**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

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**FORM 10-K**

**(Mark One)**

**x**                              ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934

**Forthe fiscal year ended December 31, 2006**

**OR**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 12 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**Forthe transition period from            to            **

**CommissionFile Number 000-50856**

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**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, Massachusetts** |   | **02451**            |
| (Address of  Principal Executive Offices)   |   | Zip Code             |

 

**(781) 890-9989**

(Registrant’s TelephoneNumber, Including Area Code)

**SecuritiesRegistered Pursuant To Section 12(b) of the Act:**

| **Title of  each class**                                                        |   | **Name of  exchange on which registered** |
|---------------------------------------------------------------------------------|--------|-------------------------------------------|
| **Common  Stock, $0.0001 par value per share  Preferred Stock Purchase Rights** |   | **The  NASDAQ Stock Market LLC**          |

 

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

**None**

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 past 90 days. Yes x   No o

Indicate by check mark if disclosure of delinquent filerspursuant to Item 405 of Regulation S-K is not contained herein, and willnot be contained, to the best of registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of this Form 10-Kor 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, 2006 the aggregate market value ofthe voting stock held by non-affiliates of the registrant was approximately$267,896,949 based on the closing sale price of the common stock as reported onthe NASDAQ Global Market on June 30, 2006. For this computation, theregistrant has excluded the market value of all outstanding shares beneficiallyowned by any director, executive officer or person known to the registrant tobeneficially own 10% or more of the registrant’s common stock; such exclusionshall not be deemed to constitute an admission that any such person is anaffiliate of the registrant.

As of March 21, 2007, there were 12,604,554 sharesof Common Stock outstanding.

**DOCUMENTS INCORPORATED BY REFERENCE**

Portionsof the registrant’s definitive proxy statement for the registrant’s 2007 annualmeeting of stockholders, which is expected to be filed pursuant toRegulation 14A within 120 days of the registrant’s year ended December 31,2006, are incorporated by reference into Part III of this Annual Report onForm 10-K.

 

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**NEUROMETRIX, INC.ANNUAL REPORT ON FORM 10-KFOR THE YEAR ENDED DECEMBER 31, 2006TABLE OF CONTENTS**
|               | ** ** | ** **                                                                                                                                | ** ** | **Page** | ** ** |
|---------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|
| PART I   |       |                                                                                                                                      |       |     |       |   |   |
| Item 1:       |       | Business                                                                                                                                  |       |     | 3          |   |   |
| Item 1A:      |       | Risk  Factors                                                                                                                             |       |     | 24         |   |   |
| Item 1B:      |       | Unresolved Staff Comments                                                                                                                 |       |     | 41         |   |   |
| Item 2:       |       | Properties                                                                                                                                |       |     | 41         |   |   |
| Item 3:       |       | Legal  Proceedings                                                                                                                        |       |     | 41         |   |   |
| Item 4:       |       | Submission of Matters to a Vote of Security Holders                                                                                       |       |     | 41         |   |   |
| PART II  |       |                                                                                                                                      |       |     |       |   |   |
| Item 5:       |       | Market for Registrant’s Common Equity, Related  Stockholder Matters and Issuer Purchases of Equity Securities                   |       |     | 42         |   |   |
| Item  6:      |       | Selected  Financial Data                                                                                                                  |       |     | 44         |   |   |
| Item 7:       |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations       |       |     | 46         |   |   |
| Item 7A:      |       | Quantitative and Qualitative Disclosures About Market  Risk                                                                               |       |     | 64         |   |   |
| Item 8:       |       | Financial Statements and Supplementary Data                                                                                               |       |     | 65         |   |   |
| Item 9:       |       | Disagreements with Accountants on Accounting and  Financial Disclosure                                                                    |       |     | 65         |   |   |
| Item 9A:      |       | Controls and Procedures                                                                                                                   |       |     | 66         |   |   |
| Item  9B:     |       | Other  Information                                                                                                                        |       |     | 67         |   |   |
| PART III |       |                                                                                                                                      |       |     |       |   |   |
| Item 10:      |       | Directors, Executive Officers and Corporate Governance                                                                                    |       |     | 68         |   |   |
| Item 11:      |       | Executive Compensation                                                                                                                    |       |     | 68         |   |   |
| Item 12:      |       | Security Ownership of Certain Beneficial Owners and  Management and Related Stockholder Matters                       |       |     | 68         |   |   |
| Item 13:      |       | Certain Relationships and Related Transactions and Director  Independence                                                                 |       |     | 68         |   |   |
| Item 14:      |       | Principal Accountant Fees and Services                                                                                                    |       |     | 68         |   |   |
| PART IV  |       |                                                                                                                                      |       |     |       |   |   |
| Item 15:      |       | Exhibits and Financial Statement Schedule                                                                                                 |       |     | 69         |   |   |
| Signatures    |       |                                                                                                                                      | 72         |     |       |

 

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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 help physicians diagnose neuropathies and neurovasculardisease. Neuropathies are diseases of the peripheral nerves and parts of thespine that frequently are caused by or associated with diabetes, low back painand carpal tunnel syndrome, as well as other clinical disorders. We believethat our neuropathy diagnostic system, the NC-stat System, improves the qualityand efficiency of patient care by offering all physicians the ability todiagnose patients with neuropathies at the point-of-service, that is, in thephysician’s office at the time the patient is examined, resulting in earlierand more accurate detection, greater patient comfort and convenience, and, inmany cases, improved clinical and economic outcomes.

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.

Neurovascular disease includes conditions such as retinopathy,an eye disease prevalent in patients with diabetes. We hold an exclusive salesand marketing license to a product known as the DigiScope®, which allowsprimary care physicians and endocrinologists to diagnose diabetic retinopathyand refer patients to the ophthalmologist for treatment if deemed necessarybased on the results. It is recommended by the American Diabetes Association (“ADA”)that all patients with diabetes receive an annual dilated 

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eye examination todetermine if there are any abnormalities. There are approximately 21 millionpeople in the United States with diabetes according to the ADA and onlyapproximately 50% comply with the recommendation to have an annual eyeexamination. We believe that a product such as the DigiScope in primary carephysicians’ and endocrinologists’ offices could potentially lead to an increasein the level of testing and result in the earlier detection of eye diseases inpatients with diabetes.

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 andneurovascular disease. To date, our primary focus has been on the diagnosis ofneuropathies. We also believe that our core technology can be adapted andextended to provide minimally invasive approaches to treating neuropathies.During the first half of 2007, we expect to enter the clinical stage ofdevelopment of a drug delivery system to enable a broad base of primary careand specialist physicians to provide this type of minimally invasive neuropathytherapy at the point-of-service. We recently obtained an exclusive sales andmarketing license to the DigiScope product for the diagnosis of diabeticretinopathy and launched our sales and marketing efforts for this product inthe first quarter of 2007. We have built a sales force of over fifty regionalsales managers and we may search for additional products that can be sold tothe primary care physician and endocrinologist market by this direct salesforce through licensing or acquisition opportunities.

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 over 4,900 physician’s offices, clinics and otherhealth care facilities. EyeTel Imaging, Inc. (“EyeTel”), the manufacturerof the DigiScope, for which we have an exclusive sales and marketing licensefor the U.S. primary care physician and endocrinologist market, has received a510(k) clearance from the FDA for this product. We hold issued utilitypatents covering a number of important aspects of our NC-stat System. In 2006,we increased our revenues from the prior year by 61.1%, generating$55.2 million in revenues, compared with $34.3 million in 2005. Ourgross margin percentage in 2006 was 75.5%, and 86.4% of our revenues wereattributable to sales of the disposable biosensors that physicians use toperform tests with our NC-stat System. We recorded net income of approximately$4.3 million in 2006 and $249,000 in 2005 and incurred a net loss ofapproximately $4.7 million in 2004. Since our inception, more than 750,000patients have been tested with the NC-stat System.

**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 ametabolic disturbance that results in widespread damage to nerves throughoutthe body. The most common clinical conditions associated with neuropathiesinclude:

·       *Diabetes.* Diabetes is a disease in whichthe body either does not produce sufficient quantities of insulin or does notproperly use insulin. Insulin is a hormone that is needed to convert sugar,starches and other food into energy needed for daily body function. Diabetesoften results in a high level of glucose in the blood, called hyperglycemia.Chronic hyperglycemia is associated with complications of diabetes includingnerve, eye and kidney disease. The most common form of diabetes-related nervedisease is a systemic neuropathy called diabetic peripheral neuropathy, or DPN.The symptoms of DPN include impaired sensation or pain in the feet and hands.The ADA currently estimates that 60% to 70% of people with diabetes areaffected by DPN, although a majority of these individuals are unaware of theirnerve disease because they have no symptoms. Clinical studies have demonstratedthat nerve conduction studies can detect DPN in cases where symptoms are notpresent. DPN, if left undiagnosed and unmanaged, can result in the developmentof lower extremity ulcers and, in severe cases, amputation. It is estimated bythe ADA that over 

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75% of all footamputations are in patients with diabetic peripheral neuropathy. Otherneuropathies may be present in as many as 30% of patients with diabetes,including carpal tunnel syndrome, radiculopathy and chronic inflammatorydemyelinating polyneuropathy, or CIDP.

·       *Low back pain.* Low back pain can have manycauses. When low back pain has a neurological source, it is often focal innature and associated with pain that radiates from the lower back region intothe leg, called sciatica. In some cases, the patient may also experience lossof sensation and weakness in the lower leg. In advanced cases, these symptomscan become disabling. The symptoms result from pressure on the nerve roots, theprecursors of the nerve, as they exit the spine. The source of the pressure isusually part of an intervertebral disc that is displaced from its normallocation between the vertebral bodies. These disorders are often calledherniated or ruptured discs.

·       *Carpal tunnel syndrome.* Carpal tunnelsyndrome, or CTS, is caused by swelling of the tendons that traverse the wristalongside the median nerve. The swollen tendons compress the median nerve,resulting in damage to the nerve that leads to numbness in the first threefingers of the hand, weakness in the thumb, and occasionally wrist and handpain. CTS is the most common focal neuropathy.

·       *Other medical conditions associated withneuropathies.* Common chronic disorders such as obesity; rheumatoidarthritis; and spinal stenosis, or narrowing of the spinal canal; are commonlyassociated with neuropathies. In these complicated cases, it is particularlyimportant for the physician to confirm or exclude neuropathies in order todevelop effective treatment programs.

·       *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.

**Limitations ofTraditional Methods for Detecting Neuropathies**

Neuropathies havetraditionally been evaluated using clinical and diagnostic methods but thereare limitations to these methods. The clinical examination is qualitativerather than quantitative, it is subjective and it does not often detectpre-clinical or early stage disease. Traditional nerve conduction studies andNCS/nEMG procedures are performed under a referral to a neurologist and thisreferral process can result in delays and inconvenience for the patient, higherexpense and loss of control of the patient’s care by the referring physician. Traditionalprocedures are complex and are therefore only performed by a small number ofphysicians, such as neurologists and the testing is therefore not generallywidely available. In addition, traditional procedures may be painful if an nEMGprocedure is involved since the physician will insert needles into the patient’smuscles often in close proximity to the site of pain.

**NeuroMetrixSolution/NC-stat System**

The NeuroMetrixpoint-of-service neurodiagnostic solution is known as the NC-stat System. TheNC-stat System is comprised of: (1) disposable single use biosensors thatare placed on the patient’s body; (2) the NC-stat device 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 diagnosis. The NC-statSystem enables the physician to make rapid and accurate diagnoses that arecost-effective for the patient and third-party payer.

·       *Biosensors.* The biosensors are single use,self-adhesive, nerve-specific, electrode devices that are placed on the bodyand connected to the NC-stat device. Through the use of a specialized gel and adigital thermometer, both of which are contained within the device, biosensorsconvert nerve signals 

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to electronic data thatcan be received and displayed by the NC-stat device. Currently, we sellbiosensors for assessment of nerve function in the median and ulnar nerves inthe upper extremities for the diagnosis of carpal tunnel syndrome and forassessment of the nerve function in peroneal, tibial and sural nerves in thelower extremities for the diagnosis of diabetic peripheral neuropathy and lowback conditions.

Thebiosensors are designed to be positioned according to common anatomicallandmarks with a configuration that facilitates correct placement. We designedthe biosensors so that they could be easily and quickly applied with minimaltraining by members of a physician’s clinical staff. The biosensors are encodedwith a unique electronic serial number, which allows us to track each biosensorthroughout the manufacturing, shipping and end-use stages. The biosensors alsoare electronically inactivated after use, thus preventing re-use. Thisinactivation is essential since prior use of the biosensor adhesive andspecialized gel would significantly degrade the quality of the measurements. Ina typical nerve conduction study, multiple nerves are evaluated and multiplebiosensors are used according to general guidelines established by the Centerfor Medicaid and Medicare Services, or CMS, and physician associations.

·       *NC-stat device.*The NC-stat device isdesigned for efficient and easy use by the physician or a member of thephysician’s clinical staff. The NC-stat device can only be operated with ourbiosensors. This instrument, which is lightweight and slightly larger than acordless telephone, customizes and calibrates the test for each patient,analyzes neurophysiological signals collected from the biosensor and displaysthe pertinent results on an LCD screen immediately at the conclusion of eachnerve conduction 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 device 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 device and the biosensors. A third generation diagnostic device, which weplan to market under the name ADVANCETM, is currently in development and isexpected to be introduced during 2007.

·       *NC-stat docking station and onCall InformationSystem.*The NC-stat docking station is an optional device thatautomatically transmits data from the NC-stat device via any availabletelephone line, such as those used by facsimile machines, to the onCallInformation System that we maintain. The docking station has its own datastorage so it does not lose data if the telephonic connection to the onCallInformation System cannot be established for some time or is disrupted duringtransmission. The data is automatically processed by the onCall InformationSystem and stored in a central database, and a detailed computer generatedreport is created for each patient that is then sent to the physician via facsimileor e-mail in three to four minutes on average. The report includes the rawwaveform data, comparisons to an age- and height-adjusted normal rangepopulation, study reference table and text summaries of the study, whichfacilitate rapid and accurate diagnosis by the physician examining the patient.Although the study data presented in the onCall report can be generatedmanually by the physician using the numerical measurements displayed by theNC-stat device, the report is a convenient and fast adjunct. Whether using theinformation from the onCall report or the NC-stat device display, the actualclinical interpretation of the NC-stat System results is always performed bythe physician ordering the study. The onCall Information System can also providedaily, monthly and quarterly reports to customers. These reports provideassistance in correct submission for third-party reimbursement and assist intracking overall clinical utilization. The onCall Information System generallyis available 24 hours per day, seven days per week. Although purchase ofthe NC-stat docking station and utilization of the onCall Information Systemare entirely optional, we believe substantially all of our customers use thissystem in all studies they 

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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.

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. Ourproprietary technology provides physicians with an in-office diagnostic systemthat 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 studiesat the point-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, including primary care and specialistphysicians. By allowing nerve conduction studies to be performed in the primarycare or specialist physician’s office, the patient can avoid the expense andinconvenience of a referral visit to a neurologist. Additionally, the NC-statSystem enables primary care and specialist physicians to retain greater controlover their patients by eliminating the need to refer them out for a traditionalNCS/nEMG procedure.

·       *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. As thecost to third-party payers for nerve conduction studies is typically based onthe 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 fournerves, whereas a nerve conduction study for the same indication performed by aneurologist upon referral could involve the testing of six nerves or more. Whenan nEMG procedure is also performed, the cost can be even higher.

·       *Requires minimal capital investment.* Wesell the NC-stat System, with equivalent technical specifications to the moreexpensive traditional instruments, for under $6,000, compared with $15,000 to$40,000 for the cost of traditional NCS/nEMG equipment. We believe the lowercapital cost of the NC-stat System will aid in the expansion of nerveconduction studies beyond neurologist offices.

·       *Simple to operate.* The biosensors aredesigned for ease in placement, which allows a wide range of physician officepersonnel to administer the technical portion of the study under thesupervision of a physician. The NC-stat device utilizes software algorithmsthat perform each step of a nerve conduction study in a reliable manner, withembedded automation technology that addresses and minimizes the technicaltraining requirements for performing nerve conduction studies, while alsoensuring that the end diagnostic result is accurate and reliable. We believethat, in combination, these features allow accurate and reliable nerveconduction studies to be performed in 15 to 30 minutes on average.

·       *Patient-friendly, non-invasive procedure.*The NC-stat System allows for reduced patient discomfort during the nerveconduction study by minimizing the magnitude of the electrical stimulus to thenerve via a proprietary patient-specific calibration procedure. In most cases,the sophisticated signal 

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processing andautomation capabilities of the NC-stat System provide sufficient diagnosticinformation to eliminate the need for an NCS/nEMG procedure. This saves thepatient the discomfort, stress and risk of this invasive procedure.

**NeurovascularDisease**

Diabetic retinopathy is a neurovascular disease and isone of the most serious complications of diabetes. Diabetic retinopathy is theleading cause of blindness in adults age 20 to 65. Microvascular complicationscaused by diabetes can lead to retinopathy and if untreated can result invision loss and even blindness. Twenty years after diagnosis nearly all patientswith Type I diabetes have some degree of diabetic retinopathy and 60% of allpatients with Type II diabetes have some degree of retinopathy, even thoughmany may not have symptoms.

Over time, diabetes affects the circulatory system ofthe retina. The earliest phase of the disease is known as background diabeticretinopathy. In this phase, the arteries in the retina become weakened andleak, forming small, dot-like hemorrhages. These leaking vessels often lead toswelling or edema in the retina and decreased vision. The next stage is knownas proliferative diabetic retinopathy. In this stage, circulation problemscause areas of the retina to become oxygen-deprived, or ischemic. New, fragile,vessels develop as the circulatory system attempts to maintain adequate oxygenlevels within the retina. This is called neovascularization. Unfortunately,these delicate vessels hemorrhage easily. Blood may leak into the retina andvitreous, causing spots or****floaters,along with decreased vision. In the later phases of the disease, continuedabnormal vessel growth and scar tissue may cause serious problems such as****retinal detachment and glaucoma. Ultimately,if untreated, diabetic retinopathy can lead to loss of vision or blindness.

The traditional approachto the detection of retinopathy in patients with diabetes is a referral to aneye specialist, such as an ophthalmologist, for an assessment. In spite of therecommendation by the ADA that all patients with diabetes have an annualdilated eye examination, only approximately 50% of these patients are actuallycomplying and being tested on an annual basis. Treatments such as laser surgeryare available for patients diagnosed with diabetic retinopathy and the earlierthe condition is detected the more likely a favorable outcome.

**The DigiScope**

The DigiScope wasdeveloped by EyeTel in clinical partnership with the Wilmer OpthalmologicalInstitute at Johns Hopkins for the risk assessment of retinopathy. TheDigiScope has a fully integrated digital fundus camera which allows for thecapture of high quality dilated retinal images in approximately ten minutes. Thetest is performed in the primary care physicians’ or endocrinologists’ officeand the images obtained are sent electronically to the Wilmer EyeTel ReadingCenter and are read by retinal specialists. The results are reviewed by thephysician and a referral will be made to the eye specialist, such as anophthalmologist, if clinically relevant abnormalities are detected. The testusing the DigiScope can be easily administered by the physician’s clinicalstaff under the supervision of the physician and requires minimal training. TheDigiScope system is self-prompting, has a touch screen and audible cues forsimple operation. The DigiScope examination is acceptable as an annual diabeticeye examination under the Health Plan Employer Data and Information Set (“HEDIS”)2004 technical specifications.

**Market Opportunity**

*NC-stat System*

The sensitivity of thenervous system to metabolic and mechanical damage, compounded by its limited regenerativeability, creates a market opportunity for a medical device that can assist inpoint-of-service diagnoses of neuropathies in a manner that is cost-effectivefor the patient and third-party payer. We 

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believethe ease of use, accuracy and convenience provided by the NC-stat Systemposition it to become a standard of care for the assessment of neuropathies atthe point-of-service. We believe that the availability of point-of-servicenerve conduction 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 toinclude DPN and low back pain, as well as other indications. CTS representedapproximately 40% of total nerve conduction testing by our customers in 2006,while DPN and low back pain represented approximately 27% and 33%, respectively.We anticipate that our future growth will be generated mainly from lowerextremity testing for DPN and low back pain. Based on our analysis of currentpatient data, we estimate that the potential for point-of-service nerveconduction studies in the diabetes, low back pain and carpal tunnel syndromemarkets in the aggregate could be greater than 9.5 million annual patienttests, estimated to be more than $1.0 billion annually for our disposablebiosensors, in the United States. However, market size is difficult to predict,and we cannot assure you that our estimates will prove to be correct. Webelieve that additional applications of a point-of-service product offeringsuch as the NC-stat System, including the clinical assessment of patients withneuropathies caused by or associated with other clinical disorders, couldfurther increase this potential market size. Additionally, although we have notyet quantified the size of the market, we believe a potential internationalmarket opportunity exists for the NC-stat System.

*DigiScope*

The high level of incidence of diabetic retinopathyand its serious complications creates a market opportunity for a device thatcan be used by primary care physicians and endocrinologists at the point ofcare for the early detection of diabetic retinopathy. There are estimated to be21 million people in the United States with diabetes and this total is expectedto grow. Diabetic retinopathy is the leading cause of blindness in adults age20 to 65. Twenty years after diagnosis nearly all patients with Type I diabeteshave some degree of diabetic retinopathy and 60% of all patients with Type IIdiabetes have some degree of retinopathy, even though many may not havesymptoms. The ADA recommends an annual dilated eye examination for all patientswith diabetes. In spite of this recommendation, only approximately 50% ofpatients with diabetes actually receive an annual eye examination. This createdan opportunity for such testing to be performed in the primary care physicianor endocrinologist office since these patients are routinely seeing theirprimary care physician or endocrinologist.

**Market Size**

We estimate thatthere are approximately 2.0 million traditional NCS/nEMG procedures currentlyperformed each year in the United States*.*Thisestimate is based on (1) data from a CDC report in 1996 regarding NCS/nEMGprocedures ordered or performed during ambulatory patient visits and(2) data from a 2001 CMS report regarding Medicare reimbursement underCurrent Procedural 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 

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States was estimated to be21.0 million, or 7.0% of the population. Among this group, approximately6.0 million were undiagnosed. According to the CDC, there are about26 million annual patient visits to office-based physicians for diabetes.We anticipate that the increasing focus on early detection and prevention ofthe chronic complications of diabetes will lead to increased nerve conductionstudies for DPN. We believe that the estimated 50% rate of annual footexaminations in patients known to have diabetes is a reasonable estimate forthe addressable testing market in diabetes. If these examinations were replacedby a nerve conduction study, or a nerve conduction study were added to theexamination, the diabetes arena would represent an opportunity for over sixmillion annual NC-stat System patient tests. The number of Americans withdiabetes is projected to more than double over the next 40 to 50 years. Atthe present time, there are no currently marketed pharmaceuticals targetedspecifically at DPN, and therefore nerve conduction studies are performed on aselective basis in order to address specific clinical issues. If a targetedtherapy for DPN were successfully developed and marketed, we believe the rateof testing would further increase. Based on current clinical trial activity, weanticipate that drugs for the treatment of DPN will eventually become availablein the marketplace, accelerating the need to detect DPN at its earliest stagesto allow 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 commonmedical conditions 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, rheumatoid arthritisand 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 are performedannually for CTS. The surgical procedure is called a carpal tunnel release, orCTR. Most third-party payers require a nerve conduction study prior toauthorizing 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 high associationwith CTS such as rheumatoid arthritis, diabetes and obesity. We also anticipatethat the high costs of CTS-related workers’ compensation claims could motivateemployers to increasingly use a point-of-service product offering such as theNC-stat System to pre-screen and monitor employees for CTS.

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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 estimate that the potential market forNC-stat System could be more than $1.0 billion annually in the UnitedStates.

We estimate that the size of the market for apoint-of-service product such as DigiScope for the detection of diabeticretinopathy could be nearly $700 million. There are estimated to be 21 millionpeople in the United States with diabetes and it is estimated that 15 millionhave actually been diagnosed with diabetes. Using an eye examination fee of $45per patient, this represents a potential market size of nearly $700 million.

Market size is difficultto predict, and we cannot assure you that our estimates will prove to becorrect. We believe that additional applications of a point-of-service productofferings such as the NC-stat System and the DigiScope, including the clinicalassessment of patients with neuropathies caused by or associated with otherclinical disorders, could further increase this market size. Additionally, althoughwe have not yet quantified the size of the market, we believe a potentialinternational market opportunity exists for the NC-stat System. The potentialmarket opportunity is dependent on a number of factors including favorablereimbursement by third-party payers. There are no assurances that third-partypayers will reimburse for an increasing level of nerve conduction studies atpresent levels or at all.

**Clinical Studiesand Clinical Validation**

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 & Environmental Medicine*,the September 2000 issue of*Neurologyand Clinical Neurophysiology*, and the May 2004 issue of the*Journal of Hand Surgery*, the correlationbetween the results generated by the NC-stat System and traditional nerveconduction studies in measuring nerve function of 198 patients was examined.The correlation was equivalent to that found between different neurologistsperforming traditional nerve conduction studies.

·       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 *AmericanJournal of Orthopedics*, the clinical utility of the NC-stat Systemwas assessed in 72 patients with carpal tunnel syndrome. The NC-stat System wasfound to have a high correlation with traditional laboratory testing. TheNC-stat System also measured statistically significant improvement in mediannerve function six months following carpal tunnel release surgery.

·       Ina study published in the August 2006 *DiabetesCare*, the NC-stat System was shown to be comparable to conventionalnerve conduction testing in a group of 72 patients with diabetes tested fordiabetic peripheral neuropathy.

·       Ina study published in the December 2006 *DiabetesTechnology and Therapeutics*, the use of the NC-stat System in 1,400patients with diabetes in 28 primary care/endocrinology clinics was assessed ina prospective open-label study. The NC-stat System identified nerve conductionabnormalities in 75% of patients, and over 50% had results suggestive ofdiabetic polyneuropathy. The NC-stat 

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System identifiedmeaningful levels of neuropathy in patients within ADA recommended bloodglucose control and in those newly diagnosed with diabetes.

·       Ina study published in the January 2007 *PhysiologicalMeasurements,* the validity of NC-stat System lower extremity nervemeasurements was assessed in 60 patients referred to a Veterans Administrationelectrodiagnostic laboratory. The authors concluded “This study shows that thetechnology used by the NC-stat System for studying the peroneal and posteriortibial nerves compares favorably . . . . with that obtained withtraditional EMG equipment used under neurologist supervision.”

·       Inthe January-February 2007*Journal ofthe American Board of Family Medicine*, a retrospective blinded studyof NC-stat System utilization by 613 family medicine, primary care, andinternal medicine physician practices was conducted. Over a two-week period1,190 patients underwent NCS for evaluation of CTS. A total of 31% of testedlimbs yielded normal results, 53% indicated CTS, and the remaining studiesidentified other neuropathies. The authors concluded “This study demonstratedthat point-of-service NCS by physicians for CTS was applied to appropriatepatient subpopulations, was performed in accordance with evidence-based testingparameters, and generated relevant diagnostic outcomes.”

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.

The performance ofthe DigiScope has been validated in clinical studies, the results of which havebeen published in peer-reviewed medical journals as highlighted below.

·       Ina study published in the May 2002 issue of *Investigational Ophthalmology and Visual Science*, theconclusions drawn were that “the DigiScope fulfills the instrumentalrequirements for a practical and cost-effective tool to acquire data needed toidentify diabetic patients who must be referred to an eye care specialist.” Thestudy further concluded that the “DigiScope may help reduce the risk of visionloss in . . . . individuals who currently do not undergo anannual eye examination.”

·       In a study of over 2,700patients published in a 2006 issue of *Telemedicineand e-Health,*the conclusions were that the “DigiScope can be usedin the primary care setting to identify patients with diabetes not currentlyunder the care of an eye specialist who require referral to an ophthalmologistfor evaluation and management of retinopathy.”

**Customers**

We market our products directly to primary care andspecialist physicians. The NC-stat System provides primary care physicians andother physicians including orthopedic surgeons, endocrinologists,rheumatologists, and pain medicine 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 aproduct that can potentially improve the care of their patients and with apotential new source of revenues. As of December 31, 2006, we had over4,900 active customers. No single customer accounted for more than 10% of ourrevenues in 2006, 2005 or 2004.

