common share           |       |                                        |       |   |   |   |   |
| Basic                                                                                 |       | 12,152,139                                  |       | 5,747,579 |   | 1,038,817 |   |
| Diluted                                                                               |       | 12,986,365                                  |       | 5,747,579 |   | 1,038,817 |   |

----

(1)          Non-cashstock-based compensation expense included in these amounts are as follows:

| Research and  development                |   | $       | 77,365  |    | $      | 249,131   |   | $ | 35,125 |   |
|------------------------------------------|--------|---------|---------|---------|--------|-----------|--------|---|--------|--------|
| Sales and  marketing                     |   | 167,699 |    | 356,422 |   | 36,790    |   |
| General and  administrative              |   | 161,266 |    | 423,042 |   | 24,535    |   |
| Total non-cash  stock-based compensation |   | $       | 406,330 |    | $      | 1,028,595 |   | $ | 96,450 |   |

 

The accompanying notes are an integral part of these financial statements.

F-5

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**NeuroMetrix, Inc.Statements of Changes in Redeemable Convertible Preferred Stock and Changes inStockholders’ (Deficit)/Equity**

| ** **                                                                                | ** ** | **Redeemable Convertible  Preferred Stock** | ** ** | ** **  | ** ** | **Common Stock** | ** ** | **Additional**             | ** ** | ** ** | ** ** | ** **           | ** ** | ** **                    | ** ** | ** **                 | ** ** |
|-------------------------------------------------------------------------------------------|------------|-------------------------------------------------------|------------|-------------|------------|-----------------------|------------|----------------------------|------------|------------|------------|----------------------|------------|-------------------------------|------------|----------------------------|------------|
| ** **                                                                                | ** ** | **Number  of Shares**                            | ** ** | **Amount**  | ** ** | ** **            | ** ** | **Number  of Shares** | ** ** | **Amount** | ** ** | **Paid-In  Capital** | ** ** | **Subscriptions  Receivable** | ** ** | **Deferred  Compensation** | ** ** | **Accumulated  Deficit** | ** ** | **Total** | ** ** |
| Balance at December 31, 2002                                                         |       | 17,498,099                                            |       | $           | 45,684,292 |                  |       |                       |       | 1,036,142  |       |                 |       | $                             | 104        |                       |       | $ | — |   |   | $ | (2,143 | ) |   |   | $ | (66,534 | ) |   |   | $ | (39,859,918 | ) |   | $ | (39,928,491 | ) |
| Issuance of common stock upon exercise of stock  options                                  |       | —                                                |       | —      |       |                  |       |                       | 8,723      |       |       |                 | —     |                          |       | 5,894                      |       |   | — |   |   |   | — |   |   |   | — |   |   | 5,894 |   |
| Purchase of treasury stock                                                                |       | —                                                |       | —      |       |                  |       |                       | (1,875     | )          |       |                 | —     |                          |       | (15                        | )          |   | — |   |   |   | — |   |   |   | — |   |   | (15 | ) |
| Accretion of redeemable convertible preferred stock  to redemption                        |       | —                                                |       | 2,009,450   |       |                  |       |                       | —     |       |       |                 | —     |                          |       | (634,728                   | )          |   | — |   |   |   | — |   |   |   | (1,374,722 | ) |   | (2,009,450 | ) |
| Adjustment to deferred compensation associated with  terminated employees                 |       | —                                                |       | —      |       |                  |       |                       | —     |       |       |                 | —     |                          |       | (2,051                     | )          |   | — |   |   |   | 2,051 |   |   |   | — |   |   | — |   |
| Deferred compensation associated with stock options                                       |       | —                                                |       | —      |       |                  |       |                       | —     |       |       |                 | —     |                          |       | 630,900                    |       |   | — |   |   |   | (630,900 | ) |   |   | — |   |   | — |   |
| Amortization of deferred compensation                                                     |       | —                                                |       | —      |       |                  |       |                       | —     |       |       |                 | —     |                          |       | —                     |       |   | — |   |   |   | 96,450 |   |   |   | — |   |   | 96,450 |   |
| Net loss                                                                                  |       | —                                                |       | —      |       |                  |       |                       | —     |       |       |                 | —     |                          |       | —                     |       |   | — |   |   |   | — |   |   |   | (3,666,708 | ) |   | (3,666,708 | ) |
| Balance at December 31, 2003                                                         |       | 17,498,099                                            |       | 47,693,742  |       |                  |       |                       | 1,042,990  |       |       |                 | 104        |                          |       | —                     |       |   | (2,143 | ) |   |   | (598,933 | ) |   |   | (44,901,348 | ) |   | (45,502,320 | ) |
| Issuance of Series E-1 redeemable  preferred stock, net of issuance costs of $22,672 |       | 7,050,771                                             |       | 10,553,484  |       |                  |       |                       | —     |       |       |                 | —     |                          |       | —                     |       |   | — |   |   |   | — |   |   |   | — |   |   | — |   |
| Issuance of common stock upon exercise of stock  options                                  |       | —                                                |       | —      |       |                  |       |                       | 49,621     |       |       |                 | 5          |                          |       | 44,926                     |       |   | — |   |   |   | — |   |   |   | — |   |   | 44,931 |   |
| Purchase of treasury stock                                                                |       | —                                                |       | —      |       |                  |       |                       | (6,251     | )          |       |                 | (1         | )                             |       | (1,249                     | )          |   | — |   |   |   | — |   |   |   | — |   |   | (1,250 | ) |
| Cash received from subscriptions receivable                                               |       | —                                                |       | —      |       |                  |       |                       | —     |       |       |                 | —     |                          |       | —                     |       |   | 2,143 |   |   |   | — |   |   |   | — |   |   | 2,143 |   |
| Beneficial conversion feature associated with  redeemable convertible preferred stock     |       | —                                                |       | 7,050,771   |       |                  |       |                       | —     |       |       |                 | —     |                          |       | —                     |       |   | — |   |   |   | — |   |   |   | (7,050,771 | ) |   | (7,050,771 | ) |
| Deemed dividend on Series D redeemable  convertible preferred stock                  |       | —                                                |       | 787,885     |       |                  |       |                       | —     |       |       |                 | —     |                          |       | —                     |       |   | — |   |   |   | — |   |   |   | (787,885 | ) |   | (787,885 | ) |
| Accretion of redeemable convertible preferred stock  to redemption                        |       | —                                                |       | 1,386,301   |       |                  |       |                       | —     |       |       |                 | —     |                          |       | (932,116                   | )          |   | — |   |   |   | — |   |   |   | (454,185 | ) |   | (1,386,301 | ) |
| Initial public offering of common stock                                                   |       | —                                                |       | —      |       |                  |       |                       | 3,450,000  |       |       |                 | 345        |                          |       | 24,005,719                 |       |   | — |   |   |   | — |   |   |   | — |   |   | 24,006,064 |   |
| Conversion of  redeemable convertible preferred stock                                |       | (24,548,870                                           | )          | (67,472,183 | )          |                  |       |                       | 7,488,758  |       |       |                 | 749        |                          |       | 67,471,434                 |       |   | — |   |   |   | — |   |   |   | — |   |   | 67,472,183 |   |
|                                                                                           |            |                                                       |            |             |            |                       |            |                            |            |            |            |                      |            |                               |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

F-6

 

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**NeuroMetrix, Inc.Statements of Changes in Redeemable Convertible Preferred Stock and Changes inStockholders’ (Deficit)/Equity (Continued)**