Currently, there areapproximately over 100 customers using the DigiScope, primarily representingthe existing customer base of EyeTel at the time we signed an exclusive salesand marketing license with them for the sale of the DigiScope into the U.S.primary care and endocrinologist market. We launched our sales and marketingefforts for this product in the first quarter of 2007.

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**GeographicInformation**

All of our assets,revenues and expenses for the years ended December 31, 2006, 2005 and 2004were located at or derived from operations in the United States.

**Sales, Marketingand Distribution**

Currently, we employ 53 regional sales managers and 5sales directors who sell directly to physician practices and also manage theactivities of more than 100 independent regional sales agencies employing atotal of more than 1,200 independent sales agents. The independent salesagencies we work with include small to medium sized regional firms as well asnational firms such as Physician Sales & Service (“PS&S”) andHenry Schein, Inc. (“Henry Schein”.) The majority of the 1,200 independentsales agents are employed by PS&S and Henry Schein. At present, ourproducts are marketed and distributed solely within the United States. Weselect our sales agencies based on their expertise and experience calling onprimary care or specialist physicians, their reputation within the targetedphysician community and their sales coverage. Each sales agency is assigned asales territory for the NC-stat System and is subject to periodic performancereviews. Typically, our independent sales representatives identify potentialcustomers for us and assist in monitoring our existing customer accounts, andour regional sales managers complete sales to these customers. Our independentsales agencies do not act as distributors of our products.

We recently launched our sales and marketing effortsfor the DigiScope product for the detection of diabetic retinopathy. Thisproduct will be sold directly to primary care physicians and endocrinologistsby our regional sales managers who are also selling the NC-stat System. We donot intend to use our independent sales agency network for the DigiScopeproduct. Our initial target market for the DigiScope will be our installed baseof NC-stat System customers. We obtained an exclusive sales and marketinglicense to the DigiScope from EyeTel in the fourth quarter of 2006.

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.

We market our products directly to primary care andspecialist physicians. The NC-stat System provides primary care and specialistphysicians, 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 product that can potentially improve thecare of their patients and with a potential new source of revenues. We believethat there are important marketing advantages of the NC-stat System. TheNC-stat System can potentially accelerate the diagnosis of neuropathies byallowing primary care and specialist physicians to perform a nerve conductionstudy at the point-of-service rather than having to make a referral to aneurologist. We also market our products at various industry conferences inorder to accelerate the market awareness of our products, our customer accrualefforts and market adoption for our products.

We generally invoice products purchased by ourcustomers directly to physician offices and other customers. We currently havea relationship with one distributor that directly invoices the physicianpractice and we invoice the distributor at list price less a negotiateddiscount. With the exception of the DigiScope, we ship all products directly tothe customer even in cases where we are selling through a distributor. TheDigiScope is manufactured and shipped by EyeTel while we are responsible for 

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installation, training andservice. 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.

Our success is highlydependent on our ability to maintain our direct sales force and independentsales agency network. We may be unable to enter into agreements with additionalqualified independent sales agencies and representatives on commerciallyreasonable terms or at all and we may not be successful in maintaining theexisting sales and marketing infrastructure we have developed. Even if we areable to enter into agreements with additional independent sales agencies, theseparties may not commit the necessary resources to effectively market and sellour products or ultimately be successful in selling our products. Promotion andsales of medical devices are also highly regulated not only by the FDA, butalso by the Federal Trade Commission, and are subject to federal and statefraud and abuse enforcement activities.

**Manufacturing andSupply**

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. Wedid not experience any significant inventory shortages on any establishedproducts in 2006. We occasionally experience transient inventory shortages,typically lasting less than one month, on new products during the initialproduction ramp-up phase. If our third-party manufacturers are unable tomanufacture our products to keep up with demand, we would not meet expectationsfor growth of our business.

Parlex Polymer Flexible Circuits, Inc., which waspreviously known as PolyFlex Circuits, Inc., a wholly owned subsidiary ofthe Parlex Corporation, or Parlex, has been manufacturing NC-stat biosensorssince early 1999. In August 2006, we entered into a mutually exclusivemanufacturing and supply agreement with Parlex pursuant to which Parlex willmanufacture and supply to us, and we will purchase from Parlex, at agreed uponprices per unit, all of our requirements of biosensors for resale in the UnitedStates. Under the agreement, Parlex has agreed not to manufacture biosensors tobe used to measure nerve conduction for any other company during the term ofthe agreement and, in some cases, for a period of one year thereafter. Eitherparty may terminate the agreement at any time upon not less than 18 months’prior written notice, provided that neither party may terminate the agreementprior to August 2, 2008. Parlex manufactures our biosensors at a facilityin Massachusetts and is in the process of validating manufacturing of ourbiosensors at a second site located in the U.K.

Sunburst EMS, Inc., or Sunburst, has beenmanufacturing our NC-stat monitors and docking stations since November 2005.We signed a formal supply agreement with Sunburst during 2006 for the continuedmanufacturing and supply of our diagnostic devices. Sunburst manufactures thecurrent generation of the 

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NC-stat diagnostic devicesat a facility in Massachusetts and they are producing the initial productionruns of the ADVANCE System.

The DigiScope is manufactured by EyeTel, the company fromwhich we obtained an exclusive sales and marketing license for the sale of theDigiScope to the primary care physician and endocrinologist market.

We and our third-partymanufacturers are registered with the FDA and subject to compliance with FDAquality system regulations. We are also ISO registered and undergo frequentquality system audits by European agencies. Our products are cleared for marketwithin the United States and Canada, and are also approved for distribution inthe European Union, although to date we have sales only in the United States.Our facility and the facilities of our manufacturers are subject to periodicunannounced inspections by regulatory authorities, and may undergo complianceinspections conducted by the FDA and corresponding state agencies. We wereinspected by the FDA in May 2003. During its inspection, the FDA issued a Form 483,which is a notice of inspection observations. Two minor items were identifiedand the corrective actions for both were initiated prior to the completion ofthe audit. The responses provided to the FDA were deemed adequate and nofurther action has been requested. As a registered device manufacturer, we andour manufacturers will undergo regularly scheduled FDA quality systeminspections; however, additional FDA inspections may occur if deemed necessaryby the FDA.

**Products UnderDevelopment and Research and Development**

Our research anddevelopment efforts are focused in the near term on further enhancing ourexisting products, which includes developing the ADVANCE System and developingnew biosensors, as well as designing a drug delivery system for the minimallyinvasive treatment of neuropathies by both primary care and specialistphysicians. Our research and development staff consists of 26 people, including6 who hold Ph.D. degrees. Our research and development group has extensiveexperience in neurophysiology, biomedical instrumentation, signal processing,biomedical sensors and information systems. These individuals work closely withour marketing group, our clinical support group (led by a board-certifiedneurologist), our scientific advisors and our customers to design products thatare intended to improve clinical and economic outcomes.

*Devices for theTreatment of Neuropathy*

In pursuit of our objectiveto develop medical devices that provide comprehensive solutions for thediagnosis and treatment of patients with neuropathies, we are seeking to expandour product base beyond the diagnostic and into the treatment arena. We believethat our core technology can be adapted and extended to provide minimallyinvasive approaches to treating neuropathies. In particular, we believe thatneuropathies that are focal, or localized, in nature can be safely andeffectively 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.During the first half of 2007, we expect to enter the clinical stage ofdevelopment of a drug delivery system to enable a broad base of primary careand specialist physicians to provide this type of minimally invasive neuropathytherapy at the point-of-service.

*NCS/nEMG Systems*

We have an ongoing program of making enhancements andimprovements to the NC-stat System. We are developing new biosensors andassociated software for the medically appropriate testing of additional nerves.We have also developed a third generation diagnostic device, the ADVANCESystem, that will 

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allow our customers toperform more complex analyses of diagnostic data. We submitted a 510(k) filingto the FDA in the first quarter of 2007 for the ADVANCE System.

The ADVANCE Systemhas a number of important innovations and features:

·       Keytechnical and engineering specifications that we believe meet those of otherelectrodiagnostic devices on the market.

·       Signalprocessing algorithms that provide physicians with high quality and detailednerve conduction data to incorporate into their diagnostic assessment. We havefiled two patents on these algorithms.

·       Auser interface consisting of a high resolution color touch screen that allowsphysicians and their clinical staff to conduct accurate nerve conductionstudies and other electrodiagnostic tests in a straightforward manner. Consistentwith the current NC-stat System, this user interface provides for real-timedata review including waveforms.

·       Compatibilitywith existing biosensors and with new nerve conduction biosensors that wedevelop in the future.

·       TheADVANCE System will also support the performance of nEMG studies.

NEUROMetrix®, NC-stat®, ADVANCETM and onCallTMare trademarks of ours.

During 2006, 2005 and2004, we spent $5.0 million, $3.8 million and $3.3 million, respectively, onresearch and development.

**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. Xltec launched a product forthe point-of-service nerve conduction studies market in 2006 and subsequentlyannounced that they were withdrawing this product from the market. We are awareof one additional company, Neumed Inc., that markets a nerve conductionstudy system to the point-of-service market.

We believe that among systems marketed for theperformance of nerve conduction studies today, only the NC-stat System providesthe level of diagnostic accuracy, the level of automation and the ease of userequired for successful penetration of the point-of-service market. We alsobelieve that the reporting and data repository functions provided by the onCallInformation System, although entirely optional, provide our customers who usethis service with added 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.

Currently, we believe thatour most direct competitors are certain specialist physicians, such asneurologists, who perform traditional nerve conduction studies and may view theNC-stat System as competitive with or a threat to their business. Because ofthe level of automation and the ease of use of the NC-stat System, the NC-stat Systemfacilitates the performance of nerve conduction studies within the 

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officesof a wider range of physicians. Accordingly, neurologists, including aprofessional society representing a subset of neurologists who most frequentlyperform traditional nerve conduction studies, have competed and may continue tocompete with us by advancing positions that are adverse to the NC-stat System.We believe this competition has come, and is most likely to continue to come,through the advancement of positions challenging the effectiveness and accuracyof the NC-stat System and the ability of non-specialist physicians to performnerve conduction studies and accurately diagnose neuropathies. Becausespecialist physicians and professional societies may be viewed as authoritative,without regard to their potential economic motives, and may have connections toor influence with various regulatory bodies and third-party payers, they mayhave a competitive advantage over us and their positions may lead to or bereflected in actions taken by these regulatory bodies and third-party payersthat are adverse to our business. In this respect, we seek to respond to thesepositions by supporting and making reference to past and future clinicalstudies substantiating the effectiveness of the NC-stat System, including thosedescribed above in the section titled “—Clinical Studies and ClinicalValidation.”

**IntellectualProperty**

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.

*Patents*

As ofDecember 31, 2006, we had 12 issued U.S. patents, 7 issued foreign patentsand 45 pending patent applications, including 23 U.S. applications, 1International PCT application and 21 foreign national applications. We alsohold an exclusive license to 2 issued U.S. patents and 2 issued foreignpatents. The issued and pending patents that we own and license cover, amongother 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.

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The medical deviceindustry is characterized by the existence of a large number of patents andfrequent litigation based on allegations of patent infringement. Patentlitigation can involve complex factual and legal questions, and its outcome isuncertain. Any claim relating to infringement of patents that is successfullyasserted against us may require us to pay substantial damages. Even if we wereto prevail, any litigation could be costly and time-consuming and would divertthe attention of our management and key personnel from our business operations.Our success will also depend in part on our not infringing patents issued toothers, including our competitors and potential competitors. If our productsare found to infringe the patents of others, our development, manufacture andsale of these potential products could be severely restricted or prohibited. Inaddition, our competitors may independently develop similar technologies.Because of the importance of our patent portfolio to our business, we may losemarket share to our competitors if we fail to protect our intellectual propertyrights.

As the number of entrantsinto our market increases, the possibility of a patent infringement claimagainst us grows. Although we have not received notice of any claims, and arenot aware that our products infringe other parties’ patents and proprietaryrights, our products and methods may be covered by U.S. patents held by ourcompetitors. In addition, our competitors may assert that future products wemay market infringe their patents.

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 to obtainany licenses required under any patents or proprietary rights of third partieson acceptable terms, or at all. Even if we were able to obtain rights to thethird-party’s intellectual property, these rights may be non-exclusive, therebygiving our competitors access to the same intellectual property. Ultimately, wemay be unable to commercialize some of our potential products or may have tocease 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 salesvolumes and prices of our products will continue to be dependent in large parton the availability of reimbursement for our customers from third-party payersand on policies issued by governmental agencies. Third-party payers includegovernmental programs such as Medicare and Medicaid, private insurance plans,and workers’ compensation plans. These organizations may deny coverage andrefuse reimbursement for a diagnostic procedure or specific product such as theNC-stat System if they determine that the diagnostic test or product was notmedically appropriate, reasonable or necessary. Tests will be considered notmedically reasonable or necessary if they are deemed “investigational” (i.e.there is insufficient evidence of efficacy or accuracy.) The third-party payersmay also place limitations on the types of physicians that can perform specifictypes of diagnostic procedures. Also, third-party payers are increasinglychallenging the prices charged for medical products and services. Ininternational markets, reimbursement and healthcare payment systems varysignificantly by country, and many countries have instituted payment ceilingson specific product lines and procedures. We cannot assure you that proceduresusing our products will be considered medically reasonable and necessary for aspecific indication, that our products will be considered cost-effective bythird-party payers, that procedures performed using our products will bereimbursed as separate procedures under existing CPT 

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codes,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 thereimbursement decision by most private insurers and CMS, which administersMedicare, is the assignment of a CPT code. This code is used in the submissionof claims to insurers for reimbursement for medical services. CPT codes areassigned, maintained and revised by the CPT Editorial Panel administered by theAmerican Medical Association, or AMA. According to present Medicare guidelines,nerve conduction studies must be performed or supervised by medical doctors, orM.D.s, and doctors of osteopathic medicine, or D.O.s, and are reimbursableunder the three CPT codes: 95900, 95903, and 95904. We believe that the nerveconduction measurements performed by the NC-stat System meet the requirementsstipulated in the code descriptions published by the AMA and that these codesare currently used by physicians to obtain reimbursement for the performance ofnerve conduction studies with the NC-stat System, except, as described below,in cases where they are seeking reimbursement from Medicare in a jurisdictionwhere the local insurance carrier processing Medicare claims has determinedthat physicians must submit these claims using a miscellaneous CPT code (95999).If the CPT codes that apply to the procedures performed using our products arechanged, or determined not to apply to tests performed with the NC-stat System,reimbursement for performances of these procedures may be adversely affected.

For Medicare, there aresixteen organizations serving as local insurance carriers that on behalf ofMedicare process claims submitted by physician practice groups and otherhealthcare providers and establish what are called local coveragedeterminations, or LCDs. In the absence of a position issued by Medicare at thenational level, the LCDs issued by these local insurance carriers govern thereimbursement of procedures performed using medical devices such as the NC-statSystem. During the second half of 2006 and early 2007, five local Medicarecarriers covering a total of twenty states issued draft LCDs, final LCDs orcoding articles particularly addressing coverage and reimbursement policies underMedicare for nerve conduction studies performed using the NC-stat System. Severalof these carriers indicated that they will not reimburse physicians underMedicare for nerve conduction studies performed using the NC-stat System underthe three existing CPT codes for conventional nerve conduction studies (95900,95903 and 95904), which provide for levels of reimbursement fixed by CMS, butrather that physicians must submit claims for reimbursement for theseprocedures under a miscellaneous CPT code (95999), in which case the localcarriers may determine the level of reimbursement to be paid, if any. We do notknow what success our customers will have in obtaining reimbursement under themiscellaneous code or what level of reimbursement they may receive if they aresuccessful. If physicians do not receive adequatereimbursement under the miscellaneous CPT code from those local carriers, ourexisting customers may limit or curtail their use of the NC-stat System and wemay be unable to obtain new customers, both of which could materially andadversely impact our revenues and profitability. The AMA CPT EditorialPanel has formed a committee which is expected to examine the reimbursementcoding of automated nerve conduction studies, including the NC-stat System andother electrodiagnostic equipment from additional manufacturers. The findingsof this committee may affect which CPT codes Medicare carriers and commercialpayers require from physicians who perform procedures with the NC-stat System.Additional third-party payers, including local Medicare carriers and commercialpayers, could potentially take a position that could reduce or eliminate thereimbursement for the NC-stat System. These payers may also impose requirementson physicians to submit additional paperwork supporting the medical necessityof nerve conduction studies performed using the NC-stat System. Suchrequirements could potentially impact the use of the NC-stat System and couldpotentially have an adverse impact on our revenues.

Additionally, the LCDs andcoding articles issued by local Medicare carriers have also addressed a numberof other issues, including (1) the background and training of physicianssupervising or performing nerve conduction studies; (2) the level oftraining requirements for technicians performing a nerve conduction study; (3) whethernerve conduction tests should be required to be performed concomitantly 

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with annEMG procedure; and (4) whether the NC-stat System is comparable toconventional nerve conduction testing equipment. We do not believe that theseLCDs prohibit physicians from receiving reimbursement under Medicare formedically necessary nerve conduction studies performed using the NC-stat System.However, these LCDs are relatively new and they do appear to be targeted atlimiting access to perform and/or reimbursement for nerve conduction studies. TheseLCDs could be interpreted or implemented in a manner that limits the ability ofphysicians to receive reimbursement under Medicare for nerve conduction studiesperformed using the NC-stat System, which could adversely affect our business.

In the United States, someinsured individuals are receiving their medical care through managed careprograms, which monitor and often require pre-approval of the services that amember will receive. Some managed care programs are paying their providers on aper capita basis, which puts the providers at financial risk for the servicesprovided to their patients by paying these providers a predetermined paymentper member per month, and consequently, may limit the willingness of these providersto use our products.

We believe that theoverall escalating cost of medical products and services has led to, and willcontinue to lead to, increased pressures on the healthcare industry to reducethe costs of products and services. We cannot assure you that third-partyreimbursement and coverage will be available or adequate, 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.

**FDA and Other Governmental Regulation**

*FDA Regulation*

Ourproducts are medical devices subject to extensive regulation by the FDA underthe U.S. Food, Drug, and Cosmetic Act, as well as other regulatory bodies. TheFDA classifies medical devices into one of three classes on the basis of thecontrols deemed necessary to reasonably ensure their safety and effectiveness:

·       Class I,requiring general controls, including labeling, device listing, reporting and,for some products, adherence to good manufacturing practices through the FDA’squality system regulations and pre-market notification;

·       Class II,requiring general controls and special controls, which may include performancestandards and post-market surveillance; and

·       Class III,requiring general 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.

*510(k) Pre-Market Notification Process*

To obtain 510(k) clearance,we must submit a pre-market notification demonstrating that the proposed deviceis substantially equivalent in intended use, safety and effectiveness to alegally marketed Class I or II medical device or to a Class IIIdevice marketed prior to May 28, 1976 for which the FDA has not yetrequired the submission of a pre-market approval application. In some cases, wemay be required to perform clinical trials to support a claim of substantialequivalence. It generally takes three months from the date of submission toobtain 510(k) clearance, but it can be significantly 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 

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companyto make this determination, but the FDA can review the decision. If the FDAdisagrees with a company’s decision not to seek FDA authorization, the FDA mayretroactively require the company to seek 510(k) clearance,*de novo* classification or pre-marketapproval. The FDA also can require the company to cease marketing and/or recallthe medical device in question until 510(k) clearance,*de novo* classification or pre-marketapproval is obtained or take other action.

*De Novo Review Process*

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 Approval Process*

If a medical device doesnot qualify for the 510(k) pre-market notification process and is noteligible for clearance through the*de novo*review process, 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’ssatisfaction through extensive submissions, including pre-clinical and clinicaltrial data, and information about the device, its design, manufacture, labelingand components. 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.

*Post-Approval Obligations*

Aftera device is placed on the market, numerous regulatory requirements continue toapply. These include:

·       theFDA’s Quality System Regulation, or QSR, which requires manufacturers,including third-party manufacturers, to follow stringent design, testing,control, documentation and other quality assurance procedures during allaspects of the manufacturing process;

·       labelingregulations and FDA prohibitions against the promotion of products foruncleared or unapproved uses (known as off-label uses), as well as requirementsto provide adequate information on both risks and benefits;

·       medicaldevice reporting, or MDR, regulations, which require that manufacturers reportto 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 the malfunction were to recur;

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·       post-marketsurveillance regulations, which apply when necessary to protect the publichealth or to provide additional safety and effectiveness data for the device;

·       regular,unannounced, inspections by FDA to review a manufacturer’s facilities and theircompliance with applicable FDA requirements; and

·       the FDA’s recall authority,whereby it can ask, or order, device manufacturers to recall from the market aproduct that is in violation of governing laws and regulations.

*NC-stat System*

The NC-stat System hasreceived six 510(k) clearances as a Class II medical device, thefirst of which was received in 1998, and the most recent (K060584) in August 2006.The NC-stat System has the following intended use, as stated in the most recent510(k) approval:

*“TheNEUROMetrix NC-stat is intended to stimulate and measure neuromuscular signalsthat are useful in diagnosing and evaluating systemic and entrapmentneuropathies.”*

*Furthermore,Section 6 (Basis for Substantial Equivalence) of the 510(k) Summarystates:*

*“Clinicaldata submitted in the 510(k) demonstrates that nerve conductionmeasurements obtained using the NC-stat are comparable to those obtained usingconventional nerve conduction measurement equipment.”*

We believe that thisintended use is consistent with the manner in which the NC-stat System ismarketed and used by our customers.

During the fourth quarterof 2006, we submitted a 510(k) filing for an updated version of the onCallInformation System, and we are currently in the process of responding to arequest for additional information from the FDA related to this filing. Priorversions of the onCall Information System were included in the 510(k) filingsfor the NC-stat System. During the first quarter of 2007, we also submitted a510(k) filing for the ADVANCE System.

*DigiScope*

The DigiScope received a510(k) clearance (K990205) as a Class II medical device in 1999 andthe intended use language is as follows:

*“TheDigiScope is intended to capture and store images of the retina taken by afundus camera. The DigiScope has the same intended use and indications as thepredicate devices, fundus cameras and computer hardware/software intended tocapture, store and transmit images of the fundus.”*

*Manufacturing Facilities*

We currently have threecontract manufacturing facilities, of which one has been inspected by FDA inthe past, and observations were noted. There were no findings that involved asignificant violation of regulatory requirements. The responses to theseobservations have been accepted by FDA, and we believe that we are insubstantial compliance with the QSR. Like all manufacturers, we expect ourcontract manufacturers to be inspected by FDA again in the future. If FDA findssignificant shortcomings, we could be subject to fines, recalls or requirementsto halt manufacturing.

*U.S. Anti-Kickback and 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,whether direct or indirect, overt or covert, in cash or in kind, intended, amongother things, to induce the purchase or recommendation of healthcare productsand services. While the federal law applies only to products and services forwhich payment may be made by a federal healthcare program, the state laws mayapply regardless of whether any 

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publichealthcare funds are involved. Violations of these laws can lead to severecivil and criminal 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 authorizes “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. Our business practices could be subject to scrutinyand challenge by federal or state enforcement officials or others under theselaws. This type of challenge could have a material adverse effect on ourbusiness, financial condition and results of operations. We are currentlysubject to an investigation by the Office of Inspector General (“OIG”) withinthe Department of Health and Human Services based on a subpoena served to us inthe second quarter of 2006. We are cooperating with the OIG with theirinformational request. In addition, we have recently become aware that we arethe subject of an investigation by the United States Department of Justice. Wehave not yet been informed of the subject of this investigation or received anyformal request for information relating to it.

**Employees**

As of December 31,2006, we had a total of 123 employees. Of the total employees, 26 were inresearch and development, 72 in sales and marketing and 25 in general andadministrative services. Two employees hold both M.D. and Ph.D. degrees, 5additional employees hold Ph.D. degrees and 1 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.

**AvailableInformation**

We were organized as a corporation in the state ofDelaware in 1996. 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 notcharge for 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.**

The extent of our futureoperating income or losses is highly uncertain, and we may not be able tosustain profitability. We have incurred significant cumulative net losses sinceour inception, including net losses of approximately $4.9 million in 2002,$3.9 million in 2003 and $4.7 million in 2004. In 2005 and 2006, werecorded net income of $249,000 and $4.3 million, respectively. At December 31,2006, we had an accumulated deficit of approximately $53.7 million. We cannotassure you that we will be able to sustain the profitability achieved in 2005and 2006.

**If physicians orother healthcare providers are unable to obtain sufficient reimbursement fromthird-party healthcare payers for procedures performed using our products, theadoption of our products and our future product sales will be severely harmed.**

Widespread adoption of our products by the medicalcommunity is unlikely to occur if physicians do not receive sufficientreimbursement from third-party payers for performing procedures using ourproducts. If physicians are unable to obtain adequate reimbursement for proceduresperformed using our products, we may be unable to sell our products and ourbusiness would suffer significantly. Additionally, even if these procedures arereimbursed by third-party payers, adverse changes in payers’ policies towardreimbursement for the procedures would harm our ability to market and sell ourproducts. Third-party payers include those governmental programs such asMedicare and Medicaid, workers’ compensation programs, private health insurersand other organizations. These organizations may deny coverage if theydetermine that a procedure was not reasonable or necessary, for example, if itsuse was not considered medically appropriate, or was experimental, or wasperformed for an unapproved indication. In addition, some health care systemsare moving towards managed care arrangements in which they contract to providecomprehensive healthcare for a fixed cost per person, irrespective of theamount of care actually provided. These providers, in an effort to controlhealthcare costs, are increasingly challenging the prices charged for medicalproducts and services and, in some instances, have pressured medical suppliersto lower their prices. If we are pressured to lower our prices, our revenuesmay decline and our profitability could be harmed. CMS guidelines set thereimbursement rates for procedures covered by Medicare. Future regulatoryaction by CMS or other governmental agencies or negative clinical results maydiminish reimbursement payments to physicians for performing procedures usingour products. Medicaid reimbursement differs from state to state, and somestate Medicaid programs may not reimburse physicians for performing proceduresusing our products in an adequate amount, if at all. Additionally, some privatepayers do not follow the CMS and Medicaid guidelines and may reimburse for onlya portion of these procedures or not at all. We are unable to predict whatchanges will be made in the reimbursement methods used by private orgovernmental third-party payers.

In particular, we note that as our presence in themarket expands and the use of the NC-stat System increases, we areexperiencing and are likely to continue to experience an increased focus fromthird-party payers and governmental agencies regarding the reimbursement ofnerve conduction studies performed 

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using the NC-stat Systemand an increased focus from these organizations regarding the professionalrequirements for performing nerve conduction studies in general. At any pointin time, a number of third-party payers may take positions adversely affectingreimbursement, including taking the position of not reimbursing our customersfor their use of the NC-stat System. During the second half of 2006 and early2007, five local Medicare carriers covering a total of twenty states issueddraft LCDs, final LCDs or coding articles particularly addressing coverage andreimbursement policies for nerve conduction studies that could adversely impactthe reimbursement of the NC-stat System. Several of these carriers indicatedthat they will not reimburse physicians under Medicare for nerve conductionstudies performed using the NC-stat System under the three existing CPT codesfor conventional nerve conduction studies (95900, 95903 and 95904), whichprovide for levels of reimbursement fixed by CMS, but rather that physiciansmust submit claims for reimbursement for these procedures under a miscellaneousCPT code (95999), in which case the local carriers will determine the level ofreimbursement to be paid, if any. We do not know what success our customerswill have in obtaining reimbursement under the miscellaneous code or what levelof reimbursement they may receive if they are successful. The AMA CPT EditorialPanel has formed a committee which is expected to examine the reimbursementcoding of automated nerve conduction studies, including the NC-stat System andother traditional equipment. The findings of this committee may affect whichCPT codes Medicare carriers require from physicians who perform procedures withthe NC-stat System. Additional third-party payers, including local Medicarecarriers and commercial payers, could potentially take a position that couldreduce or eliminate the reimbursement for the NC-stat System. These payers mayalso impose requirements on physicians to submit additional paperworksupporting the medical necessity of nerve conduction studies performed usingthe NC-stat System. Such requirements could potentially impact the use of theNC-stat System and could potentially have a material and adverse impact on our revenues.

Additionally, the LCDs and coding articles issued bylocal Medicare carriers have also addressed a number of other issues, including(1) the background and training of physicians supervising or performingnerve conduction studies; (2) the level of training requirements fortechnicians performing a nerve conduction study; (3) whether nerveconduction tests should be required to be performed concomitantly with an nEMGprocedure; and (4) whether the NC-stat System is comparable toconventional nerve conduction testing equipment. We do not believe that theseLCDs prohibit physicians from receiving reimbursement for medically necessarynerve conduction studies performed using the NC-stat System. However, theseLCDs are relatively new and they do appear targeted at limiting access toperform and/or reimbursement for nerve conduction studies. These LCDs could beinterpreted or implemented in a manner that limits the ability of physicians toreceive reimbursement under Medicare for nerve conduction studies performedusing the NC-stat System.

If physicians do notreceive access to and adequate reimbursement under the miscellaneous CPT codefrom those local carriers that currently, or in the future, require proceduresperformed using the NC-stat System to be submitted using that code, ourexisting customers in those areas may limit or curtail their use of the NC-statSystem, we may be unable to obtain new customers and we may face increasingpricing pressure, all of which could materially adversely impact our businessand our revenues and profitability, in particular. If the LCDs recently adoptedor reimbursement determinations adopted in the future relating to thereimbursement of nerve conduction studies place additional restrictions orqualifications on the performance of these procedures generally or, using theNC-stat System, our business, revenues and profitability could be materiallyadversely affected. For example, in the fourth quarter of 2006, we experienceda decline in revenues from the third quarter of 2006, which we believeprimarily resulted from the uncertainty created by the issuance of the draftLCDs, final LCDs and coding articles issued by local Medicare carriers that aredescribed above. Additionally, in the short-term, the uncertainty caused bythese recent changes, or other future changes, in third-party payers’reimbursement policies regarding nerve conduction studies may cause existingcustomers to reduce their use of the NC-stat System and potential new customersto defer a decision or decline to purchase the NC-stat System, which couldmaterially 

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adverselyaffect our business. We are expending and anticipate continuing to expendsubstantial resources to address potential reimbursement issues withthird-party payers. Widespread adoption of the NC-stat System by the medicalcommunity is unlikely to occur if physicians do not receive satisfactoryreimbursement from third-party payers for procedures performed with the NC-statSystem.

**We may be unable toexpand the market for the NC-stat System, which would limit our ability toincrease 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 actualuse of 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.

**We may not be ableto accurately predict the size of the market for our products.**

We may not be able to accuratelypredict the size of the market for our products. Neuropathies traditionallyhave been diagnosed by an NCS/nEMG procedure, performed by a neurologist orphysician in a related specialty. We estimate that there are approximately 2.0million traditional NCS/nEMG procedures performed each year in the UnitedStates; however, we anticipate that the advantages and increased availabilityof the NC-stat System will significantly increase the number of nerveconduction studies performed. Based on our analysis of current data, weestimate that the potential market size for the NC-stat System in the diabetes,low back pain and carpal tunnel syndrome markets in the aggregate could begreater than 9.5 million annual patient tests. This represents a significant increasein the size of the market for nerve conduction studies and is based upon anumber of assumptions and estimates, which themselves may not be accurate. Forexample, we have assumed that all initial office visits for low back pain mayrepresent an opportunity for use of the NC-stat System, and we have estimatedthat an annual testing rate of 50% for all individuals diagnosed with diabetesrepresents the potential addressable market in diabetes. We estimate that thesize of the market for a point-of-service product for the detection of diabeticretinopathy could be nearly $700 million. There are estimated to be 21 millionpeople in the United States with diabetes and it is estimated that 15 millionhave actually been diagnosed with diabetes. Using an eye examination fee of $45per patient, this represents a potential market size of nearly $700 million. Marketsize is difficult 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 have 

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notindependently verified those data. If our estimates of the sizes of the marketsfor our products is incorrect, our potential revenue growth may be limited.

**If we are unable tosuccessfully sell our products to primary care and specialist physicians, ourability to increase our revenues will be limited.**

We are focusing our salesand marketing efforts for the NC-stat System and the DigiScope on primary careand specialist physicians. As these physicians traditionally have not beentargeted by companies selling equipment used to perform nerve conductionstudies or eye scans, we may face difficulties in selling our products to them.Particularly, we may be unable to convince these physicians that our productsprovide effective alternatives or useful supplements to existing testingmethods. In addition, these physicians may be reluctant to make the capital investmentrequired to purchase the NC-stat System or use the DigiScope and alter theirexisting practices. If we are unable to successfully sell our products toprimary care and specialist physicians, our ability to increase our revenueswill be severely limited.

**We are dependent ontwo single source manufacturers to produce the NC-stat System, and any changein our relationship with either of these manufacturers could prevent us fromdelivering products to our customers in a timely manner and may materially adverselyimpact our future revenues or costs.**

We rely on two third-partymanufacturers to manufacture all of the components of the NC-stat System. Inthe event that either of our manufacturers ceases to manufacture sufficientquantities of our products in a timely manner and on terms acceptable to us, wewould be forced to locate an alternate manufacturer. Additionally, if either ofour manufacturers 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. Wehave entered into an exclusive manufacturing and supply agreement with Parlexfor the manufacture of the NC-stat biosensors, and currently rely on a singlemanufacturer, Sunburst, for the manufacture of our NC-stat monitors and dockingstations. We do occasionally experience transient inventory shortages on newproducts during the initial production ramp-up phase. If any of the changes inour relationships with these manufacturers as described above occurs, ourability to supply our customers will be severely limited until we are able toengage an alternate manufacturer or, if applicable, resolve any quality issueswith our existing manufacturer. This situation could prevent us from deliveringproducts to our customers in a timely manner, lead to decreased sales orincreased costs, or harm our reputation with our customers.

**If ourmanufacturers are unable to supply us with an adequate supply of products as weexpand our markets, we could lose customers, our growth could be limited andour business could be harmed.**

In order for ussuccessfully to expand our business within the United States and internationally,our contract manufacturers must be able to provide us with our products insubstantial quantities, in compliance with regulatory requirements, inaccordance with agreed upon specifications, at acceptable cost and on a timelybasis. Our anticipated growth may strain the ability of our manufacturers todeliver an increasingly large supply of products and obtain materials andcomponents in sufficient quantities. Manufacturers often experiencedifficulties in scaling up production, including problems with productionyields and quality control and assurance. If we are unable to obtain sufficientquantities of high quality products to meet customer demand on a timely basis,we could lose customers, our growth may be limited and our business could be harmed.

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**We currently relyentirely on EyeTel for the production and supply of the DigiScope to customersand on the Wilmer Eye Institute for the analysis of eye scans performed by ourcustomers. Any interruption in supply of the DigiScope systems from EyeTel orany interruption in the services provided by the Wilmer Eye Institute couldsignificantly reduce our ability to generate revenues.**

EyeTel is the solemanufacturer of the DigiScope and they serve as the only source of supply ofsystems to customers. If there were any interruption in the manufacturing andsupply capabilities of EyeTel, our ability to generate revenues from theDigiScope could be adversely impacted. The Wilmer Eye Institute receivesdigital scans from customers using the DigiScope and eye specialists employedby the Wilmer Eye Institute analyze the images and within 24-48 hoursafter receipt provide a report to the physician who performed the eye scanindicating the results of the scan. If the Wilmer Eye Institute could notcontinue to perform this service to our customers in a timely manner, ourability to generate revenues from the DigiScope could be materially adverselyimpacted.

**We currently relyentirely on sales of the products that comprise the NC-stat System to generaterevenues, and any factors that negatively impact our sales of these productscould 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 86.4%, 87.7% and 87.6% of our totalrevenues in 2006, 2005 and 2004, respectively. Our sales of these products maybe negatively impacted by many factors, including:

·       changesor proposed changes in reimbursement rates or policies relating to our productsby third-party payers;

·       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.

**The patent rightswe rely upon to protect the intellectual property underlying our products maynot be adequate, which could enable third parties to use our technology andwould 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;

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·       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 superior to ourtechnology and products without infringing on any of our patent rights. Inaddition, 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.

**Other rights andmeasures we have taken to protect our intellectual property may not beadequate, 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 require employees,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.

**We may need toinitiate lawsuits to protect or enforce our patents and other intellectualproperty rights, which could be expensive and, if we lose, could cause us tolose some of our intellectual property rights, which would harm our ability tocompete 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.

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Any lawsuits that we initiate could be expensive, takesignificant time and divert management’s attention from other businessconcerns. Litigation also puts our patents at risk of being invalidated orinterpreted narrowly and our patent applications at risk of not issuing.Additionally, we may provoke third parties to assert claims against us. We maynot prevail in any lawsuits that we initiate and the damages or other remediesawarded, if any, may not be commercially valuable. The occurrence of any ofthese events could harm our business, our ability to compete in the market orour reputation.

**Claims that our productsinfringe on the proprietary rights of others could adversely affect our abilityto sell our products and increase our costs.**

Substantial litigation over intellectual propertyrights exists in the medical device industry. We expect that our products couldbe increasingly subject to third-party infringement claims as the number ofcompetitors grows and the functionality of products and technology in differentindustry segments overlap. Third parties may currently have, or may eventuallybe issued, patents on which our products or technologies may infringe. Any ofthese third parties might make a claim of infringement against us. Anylitigation regardless of its impact would likely result in the expenditure ofsignificant financial resources and the diversion of management’s time andresources. In addition, litigation in which we are accused of infringement maycause negative publicity, adversely impact prospective customers, cause productshipment delays or require us to develop non-infringing technology, makesubstantial payments to third parties, or enter into royalty or licenseagreements, which may not be available on acceptable terms, or at all. If asuccessful claim of infringement were made against us and we could not developnon-infringing technology or license the infringed or similar technology on atimely and cost-effective basis, our revenues may decrease substantially and wecould be exposed to significant liability.

**We are subject toextensive regulation by the FDA, which could restrict the sales and marketingof the NC-stat System and could cause us to incur significant costs.**

Wesell medical devices that are subject to extensive regulation in the UnitedStates by the FDA for manufacturing, labeling, sale, promotion, distributionand shipping. Before a new medical device, or a new use of or claim for anexisting product, can be marketed in the United States, it must first receiveeither 510(k) clearance, grant of a*denovo* classification or pre-marketing approval from the FDA, unlessan exemption applies. We may be required to obtain a new 510(k) clearanceor*de novo* classification orpre-market approval for significant post-market modifications to our products.Each of these processes can be expensive and lengthy. The FDA’s process forgranting 510(k) clearance usually takes approximately three months, but itcan be significantly longer. The process for obtaining *de novo* classification involves a level ofscrutiny similar to the 510(k) clearance process. The process forobtaining pre-market approval is much more costly and uncertain and itgenerally takes from one to three years, or longer, from the time theapplication is filed with the FDA.

Medicaldevices may be marketed only for the indications for which they are approved orcleared. We have obtained 510(k) clearance for the current clinicalapplications for which we market our products. However, our clearances can berevoked if safety or effectiveness problems develop. Further, we may not beable to obtain additional 510(k) clearances or premarket approvals for newproducts or for modifications to, or additional indications for, our existingproducts in a timely fashion, or at all. Delays in obtaining future clearanceswould adversely affect our ability to introduce new or enhanced products in atimely manner, which in turn would harm our revenue and future profitability.We have made 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. If any of these events occur, we maynot be able to provide our customers with the quantity of products they requireon a timely basis, our reputation could be harmed, and we could lose customersand suffer reduced revenues and increased costs.

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We also are subjectto numerous post-marketing regulatory requirements, including quality systemregulations, which relate to the design, manufacture, packaging, labeling,storage, installation and servicing of our products, labeling regulations andmedical device reporting regulations. Our failure or the failure by anymanufacturer of our products to comply with applicable regulatory requirementscould result in enforcement action by the FDA, which may include any of thefollowing sanctions:

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

·       requiring repair,replacement, refunds, recall or seizure of our products;

·       imposing operatingrestrictions, suspension or shutdown of production;

·       refusing our requests 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 have already been granted; and

·       criminal prosecution.

If any of these events were to occur, they could harmour reputation, our ability to generate revenues and our profitability.

**If we or themanufacturers of our products 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 the facilities of themanufacturers of our products would pass any future quality system inspection.If our or any of the facilities of the manufacturers of our products fail aquality system inspection, the manufacturing or distribution of our products couldbe interrupted and our operations disrupted. Failure to take adequate andtimely corrective action in response to an adverse quality system inspectioncould force a suspension or shutdown of our packaging and labeling operations,the operations of the manufacturers of our products 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.

**Our products aresubject to recalls even after receiving FDA clearance or approval, which wouldharm our reputation, business and financial results.**

We are subject to themedical device reporting regulations, which require us to report to the FDA ifour products may have caused or contributed to a death or serious injury, orhave malfunctioned in a way that would be likely to have caused or contributedto a death or serious injury. The FDA and similar governmental bodies in othercountries have the authority to require the recall of our products if we or themanufacturers of our products fail to comply with relevant regulationspertaining to manufacturing practices, labeling, advertising or promotionalactivities, or if new informationis obtained concerning the safety or efficacy of our products. Agovernment-mandated or voluntary recall by us could occur as a result ofmanufacturing defects, labeling deficiencies, packaging defects or otherfailures to comply with applicable regulations. Any recall would divertmanagement attention and financial resources and harm our reputation withcustomers. A recall involving the NC-stat System would be particularly harmfulto our business and financial results because the products that comprise theNC-stat System currently produce substantially all of our revenues.

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**We are subject to federaland state laws prohibiting “kickbacks” and false or fraudulent claims, which,if violated, could subject us to substantial penalties. Additionally, anychallenge to or investigation into our practices under these laws could causeadverse publicity and be costly to respond to, and thus could harm ourbusiness.**

Afederal law commonly known as the Medicare/Medicaid anti-kickback law, and severalsimilar state laws, prohibit any remuneration that is intended to inducephysicians or others either to refer patients or to acquire or arrange for orrecommend the acquisition of healthcare products or services. These lawsconstrain a medical device company’s sales, marketing and other promotionalactivities by limiting the kinds of business relationships and financialarrangements, including sales programs we may have with hospitals, physiciansor other potential purchasers of medical devices. Other federal and state lawsgenerally prohibit individuals or entities from knowingly presenting, orcausing to be presented, claims for payment to Medicare, Medicaid or otherthird-party payers that are false or fraudulent, or for items or services thatwere not provided as claimed. From time to time, we may provide coding andbilling information as product support to purchasers of our products. SeveralMedicare carriers, however, have developed articles or proposed LCDs suggestingor imposing coverage, coding or billing guidelines that are not consistent withcoding information we have provided based on then-existing guidelines. There isa growing debate over how certain types of nerve conduction tests, includingthose performed using the NC-stat System, would be billed and assessed inconnection with Medicare claims. Accordingly, we cannot predict how thegovernment would regard what it might allege to be billing or coding errorsmade with respect to services rendered using our products and cannot predictwhether the government might assert that any such errors were not inadvertentand therefore potentially subject to the federal civil Federal Claims Act orother laws that could be potentially applicable to us. Anti-kickback and falseclaims laws prescribe civil and criminal penalties for noncompliance, which canbe quite substantial including exclusion from participation in federalhealthcare programs. In the event that we are found to have violated these lawsor determine to settle a claim that we have done so, our business may bematerially adversely affected as a result of any payments required to be made,restrictions on our future operations or actions required to be taken, damageto our business reputation or adverse publicity in connection with such afinding or settlement or other adverse effects relating thereto. Additionally,even an unsuccessful challenge or investigation into our practices could causeadverse publicity, and be costly to respond to, and thus could harm ourbusiness and results of operations.

We note that in the second quarter of 2006, wereceived a subpoena from the OIG of the Department of Health and Human Servicesrequesting documents from us in connection with an investigation of potentialviolations of the federal anti-kickback statute and False Claims Act. We arecooperating with the OIG with their information request and there are presentlyno actions against us of which we are aware.

**We are the subjectof an investigation by the United States Department of Justice, which couldcause adverse publicity, be costly to respond to or lead to civil or criminalcharges against us or our employees, any of which could materially adverselyaffect our business.**

We have recently become aware that we are the subjectof an investigation by the United States Department of Justice. We have not yetbeen informed of the subject matter of this investigation or received anyformal requests for information relating to it. This investigation could causeadverse publicity, be costly to respond to or lead to civil or criminal chargesagainst us or our employees, any of which could adversely affect our business.

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**If we are found tohave violated laws protecting the confidentiality of patient healthinformation, we could be subject to civil or criminal penalties, which couldincrease our liabilities and harm our reputation or our business.**

There are a number of federal and state lawsprotecting the confidentiality of individually identifiable 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 and the Wilmer EyeInstitute receives patient data on an anonymous basis, without patientidentifiers, the exact scope of these rules has not been clearly established.If we are found to be in violation of the privacy rules under HIPAA, wecould be subject to civil or criminal penalties, which could increase ourliabilities and harm our reputation or our business.

**The use of our productscould result in product liability claims that could be expensive, damage ourreputation and harm our business.**

Our business exposes us to an inherent risk ofpotential product liability claims related to the manufacturing, marketing andsale of medical devices. The medical device industry historically has beenlitigious, and we face financial exposure to product liability claims if theuse of our products were to cause or contribute to injury or death. Inparticular, the NC-stat System may be susceptible to claims of injury becauseit involves the electric stimulation of a patient’s nerves. Additionally,because the DigiScope tests for diabetic retinopathy, which is a condition thatcan lead to loss of vision or blindness if untreated, we could be subject toclaims of injury relating to any actual or claimed inadequacy, error ormalfunction of the DigiScope in testing for this condition or the Wilmer-EyeTelReading Center in reading the results of the test performed by the DigiScopeand communicating them to the physician. Although we maintain product liabilityinsurance for our products and other commercial insurance, the coverage limitsof these policies may not be adequate to cover future claims. As sales and useof our products increase, we may be unable to maintain sufficient productliability or other commercial insurance on acceptable terms or at reasonablecosts, and this insurance may not provide us with adequate coverage againstpotential liabilities. A successful claim brought against us in excess of, oroutside of, our insurance coverage could have a material adverse effect on ourfinancial condition and results of operations. A product liability claim,regardless of its merit or eventual outcome, could result in substantial coststo us, a substantial diversion of management attention and adverse publicity. Aproduct liability claim could also harm our reputation and result in a declinein revenues and an increase in expenses.

**Our products are complexin design, and defects may not be discovered prior to shipment to customers,which could result in warranty obligations or product liability or otherclaims, reducing our revenues and increasing our costs and liabilities.**

Wedepend upon third parties for the manufacture of our products. Our products,particularly our NC-stat biosensors, require a significant degree of technicalexpertise to produce. If these manufacturers fail to produce our products tospecification, or if the manufacturers use defective materials or workmanshipin the manufacturing process, the reliability and performance of our productswill be compromised.

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If our products contain defects that cannot berepaired quickly, easily and inexpensively, we may experience:

·       loss of customer orders anddelay in order fulfillment;

·       damage to our brandreputation;

·       increased cost of ourwarranty program due to product repair or replacement;

·       inability to attract newcustomers;

·       diversion of resources fromour manufacturing and research and development departments into our servicedepartment; and

·       legal action.

The occurrence of any one or more of the foregoingcould harm our reputation and materially reduce our revenues and increase ourcosts and liabilities.

**If we lose any ofour officers or key employees, our management and technical expertise could beweakened 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, our Chief Financial Officer; andour other 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 we are unable torecruit, hire and retain skilled and experienced personnel, our ability tomanage and expand our business will be harmed, which would impair our futurerevenues and profitability.**

We are a small companywith only 123 employees as of December 31, 2006, 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 grow ourbusiness.

**If we do noteffectively manage our growth, our business resources may become strained, wemay not be able to deliver our products in a timely manner and our results ofoperations may be materially adversely affected.**

In the past two years wehave significantly increased our sales force and our total headcount. Thisgrowth, as well as any other growth that we may experience in the future, willprovide challenges to our organization and may strain our management andoperations. We may misjudge the amount of time or resources that will berequired to effectively manage any anticipated or unanticipated growth in ourbusiness or we may not be able to attract, hire and retain sufficient personnelto meet our needs. If we cannot scale our business appropriately, maintaincontrol over expenses or otherwise adapt to anticipated and unanticipatedgrowth, our business resources may become strained, we may not be able todeliver our products in a timely manner and our results of operations may bematerially adversely affected.

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**If we are unable tosuccessfully expand, develop and retain our sales force and maintain ourindependent sales agent network, our revenues may decline, our future revenuegrowth may be limited and our expenses may increase.**

As of December 31,2006, we employed 50 regional sales managers and 3 sales directors and utilizeda network of over 1,000 independent sales agents. We are highly dependent onour regional sales managers and independent sales agents to generate ourrevenues. Our ability to build and develop a strong sales force will beaffected 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.

**Failure to developor enter into relationships to sell products other than our existing productsor enhance our existing products could have an adverse effect on our businessprospects.**

For the year ended December 31,2006, all of our revenues were derived from selling the NC-stat System. Ourfuture business and financial success will depend, in part, on our ability tocontinue to introduce or sell new products and upgraded products into themarketplace. Developing new products and upgrades to existing and futureproducts imposes burdens on our research and development department and ourmanagement. This process is costly, and we cannot assure you that we will beable to successfully develop new products or enhance the NC-stat System or anyfuture products. We also may not be able to enter into relationships with othercompanies to sell additional products. In addition, as we develop the marketfor our products, future competitors may develop desirable product featuresearlier than we do, which could make our competitors’ products less expensiveor more effective than our products and could render our products obsolete orunmarketable. If our product development efforts are unsuccessful, we will haveincurred significant costs without recognizing the expected benefits and ourbusiness prospects may suffer.

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**We currentlycompete, and may in the future need to compete, against certain specialistphysicians, such as neurologists, who perform traditional nerve conductionstudies and other medical device companies with potentially greater resources,more established distribution channels and other competitive advantages, andthe success of these 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 and specialist physicians to perform the same types of tests that may beperformed by primary care and specialist physicians using the NC-stat System.Additionally, in selling the NC-stat System to neurologists, which is not amarket we historically have focused on, we compete directly with the companiesthat sell traditional NCS/nEMG equipment. There are a number of companies thatsell traditional NCS/nEMG equipment including Viasys Healthcare Inc., CadwellLaboratories, Inc. and Xltec, Inc. Additionally, we are aware of onecompany, Neumed, Inc., that markets a nerve conduction study system to thepoint-of-service market. Of these companies, Viasys Healthcare, in particular,enjoy significant competitive 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 market for point-of-service nerveconduction studies, we may be faced with competition from these companies orothers that decide and are able to enter this market. Some or all of our futurecompetitors in the point-of-service market may enjoy competitive advantagessuch as those described above. If we are unable to compete effectively againstexisting and future competitors, our sales will decline and our business willbe harmed.

Currently, we believe thatour most direct competitors are certain specialist physicians, such asneurologists, who perform traditional nerve conduction studies and may view theNC-stat System as competitive with or a threat to their business. Because ofthe level of automation and the ease of use of the NC-stat System, the NC-statSystem facilitates the performance of nerve conduction studies within theoffices of a wider range of physicians. Accordingly, neurologists, including aprofessional society representing a subset of neurologists who most frequentlyperform traditional nerve conduction studies, have competed and may continue tocompete with us by advancing positions that are adverse to the NC-stat System.We believe this competition has come, and is most likely to continue to come,through the advancement of positions challenging the effectiveness and accuracyof the NC-stat System and the ability of non-specialist physicians to performnerve conduction studies and accurately diagnose neuropathies. Becausespecialist physicians and professional societies may be viewed asauthoritative, without regard to their potential economic motives, and may haveconnections to or influence with various regulatory bodies and third-partypayers, they may have a competitive advantage over us and their positions maylead to or be reflected in actions taken by these regulatory bodies and third-partypayers that are adverse to our business.

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**We are dependentupon the computer and communications infrastructure employed and utilized byour onCall Information System, and any failures or disruptions in thisinfrastructure 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 thisinfrastructure as a result of a computer virus, intentional disruption of oursystems by a third-party, manufacturing failure, telephone system failure,fire, storm, flood, power loss or other similar events, could prevent or delaythe operation of our onCall Information System, which could result in increasedcosts to eliminate these problems and address related security concerns andharm our reputation with our customers. In addition, if our infrastructurefails to accommodate growth in customer transactions, customer satisfactioncould be impaired, we could lose customers, our ability to add customers couldbe impaired or our costs could be increased, any of which would harm ourbusiness.

**If future clinicalstudies or other articles are published, or physician associations or otherorganizations announce positions, that are unfavorable to our products, oursales 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 orother procedures that may be performed using our products could endorseproducts or methods that compete with our products or otherwise announcepositions that are unfavorable to our products. We have experienced this withthe professional societies representing the neurologist community. Any of theseevents may negatively affect our sales efforts and result in decreasedrevenues.

**Our future capitalneeds are uncertain and we may need to raise additional funds in the 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 investments andthe cash to be generated from expected product sales will be sufficient to meetour projected operating requirements for at least the next 12 months. However,we may seek additional funds from public and private stock offerings,borrowings under credit lines or other sources. Our capital requirements willdepend on many factors, including:

·       therevenues generated by sales of our products;

·       thecosts associated with any expansion of 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

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·       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 we choose toacquire or invest in new businesses, products or technologies, instead ofdeveloping them ourselves, these acquisitions or investments could disrupt ourbusiness and could result in the use of significant amounts of equity, cash ora 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

·       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.

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**If we expand, orattempt to expand, into foreign markets, we will be affected by new businessrisks that may materially adversely impact our financial condition or resultsof operations.**

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

·       failureto fulfill foreign regulatory requirements to market our 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 materially adversely impact our financialcondition or results of operations. In addition, expansion into foreign marketsimposes additional burdens on our executive and administrative personnel,research and sales departments, and general managerial resources. Our effortsto introduce our products into foreign markets may not be successful, in whichcase we may have expended significant resources without realizing the expectedbenefit. Ultimately, the investment required for expansion into foreign marketscould exceed the revenues generated from this expansion.

**Our operatingresults may fluctuate due to various factors and, as a result, period-to-periodcomparisons of our results of operations will not necessarily be 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.

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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 a changeof 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.

We have adopted a Shareholder Rights Plan that couldmake it more difficult for a third party to acquire, or could discourage athird party from acquiring, the Company or a large block of our common stock. Athird party that acquires 15% or more of our common stock (an “acquiring person”)could suffer substantial dilution of its ownership interest under the terms ofthe Shareholder Rights Plan through the issuance of common stock to all shareholdersother than the acquiring person.

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 our then-currentboard of directors, including a merger, tender offer, or proxy contestinvolving 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.

**We do not intend topay 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.

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**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, 2006 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, 2006,through the solicitation of proxies or otherwise.

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**PART II**

**ITEM 5.**                MARKETFOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUERPURCHASES OF EQUITY SECURITIES

Ourcommon stock is quoted on the NASDAQ Global Market under the symbol “NURO”. Theprice range per share reflected in the table below is the high and low closingsales prices of our common stock as reported by NASDAQ for the periodsindicated.

| ** **     | ** ** | **Years ended December 31,** | ** ** |
|----------------|------------|---------------------------------------------|------------|
| ** **     | ** ** | **2006**                                    | ** ** | **2005** | ** ** |
| ** **     | ** ** | **High**                                    | ** ** | **Low** | ** ** | **High** | ** ** | **Low** | ** ** |
| First quarter  |       | $                                           | 39.19      |   | $ | 28.00 |   | $ | 11.65 |   | $ | 9.28 |   |
| Second quarter |       | $                                           | 40.39      |   | $ | 25.73 |   | $ | 20.03 |   | $ | 9.05 |   |
| Third quarter  |       | $                                           | 33.18      |   | $ | 18.74 |   | $ | 30.20 |   | $ | 19.57 |   |
| Fourth quarter |       | $                                           | 19.85      |   | $ | 13.52 |   | $ | 37.23 |   | $ | 26.91 |   |

 

On March 21, 2007, there were approximately 113 stockholdersof record of our common stock. This number does not include stockholders forwhom shares were held in a “nominee” or “street” name. On March 21, 2007,the last reported sale price per share of our common stock on the NASDAQ GlobalMarket was $9.44.