| ** **                                                                | ** ** | **Redeemable Convertible  Preferred Stock** | ** ** | ** ** | ** ** | **Common Stock** | ** ** | **Additional**             | ** ** | ** ** | ** ** | ** **           | ** ** | ** **                    | ** ** | ** **                 | ** ** |
|---------------------------------------------------------------------------|------------|-------------------------------------------------------|------------|------------|------------|-----------------------|------------|----------------------------|------------|------------|------------|----------------------|------------|-------------------------------|------------|----------------------------|------------|
| ** **                                                                | ** ** | **Number  of Shares**                            | ** ** | **Amount** | ** ** | ** **            | ** ** | **Number  of Shares** | ** ** | **Amount** | ** ** | **Paid-In  Capital** | ** ** | **Subscriptions  Receivable** | ** ** | **Deferred  Compensation** | ** ** | **Accumulated  Deficit** | ** ** | **Total** | ** ** |
| Conversion of warrant to purchase common stock                            |       |                                                  | —     |       |       |                  | —     |                       |       |       |       | —               |       |                          | —     |                       |       | 450,100 |   |   | — |   |   |   | — |   |   |   | — |   |   | 450,100 |   |
| Compensation expense associated with stock options                        |       |                                                  | —     |       |       |                  | —     |                       |       |       |       | —               |       |                          | —     |                       |       | 436,611 |   |   | — |   |   |   | — |   |   |   | — |   |   | 436,611 |   |
| Deferred compensation associated with stock options                       |       |                                                  | —     |       |       |                  | —     |                       |       |       |       | —               |       |                          | —     |                       |       | 750,566 |   |   | — |   |   |   | (750,566 | ) |   |   | — |   |   | — |   |
| Adjustment to deferred compensation associated with  terminated employees |       |                                                  | —     |       |       |                  | —     |                       |       |       |       | —               |       |                          | —     |                       |       | (12,429 | ) |   | — |   |   |   | 12,429 |   |   |   | — |   |   | — |   |
| Amortization of deferred compensation                                     |       |                                                  | —     |       |       |                  | —     |                       |       |       |       | —               |       |                          | —     |                       |       | — |   |   | — |   |   |   | 591,984 |   |   |   | — |   |   | 591,984 |   |
| Issuance of common stock under employee stock  purchase plan              |       |                                                  | —     |       |       |                  | —     |                       |       |       |       | 9,532                |       |                          | 1          |                       |       | 64,817 |   |   | — |   |   |   | — |   |   |   | — |   |   | 64,818 |   |
| Net loss                                                                  |       |                                                  | —     |       |       |                  | —     |                       |       |       |       | —               |       |                          | —     |                       |       | — |   |   | — |   |   |   | — |   |   |   | (4,283,989 | ) |   | (4,283,989 | ) |
| Balance at December 31, 2004                                         |       |                                                  | —     |       |       |                  | —     |                       |       |       |       | 12,034,650           |       |                          | 1,203      |                       |       | 92,278,379 |   |   | — |   |   |   | (745,086 | ) |   |   | (57,478,178 | ) |   | 34,056,318 |   |
| Issuance of stock upon exercise of stock options and  warrants            |       |                                                  | —     |       |       |                  | —     |                       |       |       |       | 317,361              |       |                          | 32         |                       |       | 512,825 |   |   | — |   |   |   | — |   |   |   | — |   |   | 512,857 |   |
| Compensation expense associated with stock options                        |       |                                                  | —     |       |       |                  | —     |                       |       |       |       | —               |       |                          | —     |                       |       | 120,272 |   |   | — |   |   |   | — |   |   |   | — |   |   | 120,272 |   |
| Adjustment to deferred compensation associated with  terminated employees |       |                                                  | —     |       |       |                  | —     |                       |       |       |       | —               |       |                          | —     |                       |       | (33,405 | ) |   | — |   |   |   | 33,405 |   |   |   | — |   |   | — |   |
| Amortization of deferred compensation                                     |       |                                                  | —     |       |       |                  | —     |                       |       |       |       | —               |       |                          | —     |                       |       | — |   |   | — |   |   |   | 286,058 |   |   |   | — |   |   | 286,058 |   |
| Issuance of common stock under employee stock  purchase plan              |       |                                                  | —     |       |       |                  | —     |                       |       |       |       | 23,265               |       |                          | 3          |                       |       | 299,297 |   |   | — |   |   |   | — |   |   |   | — |   |   | 299,300 |   |
| Income tax effect of the exercise of stock options                        |       |                                                  | —     |       |       |                  | —     |                       |       |       |       | —               |       |                          | —     |                       |       | 35,000 |   |   | — |   |   |   | — |   |   |   | — |   |   | 35,000 |   |
| Net income                                                                |       |                                                  | —     |       |       |                  | —     |                       |       |       |       | —               |       |                          | —     |                       |       | — |   |   | — |   |   |   | — |   |   |   | 938,258 |   |   | 938,258 |   |

| Balance at  December 31, 2005 |   |   | — |   |   |   | $ | — |   |   |   |   | 12,375,276 |   |   | $ | 1,238 |   |   | $ | 93,212,368 |   |   | $ | — |   |   |   | $ | (425,623 | ) |   |   | $ | (56,539,920 | ) |   | $ | 36,248,063 |   |
|------------------------------------|--------|--------|--------|--------|--------|--------|---|--------|--------|--------|--------|--------|------------|--------|--------|---|-------|--------|--------|---|------------|--------|--------|---|--------|--------|--------|--------|---|----------|---|--------|--------|---|-------------|---|--------|---|------------|--------|

 

The accompanying notes are an integral part of these financialstatements.

F-7

 

----

**NeuroMetrix, Inc.Statements of Cash Flows**

| ** **                                                                                          | ** ** | **Years Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                          | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Cash flows for operating  activities:**                                                           |       |                                        |       |   |   |   |   |
| Net income (loss)                                                                                   |       | $                                           | 938,258    |   | $ | (4,283,989 | ) | $ | (3,666,708 | ) |
| Adjustments to reconcile  net income (loss) to net cash provided by (used in) operating activities: |       |                                        |       |   |   |   |   |
| Depreciation and amortization                                                                       |       | 278,932                                     |       | 205,023 |   | 214,589 |   |
| Compensation expense associated with stock options                                                  |       | 406,330                                     |       | 1,028,595 |   | 96,450 |   |
| Provision for doubtful accounts                                                                     |       | 359,827                                     |       | 235,464 |   | 200,326 |   |
| Amortization of premium on investments                                                              |       | 439,734                                     |       | 89,175 |   | — |   |
| Income tax effect of the exercise of stock options                                                  |       | 35,000                                      |       | — |   | — |   |
| Accretion of debt issuance discount                                                                 |       | —                                      |       | 437,778 |   | — |   |
| Accrued payments on long-term debt                                                                  |       | —                                      |       | — |   | 12,222 |   |
| Changes in operating assets  and liabilities:                                                       |       |                                        |       |   |   |   |   |
| Accounts receivable                                                                                 |       | (1,776,601                                  | )          | (1,510,046 | ) | (1,221,910 | ) |
| Inventories                                                                                         |       | (1,399,148                                  | )          | (205,871 | ) | (216,078 | ) |
| Prepaid expenses and other current assets                                                           |       | 58,801                                      |       | (455,805 | ) | (33,974 | ) |
| Accounts payable                                                                                    |       | 799,292                                     |       | 464,906 |   | 329,401 |   |
| Accrued expenses and compensation                                                                   |       | 1,236,923                                   |       | 998,301 |   | 334,275 |   |
| Other long-term liabilities                                                                         |       | (58,182                                     | )          | 3,637 |   | 61,818 |   |
| Deferred revenue and deferred costs                                                                 |       | 588,924                                     |       | 341,201 |   | 16,217 |   |
| Net cash provided by (used in) operating activities                                                 |       | 1,908,090                                   |       | (2,651,631 | ) | (3,873,372 | ) |
| **Cash  flows for investing activities:**                                                           |       |                                        |       |   |   |   |   |
| Purchases of fixed assets                                                                           |       | (475,124                                    | )          | (545,158 | ) | (203,611 | ) |
| Purchases of investments                                                                            |       | (15,290,120                                 | )          | (30,954,418 | ) | — |   |
| Maturities of investments                                                                           |       | 18,840,191                                  |       | 2,793,492 |   | — |   |
| Release of restricted cash                                                                          |       | 438,602                                     |       | — |   | — |   |
| Net cash provided by (used in) investing activities                                                 |       | 3,513,549                                   |       | (28,706,084 | ) | (203,611 | ) |
| **Cash  flows from financing activities:**                                                          |       |                                        |       |   |   |   |   |
| Proceeds from exercise of stock options                                                             |       | 512,857                                     |       | 47,074 |   | 5,879 |   |
| Proceeds from issuance of redeemable convertible  preferred stock, net of issuance costs            |       | —                                      |       | 10,553,484 |   | — |   |
| Proceeds from initial public offering, net of  offering costs of $3,572,908                         |       | —                                      |       | 24,006,064 |   | — |   |
| Proceeds from issuance of common stock under  employee stock purchase plan                          |       | 299,300                                     |       | 64,818 |   | — |   |
| Proceeds from long-term debt and related warrants                                                   |       | —                                      |       | — |   | 3,000,100 |   |
| Payments on long-term debt                                                                          |       | —                                      |       | (3,000,000 | ) | (7,139 | ) |
| Net cash provided by financing activities                                                           |       | 812,157                                     |       | 31,671,440 |   | 2,998,840 |   |
| Net increase  (decrease) in cash and cash equivalents                                               |       | 6,233,796                                   |       | 313,725 |   | (1,078,143 | ) |
| Cash and cash  equivalents, beginning of year                                                       |       | 1,936,241                                   |       | 1,622,516 |   | 2,700,659 |   |
| Cash and cash  equivalents, end of year                                                             |       | $                                           | 8,170,037  |   | $ | 1,936,241 |   | $ | 1,622,516 |   |
| **Supplemental  disclosure of cash flow information:**                                              |       |                                        |       |   |   |   |   |
| Cash paid for interest                                                                              |       | $                                           | 2,042      |   | $ | 497,404 |   | $ | 152,992 |   |

 

The accompanying notes are an integral part of these financial statements.

F-8

----

**NeuroMetrix, Inc. Notes to Financial Statements**

**1. Nature of theBusiness**

NeuroMetrix, Inc.(the “Company”), a Delaware corporation, was formed in June 1996. TheCompany designs, develops and sells proprietary medical devices used todiagnose neuropathies. Neuropathies are diseases of the peripheral nerves andparts of the spine that frequently are caused by or associated with diabetes,low back pain and carpal tunnel syndrome, as well as other clinical disorders.The Company operates in one business segment.

On July 27, 2004, theCompany completed an initial public offering (“IPO”) of 3,000,000 shares of itscommon stock at $8.00 per share, for gross consideration of $24,000,000. All ofthe shares were sold by the Company. In connection with the IPO, the Companygranted the underwriters a 30-day over-allotment option to purchase up toan additional 450,000 shares of common stock from the Company at $8.00 pershare, which the underwriters exercised in full on August 17, 2004 forgross consideration of $3,600,000. The Company’s shares trade on The NasdaqNational Market under the symbol “NURO.”

On July 27, 2004,upon completion of the Company’s IPO, all shares of the Company’s redeemableconvertible preferred stock outstanding on that date converted into 7,488,758shares of common stock and the outstanding warrant to purchase redeemableconvertible preferred stock converted into a warrant to purchase 100,000 sharesof common stock. This warrant was exercised in full on June 13, 2005.

***Reverse Stock Split***

On June 2, 2004, theCompany’s Board of Directors approved a 1-for-4 reverse stock splitof the Company’s issued common stock, subject to stockholder approval, to beeffected prior to the Company’s proposed initial public offering. On June 18,2004, the Company’s stockholders approved this reverse stock split. Thisreverse stock split became effective on July 15, 2004 upon the filing bythe Company of an amended and restated certificate of incorporation with theDelaware Secretary of State. Common shares and other potential common shareshave been restated to reflect this reverse split for all periods presented.

**2. Basisof Presentation and Summary of Significant Accounting Policies**

Significant accountingpolicies applied by the Company in the preparation of its financial statementsare as follows:

***Cash and CashEquivalents***

The Company considers allhighly liquid investments with an original maturity of ninety days or less tobe cash equivalents. Cash equivalents are recorded at cost which approximatesfair value. The Company invests cash primarily in a money market account andother investments which management believes are subject to minimal credit andmarket risk.

***Held-to-MaturityInvestments***

The Company’s investmentportfolio is classified as held-to-maturity, and such investments are stated atamortized cost. Interest earned on investments held-to-maturity is included ininterest income. The amortized cost of investments held-to-maturity is adjustedfor amortization of premiums and accretion of discounts to maturity. Suchamortization and accretion are included in interest income.

F-9

----

**NeuroMetrix, Inc. Notes to Financial Statements (Continued)**

**2. Basis of Presentation and Summary of Significant AccountingPolicies (Continued)**

***Restricted Cash***

At December 31, 2005and 2004, the Company maintained restricted cash in the amount of $1,458,598and $1,897,200, respectively, associated with a facility lease. SeeNote 11.

***Concentration ofCredit Risk***

Financial instruments thatpotentially expose the Company to concentrations of credit risk consistprimarily of cash and cash equivalents in bank deposits accounts, short-termand long-term investments and trade receivables. The Company invests its fundsin highly rated institutions and limits its investment in any individual debtor.The Company has not experienced significant losses related to cash and cashequivalents and does not believe it is exposed to any significant credit risksrelating to its cash and cash equivalents.

The Company distributesits products through its own regional sales managers who lead independent salesagencies. At December 31, 2005 and 2004 and for the years ended December 31,2005, 2004 and 2003, no single customer accounted for more than 10% of accountsreceivable or revenue.

The Company relies on twothird-party manufacturers to manufacture all of its current products. Thedisruption or termination of the supply of these products or a significantincrease in the cost of these products from these sources could have an adverseeffect on the Company’s business, financial position and results of operations.

***Inventories***

Inventories, consistingprimarily of purchased components, are stated at the lower of cost or market.Cost is determined using the first-in, first-out method. The Company writesdown inventory to its net realizable value for excess or obsolete inventory.

***Fair Value ofFinancial Instruments***

The carrying amounts ofthe Company’s financial instruments, which include cash and cash equivalents,short-term and long-term investments, accounts receivable, accounts payable andaccrued expenses, approximate their fair value at December 31, 2005 and2004.

***Revenue Recognition***

The Company recognizesrevenue when the following criteria have been met: persuasive evidence of anarrangement exists, delivery has occurred and risk of loss has passed, theseller’s price to the buyer is fixed or determinable and collection isreasonably assured. The Company records revenue on a net basis for productsales made to distributors, based upon the amount billed to the distributors,when the distributor accepts the responsibility for invoicing the customer andthe responsibility for the risk of collections and product returns from thecustomer.

When multiple elements arecontained in a single arrangement, the Company allocates revenue between theelements based on their relative fair value, provided that each element meetsthe criteria for treatment as a separate unit of accounting. An element isconsidered a separate unit of accounting if it has value to the customer on astand-alone basis, there is objective, reliable evidence of the fair value ofthe 

F-10

----

**NeuroMetrix, Inc. Notes to Financial Statements (Continued)**

**2. Basis of Presentation and Summary of Significant AccountingPolicies (Continued)**

undeliveredelements and delivery or performance of the undelivered elements is considered probableand substantially in the control of the Company. Fair value is determined basedupon the price charged when the element is sold separately.

Diagnostic device revenuesconsist of sales of NC-stat monitors and NC-stat docking stations. Revenuesassociated with the sale of the NC-stat monitors are recognized upon shipmentprovided that the fee is fixed and determinable, evidence of a persuasivearrangement exists, collection of receivables is reasonably assured, productreturns are reasonably estimable and no continuing obligations exist. Therevenues from the sale of a NC-stat docking station and access to the onCallInformation System are considered one unit of accounting and deferred andrecognized on a straight line basis over the estimated period of time theCompany provides the service associated with the onCall Information System,which is the shorter of the estimated customer relationship period or theestimated useful life of the docking station, currently three years. Thedeferred revenue and deferred costs are presented as separate line items on theaccompanying balance sheet.

Biosensor revenues consistof sales of disposable NC-stat biosensors and are recognized upon shipmentprovided that the fee is fixed and determinable, evidence of a persuasivearrangement exists, collection of receivables is reasonably assured and productreturns are reasonably estimable.

The Company recognizesrevenues associated with installation and training upon completion of theservice. The Company determines the fair value of installation and trainingbased on hourly service billing rates.

Certain product sales aremade with a thirty-day right of return. Since the Company can reasonablyestimate future returns, the Company recognizes revenues associated withproduct sales that contain a right of return upon shipment and at the same timereduces revenue by the amount of estimated returns under the provisions ofStatement of Financial Accounting Standards (“SFAS”) No. 48, “RevenueRecognition When Right of Return Exists”.

Proceeds received inadvance of product shipment are recorded as deferred revenues.

***Accounts Receivableand Allowance for Doubtful Accounts***

Trade accounts receivableare recorded at the invoiced amount and do not bear interest. The allowance fordoubtful accounts is the Company’s best estimate of the amount of probablecredit losses in its existing accounts receivable. The Company reviews itsallowance for doubtful accounts and determines the allowance based on ananalysis of customer past payment history, product usage activity, and recentcommunications between the Company and the customer. Past due balances over90 days are reviewed individually for collectibility. Account balances arecharged off against the allowance when the Company feels it is probable thereceivable will not be recovered. The Company does not have any off-balancesheet credit exposure related to its customers.

***Income Taxes***

The Company uses the assetand liability method of accounting for income taxes. Deferred tax assets andliabilities reflect the impact of temporary differences between amounts ofassets and liabilities for financial reporting purposes and such amounts asmeasured under enacted tax laws, operating losses and 

F-11

----

**NeuroMetrix, Inc. Notes to Financial Statements (Continued)**

**2. Basis of Presentation and Summary of Significant AccountingPolicies (Continued)**

taxcredit carryforwards. A valuation allowance is required to offset any netdeferred tax assets if, based upon the available evidence, there is reasonableuncertainty as to the realization of the deferred tax assets.

***Research andDevelopment***

Costs incurred in theresearch and development of the Company’s products are expensed as incurred.Included in research and development costs are wages, benefits and otheroperating costs such as facilities, supplies and overhead directly related tothe Company’s research and development efforts.

***Product WarrantyCosts***

The Company accruesestimated product warranty costs at the time of sale which are included in costof sales in the statements of operations. The amount of the accrued warrantyliability is based on historical information such as past experience, productfailure rates, number of units repaired and estimated cost of material andlabor.

Thefollowing is a rollforward of the Company’s accrued warranty liability for theyears ended December 31, 2005, 2004 and 2003:

| ** **                      | ** ** | **Years Ended December 31,** | ** ** |
|---------------------------------|------------|---------------------------------------------|------------|
| ** **                      | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Balance at  beginning of period |       | $                                           | 59,876     |   | $ | 22,151 |   | $ | 2,711 |   |
| Accrual for  warranties         |       | 310,290                                     |       | 187,176 |   | 117,695 |   |
| Settlements made                |       | (306,044                                    | )          | (149,451 | ) | (98,255 | ) |
| Balance at end of period        |       | $                                           | 64,122     |   | $ | 59,876 |   | $ | 22,151 |   |

 

***Fixed Assets andLong-Lived Assets***

Fixed assets are recordedat cost and depreciated using the straight-line method over the estimateduseful life of each asset. Expenditures for repairs and maintenance are chargedto expense as incurred. On disposal, the related assets and accumulateddepreciation are eliminated from the accounts and any resulting gain or loss isincluded in the Company’s statement of operations. Leasehold improvements areamortized over the shorter of the estimated useful life of the improvement orthe remaining term of the lease.