We have never declared or paid any cash dividends onour common stock. We currently intend to retain future earnings, if any, tofinance the expansion and growth of our business and do not expect to pay anycash dividends in the foreseeable future. Payment of future cash dividends, ifany, will be at the discretion of our board of directors after taking intoaccount various factors, including our financial condition, operating results,current and anticipated cash needs and plans for expansion.

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

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**COMPARATIVE STOCKPERFORMANCE GRAPH**

The following graph showsthe cumulative stockholder return of our common stock from July 22, 2004(the first trading day for our common stock) through December 31, 2006 ascompared with that of the Nasdaq (U.S. Companies) Index and the Nasdaq MedicalDevice Manufacturers Index. The total stockholder return is measured bydividing the per share price change of the respective securities, plusdividends, if any, for each period shown by the share price at the end of theparticular period. The graph assumes the investment of $100 in our common stockand each of the comparison groups on July 22, 2004 and assumes thereinvestment of dividends. We have never declared a dividend on our commonstock. The stock price performance depicted in the graph below is notnecessarily indicative of future price performance.

| ** **                          | ** ** | **07/22/04** | ** ** | **12/31/04** | ** ** | **12/31/05** | ** ** | **12/31/06** | ** ** |
|-------------------------------------|------------|--------------|------------|--------------|------------|--------------|------------|--------------|------------|
| NeuroMetrix, Inc.              |       | $            | 100.00     |         | $          | 146.88       |       | $            | 341.00     |   | $ | 186.38 |   |
| Nasdaq Stock  Market (U.S.)         |       | $            | 100.00     |         | $          | 115.25       |       | $            | 117.69     |   | $ | 129.32 |   |
| Nasdaq Medical Device  Manuf. Index |       | $            | 100.00     |         | $          | 112.49       |       | $            | 123.50     |   | $ | 130.24 |   |

 

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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.

Wehave restated our financial statements as of and for the years endedDecember 31, 2005, 2004, 2003 and 2002 to correct errors in accounting forsales taxes. See Note 2—Restatement of the Notes to Financial Statements:

| ** **                                                                            | ** ** | **Years Ended December 31,**                                            | ** ** |
|---------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------|------------|
| ** **                                                                            | ** ** | **2006**                                                                               | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                                            | ** ** | ** **                                                                             | ** ** | **(as restated)** | ** ** | **(as restated)** | ** ** | **(as restated)** | ** ** | **(as restated)** | ** ** |
| ** **                                                                            | ** ** | **(In thousands, except share and per share data)** | ** ** |
| **Statements of Operations Data:**                                                    | ** ** | ** **                                                                             | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues                                                                              |       | $                                                                                      | 55,250     |   | $ | 34,298 |   | $ | 17,920 |   | $ | 9,168 |   | $ | 4,225 |   |
| Cost of revenues                                                                      |       | 13,558                                                                                 |       | 8,858 |   | 4,853 |   | 2,707 |   | 1,370 |   |
| Gross margin                                                                          |       | 41,692                                                                                 |       | 25,440 |   | 13,067 |   | 6,461 |   | 2,855 |   |
| Operating expenses:                                                                   |       |                                                                                   |       |   |   |   |   |   |   |   |   |
| Research and development(1)                                                           |       | 5,011                                                                                  |       | 3,821 |   | 3,268 |   | 2,397 |   | 2,146 |   |
| Sales and marketing(1)                                                                |       | 22,014                                                                                 |       | 14,150 |   | 8,488 |   | 4,768 |   | 2,870 |   |
| General and  administrative(1)                                                        |       | 11,805                                                                                 |       | 8,022 |   | 5,267 |   | 3,052 |   | 2,774 |   |
| Total operating expenses                                                              |       | 38,829                                                                                 |       | 25,993 |   | 17,024 |   | 10,217 |   | 7,790 |   |
| Income (loss) from  operations                                                        |       | 2,862                                                                                  |       | (553 | ) | (3,957 | ) | (3,756 | ) | (4,935 | ) |
| Interest income  (expense), net                                                       |       | 1,598                                                                                  |       | 837 |   | (750 | ) | (113 | ) | 41 |   |
| Income (loss) before  provision for income taxes                                      |       | 4,461                                                                                  |       | 284 |   | (4,707 | ) | (3,869 | ) | (4,894 | ) |
| Provision for income  taxes                                                           |       | 193                                                                                    |       | 35 |   | — |   | — |   | — |   |
| Net income (loss)                                                                     |       | 4,268                                                                                  |       | 249 |   | (4,707 | ) | (3,869 | ) | (4,894 | ) |
| Accretion of dividend on  redeemable convertible preferred stock                      |       | —                                                                                 |       | — |   | (1,386 | ) | (2,009 | ) | (1,893 | ) |
| 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                                |       | $                                                                                      | 4,268      |   | $ | 249 |   | $ | (13,932 | ) | $ | (5,878 | ) | $ | (13,660 | ) |
| Net income (loss) per common share:                                                   |       |                                                                                   |       |   |   |   |   |   |   |   |   |
| Basic                                                                                 |       | $                                                                                      | 0.34       |   | $ | 0.02 |   | $ | (2.42 | ) | $ | (5.66 | ) | $ | (13.27 | ) |
| Diluted                                                                               |       | $                                                                                      | 0.33       |   | $ | 0.02 |   | $ | (2.42 | ) | $ | (5.66 | ) | $ | (13.27 | ) |
| Weighted average common shares outstanding:                                           |       |                                                                                   |       |   |   |   |   |   |   |   |   |
| Basic                                                                                 |       | 12,501,742                                                                             |       | 12,152,139 |   | 5,747,579 |   | 1,038,817 |   | 1,029,210 |   |
| Diluted                                                                               |       | 13,097,891                                                                             |       | 12,986,365 |   | 5,747,579 |   | 1,038,817 |   | 1,029,210 |   |

----

(1)             Non-cash stock-based compensation expenseincluded in these amounts is as follows:

| Research and  development   |   | $     | 471    |   | $      | 77  |   | $  | 249    |   | $      | 35 |   | $ | 7 |   |
|-----------------------------|--------|-------|--------|--------|--------|-----|--------|----|--------|--------|--------|----|--------|---|---|--------|
| Sales and  marketing        |   | 821   |   | 168    |   | 356 |   | 37 |   | 6      |   |
| General and  administrative |   | 1,361 |   | 161    |   | 423 |   | 25 |   | 37     |   |

 

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| ** **                                           | ** ** | **As of December 31,** | ** ** |
|------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                           | ** ** | **2006**                              | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                           | ** ** | ** **                            | ** ** | **(as restated)** | ** ** | **(as restated)** | ** ** | **(as restated)** | ** ** | **(as restated)** | ** ** |
| ** **                                           | ** ** | **(in thousands)**               | ** ** |
| **Balance  Sheet Data:**                             | ** ** | ** **                            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash and cash  equivalents                           |       | $                                     | 7,910      |   | $ | 8,170 |   | $ | 1,936 |   | $ | 1,623 |   | $ | 2,701 |   |
| Short-term  investments                              |       | 32,411                                |       | 24,082 |   | 18,575 |   | — |   | — |   |
| Working capital                                      |       | 41,894                                |       | 33,268 |   | 21,774 |   | 2,451 |   | 3,623 |   |
| Long-term  investments                               |       | —                                |       | — |   | 9,497 |   | — |   | — |   |
| Total assets                                         |       | 55,706                                |       | 42,897 |   | 37,953 |   | 7,218 |   | 7,053 |   |
| Long-term debt and  other long-term liabilities      |       | 73                                    |       | 131 |   | 189 |   | 2,232 |   | 124 |   |
| Warrants for  redeemable convertible preferred stock |       | —                                |       | — |   | — |   | 450 |   | — |   |
| Redeemable  convertible preferred stock              |       | —                                |       | — |   | — |   | 47,694 |   | 45,684 |   |
| Accumulated  deficit                                 |       | (53,687                               | )          | (57,955 | ) | (58,204 | ) | (45,204 | ) | (39,961 | ) |
| Total stockholders’  equity(deficit)            |       | 43,409                                |       | 34,833 |   | 33,330 |   | (45,805 | ) | (40,029 | ) |
|                                                      |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The data set forth above have been restated asnecessary to give effect to the restatement adjustments described in Note 2 toour financial statements. The effects of the restatement adjustments on ourStatements of Operations and Balance Sheets for the years endingDecember 31, 2005 and 2004 are set forth in Note 2 to our financialstatements and the effects of the restatement adjustments on our Statements ofOperations and Balance Sheets for the years ending December 31, 2003 and2002 are set forth in the table below:

The impact of correcting these errors results in anincrease in accrued liabilities of $303,000 and $101,000 as ofDecember 31, 2003 and 2002, respectively, an increase in general andadministrative expenses of $202,000 and $101,000, respectively, and a reductionof net income available to common stockholders of $202,000 and $101,000, forthe years ended December 31, 2003 and 2002, respectively.

Thefollowing table presents the impact of the restatement:

| ** **                                             | ** ** | **2003**                         | ** ** | **2002**     | ** ** |
|--------------------------------------------------------|------------|----------------------------------|------------|--------------|------------|
| ** **                                             | ** ** | **As Previously  Reported** | ** ** | **Restated** | ** ** | **As Previously  Reported** | ** ** | **Restated** | ** ** |
| **Statements of Operations:**                          | ** ** |                             | ** ** | ** **   |       | ** ** | ** ** |   | ** ** | ** ** |   | ** ** | ** ** |   |
| General and  administrative                            |       |                             | $          | 2,850        |       |   | $ | 3,052 |   |   | $ | 2,673 |   |   | $ | 2,774 |   |   |
| Total operating  expenses                              |       |                             | 10,015     |         |       | 10,217 |   |   | 7,689 |   |   | 7,790 |   |   |
| Income (loss)  from operations                         |       |                             | (3,554     | )            |       | (3,756 | ) |   | (4,834 | ) |   | (4,935 | ) |   |
| Income (loss)  before provision for income taxes       |       |                             | (3,667     | )            |       | (3,869 | ) |   | (4,793 | ) |   | (4,894 | ) |   |
| Net income (loss)                                      |       |                             | (3,667     | )            |       | (3,869 | ) |   | (4,793 | ) |   | (4,894 | ) |   |
| Net income (loss)  attributable to common stockholders |       |                             | (5,676     | )            |       | (5,878 | ) |   | (13,559 | ) |   | (13,660 | ) |   |
| Net income (loss) per  common share:                   |       |                             |       |         |       |   |   |   |   |   |   |   |   |   |
| Basic                                                  |       |                             | (5.46      | )            |       | (5.66 | ) |   | (13.17 | ) |   | (13.27 | ) |   |
| Diluted                                                |       |                             | (5.46      | )            |       | (5.66 | ) |   | (13.17 | ) |   | (13.27 | ) |   |
| **Balance sheet:**                                     | ** ** |                             | ** ** | ** **   |       | ** ** | ** ** |   | ** ** | ** ** |   | ** ** | ** ** |   |
| Working capital                                        |       |                             | 2,754      |         |       | 2,451 |   |   | 3,724 |   |   | 3,623 |   |   |
| Accumulated  deficit                                   |       |                             | (44,901    | )            |       | (45,204 | ) |   | (39,860 | ) |   | (39,961 | ) |   |
| Total stockholders’  equity (deficit)             |       |                             | (45,502    | )            |       | (45,805 | ) |   | (39,928 | ) |   | (40,029 | ) |   |
|                                                        |            |                                  |            |              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

*You should read thefollowing discussion of our financial condition and results of operations inconjunction with our selected financial data, our financial statements and theaccompanying notes to those financial statements included elsewhere in thisAnnual Report on Form 10-K. This discussion contains forward-lookingstatements that involve risks and uncertainties. As a result of many factors,such as those set forth under the section titled “Risk Factors” and elsewherein this Annual Report on Form 10-K, our actual results may differmaterially from those anticipated in these forward-looking statements.*

We have restated ourfinancial statements as of and for the years ended December 31, 2005 and2004 to correct errors in accounting for sales taxes. See Note 2—Restatement ofthe Notes to Financial Statements.

**Overview**

NeuroMetrix was founded in June 1996. We design,develop and sell proprietary medical devices used to help physicians diagnoseneuropathies and neurovascular disease. Our proprietary technology providesphysicians with an in-office diagnostic system, the NC-stat System, whichenables physicians to make rapid and accurate diagnoses of neuropathies, includingcarpal tunnel syndrome, low back and leg pain and diabetic peripheralneuropathy. The NC-stat System is comprised of: (1) disposable single useNC-stat biosensors that are placed on the patient’s body; (2) the NC-statmonitor and related components; and (3) the NC-stat docking station, anoptional device that enables the physician’s office to transmit data to ouronCall Information System. Each component of the NC-stat System is also soldseparately. The sensitivity of the nervous system to metabolic and mechanicaldamage, compounded by its limited regenerative ability, creates a marketopportunity for a medical device that can assist in point-of-service diagnosesof neuropathies in a manner that is cost-effective for the patient andthird-party payer. We believe the ease of use, accuracy and convenienceprovided by the NC-stat System position it to become a standard of care for theassessment of neuropathies at the point-of-service.

Neurovascular disease includes conditions such asretinopathy, an eye disease prevalent in patients with diabetes. We hold anexclusive sales and marketing license to a product known as the DigiScope,which allows primary care and specialist physicians to diagnose diabeticretinopathy and refer patients to the ophthalmologist for treatment if deemednecessary based on the results. It is recommended by the ADA that all patientswith diabetes receive an annual dilated eye examination to monitor vision. Thereare approximately 21 million people in the United States with diabetesaccording to the ADA and only approximately 50% comply with the recommendationto have an annual eye examination. We believe that a product such as theDigiScope in primary care physicians’ and endocrinologists’ offices couldpotentially lead to an increase in the level of testing and result in theearlier detection of eye diseases in patients with diabetes.

We derive our revenues from the sale of NC-statbiosensors, monitors and docking stations directly to end users, which aregenerally physician practice groups.  Wedid not derive any revenues in 2006 or prior years from the DigiScope systemfor the detection of diabetic retinopathy. Sales and marketing efforts for thisproduct were initiated in the first quarter of 2007.  Our NC-stat biosensors are disposable productsthat are used once and inactivated after use. The NC-stat monitor is anelectronic instrument that is used with the NC-stat biosensors to perform nerveconduction studies for the purpose of diagnosing neuropathies. The NC-statmonitor displays the pertinent results of nerve conduction studies on an LCDscreen immediately at the conclusion of each study. The NC-stat docking stationis an optional device that is used to transmit to the onCall Information Systemdata generated by the nerve conduction study performed with the NC-statmonitor. The onCall Information System formulates the data it receives for eachtest into a detailed report that is provided to the customer through facsimileor e-mail.

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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 and governmental agencies regarding the reimbursement ofnerve conduction studies performed using the NC-stat System and an increasedfocus from these organizations regarding the professional requirements forperforming nerve conduction studies in general. At any point in time, a numberof third-party payers may take the position of not reimbursing our customersfor their use of the NC-stat System. During the second half of 2006 and early2007, five local Medicare carriers covering a total of twenty states issueddraft LCDs, final LCDs or coding articles particularly addressing coverage andreimbursement policies under Medicare for nerve conduction studies performedusing the NC-stat System. Several of these carriers indicated that they willnot reimburse physicians under Medicare for nerve conduction studies performedusing the NC-stat System under the three existing CPT codes for conventionalnerve conduction studies (95900, 95903 and 95904), which provide for levels ofreimbursement fixed by CMS, but rather that physicians must submit claims forreimbursement for these procedures under a miscellaneous CPT code (95999), inwhich case the local carriers may determine the level of reimbursement to bepaid, if any. We do not know what success our customers will have in obtainingreimbursement under the miscellaneous code or what level of reimbursement theymay receive if they are successful. If physicians donot receive adequate reimbursement under the miscellaneous CPT code from thoselocal carriers, our existing customers may limit or curtail their use of theNC-stat System and we may be unable to obtain new customers, both of whichcould materially and adversely impact our revenues and profitability. TheAMA CPT Editorial Panel has formed a committee which is expected to examine thereimbursement coding of automated nerve conduction studies, including the NC-statSystem and other traditional equipment. The findings of this committee mayaffect which CPT codes Medicare carriers and commercial payers require fromphysicians who perform procedures with the NC-stat System. Additionalthird-party payers, including local Medicare carriers and commercial payers,could potentially take a position that could reduce or eliminate thereimbursement for the NC-stat System. These payers may also impose requirementson physicians to submit additional paperwork supporting the medical necessityof nerve conduction studies performed using the NC-stat System. Suchrequirements could potentially impact the use of the NC-stat System and couldpotentially have an adverse impact on our revenues.

Additionally, the LCDs and coding articles issued bylocal Medicare carriers have also addressed a number of other issues, including(1) the background and training  ofphysicians supervising or performing nerve conduction studies; (2) thelevel of training requirements for technicians performing a nerve conductionstudy; (3) whether nerve conduction tests should be required to beperformed concomitantly with an nEMG procedure; and (4) whether theNC-stat System is comparable to conventional nerve conduction testing equipment.We do not believe that these LCDs prohibit physicians from receivingreimbursement under Medicare for medically necessary nerve conduction studiesperformed using the NC-stat System. However, these LCDs are relatively new andthey do appear to be targeted at limiting access to perform and/orreimbursement for nerve conduction studies. These LCDs could be interpreted orimplemented in a manner that limits the ability of physicians to receivereimbursement under Medicare for nerve conduction studies performed using theNC-stat System, which could adversely affect our business.

One of the primary challenges we face in our businessis successfully expanding the market for nerve conduction studies. A successfulmarket expansion will depend upon, in part, our targeting of primary care andspecialist physicians who traditionally have not been targeted by companiesselling equipment used to perform nerve conduction studies and our ability toalter physicians’ practices relating to the diagnosis of neuropathies. In orderto successfully implement this growth strategy, we have established a salesforce of 53 employees, including 50 regional sales managers, as of December 31,2006. We have also expanded the 

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network of independentsales agents we use to generate sales leads for our regional sales managersthrough the signing of agreements with PSS and with Henry Schein. PSS has adirect sales force of nearly 700 representatives and Henry Schein has a directsales force of over 300 sales representatives. As a result we now have over1,200 independent sales agents assisting us in our efforts to penetrate themarket of primary care and specialist physicians. We also will participate invarious industry conferences in order to accelerate the market awareness andadoption of our products. These efforts, as well as the overall expansion ofour business, will provide challenges to our organization and may increase theburden on our management and operations. We plan to monitor our business as itgrows and appropriately acquire and allocate resources to address these issues,with a goal of sustaining profitable growth.

Our long-term financial objectives are to grow ourbusiness through the sale of the NC-stat System and the DigiScope andadditional products that may be commercialized for the diagnosis and treatmentof neuropathies and to achieve sustainable profitability. However, during 2007 ourrevenues may not increase and could decline and we may not be able to sustainthe profitability we achieved in the second half of 2005 and in 2006 as aresult of the reimbursement and other issues we are currently facing. Ourefforts in 2007 will focus on (1) sales of the NC-stat System, (2) salesand marketing of the DigiScope for the detection of diabetic retinopathy, (3) theexpected launch of the ADVANCE System, (4) efforts to manage thereimbursement challenges posed by third-party payers for the NC-stat System and(5) our ongoing research and development programs. During 2007, weexpect to continue efforts on improvements to our biosensors, on thedevelopment of new biosensors, on the development of products to diagnoseadditional neuropathies, on the development of a product forthe minimally invasive treatment of neuropathies and on thefinal development efforts on the ADVANCE System. During 2007, we expect toenter the clinical stage of development of our product for the localdelivery of drugs for the treatment of neuropathies by both primary careand specialist physicians. We believe that the accomplishment of these goals willhave a positive impact on our progress toward the long-term objective ofgrowing the business and achieving sustainable profitability.

Effective January 1, 2006, we adopted Statementof Financial Accounting Standards (“SFAS”) No. 123(R),*“Share Based Payment”* (“SFAS No. 123(R)”),which requires that the cost resulting from all share-based paymenttransactions be recognized in the financial statements. SFAS No. 123(R) isa revision of SFAS No. 123,*“Accountingfor Stock-Based Compensation”* (“SFAS No. 123”) and supersedesAccounting Principles Board Opinion No. 25,*“Accounting for Stock Issued to Employees”* (“APB No. 25”)and SFAS No. 148,*“Accounting for StockBased Compensation—Transition and Disclosure—an amendment of FinancialAccounting Standards Board Statement No. 123”* (“SFAS No. 148”).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, weadopted SFAS No. 123(R) using the modified prospective method andhave begun reflecting the stock-based compensation expense determined underfair value based methods in the income statement rather than as pro formadisclosure in the notes to the financial statements. Prior period results havenot been revised. We use the Black-Scholes option pricing model for determiningthe fair value of its stock options and amortize our stock-based compensationexpense using the straight-line method. During 2006, we recorded stock-basedcompensation expense of approximately $2.7 million.

Prior to January 1, 2006, the Company accountedfor stock-based compensation plans in accordance with the provisions of APB No. 25,as permitted by SFAS No. 123, and accordingly did not recognizecompensation expense for the issuance of options with an exercise price equalto or greater than the fair value of common stock at the date of grant.

We expect stock-based compensation expense recognizedin accordance with the provisions of SFAS 123(R) to increase in 2007, butthis will be dependent on the magnitude of additional stock options 

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granted. The stock-basedcompensation expense recognized in accordance with Emerging Issues Task ForceIssue No. 96-18*“Accounting forEquity Instruments That Are Issued to Other Than Employees for Acquiring, or inConjunction with Selling, Goods or Services”* for option grants tonon-employees may vary significantly based on the performance of the Company’sstock price, to the extent unvested, as these grants are remeasured at the endof each reporting period.

In October 2006, weentered into an exclusive seven year licensing agreement with EyeTel. Theagreement grants us an exclusive license to market, brand and sell EyeTel’sDigiScope throughout the primary care physician and endocrinologist market. Inconnection with the agreement, we received warrants to purchase up to 500,000shares of EyeTel common stock at an exercise price of $0.16 per share, subjectto adjustment for stock splits and with a term of ten years. The warrants aresubject to a vesting schedule based on our achievement of annual performance milestonesrelating to sales and customer usage of the DigiScope through 2011. If we donot meet one or both of the requirements for any calendar year, but do meet thecombined requirements for two or more consecutive years, the shares scheduledto vest for each of the years will vest. The agreement also grants us financingparticipation rights in connection with EyeTel’s next round of venture capitalfinancing. We received an option to purchase EyeTel preferred stock, up to thelesser of (i) 30% of the total amount raised in the financing or (ii) $5.0million. In the event that we participate in the next round of financing, andour maximum permitted amount is less than $5.0 million, we have a right toparticipate in any subsequent financing rounds equal to the difference between$5.0 million and the amount previously invested.

**Results ofOperations**

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

| ** **                                       | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                       | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                       | ** ** | ** **                                  | ** ** | **(as restated)** | ** ** | **(as restated)** | ** ** |
| Revenues:                                        |       |                                        |       |   |   |   |   |   |   |   |   |
| Diagnostic device                                |       | 13.6                                        | %          |   | 12.3 | % |   |   | 12.4 | % |   |
| Biosensor                                        |       | 86.4                                        |       |   | 87.7 |   |   |   | 87.6 |   |   |
| Total revenues                                   |       | 100.0                                       |       |   | 100.0 |   |   |   | 100.0 |   |   |
| Cost of revenues                                 |       | 24.5                                        |       |   | 25.8 |   |   |   | 27.1 |   |   |
| Gross margin                                     |       | 75.5                                        |       |   | 74.2 |   |   |   | 72.9 |   |   |
| Operating  expenses:                             |       |                                        |       |   |   |   |   |   |   |   |   |
| Research and development                         |       | 9.1                                         |       |   | 11.1 |   |   |   | 18.2 |   |   |
| Sales and marketing                              |       | 39.8                                        |       |   | 41.3 |   |   |   | 47.4 |   |   |
| General and administrative                       |       | 21.4                                        |       |   | 23.4 |   |   |   | 29.4 |   |   |
| Total operating expenses                         |       | 70.3                                        |       |   | 75.8 |   |   |   | 95.0 |   |   |
| Income (loss)  from operations                   |       | 5.2                                         |       |   | (1.6 | ) |   |   | (22.1 | ) |   |
| Interest income (expense), net                   |       | 2.9                                         |       |   | 2.4 |   |   |   | (4.2 | ) |   |
| Income (loss)  before provision for income taxes |       | 8.1                                         |       |   | 0.8 |   |   |   | (26.3 | ) |   |
| Provision for income taxes                       |       | 0.3                                         |       |   | 0.1 |   |   |   | — |   |   |
| Net income (loss)                                |       | 7.7                                         | %          |   | 0.7 | % |   |   | (26.3 | )% |   |

 

49

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**Comparison of YearsEnded December 31, 2006 and December 31, 2005**

*Revenues*

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

| ** **            | ** ** | **Years Ended December 31,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|-----------------------|------------|---------------------------------------------|------------|------------|------------|------------|------------|
| ** **            | ** ** | **2006**                                    | ** ** | **2005**   | ** ** | **Change** | ** ** | **% Change** | ** ** |
| Customers             |       | 4,929                                       |       | 3,282      |       | 1,647      |       |   | 50.2 | % |   |
| Biosensor units  used |       | 1,155,300                                   |       | 704,800    |       | 450,500    |       |   | 63.9 |   |   |
|                  |       | **(In thousands)**                          |       |       |       |       |       |
| Revenues:             |       |                                        |       |       |       |       |       |   |   |   |   |
| Diagnostic device     |       | $                                           | 7,538.3    |       | $          | 4,221.3    |       | $ | 3,317.0 |   |   | 78.6 |   |   |
| Biosensor             |       | 47,711.4                                    |       | 30,076.8   |       | 17,634.6   |       |   | 58.6 |   |   |
| Total revenues        |       | $                                           | 55,249.7   |       | $          | 34,298.1   |       | $ | 20,951.6 |   |   | 61.1 |   |   |

 

Diagnostic device revenues were $7.5 million and $4.2million for the years ended December 31, 2006 and 2005, respectively, anincrease of $3.3 million, or 78.6%. Of this increase, approximately $2.6million is attributable to a greater number of units sold, primarily as aresult of increased demand for the NC-stat System and an increase in the numberof regional sales managers. In addition, $0.7 million of this increase isattributable to an increase in the list price of our NC-stat monitors anddocking stations from $4,000 to $5,000 effective January 1, 2006, whichresulted in a higher average selling price during 2006 as compared to 2005.Diagnostic device revenues accounted for 13.6% and 12.3% of our total revenuesfor the years ended December 31, 2006 and 2005, respectively.

Biosensor revenues were $47.7 million and $30.1million for the years ended December 31, 2006 and 2005, respectively, anincrease of $17.6 million, or 58.6%. The increase is primarily due to anincreased customer base for our biosensors and an increased frequency oftesting by our customers. Biosensor revenues accounted for 86.4% and 87.7% ofour total revenues for the years ended December 31, 2006 and 2005,respectively.

Our customers used 1,155,300 biosensor units in theyear ended December 31, 2006, compared to 704,800 units in the year ended December 31,2005, an increase of 450,500 units, or 63.9%. The increase in biosensor usageis primarily attributable to the increase in our customer base and to an increasein usage per customer.

Our total revenues were $55.2 million and $34.3million for the years ended December 31, 2006 and 2005, respectively, anincrease of $20.9 million, or 61.1%. During the 12-month period ending December 31,2006, a total of 4,929 customers used our NC-stat System compared to 3,282customers for the same period ending December 31, 2005. This represents a50.2% year-over-year increase in the number of customers that used our NC-statSystem.