The Company periodicallyevaluates the recoverability of its property and equipment and other long-livedassets when circumstances indicate that an event of impairment may haveoccurred in accordance with the provisions of SFAS No. 144, “Accountingfor the Impairment or Disposal of Long-Lived Assets”. This periodic review mayresult in an adjustment of estimated depreciable lives or an asset impairment.When indicators of impairment are present, the carrying values of the asset areevaluated in relation to their operating performance and future undiscountedcash flows of the underlining business. If the future undiscounted cash flowsare less than their book value, an impairment exists. The impairment ismeasured as the difference between the book value and the fair value of theunderlying asset. Fair values are based on estimates of the market prices andassumptions concerning the amount and timing of estimated future cash flows andassumed discount rates, reflecting varying degrees of perceived risk. Noimpairment was identified in the years ended December 31, 2005, 2004 and2003.

F-12

----

**NeuroMetrix, Inc. Notes to Financial Statements (Continued)**

**2. Basis of Presentation and Summary of Significant AccountingPolicies (Continued)**

***Accounting forStock-Based Compensation***

Employeestock awards granted under the Company’s compensation plans are accounted forin accordance with Accounting Principles Board Opinion No. 25, “Accountingfor Stock Issued to Employees” (“APB No. 25”), and relatedinterpretations. The Company has not adopted the fair value method ofaccounting for stock-based compensation prescribed by SFAS No. 123, “Accountingfor Stock-Based Compensation”**(“SFASNo. 123”). Accordingly, compensation expense is recorded for optionsissued to employees to the extent that the fair market value of the Company’scommon stock exceeds the exercise price of the option at the date granted andall other criteria for fixed accounting have been met. All stock-based awardsgranted to non-employees are accounted for at their fair value and theresulting compensation expense is generally recognized over the period ofservice. Effective January 1, 2006, the Company adopted SFAS No. 123(R)using the modified prospective method, and amortizing its stock-basedcompensation expense, as calculated using the Black-Scholes option pricingmodel, using the straight-line method.

TheCompany provides the disclosure requirements of SFAS No. 148, “Accountingfor Stock Based Compensation—Transition and Disclosure—an amendment ofFinancial Accounting Standards Board Statement No. 123” (“SFAS No. 148”).If compensation expense for the Company’s stock-based compensation plan hadbeen determined based on the fair value at the grant dates as calculated inaccordance with SFAS No. 123, the Company’s net income (loss) attributableto common stockholders and net income (loss) per common share would approximatethe pro forma amounts below:

| ** **                                                                            | ** ** | **Years Ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                            | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net income (loss)  attributable to common stockholders, as reported                   |       | $                                           | 938,258    |   | $ | (13,508,946 | ) | $ | (5,676,158 | ) |
| Add employee  stock based compensation expense included in reported net income (loss) |       | 406,330                                     |       | 1,028,595 |   | 96,450 |   |
| Less stock-based  compensation expense determined under fair value method             |       | (1,432,031                                  | )          | (1,503,188 | ) | (209,329 | ) |
| Net loss—pro  forma                                                              |       | $                                           | (87,443    | ) | $ | (13,983,539 | ) | $ | (5,789,037 | ) |
| Net income (loss) per  common share:                                                  |       |                                        |       |   |   |   |   |
| As reported                                                                           |       |                                        |       |   |   |   |   |
| Basic                                                                                 |       | $                                           | 0.08       |   | $ | (2.35 | ) | $ | (5.46 | ) |
| Diluted                                                                               |       | $                                           | 0.07       |   | $ | (2.35 | ) | $ | (5.46 | ) |
| Pro forma (basic and  diluted)                                                        |       | $                                           | (0.01      | ) | $ | (2.43 | ) | $ | (5.57 | ) |

 

F-13

----

**NeuroMetrix, Inc. Notes to Financial Statements (Continued)**

**2. Basis of Presentation and Summary of Significant AccountingPolicies (Continued)**

Prior to the July 2004IPO, the Company established the fair value of common stock by reference to thepreviously issued redeemable convertible preferred stock and by reference to anexpected IPO price. Prior to the IPO, assumed volatility was zero percent. TheCompany has estimated the fair value of its granted stock options by applyingthe following weighted average assumptions:

| ** **                                                       | ** ** | **Years Ended December 31,** | ** **         |
|------------------------------------------------------------------|------------|---------------------------------------------|--------------------|
| ** **                                                       | ** ** | **2005**                                    | ** **         | **2004** | ** ** | **2003** | ** ** |
| Risk-free interest rate                                          |       | 3.5%-4.6                                    | %                  | 3.5 | % | 3.0 | % |
| Expected dividend yield                                          |       | 0                                           |               | 0 |   | 0 |   |
| Expected option term                                             |       | 5 years                                     |               | 5 years |   | 5 years |   |
| Volatility                                                       |       | 52.6                                        | %                  | 65.0 | % | 0.0 | % |
| Weighted average fair  value of options   granted at fair value  |       | $                                           | 7.23               |   | $ | 4.92 |   | $ | 5.60 |   |
| Weighted average fair value of options granted below  fair value |       | $                                           | —   |   | $ | 8.34 |   | $ | — |   |

 

For 2004, the weightedaverage fair value of options granted prior to and subsequent to the IPO was$5.15 and $5.74, respectively.

***Net Income (Loss)Per Common Share***

TheCompany accounts for and discloses net income (loss) per common share inaccordance with SFAS No. 128, “Earnings Per Share”. Basic net income(loss) per common share is computed by dividing net income (loss) attributableto common stockholders by the weighted average number of common shares outstanding.Diluted net income (loss) per common share is computed by dividing net income(loss) attributable to common stockholders by the weighted average number ofcommon shares and dilutive potential common share equivalents then outstanding.Potential common shares consist of shares issuable upon the exercise of stockoptions and warrants (using the treasury stock method), unvested restrictedstock awards and the weighted average conversion of the preferred stock intoshares of common stock (using the if-converted method).

| ** **                                          | ** ** | **Years Ended December 31,** | ** ** |
|-----------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                          | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Basic:                                              |       |                                        |       |   |   |   |   |
| Net income (loss)  available to common stockholders |       | $                                           | 938,258    |   | $ | (13,508,946 | ) | $ | (5,676,158 | ) |
| Weighted average shares                             |       | 12,152,139                                  |       | 5,747,579 |   | 1,038,817 |   |
| Basic income (loss) per  common share               |       | $                                           | 0.08       |   | $ | (2.35 | ) | $ | (5.46 | ) |
| Diluted:                                            |       |                                        |       |   |   |   |   |
| Net income (loss)  available to common stockholders |       | $                                           | 938,258    |   | $ | (13,508,946 | ) | $ | (5,676,158 | ) |
| Weighted average shares                             |       | 12,152,139                                  |       | 5,747,579 |   | 1,038,817 |   |
| Effect of stock options                             |       | 821,254                                     |       | — |   | — |   |
| Effect of warrant                                   |       | 12,972                                      |       | — |   | — |   |
| Weighted average shares,  as adjusted               |       | 12,986,365                                  |       | 5,747,579 |   | 1,038,817 |   |
| Diluted income (loss) per common share              |       | $                                           | 0.07       |   | $ | (2.35 | ) | $ | (5.46 | ) |

 

F-14

----

**NeuroMetrix, Inc. Notes to Financial Statements (Continued)**

**2. Basis ofPresentation and Summary of Significant Accounting Policies (Continued)**

The following potentiallydilutive common shares were excluded from the calculation of diluted net income(loss) per common share because their effect was antidilutive for each of theperiods presented:

| ** **                   | ** ** | **Years Ended December 31,** | ** ** |
|------------------------------|------------|---------------------------------------------|------------|
| ** **                   | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Options                      |       | 45,400                                      |       | 1,132,571 |   | 450,412 |   |
| Warrants                     |       | —                                      |       | 100,000 |   | 100,000 |   |
| Convertible preferred  stock |       | —                                      |       | — |   | 5,647,289 |   |

 

***Advertising***

Advertising costs areexpensed as incurred. Advertising expense was approximately $280,000, $215,300and $329,200 in the years ended December 31, 2005, 2004 and 2003,respectively.

***Other ComprehensiveIncome (Loss)***

SFAS No. 130, “ReportingComprehensive Income” establishes standards for reporting and displayingcomprehensive income and its components in a full set of general-purposefinancial statements. For the years ended December 31, 2005, 2004 and2003, the Company had no components of comprehensive income or loss other thannet income (loss).

***Segments***

The Company is in thebusiness of designing, developing and selling proprietary medical devices. TheCompany evaluates its business activities that are regularly reviewed by theChief Executive Officer for which discrete financial information is available.As a result of this evaluation, the Company determined that it has oneoperating segment with operations in one geographical location which is theUnited States.

***Use of Estimates***

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities andthe disclosure of contingent assets and liabilities at the date of thefinancial statements and the reported amounts of revenues and expenses duringthe reporting period. Actual results could differ from those estimates.

***Risks andUncertainties***

The Company is subject torisks common to companies in the medical device industry, including, but notlimited to, development by the Company or its competitors of new technologicalinnovations, dependence on key personnel, customers’ reimbursement fromthird-party payers, protection of proprietary technology, and compliance withregulations of the U.S. Food and Drug Administration.

***Reclassification***

Certain prior year amountshave been reclassified to conform with the current year presentation.

***Recent AccountingPronouncements***

In November 2005, the FinancialAccounting Standards Board (“FASB’’) issued FASB Staff Position (“FSP”) FAS115-1/124-1 “The Meaning of Other-Than-Temporary Impairment and Its Applicationto 

F-15

----

**NeuroMetrix, Inc. Notes to Financial Statements (Continued)**

**2. Basis ofPresentation and Summary of Significant Accounting Policies (Continued)**

CertainInvestments.” The guidance in this FSP addresses the determination of when aninvestment is considered impaired, whether that impairment is other-than-temporaryand the measurement of an impairment loss. The FSP also includes accountingconsiderations subsequent to the recognition of an other-than-temporaryimpairment and requires certain disclosures about unrealized losses that havenot been recognized as other-than-temporary impairments. The guidance in thisFSP applies to reporting periods beginning after December 15, 2005. Theadoption of this FSP did not have a material impact on the Company’s financialposition or results of operations.

InMay 2005, the FASB issued SFAS No 154, “Accounting Changes and ErrorCorrections—a replacement of APB Opinion No. 20 and FASB StatementNo. 3” (“SFAS No. 154”). SFAS No. 154 changes the requirementsfor the accounting and reporting of a change in accounting principle. SFASNo. 154 applies to all voluntary changes in accounting principles. It alsoapplies to changes required by an accounting pronouncement in the unusualinstance that the pronouncement does not contain specific transitionprovisions. When a pronouncement includes specific transition provisions, thoseprovisions will continue to be followed. SFAS No. 154 is effective foraccounting changes and corrections of errors made in fiscal years beginningafter December 15, 2005. Earlier application is permitted for accountingchanges and corrections of errors occurring in fiscal years beginning afterJune 1, 2005. The adoption of SFAS No. 154 is not expected to have amaterial impact on the Company’s financial position or results of operations.

In December 2004, theFASB issued SFAS No. 123(R), “Share-Based Payment” (“SFASNo. 123(R)”), which is a revision of SFAS No. 123 and supersedes APBNo. 25**and SFASNo. 148. This statement requires that the cost resulting from allshare-based payment transactions be recognized in the financial statements.This statement establishes fair value as the measurement objective inaccounting for share-based payment arrangements and requires all entities toapply a fair value based measurement method in accounting for share-basedpayment transactions with employees except for equity instruments held byemployee share ownership plans. As a result, beginning January 1, 2006,the Company adopted SFAS No. 123(R) using the modified prospectivemethod and has begun reflecting the stock-based compensation expense determinedunder fair value based methods in the income statement rather than as pro formadisclosure in the notes to the financial statements. The Company uses theBlack-Scholes option pricing model for determining the fair value of its stockoptions and amortizes its stock-based compensation expense using thestraight-line method. The adoption of SFAS No. 123(R) will have amaterial impact on the Company’s results of operations.

**3.Inventories**

AtDecember 31, 2005 and 2004, inventories consist of the following:

| ** **            | ** ** | **December 31,** | ** ** |
|-----------------------|------------|-----------------------|------------|
| ** **            | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Purchased  components |       |                  | $          | 276,167 |   |   | $ | 293,263 |   |
| Finished goods        |       |                  | 2,407,242  |   |   | 990,998 |   |
|                  |       |                  | $          | 2,683,409 |   |   | $ | 1,284,261 |   |

 

F-16

----

**NeuroMetrix, Inc. Notes to Financial Statements (Continued)**

**4.Held-to-Maturity Investments**

Held-to-maturityinvestments as of December 31, 2005 and 2004 are as follows:

| ** **                       | ** ** | **Amortized Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated  Fair Value** | ** ** |
|----------------------------------|------------|-------------------------|------------|------------------------------|------------|-------------------------------|------------|--------------------------------|------------|
| **2005**                         |       |                    |       |                         |       |                          |       |                           |       |   |   |   |   |
| Commercial paper  and bank notes |       |                    | $          | 4,440,724                    |       |                          |       | $                              | 59,276     |   |   | $ | — |   | $ | 4,500,000 |   |
| U.S. agency  obligations         |       |                    | 2,990,521  |                         |       |                          | —     |                           |       | (4,524 | ) | 2,985,997 |   |
| Corporate bonds                  |       |                    | 10,061,701 |                         |       |                          | 1,429      |                           |       | (364,495 | ) | 9,698,635 |   |
| Certificates of  deposit         |       |                    | 6,589,000  |                         |       |                          | —     |                           |       | (13,545 | ) | 6,575,455 |   |
|                             |       |                    | $          | 24,081,946                   |       |                          |       | $                              | 60,705     |   |   | $ | (382,564 | ) | $ | 23,760,087 |   |
| **2004**                         |       |                    |       |                         |       |                          |       |                           |       |   |   |   |   |
| Commercial paper  and bank notes |       |                    | $          | 1,476,825                    |       |                          |       | $                              | 23,175     |   |   | $ | — |   | $ | 1,500,000 |   |
| U.S. agency  obligations         |       |                    | 9,625,229  |                         |       |                          | 20,713     |                           |       | (12,601 | ) | 9,633,341 |   |
| Corporate bonds                  |       |                    | 13,477,697 |                         |       |                          | —     |                           |       | (180,924 | ) | 13,296,773 |   |
| Certificates of  deposit         |       |                    | 3,492,000  |                         |       |                          | —     |                           |       | (2,756 | ) | 3,489,244 |   |
|                             |       |                    | $          | 28,071,751                   |       |                          |       | $                              | 43,888     |   |   | $ | (196,281 | ) | $ | 27,919,358 |   |

 

The following table showsthe gross unrealized losses and fair value of the Company’s held-to-maturityinvestments with unrealized losses that are not deemed to beother-than-temporarily impaired, aggregated by investment category and lengthof time that individual securities have been in a continuous unrealized lossposition, at December 31, 2005:

| ** **                              | ** ** | **Less Than 12 Months** | ** ** | **12 Months or Greater** | ** ** | **Total**                     | ** ** |
|-----------------------------------------|------------|----------------------------------------|------------|-----------------------------------------|------------|-------------------------------|------------|
| **Description of Securities** | ** ** | ** **                             | ** ** | **Fair Value**                     | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair Value** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair Value** | ** ** | **Gross  Unrealized  Losses** | ** ** |
| U.S. agency  obligations                |       | $                                      | 2,587,943  |                                    |       | $                             | (2,489     | ) |   | $ | 398,054 |   | $ | (2,035 | ) | $ | 2,985,997 |   | $ | (4,524 | ) |
| Corporate bonds                         |       | 1,479,864                              |       |                                    | (39,075    | )                             |       | 6,521,599 |   | (325,420 | ) | 8,001,463 |   | (364,495 | ) |
| Certificates of  deposit                |       | 1,290,058                              |       |                                    | (9,942     | )                             |       | 496,397 |   | (3,603 | ) | 1,786,455 |   | (13,545 | ) |
| Total                                   |       | $                                      | 5,357,865  |                                    |       | $                             | (51,506    | ) |   | $ | 7,416,050 |   | $ | (331,058 | ) | $ | 12,773,915 |   | $ | (382,564 | ) |
|                                         |            |                                        |            |                                         |            |                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

U.S. agency obligations—The unrealized losses on theCompany’s investments in three U.S. agency obligations were caused by interestrate increases since the date of purchase. The contractual terms of theseinvestments do not permit the issuer to settle the securities at a price lessthan the face value of the investment. Because the Company has the ability andintent to hold these investments until maturity, the Company does not considerthese investments to be other-than-temporarily impaired at December 31,2005.

Corporate bonds—The unrealized losses on the Company’sinvestments in seven corporate bonds were caused by interest rate increasessince the date of purchase. The contractual terms of these investments do notpermit the issuers to settle the securities at a price less than the face valueof the investment. Each of the bonds maintains a Standard & Poor’srating of A or higher and has made each of their scheduled interest payments. Therefore,it is not expected that the bonds would be settled at a price less than theamortized cost of the investment. Because the Company has the ability andintent to hold 

F-17

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**NeuroMetrix, Inc. Notes to Financial Statements (Continued)**

**4. Held-to-MaturityInvestments (Continued)**

these investments untilmaturity, the Company does not consider these investments to beother-than-temporarily impaired at December 31, 2005.

Certificates of deposit—The unrealized losses on theCompany’s investments in 18 certificates of deposit were caused by interestrate increases since the date of purchase. The contractual terms of theseinvestments do not permit the issuers to settle the securities at a price lessthan the face value of the investment. Because the Company has the ability andintent to hold these investments until maturity, the Company does not considerthese investments to be other-than-temporarily impaired at December 31,2005.