We anticipate thatrevenues in 2007 may not increase and could decline. In the fourth quarter of2006, we experienced a decline in revenues from the third quarter of 2006,which we believe primarily resulted from the uncertainty created by theissuance of draft LCDs, final LCDs and coding articles addressing reimbursementfor nerve conduction studies that were issued by five local Medicare carrierscovering a total of twenty states. These developments and other futurereimbursement decisions could adversely impact reimbursement for proceduresperformed using the NC-stat System. Our revenues in 2007 are likely to beimpacted by the level of reimbursement, if any, established for proceduresperformed using the NC-stat System by these carriers and other third-partypayers, whether final LCDs are applied in a manner that places additionalrestrictions or qualifications on the performance of these procedures, anyother reimbursement determinations relating to nerve conduction studies aremade by third-party payers or any other events causing uncertainty as to theexistence or amount of reimbursement physicians are likely to 

50

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receivefor performing procedures using the NC-stat System. We do, however, expectrevenues to be positively impacted by the initiation of our sales and marketingefforts for the DigiScope in 2007. Overall, revenues could be impacted by avariety of factors, including the level of demand for our products, potentialfor changes in third-party reimbursement for nerve conduction studies, theoverall economy, competitive factors and the factors described in the sectionof this Annual Report on Form 10-K titled “Cautionary Note RegardingForward-Looking Statements.”

*Costs and expenses*

Thefollowing table presents our costs and expenses and net income:

| ** **                                   | ** ** | **Years Ended December 31,** | ** ** | ** **              | ** ** | ** ** | ** ** |
|----------------------------------------------|------------|---------------------------------------------|------------|-------------------------|------------|------------|------------|
| ** **                                   | ** ** | **2006**                                    | ** ** | **2005**                | ** ** | **Change** | ** ** | **% Change** | ** ** |
| ** **                                   | ** ** | ** **                                  | ** ** | **(as restated)**       | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                   | ** ** | ** **                                  | ** ** | **(in thousands)** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cost of revenues:                            |       |                                        |       |                    |       |       |       |   |   |   |   |   |   |
| Diagnostic device                            |       | $                                           | 1,320.5    |                    |       | $          | 1,059.7    |   |   | $ | 260.8 |   |   | 24.6 | % |   |
| Biosensor                                    |       | 12,237.6                                    |       |                    | 7,798.4    |       |       | 4,439.2 |   |   | 56.9 |   |   |
| Total cost of revenues                       |       | 13,558.1                                    |       |                    | 8,858.1    |       |       | 4,700.0 |   |   | 53.1 |   |   |
| Gross margin:                                |       |                                        |       |                    |       |       |       |   |   |   |   |   |   |
| Diagnostic device                            |       | 6,217.8                                     |       |                    | 3,161.6    |       |       | 3,056.2 |   |   | 96.7 |   |   |
| Biosensor                                    |       | 35,473.9                                    |       |                    | 22,278.5   |       |       | 13,195.4 |   |   | 59.2 |   |   |
| Total gross margin                           |       | 41,691.7                                    |       |                    | 25,440.0   |       |       | 16,251.6 |   |   | 63.9 |   |   |
| Gross Margin%:                               |       |                                        |       |                    |       |       |       |   |   |   |   |   |   |
| Diagnostic device                            |       | 82.5                                        | %          |                    | 74.9       | %          |       |   |   |   |   |   |   |
| Biosensor                                    |       | 74.4                                        |       |                    | 74.1       |       |       |   |   |   |   |   |   |
| Total gross margin                           |       | 75.5                                        |       |                    | 74.2       |       |       |   |   |   |   |   |   |
| Operating expenses:                          |       |                                        |       |                    |       |       |       |   |   |   |   |   |   |
| Research and development(1)                  |       | 5,010.5                                     |       |                    | 3,820.6    |       |       | 1,189.9 |   |   | 31.1 |   |   |
| Sales and marketing(1)                       |       | 22,013.7                                    |       |                    | 14,150.2   |       |       | 7,863.5 |   |   | 55.6 |   |   |
| General and administrative(1)                |       | 11,805.1                                    |       |                    | 8,021.8    |       |       | 3,783.3 |   |   | 47.2 |   |   |
| Total operating expenses                     |       | 38,829.3                                    |       |                    | 25,992.6   |       |       | 12,836.7 |   |   | 49.4 |   |   |
| Income from  operations                      |       | 2,862.4                                     |       |                    | (552.5     | )          |       | 3,414.9 |   |   | (618.1 | ) |   |
| Interest income                              |       | 1,598.4                                     |       |                    | 838.8      |       |       | 759.6 |   |   | 90.6 |   |   |
| Interest expense                             |       | —                                      |       |                    | (2.0       | )          |       | 2.0 |   |   | (100.0 | ) |   |
| Income before  provision for income taxes    |       | 4,460.8                                     |       |                    | 284.3      |       |       | 4,176.5 |   |   | 1,469.3 |   |   |
| Provision for  income taxes                  |       | 193.0                                       |       |                    | 35.0       |       |       | 158.0 |   |   | 451.4 |   |   |
| Net income available to  common stockholders |       | $                                           | 4,267.8    |                    |       | $          | 249.3      |   |   | $ | 4,018.5 |   |   | 1,612.2 |   |   |

----

(1)          Non-cash stock-basedcompensation expense included in these amounts is as follows:

| Research and development    |   | $       | 470.6  |   |   | $      | 77.4   |   |   |   |   |   |   |   |   |
|-----------------------------|--------|---------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|
| Sales and marketing         |   | 821.0   |   |   | 167.7  |   |   |   |   |   |   |   |   |
| General and  administrative |   | 1,361.1 |   |   | 161.3  |   |   |   |   |   |   |   |   |

 

*Gross Margin*

Diagnostic device gross margin increased to $6.2million, or 82.5% of diagnostic device revenue, for the year ended December 31,2006, as compared to $3.2 million, or 74.9% of diagnostic device revenue, forsame period in 2005. The increase in the gross margin percentage in 2006compared to 2005 is primarily attributable to an increase in the list price ofour NC-stat System from $4,000 to $5,000 effective January 1, 2006 andmanufacturing price reductions realized for our device beginning in the secondquarter of 2006.

51

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Biosensor gross margin increased to $35.5 million, or74.4% of biosensor revenue for the year ended December 31, 2006, ascompared to $22.3 million, or 74.1% of biosensor revenue, for the same periodin 2005. The increase in biosensor gross margin percentage is primarily due tomanufacturing price reductions realized for several of our biosensors duringthe second half of 2005 and the first quarter of 2006 partially offset by achange in the mix of biosensors sold.

Our overall gross margin increased to $41.7 million,or 75.5% of revenues, for the year ended December 31, 2006, as compared to$25.4 million, or 74.2% of revenues, for same period in 2005.

Our gross margins maydecline in 2007 with the potential introduction of the ADVANCE System, which isexpected to have lower gross margins due to higher production costs comparedwith the current diagnostic devices.

*Research andDevelopment*

Our research and development, or R&D, expensesinclude expenses associated with our research, product development, clinical,regulatory, and quality assurance departments.

R&D expenses increased $1.2 million, or 31.1%, to$5.0 million for the year ended December 31, 2006 from $3.8 million forthe year ended December 31, 2005. As a percentage of revenues, R&Dexpenses were 9.1% and 11.1% for the years ended December 31, 2006 and2005, respectively. The increase in expenses is primarily due to an increase of$614,000 in personnel costs resulting from the hiring of additional employeesin our R&D department and increases in employee compensation. In addition,product development and temporary labor costs increased $77,700 and $51,700,respectively. These increases are primarily related to the development of theADVANCE System and new biosensors. Also contributing to the increase was anincrease of $393,200 in stock-based compensation expense due to the adoption ofthe provisions of SFAS No. 123(R).

We expect our spending onR&D will be relatively unchanged in 2007. We anticipate that resourcesdevoted to the development of the ADVANCE System, during 2006 will bereallocated to other research and development efforts. This amount may vary,however, depending on the opportunities and challenges that arise during theyear.

*Sales and Marketing*

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

Sales and marketing expenses increased $7.9 million,or 55.6%, to $22.0 million for year ended December 31, 2006 from $14.2million for the year ended December 31, 2005. As a percentage of revenues,sales and marketing expenses were 39.8% and 41.3% for the years ended December 31,2006 and 2005, respectively. The change in expenses is primarily due to anincrease of $4.1 million in employee compensation and benefit costs,including sales commissions paid to our regional sales managers. This increaseis attributable to the expansion of the sales force and higher revenues in 2006as compared to 2005. Also contributing to the change in expenses are (a) anincrease of $1.6 million in sales commissions paid to our independent regionalsales agencies, which is related to our higher revenues in 2006 as well as theaddition of PSS as a distributor in May 2006; (b) an increase instock-based compensation expense of $653,300 due to the adoption of theprovisions of SFAS No. 123(R); (c) an increase of $400,700 in travelexpenses due to the expansion of the sales force; (d) an increase inconsulting services of $299,300, primarily to assist us with the reimbursement challengeswe are currently facing;  and (e) anincrease of $267,500 in costs for new promotional materials.

52

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We have increased oursales force to 53 employees, including 50 regional sales managers, as of December 31,2006 from 36 employees, including 31 regional sales managers as of December 31,2005. We plan to sell the DigiScope through the same sales force used to sellthe NC-stat System and as a result we do not anticipate the need to expand thesales force to support the sales and marketing efforts for the DigiScope. However,we may incur additional expenses relating to sales commissions and marketingmaterials in connection with the sale of the DigiScope. For 2007, we expectsales and marketing expenses to be relatively unchanged; however, this mayvary, depending primarily on our revenues for 2007.

*General andAdministrative*

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

General and administrative expenses increased $3.8million, or 47.2%, to $11.8 million for year ended December 31, 2006 from$8.0 million for the year ended December 31, 2005. As a percentage ofrevenues, general and administrative expenses were 21.4% and 23.4% for theyears ended December 31, 2006 and 2005, respectively. The increase inexpenses is primarily due to (a) an increase in stock-based compensationexpense of $1.2 million from the adoption of the provisions of SFAS No. 123(R);(b) an increase of $661,300 in bad debt expense resulting from an increasein past due accounts; (c) an increase of $538,400 in professional fees forlegal and accounting services; (d) an increase of $456,000 in our accrualfor sales taxes; (e) an increase of $268,800 in our insurance costs; (f) anincrease in credit card and bank fees of $238,800 related to increased customertransactions; and (g) an increase in personnel costs of $120,700 from theexpansion of staff and increases in employee compensation.

We expect our general andadministrative expenses to increase during 2007 as a result of consultingexpenses and legal fees associated with our efforts to address the reimbursementand other legal challenges we face, including the investigation by the UnitedStates Department of Justice of which we recently became aware..

*Interest Income*

Interest income was$1,598,400 and $838,800 during the years ended December 31, 2006 and 2005,respectively, representing an increase of $759,600. Interest income was earnedfrom cash equivalents, short-term investments and long-term investments. Theincrease in interest income for the year ended December 31, 2006, ascompared to the year ended December 31, 2005 is primarily due to higheraverage cash balances and an increase in the average portfolio yieldattributable to the impact of higher market interest rates in 2006. Interestexpense was not material for the years ended December 31, 2006 and 2005.

*Provision forIncome Taxes*

We recorded a taxprovision related to the alternative minimum tax of $193,000 and $35,000 forthe years ended December 31, 2006 and 2005, respectively.

53

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**Comparison of YearsEnded December 31, 2005 and December 31, 2004**

*Revenues*

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

| ** **            | ** ** | **Years 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 2004, respectively, anincrease of $2.0 million, or 90.2%. Of this increase, approximately $1.4million is attributable to a greater number of units sold, primarily as aresult of an increase in the number of regional sales managers and expandedclinical uses for the NC-stat System. In addition, approximately $627,600 ofthis increase is attributable to an increase in the list price of our NC-statmonitors 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 2004, respectively.

Biosensor revenues were $30.1 million and $15.7million for the years ended December 31, 2005 and 2004, respectively, anincrease of $14.4 million, or 91.6%. The increase is primarily due to anincreased customer base for our biosensors, increased frequency of testing byour customers and the introduction of new biosensors, including the suralbiosensor in the fourth quarter of 2004. Biosensor revenues accounted for 87.7%and 87.6% of our total revenues for the years ended December 31, 2005 and2004, 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 $17.9 million for the years ended December 31, 2005 and2004, 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.

54

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*Costs and expenses*

Thefollowing table presents our costs and expenses and net income (loss):

| ** **                                                                                   | ** ** | **Years Ended December 31,** | ** ** | ** **             | ** ** | ** ** | ** ** |
|----------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|------------------------|------------|------------|------------|
| ** **                                                                                   | ** ** | **2005**                                    | ** ** | **2004**               | ** ** | **Change** | ** ** | **% Change** | ** ** |
| ** **                                                                                   | ** ** | **(as restated)**                      | ** ** | **(as restated)** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                                   | ** ** | **(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)                                                                |       |                                        | 8,021.8    |                   |       | 5,267.4    |       | 2,754.4 |   |   | 52.3 |   |   |
| Total operating expenses                                                                     |       |                                        | 25,992.6   |                   |       | 17,023.8   |       | 8,968.8 |   |   | 52.7 |   |   |
| Income (loss)  from operations                                                               |       |                                        | (552.5     | )                      |       | (3,957.0   | )          | 3,404.5 |   |   | (86.0 | ) |   |
| Interest income                                                                              |       |                                        | 838.8      |                   |       | 214.1      |       | 624.7 |   |   | 291.8 |   |   |
| Interest expense                                                                             |       |                                        | (2.0       | )                      |       | (964.1     | )          | 962.0 |   |   | (99.8 | ) |   |
| Income (loss)  before provision for income taxes                                             |       |                                        | 284.3      |                   |       | (4,707.0   | )          | 4,991.2 |   |   | (106.0 | ) |   |
| Provision for  income taxes                                                                  |       |                                        | 35.0       |                   |       | —     |       | 35.0 |   |   | 100.0 |   |   |
| Net income (loss)                                                                            |       |                                        | 249.3      |                   |       | (4,707.0   | )          | 4,956.2 |   |   | (105.3 | ) |   |
| 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                                          |       |                                        | $          | 249.3                  |       |       | $          | (13,931.9 | ) | $ | 14,181.2 |   |   | (101.8 | ) |   |

----

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

| Research and development    |   | $     | 77.4   |   | $      | 249.1  |   |   |   |   |   |   |   |
|-----------------------------|--------|-------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|
| Sales and marketing         |   | 167.7 |   | 356.4  |   |   |   |   |   |   |   |
| General and  administrative |   | 161.3 |   | 423.0  |   |   |   |   |   |   |   |

 

*Gross Margin*

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

55

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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 marginpercentage was 74.2% for the year ended December 31, 2005 compared to72.9% for 2004.

*Research andDevelopment*

R&D expenses increased$552,300, or 16.9%, to $3.8 million for the year ended December 31, 2005from $3.3 million for the year ended December 31, 2004. As a percentage ofrevenues, R&D expenses were 11.1% and 18.2% for the years ended December 31,2005 and 2004, respectively. This increase was primarily due to a $434,200increase in employee compensation and benefit costs and a $54,400 increase inrecruiting costs. These increases resulted from the hiring of additionalemployees in our R&D department, particularly in product development tosupport our efforts on the development of the ADVANCE System, new biosensors,improvements to existing biosensors, products to diagnose additionalneuropathies and a drug delivery system for the minimally invasive treatment ofneuropathies. Also contributing to the change was an increase of $283,600 inoutside consulting costs primarily related to efforts expended on thedevelopment of the ADVANCE System and on new biosensors and improvements toexisting biosensors. These increases were partially offset by a decrease instock-based compensation expense of $171,800 related to employee stock options

*Sales and Marketing*

Sales and marketing expensesincreased $5.7 million, or 66.7%, to $14.2 million for year ended December 31,2005 from $8.5 million for the year ended December 31, 2004. As apercentage of revenues, sales and marketing expenses were 41.3% and 47.4% forthe years ended December 31, 2005 and 2004, respectively. The change inexpenses was primarily due to an increase of $3.7 million in employeecompensation and benefit costs, including sales commissions paid to ourregional sales managers. This increase is due to the expansion of the salesforce and higher revenues in 2005 as compared to 2004. Also contributing to thechange in expenses was an increase of $1.5 million in sales commissions paid toour independent sales agencies, which were related to our higher revenues in2005, and increases of $351,400 in travel expenses and $73,300 in recruitingcosts due 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.

*General andAdministrative*

General and administrativeexpenses increased $2.8 million, or 52.3%, to $8.0 million for year ended December 31,2005 from $5.3 million for the year ended December 31, 2004. As apercentage of revenues, general and administrative expenses were 23.4% and 29.4%for the years ended December 31, 2005 and 2004, respectively. The increasein expenses was primarily due to (a) an increase in employee compensationand benefit 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, 

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primarilyrelating to increases in director and officer insurance premiums as a result ofthe transition to a publicly-traded company; (d) an increase of $266,000in our accrual for sales taxes; (e) an increase of $177,600 in credit cardand bank transaction fees related to customer sales; (f) an increaseof $148,000 in franchise taxes and other fees; and (g) an increase inrecruiting costs of $94,300 associated with new hires. The increases are offsetin part by a decrease of $261,800 in stock-based compensation expense relatedto employee stock options.

*Interest Income*

Interest income was$838,800 and $214,100 for 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 Company’s initial public offering (“IPO”), which wascompleted in the third quarter of 2004, the investment of the proceeds from thesale of preferred stock in March 2004 and increased yields on investedfunds in 2005.

*Interest Expense*

Interest expense was$2,000 and $964,100 for the years ended December 31, 2005 and 2004,respectively, representing a decrease of $962,000. The decrease in interestexpense was due to the payment in the third quarter of 2004 of an outstandingdebt balance of $3.0 million under our line of credit with Lighthouse Capital Partnersby using a portion of the proceeds received from the IPO.

*Provision forIncome Taxes*

We recorded a taxprovision related to the alternative minimum tax of $35,000 for the year ended December 31,2005. In 2004, we recorded no provision for income taxes.

*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 redeemableconvertible preferred stock issued in March 2004. There was no deemeddividend or beneficial conversion charge in 2005. All issued and outstandingshares of preferred stock were converted into shares of common stock inconnection with the IPO.

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**Liquidity andCapital Resources**

Ourprincipal source of liquidity is our current cash and cash equivalents andshort-term held-to-maturity investments. As of December 31, 2006, theweighted average maturity of our short-term held-to-maturity investments was149 days. Our ability to generate cash from operations is dependent uponour ability to generate revenue from sales of our products, as well as ourability to manage our operating costs and net assets. A decrease in demand forour products or unanticipated increases in our operating costs would likelyhave an adverse effect on our liquidity and cash generated from operations. Thefollowing sets forth information relating to our liquidity:

| ** **                                                                | ** ** | **December 31,**   | ** ** | ** ** | ** ** | ** ** | ** ** |
|---------------------------------------------------------------------------|------------|-------------------------|------------|------------|------------|------------|------------|
| ** **                                                                | ** ** | **2006**                | ** ** | **2005**   | ** ** | **Change** | ** ** | **% Change** | ** ** |
| ** **                                                                | ** ** | **(in thousands)** | ** ** | ** ** | ** ** |
| Cash and cash  equivalents                                                |       | $                       | 7,909.8    |       | $          | 8,170.0    |       | $ | (260.2 | ) |   | (3.2 | )% |   |
| Short-term  held-to-maturity investments                                  |       | 32,410.7                |       | 24,081.9   |       | 8,328.8    |       |   | 34.6 |   |   |
| Total cash, cash  equivalents and short-term held-to-maturity investments |       | $                       | 40,320.5   |       | $          | 32,251.9   |       | $ | 8,068.6 |   |   | 25.0 | % |   |

 

During 2006, our cash and cash equivalents andshort-term held-to-maturity investments increased by $8.1 million, primarilydue to $7.3 million of cash provided by operations and $1.6 million of proceedsreceived from the exercise of stock options and the issuance of common stockunder our employee stock purchase plan, offset in part by cash used for capitalexpenditures of $620,500.

Inmanaging our working capital, two of the financial measurements we monitor aredays’ sales outstanding, or DSO, and inventory turnover rate, which arepresented in the table below for the years ended December 31, 2006 and December 31,2005:

| ** **                                | ** ** | **Years Ended  December 31,** | ** ** |
|-------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                | ** ** | **2006**                                | ** ** | **2005** | ** ** |
| Days’ sales  outstanding (days)      |       |                                    | 40         |   |   |   | 40 |   |   |
| Inventory turnover rate  (times per year) |       |                                    | 4.3        |   |   |   | 4.5 |   |   |

 

Our payment terms extended to our customers generallyrequire payment within 30 days from invoice date. During the fourth quarter of2006, we experienced an increase in DSO to 49 days and there was a significantincrease in the percentage of accounts receivable past due 60 days or more. Webelieve that these increases were primarily the result of uncertaintysurrounding the reimbursement by Medicare in certain regions of the UnitedStates for nerve conduction studies performed using the NC-stat System. We arecurrently experiencing the effect of this reimbursement uncertainty and it isexpected to continue in 2007. As a result this may continue to adversely impactour DSO and our working capital. Accounts payable are normally paid within 30to 40 days from receipt of a vendor’s invoice.

Our inventory turnover for the year ended December 31,2006 was 4.3 times, compared with 4.5 times for the year ended December 31,2005. The decrease in the inventory turnover rate for the year ended December 31,2006 as compared to the year ended December 31, 2005 was primarily due toan increase in inventory levels in preparation for the release of the ADVANCESystem. Our inventory levels increased in the fourth quarter of 2006 as aresult of decreased demand for the NC-stat System, increased production ofbiosensors at our third-party manufacturer and the initial production of theADAVANCE System. We anticipate additional increases in inventory levels byapproximately $1.5 million to $2.0 million in preparation for the expectedrelease of the ADVANCE System in the summer of 2007. We anticipate this willhave the impact of reducing our inventory turnover as we build inventory priorto the initial sale of this new product.

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

| ** **                                           | ** ** | **Years Ended December 31,** | ** ** |
|------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                           | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                           | ** ** | **(in thousands)**                     | ** ** |
| Net cash provided  by (used in) operating activities |       | $                                           | 7,297.9    |   | $ | 1,908.1 |   | $ | (2,651.6 | ) |
| Net cash provided  by (used in) investing activities |       | $                                           | (9,133.4   | ) | $ | 3,514.5 |   | $ | (28,706.1 | ) |
| Net cash provided by  financing activities           |       | $                                           | 1,575.3    |   | $ | 812.2 |   | $ | 31,671.4 |   |

 

Cash provided by operating activities was $7.3 millionand $1.9 million in 2006 and 2005, respectively, while cash used in operatingactivities was $2.7 million in 2004.  In2006, a net use of cash of approximately $1.2 million for our investment inworking capital was offset by $4.3 million in net income and $4.2 million innon-cash items, mainly compensation expense associated with stock options. Theprimary drivers of our investment in working capital were as follows: Ouraccounts receivable increased $4.1 million, excluding the change in theallowance for doubtful accounts, due to growth in revenues. Our inventoriesincreased $950,000 primarily due to the growth in our business and ourpreparation for the release of the ADVANCE System.  These items were partially offset by a $2.1million increase in accrued expenses. In 2005, increases in accrued expenses,deferred revenue (net of deferred costs) and accounts payable of $1.9 million,$588,900 and $799,300, respectively; non-cash items of $1.4 million andnet income of $249,300 were offset in part by increases in accounts receivableand inventory of $1.7 million and $1.4 million, respectively. Cash used inoperations in 2004 was driven by the net loss of $4.7 million offset by $2.0million in non-cash items and an increase of $73,000 in cash from changes inworking capital. As a result of the potential decline in revenues and increasein expenses, we may be unable to sustain the profitability we achieved in thesecond half of 2005 and in 2006. This may have an adverse impact on our cashflows from operating activities in 2007. In addition, we expect to haveincreased investments in working capital, especially inventories, due to thepre-launch production of the ADVANCE System.

Our investing activities used $9.1 million of cash in2006, provided $3.5 million of cash in 2005 and used $28.7 million of cash in2004. In 2006, we used $8.5 million in cash for net purchases of investmentsand $620,500 in cash to fund purchases of fixed assets, primarily related tocomputer equipment. In 2005, net maturities of investments of $3.6 millionprovided cash, which was primarily reinvested in cash equivalents. This wasoffset by $475,100 of cash to fund purchases of fixed assets primarily relatedto leasehold improvements and tooling equipment for new products. In 2004,$31.0 million of proceeds from equity financings was invested in short-term andlong-term held-to-maturity investments and $545,200 was used to fund thepurchase of fixed assets, primarily related to production tooling and computerequipment. During 2007, we expect to continue to maintain our cash andinvestments in money market funds and short-term investment vehicles. We do notcurrently have any significant commitments to purchase capital equipment and weexpect that our capital expenditures will be comparable to the level of suchexpenditures in 2006.

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. The letterof credit is secured by a certificate of deposit in an amount equal to 102% ofthe letter of credit. The lease expires in March 2009. The certificate ofdeposit is renewable in 30-day increments. This amount is classified asrestricted cash in the balance sheet. The reduction in the restricted cashbalance provided $438,600 in 2005.

Cash provided by financing activities was $1.6million, $812,200 and $31.7 million in 2006, 2005 and 2004, respectively. Cashprovided by financing activities in 2006 and 2005 represents the proceeds fromthe exercise of stock options and the issuance of shares under our employeestock purchase plan. The cash 

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provided by financingactivities in 2004 primarily represented the net proceeds of $24.0 millionrealized from our IPO, including the net proceeds from over-allotment shares,as well as net proceeds of $10.6 million received from the issuance ofpreferred stock in a private placement, offset by payments on long-term debt of$3.0 million.

During 2007, we may (a) expend funds to expandour sales and marketing for the NC-stat System, although more modestly than theexpansion in 2006, (b) fund sales and marketing efforts for the DigiScope,and (c) continue our ongoing program of making enhancements andimprovements to the NC-stat System, including the development of new and/orimproved biosensors, products for the diagnosis of additional neuropathies, anddevelopment activities relating to the ADVANCE System.

In addition, we plan to expend funds on the design ofa drug delivery system, which is expected to enter the clinical stage ofdevelopment in 2007, for the minimally invasive delivery of therapeutic agentsto treat neuropathies by both primary care and specialist physicians. We alsoexpect 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, 2006, we have federal andstate net operating loss carryforwards available to offset future taxableincome of $29.5 million and $16.1 million, respectively, and federaland state tax credits of $890,000 and $317,000, respectively, which may beavailable to reduce future taxable income and the related taxes thereon. Thenet operating loss and research and development credit carryforwards expire atvarious dates beginning in 2011 for federal and 2007 for state. Ownershipchanges in our company, as defined in the Internal Revenue Code, are expectedto have a modest limitation on the amount of net operating loss and researchand development credit carryforwards that can be utilized annually to offsetfuture taxable income and taxes, based on an analysis of the provisions of Section 382of the Internal Revenue Code. Subsequent changes in our ownership could furtheraffect 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, 2006, we did not have anyoff-balance sheet financing arrangements.

Thefollowing table summarizes our principal contractual obligations as of December 31,2006 and the effects such obligations are expected to have on our liquidity andcash flows in future periods.

| ** **                       | ** ** | **Payments due in** | ** ** |
|----------------------------------|------------|-------------------------------|------------|
| **Contractual Obligations** | ** ** | ** **                    | ** ** | **Total** | ** ** | **2007** | ** ** | **2008 and 2009** | ** ** | **20010 and 2011** | ** ** | **After 2011** | ** ** |
| Operating lease  obligations     |       | $                             | 2,092,500  |   | $ | 930,000 |   |   | $ | 1,162,500 |   |   |   | $ | —         — |   |   | $ | — |   |
| Purchase order  obligations      |       | 5,629,700                     |       | 5,629,700 |   |   | — |   |   |   | — |   |   | — |   |
| License agreement  obligations   |       | 85,000                        |       | 85,000 |   |   | — |   |   |   | — |   |   | — |   |
| Total contractual  obligations   |       | $                             | 7,807,200  |   | $ | 6,644,700 |   |   | $ | 1,162,500 |   |   |   | $ | — |   |   | $ | — |   |
|                                  |            |                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Critical AccountingPolicies**

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 

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judgmentand complexity in their application than our other accounting policies andrepresent the critical accounting policies used in the preparation of ourfinancial statements. If different assumptions or conditions were to prevail,the results could be materially different from our reported results. Oursignificant accounting policies are presented within Note 1—Business andSummary of Significant Accounting Policies of the Notes to FinancialStatements.