Theamortized cost and fair value of fixed maturity securities at December 31,2005 and 2004, by contractual maturity, are shown below:

| ** **                             | ** ** | **December 31,**   | ** ** |
|----------------------------------------|------------|-------------------------|------------|
| ** **                             | ** ** | **2005**                | ** ** | **2004** | ** ** |
| ** **                             | ** ** | **Amortized Cost** | ** ** | **Fair Value** | ** ** | **Amortized Cost** | ** ** | **Fair Value** | ** ** |
| Due in one year  or less               |       |                    | $          | 24,081,946 |   |   | $ | 23,760,087 |   |   | $ | 18,574,593 |   |   | $ | 18,529,593 |   |
| Due after one  year through five years |       |                    | —     |   |   | — |   |   | 9,497,158 |   |   | 9,389,765 |   |
|                                   |       |                    | $          | 24,081,946 |   |   | $ | 23,760,087 |   |   | $ | 28,071,751 |   |   | $ | 27,919,358 |   |

 

**5. Fixed Assets**

Fixedassets consist of the following:

| ** **                          | ** ** | **Estimated  Useful Life** | ** ** | **December 31,** | ** ** |
|-------------------------------------|------------|---------------------------------|------------|-----------------------|------------|
| ** **                          | ** ** | **(Years)**                     | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Computer and  laboratory equipment  |       |                            | 3          |                  |       | $ | 1,366,553 |   | $ | 1,195,816 |   |
| Furniture and equipment             |       |                            | 3          |                  |       | 198,330 |   | 188,859 |   |
| Production  equipment               |       |                            | 7          |                  |       | 636,406 |   | 620,511 |   |
| Construction in  progress           |       |                            | —     |                  |       | 173,103 |   | 7,546 |   |
| Leasehold  improvements             |       |                            | *          |                  |       | 132,907 |   | 19,443 |   |
|                                |       |                            |       |                  |       | 2,507,299 |   | 2,032,175 |   |
| Less—accumulated  depreciation |       |                            |       |                  |       | (1,631,748 | ) | (1,352,816 | ) |
|                                |       |                            |       |                  |       | $ | 875,551 |   | $ | 679,359 |   |

----

*—Lesser of life of lease or estimated useful life

Depreciation expense was$278,932, $205,023 and $214,589 for the years ended December 31, 2005,2004 and 2003, respectively.

F-18

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**NeuroMetrix, Inc. Notes to Financial Statements (Continued)**

**6. Accrued Expenses**

Accruedexpenses consist of the following for the fiscal years ended December 31,2005 and 2004:

| ** **             | ** ** | **December 31,** | ** ** |
|------------------------|------------|-----------------------|------------|
| ** **             | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Professional  services |       | $                     | 438,519    |   | $ | 164,701 |   |
| Other                  |       | 775,409               |       | 428,719 |   |
|                   |       | $                     | 1,213,928  |   | $ | 593,420 |   |

 

**7. Long-Term Debt**

In March 1999, the Company obtained a commitmentfrom a bank for a $300,000 equipment term loan facility (the “Equipment Line”).On February 28, 2000, the bank increased the Equipment Line to $400,000and extended the maturity date to February 27, 2003. Advances under theEquipment Line bore interest at the bank’s prime rate, plus 0.75% and wererepayable in 30 equal monthly installments. In February 2003, theequipment line was repaid in full and terminated.

On May 21, 2003, the Company entered into anagreement with Lighthouse Capital Partners IV, L.P. (“Lighthouse”) to establisha line of credit for $3,000,000 (“Line of Credit”). The Company drew down $3,000,000 millionthrough December 31, 2003. All borrowings under the line of credit werecollateralized by substantially all the assets of the Company. Borrowings boreinterest at nominal rate of 11% per annum. Upon the final maturity date or theearlier prepayment of each advance, the Company was required to pay, inaddition to the principal and interest, an additional amount equal to 11% ofthe original principal, or $330,000. This additional amount was being accretedover the applicable borrowing period as additional interest expense.

On July 29, 2004, the Company paid $3,123,521 toLighthouse. This amount represented payment in full of all outstandingobligations under the line of credit with Lighthouse.

In connection with theLine of Credit, the Company issued Lighthouse warrants to purchase up to400,000 shares of Series E-1 redeemable convertible preferred stockat an exercise price of $1.50 per share, for a term of seven years. The fairvalue of the warrants calculated using the Black-Scholes option pricing modelwas estimated to be $450,100, and was recorded as a debt discount. Thisdiscount was being accreted over the repayment term of 36 months asadditional interest expense. Upon completion of the Company’s IPO, this warrantconverted into a warrant to purchase 100,000 shares of common stock. Thiswarrant was exercised in full on a net basis on June 13, 2005, resultingin the issuance of 63,707 shares of common stock.

**8.**RedeemableConvertible Preferred Stock

The Company’s redeemable convertible preferred stockwas mandatorily redeemable by the holders based on facts and circumstances notin the Company’s control. The carrying value of this preferred stock was beingaccreted to redemption value over the term to the redemption date. Theseadjustments were affected through charges first against retained earnings, thenagainst additional paid-in capital until it was reduced to zero and then toaccumulated deficit. Accretion for the years ended December 31, 2004 and2003 was $1,386,301 and $2,009,450, respectively.

F-19

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**NeuroMetrix, Inc. Notes to Financial Statements (Continued)**

**8. RedeemableConvertible Preferred Stock (Continued)**

The Company’s 875,000 shares of Series Aredeemable convertible preferred stock, 625,000 shares of Series Bredeemable convertible preferred stock, 3,998,100 shares of Series Cconvertible preferred stock, of which 2,850,000 shares were designated as Series C-1redeemable convertible preferred stock and 1,148,100 shares were designated as Series C-2nonvoting redeemable convertible preferred stock, 6,222,220 shares of Series Dredeemable convertible preferred stock, 7,111,110 shares of Series E redeemableconvertible preferred stock and 2,333,333 shares of Series E-1 redeemableconvertible preferred stock automatically converted into 7,488,758 shares ofcommon stock upon the completion of the Company’s initial public offering in July 2004.

In March 2004, theCompany sold 7,050,771 shares of Series E-1 redeemable convertible preferredstock at a price of $1.50 per share, resulting in gross proceeds of$10,576,157. The conversion rate associated with Series E-1 redeemableconvertible preferred stock resulted in a 1-for-4 exchange or aconversion price of $6.00 per share. The Series E-1 redeemable convertiblepreferred stock contained a beneficial conversion feature as the estimated fairvalue of the Company’s common stock was in excess of the $1.50 per shareconversion price. Accordingly, the Company recorded a charge of $7,050,771 as abeneficial conversion feature in March 2004. Also, as a result of this Series E-1redeemable convertible preferred stock financing and the anti-dilutionprovisions associated with the Series D redeemable convertible preferredstock, the Company recorded a charge in the form of a deemed dividend of$787,885 in March 2004. This charge resulted from an adjustment to theconversion price as a result of anti-dilution protection associated with the Series Dredeemable convertible preferred stock.

**9. Common Stock and StockOption Plans**

As of December 31, 2005, the Company had50,000,000 shares of common stock authorized and 12,375,276 shares issued andoutstanding. There were no treasury shares outstanding at December 31,2005 and 2004, as all treasury shares have been issued upon employee stockoption exercises.

Each share of common stockentitles the holder to one vote on all matters submitted to a vote of theCompany’s stockholders. Common stockholders are not entitled to receivedividends unless declared by the Board of Directors.

***Stock Option Plans***

During 1996, the Company’s Board of Directors adoptedthe 1996 Stock Option/Restricted Stock Plan (the “1996 Stock Plan”). The 1996Stock Plan provides for the granting of incentive and non-qualified stockoptions and stock bonus awards to officers, directors and employees of theCompany. The maximum number of shares that may be issued pursuant to the 1996Stock Plan is 156,250. All of the outstanding options under the 1996 Stock Planare fully vested and terminate 10 years after the grant date, or earlier if theoption holder is no longer an executive officer, employee, consultant, advisoror director, as applicable, of the Company. As of December 31, 2005, 6,250shares were subject to outstanding options at a weighted average exercise priceof $0.20 per share, 127,962 shares had been issued under the 1996 Stock Planand no shares were available for future grant. If any options granted under the1996 Stock Plan are forfeited, such shares are not available for future grantand revert back to the founder.

During 1998, the Company adopted the 1998 EquityIncentive Plan (the “1998 Stock Plan”). The 1998 Stock Plan also provides forgranting of incentive and nonqualified stock option and stock bonus awards toofficers, consultants and employees of the Company. As of December 31,2005, 1,250,000 shares of 

F-20

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**NeuroMetrix, Inc. Notes to Financial Statements (Continued)**

**9. CommonStock and Stock Option Plans (Continued)**

common stock wereauthorized for issuance under the 1998 Stock Plan, of which 430,061 shares hadbeen issued and 747,294 shares were subject to outstanding options at aweighted average price of $6.32 per share. Outstanding options under the 1998Stock Plan generally vest over three or four years and terminate 10 years afterthe grant date, or earlier if the option holder is no longer an executiveofficer, employee, consultant, advisor or director, as applicable, of theCompany. The 1998 Stock Plan was closed to any future grants at the time of theIPO and therefore we will not make any additional grants under the 1998 StockPlan.