*Revenue Recognition*

Our revenue recognition policy is to recognizerevenues from our monitor and biosensors upon shipment if the fee is fixed ordeterminable, persuasive evidence of an arrangement exists, delivery hasoccurred and risk of loss has passed, collection of the resulting receivablesis reasonably assured and product returns are reasonably estimable. Revenuesfrom our docking station and access to the onCall Information System areconsidered one unit of accounting and are deferred and recognized over theshorter of the estimated customer relationship period or the estimated usefullife of the product, currently three years. We record revenue on a net basisfor product sales made to distributors, based upon the amount billed to thedistributors, when the distributor accepts the responsibility for invoicing thecustomer and the responsibility for the risk of collections and product returnsfrom the customer.

When multiple elements are contained in a singlearrangement, we allocate revenue between the elements based on their relativefair value, provided that each element meets the criteria for treatment as aseparate unit of accounting. An element is considered a separate unit ofaccounting if it has value to the customer on a stand-alone basis, there isobjective, reliable evidence of the fair value of the undelivered elements anddelivery or performance of the undelivered elements is considered probable andsubstantially in our control. Fair value is determined based upon the pricecharged 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 30-day right of return. Since we can reasonably estimatefuture returns, we recognize revenues associated with product sales thatcontain a right of return upon shipment and at the same time reduce revenue bythe amount of estimated returns under the provisions of SFAS No. 48, “*Revenue Recognition When Right of Return Exists*.”

*Accounts Receivableand Allowance for Doubtful Accounts*

Trade accounts receivableare recorded at the invoiced amount and do not bear interest. The allowance fordoubtful accounts is our best estimate of the amount of probable credit lossesin its existing accounts receivable. We review our allowance for doubtfulaccounts and determine the allowance based on an analysis of customer pastpayment history, product usage activity, and recent communications between usand the customer. Past due balances over 90 days are reviewed individuallyfor collectibility.  Account balances arecharged off against the allowance when we feel it is probable the receivablewill not be recovered. We do not have any off-balance sheet credit exposurerelated to our customers.

*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. 

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Shouldactual product failure and user error rates, material usage or delivery costsdiffer from our estimates, the amount of actual warranty costs could materiallydiffer from our estimates. Warranty costs are based on the cost of repairing orreplacing monitors and docking stations and based on the replacement cost ofbiosensors.

*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. The realizable value of inventories is based upon thetypes and levels of inventory held, forecasted demand, pricing, competition andchanges in technology. Should current market and economic conditionsdeteriorate, our actual recoveries could be less than our estimates. Therecoverability of our fixed assets and other long-lived assets are evaluatedwhen circumstances indicate that an event of impairment may have occurred inaccordance with the provisions of SFAS No. 144, “*Accounting for the Impairment or Disposal ofLong-Lived Assets*”.

*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.

*Accounting forStock-Based Compensation*

Effective January 1,2006, we adopted SFAS No. 123(R) using the modified prospectivemethod and began reflecting the stock-based compensation expense determinedunder fair value based methods in our statement of operations rather than aspro forma disclosure in our notes to the financial statements. Under thistransition method, the compensation cost recognized beginning January 1,2006 includes compensation cost for (i) all share-based payments grantedprior to, but not yet vested as of January 1, 2006, based on thegrant-date fair value estimated in accordance with the provisions of SFAS No. 123,and (ii) all share based payments granted subsequent to January 1,2006 based on the grant-date fair value estimated in accordance with theprovisions of SFAS No. 123(R). Compensation cost is generally recognizedratably over the requisite service period. Prior period amounts have not beenrestated. We use the Black-Scholes option pricing model for determining thefair value of our stock options and amortize our stock-based compensationexpense using the straight-line method.

**New AccountingPronouncements**

In June 2006, the Financial Accounting StandardsBoard (“FASB”) issued FASB Interpretation No. 48,*“Accounting for Uncertainty in Income Taxes—aninterpretation of FASB Statement No. 109”* (“FIN No. 48”),which clarifies the accounting and disclosure for uncertainty in tax positions,as defined. FIN No. 48 requires that we recognize in our financialstatements the impact of the tax position if that position is more likely thannot of being sustained upon examination, based on the technical merits of theposition. The provisions of FIN No. 48 are effective as of the beginningof the 2007 calendar year, with the 

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cumulative effect of thechange in accounting principle recorded as an adjustment to opening retainedearnings.  We believe that FIN No. 48will not have a material effect on our financial position, results fromoperations or cash flows.

In September 2006, the FASB issued SFAS No. 157,*“Fair Value Measurements”* (“SFAS No. 157”).SFAS No. 157 defines fair value in numerous accounting pronouncements,establishes a framework for measuring fair value in generally acceptedaccounting principles (“GAAP”) and expands disclosures related to the use offair value measures in financial statements. SFAS No. 157 does not expandthe use of fair value measures in financial statements, but standardizes itsdefinition and guidance in GAAP.  TheStandard emphasizes that fair value is a market-based measurement and not anentity-specific measurement based on an exchange transaction in which theentity sells an asset or transfers a liability (exit price). SFAS No. 157establishes a fair value hierarchy from observable market data as the highest levelto fair value based on an entity’s own fair value assumptions as the lowestlevel. SFAS No. 157 is effective for our financial statements issued in2008; however, earlier application is encouraged. We have not yet determinedthe impact that the adoption of SFAS No. 157 will have on our financialposition, results of operations or its cash flows.

In September 2006, the Securities and ExchangeCommission issued Staff Accounting Bulletin No. 108 *“Considering the Effects of Prior Year Misstatementswhen Quantifying Misstatements in Current Year Financial Statements”*(“SAB 108”). SAB 108 provides guidance on how the effects of the carryover orreversal of prior year financial statement misstatements should be consideredin quantifying a current year misstatement. Prior practice allowed theevaluation of materiality on the basis of: (1) the error quantified as theamount by which the current year income statement was misstated (rollovermethod); or (2) the cumulative error quantified as the cumulative amount bywhich the current year balance sheet was misstated (iron curtain method). Relianceon either method in prior years could have resulted in misstatement of thefinancial statements. The guidance provided in SAB No. 108 requires bothmethods to be used in evaluating materiality. Immaterial prior year errors maybe corrected with the first filing of prior year financial statements afteradoption. The cumulative effect of the correction would be reflected in theopening balance sheet with appropriate disclosure of the nature and amount ofeach individual error corrected in the cumulative adjustment, as well as adisclosure of the cause of the error and that the error had been deemed to beimmaterial in the past. SAB No. 108 did not have a material impact on ourfinancial position, results of operations or its cash flows.

In February 2007, theFASB issued SFAS No. 159, “*The FairValue Option for Financial Assets and Financial Liabilities, including anamendment of FASB Statement No. 115*.” (“SFASNo. 159”)  SFAS No. 159 permitsentities to choose to measure many financial instruments and certain otheritems at fair value that are not currently required to be measured at fairvalue. Unrealized gains and losses on items for which the fair value option hasbeen elected are reported in earnings. SFAS No. 159 does not affect anyexisting accounting literature that requires certain assets and liabilities tobe carried at fair value. SFAS No. 159 is effective for fiscal yearsbeginning after November 15, 2007. We believe that our adoption of SFASNo. 159 will not have a material impact on our financial position, resultsof operations or cash flows.

**Subsequent Event**

On March 7, 2007, our Board of Directors adopteda Shareholder Rights Plan and declared a dividend distribution of one preferredstock purchase right for each outstanding share of our common stock toshareholders of record as of the close of business on March 8, 2007. Initially,these rights will not be exercisable and will trade with the shares of ourcommon stock. Under the Shareholder Rights Plan, the rights generally willbecome exercisable if a person becomes an “acquiring person” by acquiring 15%or more of our common stock or if a person commences a tender offer that couldresult in that person owning 15% or more of our common stock. If a personbecomes an acquiring person, each holder of a right (other than the acquiringperson) would be entitled to purchase, at the then-current exercise price, suchnumber 

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of shares of preferredstock which are equivalent to shares of our common stock having a value oftwice the exercise price of the right. If we are acquired in a merger or otherbusiness combination transaction after any such event, each holder of a rightwould then be entitled to purchase, at the then-current exercise price, sharesof the acquiring company’s common stock having a value of twice the exerciseprice of the right.

A copy of the ShareholderRights Plan has been filed on Form 8-K filed with the SEC on March 8,2007.

**CAUTIONARY NOTEREGARDING 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 derivative financial instruments in ourinvestment portfolio and have no foreign exchange contracts. Our financialinstruments consist of cash, cash equivalents, short-term investments, accountsreceivable, accounts payable and accrued expenses. We consider investmentsthat, when purchased, have a remaining maturity of 90 days or less to becash equivalents. The primary objectives of our investment strategy are topreserve principal, maintain proper liquidity to meet operating needs, andmaximize yields. To minimize our exposure to an adverse shift in interestrates, we invest mainly in cash equivalents and short-term investments with amaturity of 12 months or less and maintain an average maturity of twelvemonths or less. We do not believe that a notional or hypothetical 10% change ininterest rate percentages would have a material impact on the fair value of ourinvestment portfolio or our interest income.

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**ITEM8.**                FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA

The information required by this item may be found on pages F-1through F-28 of this Form 10-K with the exception of the unauditedquarterly financial information which is presented below.

Wehave restated our unaudited quarterly financial information for each of the firstthree quarters of the year ended December 31, 2006, and for each of thequarters of the year ended December 31, 2005 to correct errors inaccounting for sales taxes. See Note 2—Restatement of the Notes to Financial Statements:

| ** **                                                                   | ** ** | **Year Ended December 31, 2006** | ** ** |
|------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                   | ** ** | **First  Quarter**                                   | ** ** | **Second  Quarter** | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter** | ** ** | **Total** | ** ** |
| ** **                                                                   | ** ** | **(as restated)**                               | ** ** | **(as restated)** | ** ** | **(as restated)** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues                                                                     |       | $                                                    | 11,823,275 |   | $ | 13,970,050 |   | $ | 15,261,251 |   | $ | 14,195,140 |   | $ | 55,249,716 |   |
| Gross margin                                                                 |       | $                                                    | 8,943,362  |   | $ | 10,592,584 |   | $ | 11,525,299 |   | $ | 10,630,417 |   | $ | 41,691,662 |   |
| Net income (loss)  attributable to common shareholders                       |       | $                                                    | (102,662   | ) | $ | 1,233,700 |   | $ | 2,104,630 |   | $ | 1,032,138 |   | $ | 4,267,806 |   |
| Net income (loss) per  common share:                                         |       |                                                 |       |   |   |   |   |   |   |   |   |
| Basic                                                                        |       | $                                                    | (0.01      | ) | $ | 0.10 |   | $ | 0.17 |   | $ | 0.08 |   | $ | 0.34 |   |
| Diluted                                                                      |       | $                                                    | (0.01      | ) | $ | 0.09 |   | $ | 0.16 |   | $ | 0.08 |   | $ | 0.33 |   |
| Weighted average shares  used to compute net income (loss) per common share: |       |                                                 |       |   |   |   |   |   |   |   |   |
| Basic                                                                        |       | 12,414,479                                           |       | 12,485,205 |   | 12,539,709 |   | 12,583,825 |   | 12,501,742 |   |
| Diluted                                                                      |       | 12,414,479                                           |       | 13,137,867 |   | 13,095,430 |   | 12,926,449 |   | 13,097,891 |   |

 

| ** **                                                                   | ** ** | **Year Ended December 31, 2005** | ** ** |
|------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                   | ** ** | **First  Quarter**                                   | ** ** | **Second  Quarter** | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter** | ** ** | **Total** | ** ** |
| ** **                                                                   | ** ** | **(as restated)**                               | ** ** | **(as restated)** | ** ** | **(as restated)** | ** ** | **(as restated)** | ** ** | **(as restated)** | ** ** |
| 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                       |       | $                                                    | (736,314   | ) | $ | (194,144 | ) | $ | 597,265 |   | $ | 582,451 |   | $ | 249,258 |   |
| Net income (loss) per  common share:                                         |       |                                                 |       |   |   |   |   |   |   |   |   |
| Basic                                                                        |       | $                                                    | (0.06      | ) | $ | (0.02 | ) | $ | 0.05 |   | $ | 0.05 |   | $ | 0.02 |   |
| Diluted                                                                      |       | $                                                    | (0.06      | ) | $ | (0.02 | ) | $ | 0.05 |   | $ | 0.04 |   | $ | 0.02 |   |
| 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 |   |

 

**Item9.**                Disagreements with Accountants on Accountingand Financial Disclosure

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

65

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**Item9A.**        Controls and Procedures

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

Our management carried out an evaluation, with theparticipation of our Chief Executive Officer and our Chief Financial Officer,of the effectiveness of our disclosure controls and procedures (as defined inRules 13a-15(e) and 15d-15(e) under the SecuritiesExchange Act of 1934, as amended (the “Exchange Act”)) as of December 31,2006. Our disclosure controls and procedures are designed to provide reasonableassurance that information required to be disclosed by us in the reports thatwe file or submit under the Exchange Act is recorded, processed, summarized andreported within the time periods specified in the SEC’s rules and forms,and that such information is accumulated and communicated to our management,including our Chief Executive Officer and our Chief Financial Officer, to allowtimely decisions regarding required disclosures.

Based upon thisevaluation, our management, including our Chief Executive Officer and our ChiefFinancial Officer, concluded that our disclosure controls and procedures werenot effective as of December 31, 2006 given the existence of the materialweakness in internal controls over financial reporting relating to state salestax as described below. Notwithstanding the material weakness described below,our management believes that the financial statements included in this AnnualReport on Form 10-K are fairly presented in all material respects inaccordance with generally accepted accounting principles.

**(b)****         Management’sReport 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). 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. Under the supervision and with theparticipation of our management, including our Chief Executive Officer and ourChief Financial Officer, we conducted an evaluation of the effectiveness of ourinternal control over financial reporting as of December 31, 2006 based onthe criteria in*Internal Control—IntegratedFramework* issued by the Committee of Sponsoring Organizations of theTreadway Commission (“COSO”).

A material weakness is a control deficiency, orcombination of control deficiencies, that results in more than a remotelikelihood that a material misstatement of the annual or interim financialstatements will not be prevented or detected. Based on its evaluation, ourmanagement identified the following material weakness as of December 31,2006: We did not maintain effectivecontrols over our sales tax liability and related expense accounts. Specifically*,*we did not have adequate controlsdesigned and in place to assure that state sales taxes were properly collectedand remitted in all states in which the Company operates. This controldeficiency resulted in the restatement of the Company’s financial statementsfor the years ended December 31, 2005 and 2004, each of the quarters of2005 and the first three quarters of the year ended December 31, 2006.Additionally, this control deficiency could result in a misstatement of oursales tax liability and related accounts that, in the future, would result in amaterial misstatement to the annual or interim financial statements that wouldnot be prevented or detected. Accordingly, management has concluded that thiscontrol deficiency constitutes a material weakness.

Because of the material weakness described above, ourmanagement concluded that our internal control over financial reporting was noteffective as of December 31, 2006 based on our evaluation under theframework in *Internal Control—Integrated Framework*issued bythe COSO.

66

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Management’s assessment of the effectiveness of ourinternal control over financial reporting as of December 31, 2006, hasbeen audited by PricewaterhouseCoopers LLP, an independent registeredaccounting firm, as stated in their report which is included herein.

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

There have been no changesto the Company’s internal control over financial reporting (as defined inRule 13a-15(f) under the Exchange Act) during the quarter endedDecember 31, 2006 that has materially affected, or is reasonably likely tomaterially affect, the Company’s internal control over financial reporting.

**Item9B.**       Other Information

None.

67

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**PART III**

**Item10.**         Directors, Executive Officers and Corporate Governance

The response to this itemis contained in our Proxy Statement relating to our 2007 Annual Meeting ofStockholders (the “Proxy Statement”) and is incorporated herein by reference.

**Item11.**         Executive Compensation

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

**Item12.**         Security Ownership of Certain Beneficial Owners and Management andRelated Stockholder Matters

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

**Item13.**         Certain Relationships and Related Transactionsand Director Independence

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

**Item14.**         Principal Accountant Fees and Services

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

68

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**PART IV**

**Item15.**         Exhibits and Financial Statement Schedule

**1.   *****Financial Statements***

The consolidated financial statements are listed inthe accompanying index to financial statements on page F-1.

**2.   *****Financial Statement Schedule***

None.

**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)                                                                                            |
| 3.3              |       | Certificate of Designations for Series A Junior  Cumulative Preferred Stock, par value $0.001 per share (10)                                                                             |
| 4.1              |       | Specimen certificate for shares of common stock(1)                                                                                                                                            |
| 4.2              |       | Form of Shareholder Rights Agreement, dated as  of March 7, 2007, between NeuroMetrix, Inc. and American Stock  Transfer & Trust Company, as Rights Agent (10)        |
| 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             |       | Amended and Restated  2004 Stock Option and Incentive Plan(2)                                                                                                                                 |
| 10.6             |       | 2004 Employee Stock  Purchase Plan(1)                                                                                                                                                         |
| 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) |

69

----

 

| 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(3)                                                                    |
| 10.20   |   | Form of  Non-Qualified Stock Option Agreement For Company Employees, under the  NeuroMetrix, Inc. 2004 Stock Option And Incentive Plan(3)                                          |
| 10.21   |   | Form of  Non-Qualified Stock Option Agreement For Non-Employee Directors, under the  NeuroMetrix, Inc. 2004 Stock Option And Incentive Plan(3)                                     |
| 10.22   |   | Letter Agreement, dated  February 7, 2005, by and between NeuroMetrix, Inc. and  W. Bradford Smith(4)                                                                         |
| 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(4) |
| 10.24   |   | NeuroMetrix, Inc.  Confidentiality & Non-Compete Agreement, dated as of  February 7, 2005, by and between W. Bradford Smith and  NeuroMetrix, Inc.(4)           |
| 10.25   |   | Executive Officer  Compensation Arrangements (2004 Bonus and 2005 Salaries and Bonus Targets)(5)                                                                                             |
| 10.26   |   | Director Compensation  Arrangements(6)                                                                                                                                                       |
| **10.27 |   | Manufacturing and Supply  Agreement, dated as of August 2, 2006, by and between Parlex Polymer  Flexible Circuits, Inc. and NeuroMetrix, Inc. (7)                             |
| 10.28   |   | Executive Officer  Compensation Arrangements (2006 Bonus)(8)                                                                                                                                 |
| 10.29   |   | Executive Officer  Compensation Arrangements (2006 Salaries)(9)                                                                                                                              |
| 10.30   |   | NeuroMetrix, Inc.  Shareholder Rights Plan (10)                                                                                                                                         |
| *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                                                |

----

*                    Filedherewith.

70

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**    Portions ofexhibit 10.27 have been omitted pursuant to a request for confidentialtreatment.

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

       (2) Incorporated herein by reference to NeuroMetrix, Inc.’s CurrentReport on Form 8-K filed on May 26, 2006 (File No. 000-50856).

       (3) Incorporated herein by reference to NeuroMetrix, Inc.’sQuarterly Report on Form 10-Q filed on November 15, 2004(File No. 000-50856).

       (4) Incorporated herein by reference to NeuroMetrix, Inc.’s CurrentReport on Form 8-K filed on February 11, 2005 (File No. 000-50856).

       (5) Incorporated herein by reference to NeuroMetrix, Inc.’sQuarterly Report on Form 10-Q filed on May 11, 2005 (File No. 000-50856).

       (6) Incorporated herein by reference to NeuroMetrix, Inc.’s AnnualReport on Form 10-K filed on March 16, 2006 (File No. 000-50856).

       (7) Incorporated herein by reference to NeuroMetrix, Inc.’s CurrentReport on Form 8-K filed on August 2, 2006 (File No. 000-50856).

       (8) Incorporated herein by reference to NeuroMetrix, Inc.’sQuarterly Report on Form 10-Q filed on November 9, 2006 (File No. 000-50856).

       (9) Incorporated herein by reference to NeuroMetrix, Inc.’sQuarterly Report on Form 10-Q filed on May 10, 2006 (File No. 000-50856).

(10) Incorporated herein by reference to NeuroMetrix, Inc.’s CurrentReport on Form 8-K filed on March 8, 2007 (File No. 000-50856).

71

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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 29, 2007 |   |              |   |   |

 

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 29,2007 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                        |       |                                                  |

 

72

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**INDEXTO FINANCIAL STATEMENTSNeuroMetrix, Inc.Years ended December 31, 2006, 2005 and 2004**

|                                                                                                                     | ** ** | **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-7        |   |   |
| Notes  to Financial Statements                                                                                      |       |     | F-8        |   |   |

 

F-1

----

**Report ofIndependent Registered Public Accounting Firm**

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

We have completed integratedaudits of NeuroMetrix, Inc.’s 2006 and 2005 financial statements and of itsinternal control over financial reporting as of December 31, 2006, and anaudit of its 2004 financial statements in accordance with the standards of thePublic Company Accounting Oversight Board (United States). Our opinions, based on our audits, arepresented below.

Financial statements

In our opinion, theconsolidated financial statements listed in the index appearing under Item 15 (a) (1) presentfairly, in all material respects, the financial position ofNeuroMetrix, Inc. at December 31, 2006 and 2005, and the results ofits operations and its cash flows for each of the three years in the periodended December 31, 2006 in conformity with accounting principles generallyaccepted in the United States of America. These financial statements are theresponsibility of the Company’s management. Our responsibility is to express anopinion on these financial statements based on our audits. We conducted ouraudits of these statements in accordance with the standards of the PublicCompany Accounting Oversight Board (United States). Those standards requirethat we plan and perform the audit to obtain reasonable assurance about whetherthe financial statements are free of material misstatement. An audit offinancial statements includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements, assessing theaccounting principles used and significant estimates made by management, andevaluating the overall financial statement presentation. We believe that ouraudits provide a reasonable basis for our opinion.

As discussed in Note 2 to the financial statements,the Company has restated its financial statements as of and for the years endedDecember 31, 2005 and 2004. 

In addition, as discussedin Note 3 to the financial statements, effective January 1, 2006 theCompany changed its method of accounting for stock based compensation.

Internal control over financial reporting

Also, we have audited management’s assessment,included in “Management’s Report on Internal Control over Financial Reporting”appearing under Item 9A, that NeuroMetrix, Inc. did not maintain effectiveinternal control over financial reporting as of December 31, 2006, because of the effect of the Company notmaintaining effective controls over accounting for state sales taxes,****tax liabilities and related expense accounts, based oncriteria established in *Internal Control—IntegratedFramework* issued by the Committee of Sponsoring Organizations of theTreadway Commission (COSO). The Company’s management is responsible formaintaining effective internal control over financial reporting and for itsassessment of the effectiveness of internal control over financial reporting.Our responsibility is to express opinions on management’s assessment and on theeffectiveness of the Company’s internal control over financial reporting basedon our audit.

We conducted our audit of internal control overfinancial reporting in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that weplan and perform the audit to obtain reasonable assurance about whethereffective internal control over financial reporting was maintained in allmaterial respects. An audit of internal control over financial reportingincludes obtaining an understanding of internal control over financialreporting, evaluating management’s assessment, testing and evaluating thedesign and operating effectiveness of internal control, and performing suchother procedures as we consider necessary in the circumstances. We believe thatour audit provides a reasonable basis for our opinions.

F-2

----

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. Acompany’s internal control over financial reporting includes those policies andprocedures that (i) pertain to the maintenance of records that, in reasonabledetail, accurately and fairly reflect the transactions and dispositions of theassets of the company; (ii) provide reasonable assurance that transactionsare recorded as necessary to permit preparation of financial statements inaccordance with generally accepted accounting principles, and that receipts andexpenditures of the company are being made only in accordance withauthorizations of management and directors of the company; and(iii) provide reasonable assurance regarding prevention or timely detectionof unauthorized acquisition, use, or disposition of the company’s assets thatcould have a material effect on the financial statements.

Because of its inherent limitations, internal controlover financial reporting may not prevent or detect misstatements. Also,projections of any evaluation of effectiveness to future periods are subject tothe risk that controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures maydeteriorate.

Amaterial weakness is a control deficiency, or combination of controldeficiencies, that results in more than a remote likelihood that a materialmisstatement of the annual or interim financial statements will not beprevented or detected. The following material weakness has been identified andincluded in management’s assessment. As of December 31, 2006 the Companydid not maintain effective controls over sales tax liabilities and relatedexpense accounts. Specifically, the Company did not have adequate controlsdesigned and in place to assure that state sales taxes were properly collectedand remitted in all states in which the Company operates. This control deficiencyresulted in the restatement of the Company’s financial statements for the yearsended December 31, 2005 and 2004, each of the quarters of 2005 and the firstthree quarters of the year ended December 31, 2006. Additionally, this controldeficiency could result in a misstatement of the Company’s sales tax liabilityand related accounts that would result in a material misstatement to the annualor interim financial statements that would not be prevented or detected. Thismaterial weakness was****consideredin determining the nature, timing, and extent of audit tests applied in ouraudit of the 2006 financial statements, and our opinion regarding theeffectiveness of the Company’s internal control over financial reporting doesnot affect our opinion on those financial statements.

In our opinion,management’s assessment that NeuroMetrix, Inc. did not maintain effectiveinternal control over financial reporting as of December 31, 2006 , is fairly stated, in all material respects, basedon criteria established in *Internal Control—IntegratedFramework* issued by the COSO. Also, in our opinion, because of theeffect of the material weakness described above on the achievement of theobjectives of the control criteria, NeuroMetrix Inc. has not maintainedeffective internal control over financial reporting as of December 31,2006, based on criteria established in *Internal Control—IntegratedFramework* issued by the COSO.

/s/ PricewaterhouseCoopers LLP

Boston, MassachusettsMarch 29, 2007

F-3

----

**NeuroMetrix, Inc.Balance Sheets**

| ** **                                                                                                                                                         | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                         | ** ** | **2006**              | ** ** | **2005** | ** ** |
| ** **                                                                                                                                                         | ** ** | ** **            | ** ** | **(as restated)** | ** ** |
| **Assets**                                                                                                                                                         | ** ** | ** **            | ** ** | ** ** | ** ** |
| Current assets:                                                                                                                                                    |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                                                          |       | $                     | 7,909,778  |   | $ | 8,170,037 |   |
| Short-term held-to-maturity investments                                                                                                                            |       | 32,410,685            |       | 24,081,946 |   |
| Accounts receivable, net of allowance for doubtful  accounts of $900,000 and $400,000 at December 31, 2006 and 2005,  respectively                            |       | 7,698,550             |       | 4,543,339 |   |
| Inventories, net                                                                                                                                                   |       | 3,633,389             |       | 2,683,409 |   |
| Prepaid expenses and other current assets                                                                                                                          |       | 761,400               |       | 614,169 |   |
| Current portion of deferred costs                                                                                                                                  |       | 370,013               |       | 223,009 |   |
| Total current assets                                                                                                                                               |       | 52,783,815            |       | 40,315,909 |   |
| Restricted cash                                                                                                                                                    |       | 1,458,598             |       | 1,458,598 |   |
| Fixed assets, net                                                                                                                                                  |       | 1,115,436             |       | 875,551 |   |
| Deferred costs                                                                                                                                                     |       | 348,430               |       | 247,013 |   |
| Total assets                                                                                                                                                       |       | $                     | 55,706,279 |   | $ | 42,897,071 |   |
| **Liabilities  and Stockholders’ Equity**                                                                                                                     | ** ** | ** **            | ** ** | ** ** | ** ** |
| Current liabilities:                                                                                                                                               |       |                  |       |   |   |
| Accounts payable                                                                                                                                                   |       | $                     | 2,766,650  |   | $ | 1,698,583 |   |
| Accrued compensation                                                                                                                                               |       | 2,460,328             |       | 1,959,621 |   |
| Accrued expenses                                                                                                                                                   |       | 4,275,983             |       | 2,628,928 |   |
| Current portion of deferred revenue                                                                                                                                |       | 1,386,867             |       | 760,613 |   |
| Total current liabilities                                                                                                                                          |       | 10,889,828            |       | 7,047,745 |   |
| Deferred revenue                                                                                                                                                   |       | 1,335,138             |       | 885,354 |   |
| Other long-term  liabilities                                                                                                                                       |       | 72,727                |       | 130,909 |   |
| Total liabilities                                                                                                                                                  |       | 12,297,693            |       | 8,064,008 |   |
| 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; 12,601,224 and 12,375,276 shares issued and outstanding at  December 31, 2006 and 2005, respectively |       | 1,260                 |       | 1,238 |   |
| Additional paid-in capital                                                                                                                                         |       | 97,205,145            |       | 93,212,368 |   |
| Deferred compensation                                                                                                                                              |       | (110,705              | )          | (425,623 | ) |
| Accumulated deficit                                                                                                                                                |       | (53,687,114           | )          | (57,954,920 | ) |
| Total stockholders’ equity                                                                                                                                    |       | 43,408,586            |       | 34,833,063 |   |
| Total liabilities and  stockholders’ equity                                                                                                                   |       | $                     | 55,706,279 |   | $ | 42,897,071 |   |

 

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

F-4

----

**NeuroMetrix, Inc.Statements of Operations**

| ** **                                                                            | ** ** | **Years Ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                            | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                            | ** ** | ** **                                  | ** ** | **(as restated)** | ** ** | **(as restated)** | ** ** |
| Revenues:                                                                             |       |                                        |       |   |   |   |   |
| Diagnostic device                                                                     |       | $                                           | 7,538,320  |   | $ | 4,221,311 |   | $ | 2,219,489 |   |
| Biosensor                                                                             |       | 47,711,396                                  |       | 30,076,822 |   | 15,700,600 |   |
| Total revenues                                                                        |       | 55,249,716                                  |       | 34,298,133 |   | 17,920,089 |   |
| Cost of revenues                                                                      |       | 13,558,054                                  |       | 8,858,094 |   | 4,853,326 |   |
| Gross margin                                                                          |       | 41,691,662                                  |       | 25,440,039 |   | 13,066,763 |   |
| Operating expenses:                                                                   |       |                                        |       |   |   |   |   |
| Research and development(1)                                                           |       | 5,010,513                                   |       | 3,820,624 |   | 3,268,363 |   |
| Sales and marketing(1)                                                                |       | 22,013,682                                  |       | 14,150,157 |   | 8,488,047 |   |
| General and administrative(1)                                                         |       | 11,805,062                                  |       | 8,021,783 |   | 5,267,378 |   |
| Total operating expenses                                                              |       | 38,829,257                                  |       | 25,992,564 |   | 17,023,788 |   |
| Income (loss) from operations                                                         |       | 2,862,405                                   |       | (552,525 | ) | (3,957,025 | ) |
| Interest income                                                                       |       | 1,598,401                                   |       | 838,825 |   | 214,092 |   |
| Interest expense                                                                      |       | —                                      |       | (2,042 | ) | (964,056 | ) |
| Income (loss)  before provision for income taxes                                      |       | 4,460,806                                   |       | 284,258 |   | (4,706,989 | ) |
| Provision for income taxes                                                            |       | 193,000                                     |       | 35,000 |   | — |   |
| Net income (loss)                                                                     |       | 4,267,806                                   |       | 249,258 |   | (4,706,989 | ) |
| Accretion of redeemable convertible preferred stock                                   |       | —                                      |       | — |   | (1,386,301 | ) |
| 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                                |       | $                                           | 4,267,806  |   | $ | 249,258 |   | $ | (13,931,946 | ) |
| Net income (loss)  per common share:                                                  |       |                                        |       |   |   |   |   |
| Basic                                                                                 |       | $                                           | 0.34       |   | $ | 0.02 |   | $ | (2.42 | ) |
| Diluted                                                                               |       | $                                           | 0.33       |   | $ | 0.02 |   | $ | (2.42 | ) |
| Weighted average  shares used to compute net income (loss) per common share:          |       |                                        |       |   |   |   |   |
| Basic                                                                                 |       | 12,501,742                                  |       | 12,152,139 |   | 5,747,579 |   |
| Diluted                                                                               |       | 13,097,891                                  |       | 12,986,365 |   | 5,747,579 |   |

----

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

| Research and  development   |   | $         | 470,582 |    | $      | 77,365  |   | $ | 249,131 |   |
|-----------------------------|--------|-----------|---------|---------|--------|---------|--------|---|---------|--------|
| Sales and  marketing        |   | 820,984   |    | 167,699 |   | 356,422 |   |
| General and  administrative |   | 1,361,071 |    | 161,266 |   | 423,042 |   |

 

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 andChanges in Stockholders’ (Deficit)/Equity**

| ** **                                                                                | ** ** | **Redeemable Convertible  Preferred Stock** | ** ** | ** **  | ** ** | **Common Stock** | ** ** | **Additional**     | ** ** | ** ** | ** ** | ** **  | ** ** | ** **        | ** ** | ** **       | ** ** |
|-------------------------------------------------------------------------------------------|------------|-------------------------------------------------------|------------|-------------|------------|-----------------------|------------|--------------------|------------|------------|------------|-------------|------------|-------------------|------------|------------------|------------|
| ** **                                                                                | ** ** | **Number**                                            | ** ** | ** **  | ** ** | ** **            | ** ** | **Number**         | ** ** | ** ** | ** ** | **Paid-In** | ** ** | **Subscriptions** | ** ** | **Deferred**     | ** ** | **Accumulated** | ** ** | ** ** | ** ** |
| ** **                                                                                | ** ** | **of Shares**                                    | ** ** | **Amount**  | ** ** | ** **            | ** ** | **of Shares** | ** ** | **Amount** | ** ** | **Capital** | ** ** | **Receivable**    | ** ** | **Compensation** | ** ** | **Deficit** | ** ** | **Total** | ** ** |
| Balance at December 31, 2003—as restated                                        |       | 17,498,099                                            |       | $           | 47,693,742 |                  |       |               | 1,042,990  |       |       | $           | 104        |              |       | $                | —     |   |   | $ | (2,143 | ) |   |   | $ | (598,933 | ) |   |   | $ | (45,204,348 | ) |   | $ | (45,805,320 | ) |
| 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 |   |
| 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—as restated                                                                 |       | —                                                |       | —      |       |                  |       | —             |       |       | —     |        |       | —            |       |             | —     |   |   |   | — |   |   |   | (4,706,989 | ) |   | (4,706,989 | ) |
| Balance at December 31, 2004—as restated                                        |       | —                                                |       | —      |       |                  |       | 12,034,650         |       |       | 1,203      |        |       | 92,278,379        |       |             | —     |   |   |   | (745,086 | ) |   |   | (58,204,178 | ) |   | 33,330,318 |   |
| 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—as restated                                                               |       | —                                                |       | —      |       |                  |       | —             |       |       | —     |        |       | —            |       |             | —     |   |   |   | — |   |   |   | 249,258 |   |   | 249,258 |   |
| Balance at December 31, 2005—as restated                                        |       | —                                                |       | —      |       |                  |       | 12,375,276         |       |       | 1,238      |        |       | 93,212,368        |       |             | —     |   |   |   | (425,623 | ) |   |   | (57,954,920 | ) |   | 34,833,063 |   |
| Issuance of stock upon exercise of stock options                                          |       | —                                                |       | —      |       |                  |       | 202,808            |       |       | 20         |        |       | 1,180,637         |       |             | —     |   |   |   | — |   |   |   | — |   |   | 1,180,657 |   |
| Stock-based compensation  expense                                                         |       |                                                  |       |        |       |                  |       |               |       |       |       |        |       | 2,403,222         |       |             |       |   |   |   |   |   |   |   |   |   |   | 2,403,222 |   |
| Adjustment to deferred compensation associated with  terminated employees                 |       | —                                                |       | —      |       |                  |       | —             |       |       | —     |        |       | (65,503           | )          |             | —     |   |   |   | 65,503 |   |   |   | — |   |   | — |   |
| Amortization of deferred compensation                                                     |       | —                                                |       | —      |       |                  |       | —             |       |       | —     |        |       | —            |       |             | —     |   |   |   | 249,415 |   |   |   | — |   |   | 249,415 |   |
| Issuance of common stock under employee stock  purchase plan                              |       | —                                                |       | —      |       |                  |       | 23,140             |       |       | 2          |        |       | 394,621           |       |             | —     |   |   |   | — |   |   |   | — |   |   | 394,623 |   |
| Income tax effect of the exercise of stock options                                        |       | —                                                |       | —      |       |                  |       | —             |       |       | —     |        |       | 79,800            |       |             | —     |   |   |   | — |   |   |   | — |   |   | 79,800 |   |
| Net income                                                                                |       | —                                                |       | —      |       |                  |       | —             |       |       | —     |        |       | —            |       |             | —     |   |   |   | — |   |   |   | 4,267,806 |   |   | 4,267,806 |   |
| Balance at December 31, 2006                                                         |       | —                                                |       | $           | —     |                  |       |               | 12,601,224 |       |       | $           | 1,260      |              |       | $                | 97,205,145 |   |   | $ | — |   |   |   | $ | (110,705 | ) |   |   | $ | (53,687,114 | ) |   | $ | 43,408,586 |   |

 

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

F-6

----

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

| ** **                                                                                          | ** ** | **Years Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                          | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                                          | ** ** | ** **                                  | ** ** | **(as restated)** | ** ** | **(as restated)** | ** ** |
| **Cash flows for operating  activities:**                                                           | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income (loss)                                                                                   |       | $                                           | 4,267,806  |   | $ | 249,258 |   | $ | (4,706,989 | ) |
| Adjustments to reconcile  net income (loss) to net cash provided by (used in) operating activities: |       |                                        |       |   |   |   |   |
| Depreciation and amortization                                                                       |       | 380,655                                     |       | 278,932 |   | 205,023 |   |
| Compensation expense associated with stock options                                                  |       | 2,652,637                                   |       | 406,330 |   | 1,028,595 |   |
| Provision for doubtful accounts                                                                     |       | 946,850                                     |       | 281,684 |   | 221,796 |   |
| Amortization of premium on investments                                                              |       | 184,163                                     |       | 439,734 |   | 89,175 |   |
| Income tax effect of the exercise of stock options                                                  |       | 79,800                                      |       | 35,000 |   | — |   |
| Accretion of debt issuance discount                                                                 |       | —                                      |       | — |   | 437,778 |   |
| Changes in operating assets  and liabilities:                                                       |       |                                        |       |   |   |   |   |
| Accounts receivable                                                                                 |       | (4,102,061                                  | )          | (1,698,458 | ) | (1,496,378 | ) |
| Inventories                                                                                         |       | (949,980                                    | )          | (1,399,148 | ) | (205,871 | ) |
| Prepaid expenses and other current assets                                                           |       | (147,231                                    | )          | 58,801 |   | (455,805 | ) |
| Accounts payable                                                                                    |       | 1,068,067                                   |       | 799,292 |   | 464,906 |   |
| Accrued expenses and compensation                                                                   |       | 2,147,762                                   |       | 1,925,923 |   | 1,421,301 |   |
| Other long-term liabilities                                                                         |       | (58,182                                     | )          | (58,182 | ) | 3,637 |   |
| Deferred revenue and deferred costs                                                                 |       | 827,617                                     |       | 588,924 |   | 341,201 |   |
| Net cash provided by (used in) operating activities                                                 |       | 7,297,903                                   |       | 1,908,090 |   | (2,651,631 | ) |
| **Cash flows for investing  activities:**                                                           | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Purchases of fixed assets                                                                           |       | (620,540                                    | )          | (475,124 | ) | (545,158 | ) |
| Purchases of investments                                                                            |       | (42,141,626                                 | )          | (15,290,120 | ) | (30,954,418 | ) |
| Maturities of investments                                                                           |       | 33,628,724                                  |       | 18,840,191 |   | 2,793,492 |   |
| Release of restricted cash                                                                          |       | —                                      |       | 438,602 |   | — |   |
| Net cash provided by (used in) investing activities                                                 |       | (9,133,442                                  | )          | 3,513,549 |   | (28,706,084 | ) |
| **Cash flows from financing  activities:**                                                          | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Proceeds from exercise of stock options                                                             |       | 1,180,657                                   |       | 512,857 |   | 47,074 |   |
| 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                          |       | 394,623                                     |       | 299,300 |   | 64,818 |   |
| Payments on long-term debt                                                                          |       | —                                      |       | — |   | (3,000,000 | ) |
| Net cash provided by financing activities                                                           |       | 1,575,280                                   |       | 812,157 |   | 31,671,440 |   |
| Net increase  (decrease) in cash and cash equivalents                                               |       | (260,259                                    | )          | 6,233,796 |   | 313,725 |   |
| Cash and cash  equivalents, beginning of year                                                       |       | 8,170,037                                   |       | 1,936,241 |   | 1,622,516 |   |
| Cash and cash  equivalents, end of year                                                             |       | $                                           | 7,909,778  |   | $ | 8,170,037 |   | $ | 1,936,241 |   |
| **Supplemental disclosure of cash  flow information:**                                              | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash paid for interest                                                                              |       | $                                           | —     |   | $ | 2,042 |   | $ | 497,404 |   |

 

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

F-7

----

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

**1.   Businessand Summary of Significant Accounting Policies**

**Business**

NeuroMetrix, Inc. (the “Company”), a Delawarecorporation, was formed in June 1996. The Company designs, develops andsells proprietary medical devices used to help physicians diagnose neuropathiesand neurovascular diseases. Neuropathies are diseases of the peripheral nervesand parts of the spine that frequently are caused by or associated withdiabetes, low back pain and carpal tunnel syndrome, as well as other clinicaldisorders. Diabetic retinopathy is a neurovascular disease affecting the visionof patients with diabetes. The Company has an exclusive sales and marketinglicense with EyeTel Imaging, Inc. (“EyeTel”) to market the DigiScope®, aproduct designed to detect diabetic retinopathy. The Company operates in onebusiness segment.

On July 27, 2004, the Company completed aninitial public offering (“IPO”) of 3,000,000 shares of its common stock at$8.00 per share, for gross consideration of $24,000,000. All of the shares weresold by the Company. In connection with the IPO, the Company granted theunderwriters a 30-day over-allotment option to purchase up to anadditional 450,000 shares of common stock from the Company at $8.00 per share,which the underwriters exercised in full on August 17, 2004 for grossconsideration of $3,600,000. The Company’s shares trade on The NASDAQ GlobalMarket under the symbol “NURO.”

On July 27, 2004, upon completion of the Company’sIPO, all shares of the Company’s redeemable convertible preferred stockoutstanding on that date converted into 7,488,758 shares of common stock andthe outstanding warrant to purchase redeemable convertible preferred stockconverted into a warrant to purchase 100,000 shares of common stock. Thiswarrant was exercised in full on June 13, 2005.

In October 2006, theCompany entered into an exclusive seven year licensing agreement with EyeTel.The agreement grants the Company an exclusive license to market, brand, andsell EyeTel’s DigiScope throughout the primary care physician andendocrinologist market. The DigiScope, developed in collaboration with theWilmer Eye Institute at Johns Hopkins, is a United States Food and DrugAdministration, or FDA, cleared diagnostic device that primary care physiciansand endocrinologists can use for the early detection of diabetic retinopathy.In connection with the agreement, the Company received warrants to purchase upto 500,000 shares of EyeTel common stock at an exercise price of $0.16 per share,subject to adjustment for stock splits and with a term of ten years. Thewarrants are subject to a vesting schedule based on the Company’s achievementof annual performance milestones relating to units placed and customer usage ofthe DigiScope through 2011. If the Company does not meet one or both of therequirements for any calendar year, but does meet the combined requirements fortwo or more consecutive years, the shares scheduled to vest for each of theyears will vest. The agreement also grants the Company financing participationrights in connection with EyeTel’s next round of venture capital financing. TheCompany received an option to purchase EyeTel preferred stock, up to the lesserof (i) 30% of the total amount raised in the financing or (ii) $5.0million. In the event that the Company participates in the next round offinancing, and the Company’s maximum permitted amount is less than $5.0million, the Company has the right to participate in any subsequent financingrounds equal to the difference between $5.0 million and the amount previouslyinvested.

F-8

----

**SignificantAccounting Policies**

Significantaccounting policies applied by the Company in the preparation of its financialstatements are as follows:

***Cash and Cash Equivalents***

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-Maturity Investments***

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.

***Restricted Cash***

At December 31, 2006and 2005, the Company maintained restricted cash in the amount of $1,458,598associated with a facility lease. See Note 11—Commitments andContingencies.

***Concentration of Credit Risk***

Financial instruments that potentially expose theCompany to concentrations of credit risk consist primarily of cash and cashequivalents in bank deposits accounts, short-term investments and tradereceivables. The Company invests its funds in highly rated institutions andlimits its investment in any individual debtor. The Company has not experiencedsignificant losses related to cash and cash equivalents and does not believe itis exposed to any significant credit risks relating to its cash and cashequivalents.

The Company distributes its products through its ownregional sales managers who manage independent sales agencies. At December 31,2006 and 2005 and for the years ended December 31, 2006, 2005 and 2004, nosingle customer accounted for more than 10% of accounts receivable 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 of Financial Instruments***

The carrying amounts ofthe Company’s financial instruments, which include cash and cash equivalents,short-term investments, accounts receivable, accounts payable and accruedexpenses, approximate their fair value at December 31, 2006 and 2005.

F-9

----

***Revenue Recognition***

The Company recognizes revenue when the followingcriteria have been met: persuasive evidence of an arrangement exists, deliveryhas occurred and risk of loss has passed, the seller’s price to the buyer isfixed or determinable and collection is reasonably assured. The Company recordsrevenue on a net basis for product sales made to distributors, based upon theamount billed to the distributors, when the distributor accepts theresponsibility for invoicing the customer and the responsibility for the riskof collections and product returns 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 undeliveredelements and delivery or performance of the undelivered elements is consideredprobable and substantially in the control of the Company. Fair value is determinedbased upon the price charged when the element is sold separately.

Diagnostic device revenues consist of sales of NC-statmonitors and NC-stat docking stations. Revenues associated with the sale of theNC-stat monitors are recognized upon shipment provided that the fee is fixed ordeterminable, evidence of a persuasive arrangement exists, collection ofreceivables is reasonably assured, product returns are reasonably estimable andno continuing obligations exist. The revenues from the sale of a NC-statdocking station and access to the onCall Information System are considered oneunit of accounting and deferred and recognized on a straight line basis overthe estimated period of time the Company provides the service associated withthe onCall Information System, which is the shorter of the estimated customerrelationship period or the estimated useful life of the docking station,currently three years. The resulting deferred revenue and deferred costsare presented as separate line items on the accompanying balance sheet.

Biosensor revenues consist of sales of disposableNC-stat biosensors and are recognized upon shipment provided that the fee isfixed or determinable, persuasive evidence of an arrangement exists, collectionof receivables is reasonably assured and product returns are reasonablyestimable.

The Company recognizes revenues associated withinstallation and training upon completion of the service. The fair value of theinstallation and training is based on hourly service billing rates.

Certain product sales are made with a 30-dayright of return. Since the Company can reasonably estimate future returns, theCompany recognizes revenues associated with product sales that contain a rightof return upon shipment and at the same time reduces revenue by the amount ofestimated returns under the provisions of Statement of Financial AccountingStandards (“SFAS”) No. 48, “*RevenueRecognition When Right of Return Exists*”.

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

***Accounts Receivable and Allowance for DoubtfulAccounts***

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 are charged off against theallowance when the Company feels it is probable the receivable will not berecovered. The Company does not have any off-balance sheet credit exposurerelated to its customers.

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***Income Taxes***

The Company records incometaxes using the asset and liability method. Deferred income tax assets andliabilities are recognized for the future tax consequences attributable todifferences between the financial statement carrying amounts of existing assetsand liabilities and their respective income tax bases, and operating loss andtax credit carryforwards. The Company’s financial statements contain certaindeferred tax assets, which have arisen primarily as a result of operatinglosses, as well as other temporary differences between financial and taxaccounting. SFAS No. 109 “*Accounting for Income Taxes*,” requires the Company to establish a valuation allowance ifthe likelihood of realization of the deferred tax assets is reduced based on anevaluation of objective verifiable evidence. Significant management judgment isrequired in determining the Company’s provision for income taxes, the Company’sdeferred tax assets and liabilities and any valuation allowance recordedagainst those net deferred tax assets. The Company evaluates the weight of allavailable evidence to determine whether it is more likely than not that someportion or all of the net deferred income tax assets will not be realized.

***Research and Development***

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 Warranty Costs***

The Company accrues estimated product warranty costsat the time of sale which are included in cost of sales in the statements ofoperations. The amount of the accrued warranty liability is based on historicalinformation such as past experience, product failure rates, number of unitsrepaired and estimated cost of material and labor.

Thefollowing is a rollforward of the Company’s accrued warranty liability for theyears ended December 31, 2006, 2005 and 2004:

| ** **                      | ** ** | **Years Ended December 31,** | ** ** |
|---------------------------------|------------|---------------------------------------------|------------|
| ** **                      | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Balance at  beginning of period |       | $                                           | 124,852    |   | $ | 116,779 |   | $ | 79,054 |   |
| Accrual for  warranties         |       | 688,234                                     |       | 314,117 |   | 187,176 |   |
| Settlements made                |       | (581,361                                    | )          | (306,044 | ) | (149,451 | ) |
| Balance at end of period        |       | $                                           | 231,725    |   | $ | 124,852 |   | $ | 116,779 |   |

 

***Fixed Assets and Long-Lived Assets***

Fixed assets are recorded at cost and depreciatedusing the straight-line method over the estimated useful life of each asset.Expenditures for repairs and maintenance are charged to expense as incurred. Ondisposal, the related assets and accumulated depreciation are eliminated fromthe accounts and any resulting gain or loss is included in the Company’sstatement of operations. Leasehold improvements are amortized over the shorterof the estimated useful life of the improvement or the remaining term of thelease.

The Company periodicallyevaluates the recoverability of its fixed assets and other long-lived assetswhen circumstances indicate that an event of impairment may have occurred inaccordance with the provisions of SFAS No. 144, “*Accounting for the Impairment or Disposal ofLong-Lived Assets*”. This periodic review may result in an adjustmentof estimated depreciable lives or an asset impairment. When indicators ofimpairment are present, the carrying values of the asset are evaluated inrelation to their operating performance and future undiscounted cash flows ofthe underlying business. If the future 

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undiscountedcash flows are less than their book value, an impairment exists. The impairmentis measured 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. Noimpairments were identified in the years ended December 31, 2006, 2005 and2004.

***Accounting for Stock-Based Compensation***

In December 2004, the Financial AccountingStandards Board (“FASB”) issued SFAS No. 123(R),*“Share Based Payment”* (“SFAS No. 123(R)”), whichrequires that the cost resulting from all share-based payment transactions berecognized in the financial statements. SFAS No. 123(R) revises SFAS No. 123*“Accounting for Stock-Based Compensation”*(“SFAS No. 123”) and supersedes Accounting Principles Board Opinion No. 25,*“Accounting for Stock Issued to Employees”*(“APB No. 25”) and SFAS No. 148,*“Accountingfor Stock Based Compensation—Transition and Disclosure—an amendment ofFinancial Accounting Standards Board Statement No. 123*” (“SFAS No. 148”.)  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 statement of operations rather than as proforma disclosure in the notes to the financial statements. Under thistransition method, the compensation cost recognized beginning January 1,2006 includes compensation cost for (i) all share-based payments grantedprior to, but not yet vested as of January 1, 2006, based on thegrant-date fair value estimated in accordance with the provisions of SFAS No. 123,and (ii) all share based payments granted or modified subsequent to January 1,2006 based on the grant-date fair value estimated in accordance with theprovisions of SFAS No. 123(R). Compensation cost is generally recognizedratably over the requisite service period. Prior period amounts have not beenrestated. The Company uses the Black-Scholes option pricing model fordetermining the fair value of its stock options and amortizes its stock-basedcompensation expense using the straight-line method.

Prior to the adoption ofSFAS 123(R), the Company accounted for stock options granted to employeesin accordance with APB 25 and provided the disclosures required underSFAS 148 only in the notes to our financial statements. Accordingly,compensation expense was recorded for options issued to employees to the extentthat the fair market value of the Company’s common stock exceeded the exerciseprice of the option at the date granted and all other criteria for fixedaccounting were met. All stock-based awards granted to non-employees wereaccounted for at their fair value and the resulting compensation expense wasgenerally recognized over the period of service.

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

TheCompany accounts for and discloses net income (loss) per common share inaccordance with SFAS No. 128, “*EarningsPer Share*”. Basic net income (loss) per common share is computed bydividing net income (loss) attributable to common stockholders by the weightedaverage number of common shares outstanding. Diluted net income (loss) percommon share is computed by dividing net income (loss) attributable to commonstockholders by the weighted average number of common shares and dilutivepotential common share equivalents then outstanding. Potential common sharesconsist of shares issuable upon the exercise of stock options and warrants(using the treasury stock method.)

| ** **                                          | ** ** | **Years Ended December 31,** | ** ** |
|-----------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                          | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                          | ** ** | ** **                                  | ** ** | **(as restated)** | ** ** | **(as restated)** | ** ** |
| Basic:                                              |       |                                        |       |   |   |   |   |
| Net income (loss)  available to common stockholders |       | $                                           | 4,267,806  |   | $ | 249,258 |   | $ | (13,931,946 | ) |
| Weighted average  shares                            |       | 12,501,742                                  |       | 12,152,139 |   | 5,747,579 |   |
| Basic income  (loss) per common share               |       | $                                           | 0.34       |   | $ | 0.02 |   | $ | (2.42 | ) |
| Diluted:                                            |       |                                        |       |   |   |   |   |
| Net income (loss)  available to common stockholders |       | $                                           | 4,267,806  |   | $ | 249,258 |   | $ | (13,931,946 | ) |
| Weighted average  shares                            |       | 12,501,742                                  |       | 12,152,139 |   | 5,747,579 |   |
| Effect of stock  options                            |       | 596,149                                     |       | 821,254 |   | — |   |
| Effect of  warrants                                 |       | —                                      |       | 12,972 |   | — |   |
| Weighted average  shares, as adjusted               |       | 13,097,891                                  |       | 12,986,365 |   | 5,747,579 |   |
| Diluted income (loss)  per common share             |       | $                                           | 0.33       |   | $ | 0.02 |   | $ | (2.42 | ) |

 

Thefollowing potentially dilutive common shares were excluded from the calculationof diluted net income (loss) per common share because their effect wasantidilutive for each of the periods presented:

| ** ** | ** ** | **Years Ended December 31,** | ** ** |
|------------|------------|---------------------------------------------|------------|
| ** ** | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Options    |       | 366,618                                     |       | 45,400 |   | 1,132,571 |   |
| Warrants   |       | —                                      |       | — |   | 100,000 |   |

 

***Advertising and Promotional Costs***

Advertising andpromotional costs are expensed as incurred. Advertising and promotion expensewas $547,441, $280,034 and $215,321 in the years ended December 31, 2006,2005 and 2004, respectively.

***Other Comprehensive Income (Loss)***

SFAS No. 130, “*Reporting Comprehensive Income*”establishes standards for reporting and displaying comprehensive income and itscomponents in a full set of general-purpose financial statements. For the yearsended December 31, 2006, 2005 and 2004, the Company had no components ofcomprehensive income or loss other than net 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.

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***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 during thereporting period. Actual results could differ from those estimates.

***Risks and Uncertainties***

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 Accounting Pronouncements***

In June 2006, the FASB issued FASB InterpretationNo. 48,*“Accounting for Uncertainty inIncome Taxes—an interpretation of FASB Statement No. 109”* (“FINNo. 48”), which clarifies the accounting and disclosure for uncertainty intax positions, as defined. FIN No. 48 requires that management recognizein the Company’s financial statements the impact of the tax position  if that position is more likely than not ofbeing sustained upon examination, based on the technical merits of the position.The provisions of FIN No. 48 are effective as of the beginning of the 2007calendar year, with the cumulative effect of the change in accounting principlerecorded as an adjustment to opening retained earnings.  The Company believes that FIN No. 48 willnot have a material effect on its financial position, results from operationsor cash flows.

In September 2006, the FASB issued SFAS No. 157,*“Fair Value Measurements”* (“SFAS No. 157”).SFAS No. 157 defines fair value in numerous accounting pronouncements,establishes a framework for measuring fair value in generally acceptedaccounting principles (“GAAP”) and expands disclosures related to the use offair value measures in financial statements. SFAS No. 157 does not expandthe use of fair value measures in financial statements, but standardizes itsdefinition and guidance in GAAP.  TheStandard emphasizes that fair value is a market-based measurement and not an entity-specificmeasurement based on an exchange transaction in which the entity sells an assetor transfers a liability (exit price). SFAS No. 157 establishes a fairvalue hierarchy from observable market data as the highest level to fair valuebased on an entity’s own fair value assumptions as the lowest level. SFAS No. 157is effective for our financial statements issued in 2008; however, earlierapplication is encouraged. The Company has not yet determined the impact thatthe adoption of SFAS No. 157 will have on its financial position, resultsof operations or its cash flows.