During 2004, the Company adopted the 2004 Stock Optionand Incentive Plan (the “2004 Stock Plan”). The 2004 Stock Plan also provides forgranting of incentive and nonqualified stock option and stock bonus awards toofficers, consultants and employees of the Company. Outstanding options underthe 2004 Stock Plan generally vest over three or four years and terminate 10years after the grant date, or earlier if the option holder is no longer anexecutive officer, employee, consultant, advisor or director, as applicable, ofthe Company. As of December 31, 2005, 946,022 shares of common stock wereauthorized for issuance under the 2004 Stock Plan, of which 875 shares had beenissued, 367,075 shares were subject to outstanding options at a weightedaverage price of $12.56 per share and 578,072 shares were available for futuregrant. Also, on December 31 of each year an additional number of shares,equal to 15% of the annual net increase in the total number of outstandingshares of common stock during the year, will be added to the shares availablefor the issuance of awards under the 2004 Stock Plan.

The exercise price of each stock option issued underthe 1996 and 1998 Stock Plans was specified by the Board of Directors at thetime of grant. However, incentive stock options may not be granted at less thanthe fair market value of the Company’s common stock as determined by the Boardof Directors at the date of grant or for a term in excess of 10 years. Theexercise price of stock options awarded under the 2004 Stock Plan may not beless than the fair market value of the common stock on the date of the option grantin the case of incentive stock options and no less than 85% of the fair marketvalue of the common stock on the date of the option grant in the case ofnon-qualified stock options. For holders of more than 10% of the Company’stotal combined voting power of all classes of stock, incentive stock optionsmay not be granted at less than 110% of the fair market value of the Company’scommon stock at the date of grant and for a term not to exceed five years. Alloptions granted under the 1996 and 1998 Stock Plans become exercisable at suchtime as the Board of Directors specifies and expire 10 years from the dateof grant.

F-21

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**NeuroMetrix, Inc. Notes to Financial Statements (Continued)**

**9. CommonStock and Stock Option Plans (Continued)**

A summary of activityunder the Company’s 1996, 1998 and 2004 Stock Plans for the years ended December 31,2005, 2004 and 2003 is presented below:

| ** **                             | ** ** | **Number of  Shares** | ** ** | **Exercise  Price Range** | ** **          | **Weighted  Average  Exercise Price** | ** ** |
|----------------------------------------|------------|----------------------------|------------|--------------------------------|---------------------|--------------------------------------------|------------|
| **Stock  Option Awards**               |       |                       |       |                           |                |                                       |       |   |   |
| Outstanding at  December 31, 2002 |       | 381,651                    |       | $                              | 0.008 – 2.250  |                                       |       | $ | 1.5264 |   |   |
| Granted at fair value                  |       | 120,215                    |       | 2.250                          |                |                                       | 2.2500     |   |   |
| Exercised                              |       | (8,723                     | )          | 0.008 – 1.350             |                |                                       | 0.6738     |   |   |
| Forfeited                              |       | (42,731                    | )          | 0.900 – 2.250             |                |                                       | 1.3952     |   |   |
| Outstanding at  December 31, 2003 |       | 450,412                    |       | 0.200 – 2.250             |                |                                       | 1.7485     |   |   |
| Granted at fair value                  |       | 657,344                    |       | 8.000 – 10.420            |                |                                       | 8.1615     |   |   |
| Granted below fair value               |       | 90,900                     |       | 0.900 – 4.480             |                |                                       | 2.6600     |   |   |
| Exercised                              |       | (49,621                    | )          | 0.200 – 2.250             |                |                                       | 0.9055     |   |   |
| Forfeited                              |       | (16,464                    | )          | 0.900 – 8.530             |                |                                       | 2.8206     |   |   |
| Outstanding at  December 31, 2004 |       | 1,132,571                  |       | 0.200 – 10.420            |                |                                       | 5.6275     |   |   |
| Granted at fair value                  |       | 278,650                    |       | 9.280 – 37.230            |                |                                       | 13.7797    |   |   |
| Exercised                              |       | (253,654                   | )          | 0.400 – 10.000            |                |                                       | 2.0219     |   |   |
| Forfeited                              |       | (36,948                    | )          | 2.250 – 29.020            |                |                                       | 9.8482     |   |   |
| Outstanding at  December 31, 2005 |       | 1,120,619                  |       | $                              | 0.200 – 37.230 |                                       |       | $ | 8.3316 |   |   |

 

Thefollowing table summarizes information about stock options outstanding at December 31,2005:

| **Exercise   Price** | ** ** | ** ** | ** ** | **Number of  Options  Outstanding** | ** ** | **Weighted Average  Remaining Contractual  Life (Years)** | ** ** | **Number of  Options  Exercisable** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|--------------------------------|------------|------------|------------|------------------------------------------|------------|--------------------------------------------------------------------------|------------|------------------------------------------|------------|--------------------------------------------|------------|
| $0.20 – 1.35              |       |       | 31,224     |                                     |       |                                                                     | 3.6        |                                     |       |                                       | 31,224     |   |   |   | $ | 0.6581 |   |   |
| $2.25 – 2.25              |       |       | 180,178    |                                     |       |                                                                     | 7.3        |                                     |       |                                       | 79,093     |   |   |   | 2.2500 |   |   |
| $4.48 – 8.00              |       |       | 533,864    |                                     |       |                                                                     | 8.5        |                                     |       |                                       | 204,905    |   |   |   | 7.8094 |   |   |
| $8.25 – 9.92              |       |       | 262,525    |                                     |       |                                                                     | 9.0        |                                     |       |                                       | 11,754     |   |   |   | 9.2699 |   |   |
| $10.00 – 14.76            |       |       | 60,428     |                                     |       |                                                                     | 9.1        |                                     |       |                                       | 4,991      |   |   |   | 10.1601 |   |   |
| $17.34 – 37.23            |       |       | 52,400     |                                     |       |                                                                     | 9.7        |                                     |       |                                       | —     |   |   |   | N/A |   |   |
|                           |       |       | 1,120,619  |                                     |       |                                                                     | 8.4        |                                     |       |                                       | 331,967    |   |   |   | $ | 5.8993 |   |   |

 

The Company recorded deferred compensation of $0,$750,566 and $630,900 in the years ended December 31, 2005, 2004 and 2003,respectively, related to stock option grants to employees and non-employees.The deferred compensation represents the difference between the estimated fairvalue of common stock on the date of grant and the exercise price associatedwith the stock options. The deferred compensation is amortized to expense overthe vesting period of the related stock options. The Company recordedcompensation expense for the years ended December 31, 2005, 2004 and 2003of $406,330, $1,028,595 and $96,450, respectively. Included in the compensationexpense recorded by the Company is $35,790, $436,611 and $0 of compensationexpense associated with the modification of stock options in the years endedDecember 31, 2005, 2004 and 2003, respectively.

F-22

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**NeuroMetrix, Inc. Notes to Financial Statements (Continued)**

**9. CommonStock and Stock Option Plans (Continued)**

Unamortized deferredcompensation on forfeited options is recorded as a reduction to additionalpaid-in capital.

***Employee Stock Purchase Plan***

In June 2004, the Company’s stockholders approvedour 2004 Employee Stock Purchase Plan (“ESPP”). All of our employees who havebeen employed by the Company for at least 60 days and whose customaryemployment is for more than 20 hours per week and for more than five months inany calendar year are eligible to participate. Any employee who owns 5% or moreof the voting power or value of our stock is not eligible to participate and anemployee may purchase no more than $25,000 worth of common stock, valued at thestart of the purchase period, in any calendar year. The ESPP authorizes theissuance of up to a total of 375,000 shares of our common stock toparticipating employees.

Under the ESPP,participating employees can authorize the Company to withhold up to 10% oftheir earnings during consecutive six-month payment periods for the purchase ofthe shares. At the conclusion of the period, participating employees canpurchase shares at 85% of the lower of their fair market value at the beginningor end of the period. Under this plan, the Company issued 23,265 and 9,532shares of its common stock during the years ended December 31, 2005 and2004, respectively.

***Common Stock Reserved for Future Issuance***

AtDecember 31, 2005, the Company has reserved authorized shares of commonstock for future issuance as follows:

| ** **                                                   | ** ** | ** ** | ** ** |
|--------------------------------------------------------------|------------|------------|------------|
| Outstanding stock  options                                   |       |       | 1,120,619  |   |   |
| Possible future  issuance under stock option plans           |       |       | 578,072    |   |   |
| Possible future  issuance under employee stock purchase plan |       |       | 342,203    |   |   |
| Total                                                        |       |       | 2,040,894  |   |   |

 

**10. Income Taxes**

Theincome tax provision consists of the following for the years endedDecember 31, 2005, 2004 and 2003:

| ** **           | ** ** | **Years Ended December 31,** | ** ** |
|----------------------|------------|---------------------------------------------|------------|
| ** **           | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Federal tax  expense |       | $                                           | 35,000     |   |   | $ | — |   |   |   | $ | — |   |   |
| State tax expense    |       | —                                      |       |   | — |   |   |   | — |   |   |
| Total                |       | $                                           | 35,000     |   |   | $ | — |   |   |   | $ | — |   |   |

 

F-23

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**NeuroMetrix, Inc. Notes to Financial Statements (Continued)**

**10. Income Taxes(Continued)**

TheCompany’s effective income tax rate differs from the statutory federal incometax rate as follows for the years ended December 31, 2005, 2004 and 2003.

| ** **                                                          | ** ** | **Years Ended December 31,** | ** ** |
|---------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                          | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Federal tax  provision (benefit) rate                               |       | 34.0                                        | %          | (34.0 | )% | (34.0 | )% |
| State tax  provision (benefit), net of federal provision (benefits) |       | 7.7                                         |       | (3.5 | ) | (5.5 | ) |
| Permanent items                                                     |       | 16.3                                        |       | 4.2 |   | 1.3 |   |
| Federal research  and development credits                           |       | (15.8                                       | )          | (1.8 | ) | (1.5 | ) |
| Alternative  minimum tax                                            |       | 3.6                                         |       | — |   | — |   |
| Valuation  allowance                                                |       | (42.2                                       | )          | 35.1 |   | 39.7 |   |
| Effective income tax  rate                                          |       | 3.6                                         | %          | 0.0 | % | 0.0 | % |

 

TheCompany’s deferred tax assets consist of the following:

| ** **                                    | ** ** | **December 31,** | ** ** |
|-----------------------------------------------|------------|-----------------------|------------|
| ** **                                    | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Deferred tax assets:                          |       |                  |       |   |   |
| Net operating loss carryforwards              |       | $                     | 13,870,554 |   | $ | 12,853,450 |   |
| Research and development credit carryforwards |       | 645,809               |       | 533,820 |   |
| Accrued expenses                              |       | 983,958               |       | 645,807 |   |
| Other                                         |       | 3,594                 |       | (81,537 | ) |
| Total gross  deferred tax assets              |       | 15,503,915            |       | 13,951,540 |   |
| Valuation  allowance                          |       | (15,503,915           | )          | (13,951,540 | ) |
| Net deferred tax assets                       |       | $                     | —     |   | $ | — |   |

 

As of December 31, 2005, the Company had federaland state net operating loss carryforwards (“NOL”) of approximately $35,491,000and $28,768,000, respectively, as well as federal and state research andexperimentation credits of approximately $563,000 and $126,000, respectively,which may be available to reduce future taxable income and the related taxesthereon. The federal NOLs begin to expire in 2011 and the state NOLs begin toexpire in 2006. As required by SFAS 109, the Company has evaluated thepositive and negative evidence bearing upon the realizability of its deferredtax assets, which are comprised principally of net operating loss carryforwards.Management has determined that it is more likely than not that the Company willnot recognize the benefits of federal and state deferred tax assets and, as aresult, a valuation allowance of approximately $15,503,915 and $13,951,540 hasbeen established at December 31, 2005 and 2004, respectively. Deferred taxassets and related valuation allowance of $2,290,695 attributable to netoperating loss carryforwards and $49,000 attributable to federal and stateresearch and experimentation credits result from the exercise of employee stockoptions, the tax benefit of which, when recognized, will be accounted for as acredit to additional paid-in capital rather than a reduction of income taxexpense.

Ownership changes, asdefined in the Internal Revenue Code, have limited the amount of net operatingloss carryforwards that can be utilized annually to offset future taxableincome. The Company anticipates that these limitations will have no materialimpact on their ability to utilize the affected loss 

F-24

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**NeuroMetrix, Inc. Notes to Financial Statements (Continued)**

**10. IncomeTaxes (Continued)**

carryforwardsin future years. Subsequent ownership changes could further affect thelimitation in future years.

**11. Commitments andContingencies**

**Operating Leases**

In September 2000, the Company entered into anoncancelable operating lease, commencing January 1, 2001, for office andlaboratory space. The lease expires on March 31, 2009.

Futureminimum lease payments under noncancelable operating leases as of December 31,2005 are as follows:

| 2006                          |   | $       | 930,000   |   |
|-------------------------------|--------|---------|-----------|--------|
| 2007                          |   | 930,000 |      |
| 2008                          |   | 930,000 |      |
| 2009                          |   | 232,500 |      |
| Total minimum lease  payments |   | $       | 3,022,500 |   |

 

Total recorded rentexpense was $871,819 for each the years ended December 31, 2005, 2004 and2003. The Company records rent expense on its facility lease on a straight linebasis over the term. Accordingly, the Company has recorded a liability foraccrued rent expense at December 31, 2005 and 2004 of $189,091 and$247,273, respectively on the accompanying balance sheets.

**Restricted TimeDeposit**

In connection with theCompany’s facility lease, the Company is required to maintain, for the benefitof the lessor, an irrevocable standby letter of credit stating the lessor asthe beneficiary over the term of the lease, which is secured by a certificateof deposit in an amount equal to 102% of the letter of credit as security. Thelease expires in March 2009. The certificate of deposit is renewable in 30-dayincrements. At December 31, 2005 and 2004, the Company has $1,458,598 and$1,897,200 recorded as restricted cash associated with this lease on theaccompanying balance sheet.

**Royalty Agreements**

In June 1996, the Company entered into a licenseagreement with the Massachusetts Institute of Technology, (“M.I.T.”), a relatedparty, as amended on February 25, 1998, under which the Company obtainedan exclusive right to use certain technology through the term of M.I.T.’spatent rights on such technology. In exchange, the Company is required to payroyalties of 2.15% of net sales of products incorporating the licensedtechnology. In addition, the Company is required to pay royalties ranging from25% to 50% of payments received from sublicensees, depending on the degree towhich M.I.T.’s technology was incorporated into the products sublicensed by theCompany. Through the year ended December 31, 2005, the Company has notincorporated this licensed technology into its products and therefore, noamounts have been accrued as being owed.

In addition, the Company is obligated to pay M.I.T.annual license maintenance fees if certain minimum net sales requirements arenot met. These payments can be used to offset future royalties 

F-25

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**NeuroMetrix, Inc. Notes to Financial Statements (Continued)**

**11. Commitmentsand Contingencies (Continued)**

payable under theagreement. Under the amended agreement, the Company has a right to terminatethis agreement at anytime upon a written notice and has recorded royaltyexpense totaling $75,000 for each of the years ended December 31, 2005,2004 and 2003 relating to these fees. At December 31, 2005, 2004 and 2003,M.I.T. owned approximately 0.0%, 4.6% and 9.3%, respectively, of the Company’scommon stock outstanding and 0.0%, 0.0% and 5.6%, respectively, of the Company’sredeemable convertible preferred stock outstanding.

In February 1999 theCompany entered into another license agreement with an unrelated third partyunder which the Company obtained the right to use certain technology throughthe term of the licensor’s patent right on such technology. In exchange, theCompany was required to pay the licensor $50,000 annually for the first threeyears of the agreement. In subsequent years, the Company is required to pay$10,000 annually as long as it continues to use the licensed technology. Underthis agreement, the Company has a right to terminate this agreement at anytimeupon a written notice. During each of the years ended December 31, 2005,2004 and 2003, $10,000 was paid and recorded as cost of goods sold.

**12. Retirement Plan**

The Company established a 401(k) definedcontribution savings plan for its employees who meet certain service period andage requirements. Contributions are permitted up to the maximum allowed underthe Internal Revenue Code of each covered employee’s salary. The savings planpermits the Company to contribute at its discretion. For the years ended December 31,2005, 2004 and 2003 the Company made no contributions to the plan.

F-26

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**NeuroMetrix, Inc.**

**Schedule II—Valuation and Qualifying Accounts**

Forthe three years ended December 31, 2005, 2004 and 2003:

| ** **                                   | ** ** | **Balance at  Beginning of  Period** | ** ** | **Additions** | ** ** | **Deductions** | ** ** | **Balance at End  of Period** | ** ** |
|----------------------------------------------|------------|------------------------------------------------|------------|---------------|------------|----------------|------------|----------------------------------------------|------------|
| **Allowance  for Doubtful Accounts:**        |       |                                           |       |          |       |           |       |                                         |       |   |   |   |   |
| 2005                                         |       | $                                              | 300,000    |          | $          | 359,827        |       |                                         | $          | 259,827 |   |   |   | $ | 400,000 |   |   |
| 2004                                         |       | 300,000                                        |       | 235,464       |       |           | 235,464    |                                         |       |   | 300,000 |   |   |
| 2003                                         |       | 200,000                                        |       | 200,326       |       |           | 100,326    |                                         |       |   | 300,000 |   |   |
| **Deferred  Tax Asset Valuation Allowance:** |       |                                           |       |          |       |           |       |                                         |       |   |   |   |   |
| 2005                                         |       | $                                              | 13,951,540 |          | $          | 1,552,375      |       |                                         | $          | — |   |   |   | $ | 15,503,915 |   |   |
| 2004                                         |       | 12,449,478                                     |       | 1,502,062     |       |           | —     |                                         |       |   | 13,951,540 |   |   |
| 2003                                         |       | 10,996,007                                     |       | 1,453,471     |       |           | —     |                                         |       |   | 12,449,478 |   |   |

 

S-1

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