In September 2006,the Securities and Exchange Commission (“SEC”) issued Staff Accounting BulletinNo. 108 *“Considering the Effects ofPrior Year Misstatements when Quantifying Misstatements in Current YearFinancial Statements”* (“SAB 108”). SAB 108 provides guidance on howthe effects of the carryover or reversal of prior year financial statementmisstatements should be considered in quantifying a current year misstatement. Priorpractice allowed the evaluation of materiality on the basis of: (1) theerror quantified as the amount by which the current year income statement wasmisstated (rollover method); or (2) the cumulative error quantified as thecumulative amount by which the current year balance sheet was misstated (ironcurtain method). Reliance on either method in prior years could have resultedin misstatement of the financial statements. The guidance provided in SAB No. 108requires both methods to 

F-14

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be usedin evaluating materiality. Immaterial prior year errors may be corrected withthe first filing of prior year financial statements after adoption. Thecumulative effect of the correction would be reflected in the opening balancesheet with appropriate disclosure of the nature and amount of each individualerror corrected in the cumulative adjustment, as well as a disclosure of thecause of the error and that the error had been deemed to be immaterial in thepast. SAB No. 108 did not have a material impact on the Company’s financialposition, results of operations or cash flows.

In February 2007, theFASB issued SFAS No. 159, “*The FairValue Option for Financial Assets and Financial Liabilities, including anamendment of FASB Statement No. 115*.” (“SFASNo. 159”)  SFAS No. 159 permitsentities to choose to measure many financial instruments and certain otheritems at fair value that are not currently required to be measured at fairvalue. Unrealized gains and losses on items for which the fair value option hasbeen elected are reported in earnings. SFAS No. 159 does not affect anyexisting accounting literature that requires certain assets and liabilities tobe carried at fair value. SFAS No. 159 is effective for fiscal yearsbeginning after November 15, 2007. The Company does not believe that theadoption of SFAS No. 159 will have a material impact on its financialposition, results of operations or cash flows.

**2.**   Restatement

The Company has restated its financial statements asof and for the years ended December 31, 2005 and 2004 to correct errors inaccounting for sales tax liabilities. The errors arose from the Company’sfailure in certain states within the United States to charge sales tax tocustomers as required by state law and subsequently file and remit suchcollections to the state tax authorities. The Company has computed the error asthe total of the sales tax due, based on historical sales in those states wheresales tax should have been collected, and the resulting interest and penaltiesin accordance with the applicable state law.

The impact of correcting these errors results in anincrease in accrued liabilities of $1,415,000 and $726,000 as of December 31,2005 and 2004, respectively, an increase in general and administrative expensesof $689,000 and $423,000 and a reduction of net income available to commonstockholders of $689,000 and $423,000 for the years ended December 31,2005 and 2004, respectively.

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Thefollowing table presents the impact of the restatement:

| ** **                                             | ** ** | **2005**                     | ** **  | **2004**     | ** ** |
|--------------------------------------------------------|------------|------------------------------|-------------|--------------|------------|
| ** **                                             | ** ** | **As  Previously  Reported** | ** **  | **Restated** | ** ** | **As  Previously  Reported** | ** ** | **Restated** | ** ** |
| **Statement  of Operations:**                          |       |                         |        |         |       |   |   |   |   |
| General and  administrative                            |       | $                            | 7,332,783   |         | $          | 8,021,783 |   | $ | 4,844,378 |   | $ | 5,267,378 |   |
| Total operating  expenses                              |       | 25,303,564                   |        | 25,992,564   |       | 16,600,788 |   | 17,023,788 |   |
| Income (loss)  from operations                         |       | 136,475                      |        | (552,525     | )          | (3,534,025 | ) | (3,957,025 | ) |
| Income (loss) before  provision for income taxes       |       | 973,258                      |        | 284,258      |       | (4,283,989 | ) | (4,706,989 | ) |
| Net income (loss)                                      |       | 938,258                      |        | 249,258      |       | (4,283,989 | ) | (4,706,989 | ) |
| Net income (loss)  attributable to common stockholders |       | $                            | 938,258     |         | $          | 249,258 |   | $ | (13,508,946 | ) | $ | (13,931,946 | ) |
| Net income (loss)  per common share:                   |       |                         |        |         |       |   |   |   |   |
| Basic                                                  |       | $                            | 0.08        |         | $          | 0.02 |   | $ | (2.35 | ) | $ | (2.42 | ) |
| Diluted                                                |       | $                            | 0.07        |         | $          | 0.02 |   | $ | (2.35 | ) | $ | (2.42 | ) |
| **Balance sheet:**                                     |       |                         |        |         |       |   |   |   |   |
| Accrued expenses                                       |       | $                            | 1,213,928   |         | $          | 2,628,928 |   |   |   |   |   |
| Total current  liabilities                             |       | $                            | 5,632,745   |         | $          | 7,047,745 |   |   |   |   |   |
| Total liabilities                                      |       | $                            | 6,649,008   |         | $          | 8,064,008 |   |   |   |   |   |
| Accumulated  deficit                                   |       | $                            | (56,539,920 | )            | $          | (57,954,920 | ) | $ | (57,478,178 | ) | $ | (58,204,178 | ) |
| Total  stockholders’ equity                       |       | $                            | 36,248,063  |         | $          | 34,833,063 |   | $ | 34,056,318 |   | $ | 33,330,318 |   |
| **Cash flows:**                                        |       |                         |        |         |       |   |   |   |   |
| Net income (loss)                                      |       | $                            | 938,258     |         | $          | 249,258 |   | $ | (4,283,989 | ) | $ | (4,706,989 | ) |
| Accrued expenses and  compensation                     |       | $                            | 1,236,923   |         | $          | 1,925,923 |   | $ | 998,301 |   | $ | 1,421,301 |   |

 

In addition, previously reported accumulated deficitand total stockholders’ deficit as of December 31, 2003 of $44,901,348 and$45,502,320, respectively, have been restated to $45,204,348 and $45,805,320,respectively in the Statements of Changes in Redeemable Convertible PreferredStock and Changes in Stockholders’ (Deficit)/Equity.

As applicable, the footnotes contained elsewherewithin these financial statements have also been restated to correct theseerrors.

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**3.   StockOption Plans, Stock-Based Compensation and Common Stock**

**Stock Option Plans**

During 1996, the Company adopted the 1996 StockOption/Restricted Stock Plan (the “1996 Stock Plan”). The 1996 Stock Planprovides for the granting of incentive and non-qualified stock options andstock bonus awards to officers, directors and employees of the Company. Themaximum number of shares that may be issued pursuant to the 1996 Stock Plan is156,250. All of the outstanding options under the 1996 Stock Plan are fullyvested and terminate 10 years after the grant date, or earlier if the optionholder is no longer an executive officer, employee, consultant, advisor ordirector, as applicable, of the Company. As of December 31, 2006, allshares had been issued under the 1996 Stock Plan.

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, employees and outside consultants. 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. As of December 31, 2006, 1,250,000 shares of common stock wereauthorized for issuance under the 1998 Stock Plan, of which 534,774 shares hadbeen issued and 627,764 shares were subject to outstanding options at aweighted average exercise price of $7.05 per share. The 1998 Stock Plan wasclosed to any future grants at the time of the Company’s IPO and therefore theCompany will not make any additional grants under the 1998 Stock Plan.

During 2004, the Company adopted the 2004 Stock Optionand Incentive Plan, as amended and restated in 2006 (the “2004 Stock Plan”).The 2004 Stock Plan also provides for granting of incentive and nonqualifiedstock option and stock bonus awards to officers,  employees and outside consultants. Outstandingoptions under the 2004 Stock Plan generally vest over three or four years andterminate 10 years after the grant date, or earlier if the option holder is nolonger an executive officer, employee, consultant, advisor or director, asapplicable, of the Company. As of December 31, 2006, 1,946,022 shares ofcommon stock were authorized for issuance under the 2004 Stock Plan, of which92,713 shares had been issued, 587,330 shares were subject to outstandingoptions at a weighted average exercise price of $22.79 per share and 1,265,979shares were available for future grant. In March 2006, the Company’s Boardof Directors voted to discontinue the provision of the 2004 Stock Plan whichautomatically increased the number of options available for grant under the2004 Stock Plan based on the net increase in the total number of outstandingshares of common stock during the year.

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. The exercise price of stock options awarded under the 2004 StockPlan may not be less than the fair market value of the common stock on the dateof the option grant. For holders of more than 10% of the Company’s totalcombined voting power of all classes of stock, incentive stock options may notbe granted at less than 110% of the fair market value of the Company’s commonstock at the date of grant and for a term not to exceed five years.

Certain stock options granted prior toJanuary 1, 2006 covering a total of 15,480 shares were modifiedduring 2006 to increase the exercise price to the fair market value as ofthe original date of grant. These stock options were originallyissued at a discount to fair market value in the first half of 2004 priorto the Company’s IPO. The grants have been revalued using the Black Scholesoption pricing model and for unvested shares, the sum of the difference betweenfair value immediately before and after the modifications and the remainingoriginal intrinsic value is being amortized to expense over the remainingvesting period.

In June 2004, the Company adopted the 2004Employee Stock Purchase Plan (“ESPP”). All of our employees who have beenemployed by the Company for at least 60 days and whose customary 

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employment is for morethan 20 hours per week and for more than five months in any calendar year areeligible to participate. Any employee who owns 5% or more of the voting poweror value of our stock is not eligible to participate and an employee maypurchase no more than $25,000 worth of common stock, valued at the start of thepurchase period, in any calendar year. The ESPP authorizes the issuance of upto a total of 375,000 shares of our common stock to participating employees.

Under the ESPP, participating employees can authorizethe Company to withhold up to 10% of their earnings during consecutivesix-month payment periods for the purchase of the shares. At the conclusion ofeach period, participating employees can purchase shares at 85% of the lower oftheir fair market value at the beginning or end of the period. The ESPP isregarded as a compensatory plan according to the provisions of SFASNo. 123(R). Under this plan, the Company has issued 23,140, 23,265 and9,532 shares of its common stock during the years ended December 31, 2006,2005 and 2004, respectively.

Asummary of activity under the Company’s 1996, 1998 and 2004 Stock Plans for theyears ended December 31, 2006, 2005 and 2004 is presented below:

| ** **                             | ** ** | **Number of  Shares** | ** ** | **Exercise  Price Range** | ** **                             | **Weighted  Average   Exercise Price** | ** ** |
|----------------------------------------|------------|----------------------------|------------|--------------------------------|----------------------------------------|--------------------------------------------------|------------|
| **Stock Option Awards**                | ** ** | ** **                 | ** ** | ** **                     | ** **                             |                                             | ** ** | ** ** |   |
| Outstanding at  December 31, 2003 |       | 450,412                    |       | $                              |   0.20—  2.25 |                                             |       | $ | 1.75 | ** ** |   |
| Granted at fair value                  |       | 657,344                    |       | 8.00—10.42                |                                   |                                             | 8.16       | ** ** |   |
| Granted below fair value               |       | 90,900                     |       | 0.90—  4.48     |                                   |                                             | 2.66       | ** ** |   |
| Exercised                              |       | (49,621                    | )          | 0.20—  2.25     |                                   |                                             | 0.91       | ** ** |   |
| Forfeited                              |       | (16,464                    | )          | 0.90—  8.53     |                                   |                                             | 2.82       | ** ** |   |
| Outstanding at  December 31, 2004 |       | 1,132,571                  |       | 0.20—10.42                |                                   |                                             | 5.63       | ** ** |   |
| Granted at fair value                  |       | 278,650                    |       | 9.28—37.23                |                                   |                                             | 13.78      | ** ** |   |
| Exercised                              |       | (253,654                   | )          | 0.40—10.00                |                                   |                                             | 2.02       | ** ** |   |
| Forfeited                              |       | (36,948                    | )          | 2.25—29.02                |                                   |                                             | 9.85       | ** ** |   |
| Outstanding at  December 31, 2005 |       | 1,120,619                  |       | 0.20—37.23                |                                   |                                             | 8.33       | ** ** |   |
| Granted at fair value                  |       | 387,800                    |       | 13.52—38.96               |                                   |                                             | 29.88      | ** ** |   |
| Exercised                              |       | (202,808                   | )          | 0.20—12.60                |                                   |                                             | 5.82       | ** ** |   |
| Forfeited                              |       | (90,517                    | )          | 2.25—36.11                |                                   |                                             | 21.67      | ** ** |   |
| Outstanding at  December 31, 2006 |       | 1,215,094                  |       | $                              | 0.40—38.96                        |                                             |       | $ | 14.66 | ** ** |   |

 

The aggregate intrinsic value of options exercisedduring the years ended December 31, 2006, 2005 and 2004 was $5,304,033,$6,713,552, and $260,049, respectively.

Thefollowing table summarizes information about stock options outstanding at December 31,2006:

| **Exercise Price**                 | ** ** | ** ** | ** ** | **Number of  Options  Outstanding** | ** ** | **Weighted Average  Remaining  Contractual  Life (Years)** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|-----------------------------------------|------------|------------|------------|------------------------------------------|------------|----------------------------------------------------------------------|------------|--------------------------------------------|------------|
| $  0.40—  4.48 |       |       | 109,747    |                                     |       |                                                                 | 6.2        |                                       |       |   | $ | 2.46 |   |   |
| $  8.00—  8.00 |       |       | 511,563    |                                     |       |                                                                 | 7.5        |                                       |       |   | 8.00 |   |   |
| $  8.25—  9.78 |       |       | 68,902     |                                     |       |                                                                 | 7.9        |                                       |       |   | 9.18 |   |   |
| $  9.90—14.76            |       |       | 145,857    |                                     |       |                                                                 | 8.1        |                                       |       |   | 10.34 |   |   |
| $15.15—29.50                       |       |       | 107,750    |                                     |       |                                                                 | 9.2        |                                       |       |   | 25.11 |   |   |
| $30.10—38.96                       |       |       | 271,275    |                                     |       |                                                                 | 9.0        |                                       |       |   | 31.72 |   |   |
|                                    |       |       | 1,215,094  |                                     |       |                                                                 | 8.0        |                                       |       |   | $ | 14.66 |   |   |

 

F-18

----

Thefollowing table summarizes information about stock options exercisable at December 31,2006:

| **Exercise Price**                 | ** ** | ** ** | ** ** | **Number of  Options  Exercisable** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|-----------------------------------------|------------|------------|------------|------------------------------------------|------------|--------------------------------------------|------------|
| $  0.40—  4.48 |       |       | 67,731     |                                     |       |                                       | $          | 2.48 |   |   |
| $  8.00—  8.00 |       |       | 318,375    |                                     |       |                                       | 8.00       |   |   |
| $  8.25—  9.78 |       |       | 27,562     |                                     |       |                                       | 9.20       |   |   |
| $  9.90—14.76            |       |       | 28,874     |                                     |       |                                       | 10.41      |   |   |
| $15.15—29.50                       |       |       | 8,217      |                                     |       |                                       | 25.05      |   |   |
| $30.10—38.96                       |       |       | 4,225      |                                     |       |                                       | 34.00      |   |   |
|                                    |       |       | 454,984    |                                     |       |                                       | $          | 7.95 |   |   |

 

The weighted averageremaining contractual life for stock options exercisable at December 31,2006 was 8.0 years. The aggregate intrinsic value for stock options outstandingand exercisable at December 31, 2006 was $5,963,981 and $3,328,929respectively.

**Stock-BasedCompensation**

Prior to January 1, 2006, the Company accountedfor stock-based compensation plans in accordance with the provisions of APB No. 25,as permitted by SFAS No. 123, and accordingly did not recognizecompensation expense for the issuance of options with an exercise price equalto or greater than the fair value at the date of grant.

Thefollowing table illustrates the effect on net income (loss) and net income(loss) per common share for the years ended December 31, 2005 and 2004 hadthe Company applied the fair value based method as prescribed by SFAS No. 123:

| ** **                                                                         | ** ** | **2005**          | ** ** | **2004**          | ** ** |
|------------------------------------------------------------------------------------|------------|-------------------|------------|-------------------|------------|
| ** **                                                                         | ** ** | **(as restated)** | ** ** | **(as restated)** | ** ** |
| Net income (loss)  attributable to common stockholders, as reported                |       | $                 | 249,258    |              | $          | (13,931,946 | ) |
| Add employee  stock-based compensation expense included in reported net income     |       | 406,330           |       | 1,028,595         |       |
| Less employee  stock-based compensation expense determined under fair value method |       | (1,432,031        | )          | (1,503,188        | )          |
| Net income  (loss)—pro forma                                                  |       | $                 | (776,443   | )                 | $          | (14,406,539 | ) |
| Net income (loss) per  common share (basic and diluted):                           |       |              |       |              |       |
| As reported                                                                        |       | $                 | 0.02       |              | $          | (2.42 | ) |
| Pro forma                                                                          |       | $                 | (0.06      | )                 | $          | (2.51 | ) |

 

F-19

----

Theweighted average grant-date fair value used in the calculation of stock-basedcompensation expense in the accompanying statement of operations for the yearsended December 31, 2006, 2005 and 2004 and the pro forma net income (loss)and net income (loss) per common share information presented above iscalculated using the Black-Scholes option pricing model with the followingweighted average assumptions:

| ** **                                                       | ** ** | **Years Ended December 31,** | ** ** |
|------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                       | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004 (1)** | ** ** |
| Risk-free  interest rate                                         |       | 4.3%—5.2                               | %          | 3.5%—4.6 | % | 3.5 | % |
| Expected dividend  yield                                         |       | —                                      |       | — |   | — |   |
| Expected option  term                                            |       | 5 years                                     |       | 5 years |   | 5 years |   |
| Volatility                                                       |       | 50.0%—75.0                             | %          | 52.6 | % | 65.0 | % |
| Weighted average  fair value of options granted at  fair value   |       | $                                           | 14.76      |   | $ | 7.23 |   | $ | 4.92 |   |
| Weighted average fair  value of options granted below fair value |       | $                                           | —     |   | $ | — |   | $ | 8.34 |   |

----

(1)          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.

The risk-free interest rate assumption is based on theUnited States Treasury’s constant maturity rate for a five year term(corresponding to the expected option term) on the date the option was granted.The expected dividend yield is zero because the Company does not currently paydividends nor expect to do so during the expected option term. The expectedoption term of five years is estimated based on an analysis of actual optionexercises and a review of comparable medical device companies. The volatilityassumption is based on weekly historical volatility during the time period thatcorresponds to the expected option term, a review of comparable medical devicecompanies and expected future stock price volatility. The post-vestingforfeiture rate is based on the historical and projected average turnover rateusing four classifications of employees. These assumptions will be evaluatedand revised as necessary based on changes in market conditions and historicalexperience. For 2004, the weighted average fair value of options granted priorto and subsequent to the IPO was $5.15 and $5.74, respectively.

The Company uses the Black-Scholes option pricingmodel for determining the fair value of shares of common stock issued or to beissued under the ESPP. The following assumptions are used in determining fairvalue: The risk-free interest rate assumption is based on the United StatesTreasury’s constant maturity rate for a six month term (corresponding to theexpected option term) on the date the option was granted. In 2006, the Companyused a risk-free interest rate assumption that ranged from 5.1% to 5.2%. Theexpected dividend yield is zero because the Company does not currently paydividends nor expect to do so during the expected option term. An expected termof six months is used based on the duration of each plan offering period. Thevolatility assumption is based on stock price volatility over the most recentperiod of time corresponding to the expected term and is also based on expectedfuture stock price volatility. In 2006, the expected future stock pricevolatility ranged from 50.0% to 90.0%. These assumptions will be evaluated andrevised as necessary based on changes in market conditions and historicalexperience.

The Company recorded stock-based compensation expenseof $2,652,637, $406,330 and $1,028,595 for the years ended December 31,2006, 2005 and 2004 , respectively Included in the stock-based compensation expense recorded by the Companyfor the year ended December 31, 2006 is (a) $2,265,556 incompensation expense relating to stock options granted to employees subsequentto the Company’s July 2004 IPO that are accounted for according to theprovisions of SFAS No. 123(R); (b) $53,471 in reductions ofcompensation expense related to stock options granted to non-employees that areaccounted 

F-20

----

for according to theprovisions of Emerging Issues Task Force (“EITF”) Issue No. 96-18*  “Accountingfor Equity Instruments That Are Issued to Other Than Employees for Acquiring,or in Conjunction with Selling, Goods or Services”*  (“EITF No. 96-18”); (c) $159,480in compensation expense related to the ESPP and accounted for under theprovisions of SFAS No. 123(R): (d) $249,415 in compensation expenserelating to stock options granted to employees prior to the Company’s IPO thatare being accounted for using the intrinsic value method according to theprovisions of SFAS No. 123(R) and (e) $31,657 in modificationsto pre-IPO option grants. Compensation expense recorded by the Company for themodification of stock options for the years ended December 31, 2005 and2004, respectively, is $35,790 and $436,611.

The additional costs incurred as a result of theimplementation of SFAS No. 123(R) reflected in income beforeprovision of income taxes and net income attributable to common stockholdersfor the year ended December 31, 2006 was $2,425,036.  The effect on basic and diluted earnings pershare for the year ended December 31, 2006 was $0.19, respectively.

Stock options granted to non-employees are recorded atfair value and adjusted to market over the vesting period according to theprovisions of EITF No. 96-18. The Company determines fair valueusing the Black-Scholes option pricing model, an expected term equal to theoption term, a risk-free interest rate corresponding to the expected term, anexpected volatility of 70% -75% and a dividend yield of zero.

Deferred compensation was recorded in connection withstock option grants made prior to the Company’s IPO. The deferred compensationrepresents the difference between the estimated market value of common stock onthe date of grant and the exercise price associated with the stock options. Thedeferred compensation is amortized to expense over the vesting period of therelated stock options. The unamortized balance of deferred compensation as of December 31,2006 is $110,705.

Total unrecognized stock-based compensation costsrelated to non-vested stock options was approximately $6,703,540 as of December 31,2006 which related to approximately 759,476 shares with a per share weightedfair value of $8.83. This unrecognized cost is expected to be recognized over aweighted average period of approximately 2.0 years.

The Company has no tax windfallor shortfall as of December 31, 2006.

**Common Stock**

As of December 31, 2006, the Company had50,000,000 shares of common stock authorized and 12,601,224 shares issued andoutstanding. There were no treasury shares outstanding at December 31,2006 and 2005, as all treasury shares have been issued upon employee stockoption exercises.

Each share of common stock entitles the holder to onevote on all matters submitted to a vote of the Company’s stockholders. Commonstockholders are not entitled to receive dividends unless declared by the Boardof Directors.

At December 31,2006, the Company has reserved authorized shares of common stock for futureissuance as follows:

| Outstanding stock  options                                   |   | 1,215,094 |   |
|--------------------------------------------------------------|--------|-----------|--------|
| Possible future  issuance under stock option plans           |   | 1,265,979 |   |
| Possible future  issuance under employee stock purchase plan |   | 319,063   |   |
| Total                                                        |   | 2,800,136 |   |

 

F-21

----

On March 7,2007, the Company’s Board of Directors adopted a Shareholder Rights Plan anddeclared a dividend distribution of one preferred stock purchase right for eachoutstanding share of the Company’s common stock to shareholders of record as ofthe close of business on March 8, 2007. (See Note 13—Subsequent Event.)

**4.   Inventories**

At December 31,2006 and 2005, inventories consist of the following:

| ** **            | ** ** | **December 31,** | ** ** |
|-----------------------|------------|-----------------------|------------|
| ** **            | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Purchased  components |       | $                     | 345,852    |   | $ | 276,167 |   |
| Finished goods        |       | 3,287,537             |       | 2,407,242 |   |
|                  |       | $                     | 3,633,389  |   | $ | 2,683,409 |   |

 

**5.   Held-to-MaturityInvestments**

Held-to-maturityinvestments as of December 31, 2006 and 2005 are as follows:
|                                  | ** ** | **Amortized Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated  Fair Value** | ** ** |
|----------------------------------|------------|-------------------------|------------|------------------------------|------------|-------------------------------|------------|--------------------------------|------------|
| **2006**                         | ** ** |                    | ** ** | ** **                   |       |                          | ** ** | ** **                     |       | ** ** | ** ** | ** ** | ** ** |
| Commercial paper  and bank notes |       |                    | $          | 3,895,713                    | ** ** |                          |       | $                              | 104,287    | ** ** |   | $ | — |   | $ | 4,000,000 |   |
| U.S. agency  obligations         |       |                    | 997,752    | ** **                   |       |                          | 4,110      | ** **                     |       | — |   | 1,001,862 |   |
| Corporate bonds                  |       |                    | 27,517,220 | ** **                   |       |                          | 23,700     | ** **                     |       | (128,350 | ) | 27,412,570 |   |
|                             |       |                    | $          | 32,410,685                   | ** ** |                          |       | $                              | 132,097    | ** ** |   | $ | (128,350 | ) | $ | 32,414,432 |   |
| **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 |   |

 

Thefollowing table shows the gross unrealized losses and fair value of the Company’sheld-to-maturity investments 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, 2006 and 2005:

| ** **               | ** ** | **12 Months or less** | ** ** | **Greater than 12 Months** | ** ** | **Total**           | ** ** |
|--------------------------|------------|--------------------------------------|------------|-------------------------------------------|------------|---------------------|------------|
| ** **               | ** ** | **Fair Value**                  | ** ** | **Gross  Unrealized  Losses**             | ** ** | **Fair Value** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair Value** | ** ** | **Gross  Unrealized  Losses** | ** ** |
| **2006**                 |       |                                 |       |                                      |       |                |       |   |   |   |   |   |   |
| Corporate bonds          |       | $                                    | 20,998,098 |                                      | $          | (128,350            | )          | $ | — |   | $ | — |   | $ | 20,998,098 |   | $ | (128,350 | ) |
| **2005**                 |       |                                 |       |                                      |       |                |       |   |   |   |   |   |   |
| 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 | ) |

 

F-22

----

Corporate bonds—At December 31, 2006, the Companyheld 21 corporate bonds in an unrealized loss position which was primarily theresult of higher market interest rates since the date of purchase, rather thana decline in credit quality of these investments. The contractual terms ofthese investments do not permit the issuers to settle the securities at a priceless than the face value of the investment. Each of the bonds maintains aStandard & Poor’s rating of A or higher and has made each of theirscheduled interest payments. Therefore, it is not expected that the bonds wouldbe settled at a price less than the amortized cost of the investment. Becausethe Company has the ability and intent to hold these investments untilmaturity, the Company does not consider these investments to beother-than-temporarily impaired at December 31, 2006.

Theamortized cost and fair value of fixed maturity securities at December 31,2006 and 2005, by contractual maturity, are shown below:
|                          | ** ** | **December 31,**   | ** ** |
|--------------------------|------------|-------------------------|------------|
| ** **               | ** ** | **2006**                | ** ** | **2005** | ** ** |
| ** **               | ** ** | **Amortized Cost** | ** ** | **Fair Value** | ** ** | **Amortized Cost** | ** ** | **Fair Value** | ** ** |
| Due in one year  or less |       |                    | $          | 32,410,685 |   |   | $ | 32,414,432 |   |   | $ | 24,081,946 |   |   | $ | 23,760,087 |   |
|                          |            |                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**6.   FixedAssets**

Fixedassets consist of the following:
|                                     | ** ** | **Estimated  Useful Life** | ** ** | **December 31,** | ** ** |
|-------------------------------------|------------|---------------------------------|------------|-----------------------|------------|
| ** **                          | ** ** | **(Years)**                     | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Computer and  laboratory equipment  |       |                            | 3          |                  |       | $ | 1,746,322 |   | $ | 1,366,553 |   |
| Furniture and  equipment            |       |                            | 3          |                  |       | 350,678 |   | 198,330 |   |
| Production  equipment               |       |                            | 7          |                  |       | 665,266 |   | 636,406 |   |
| Construction in  progress           |       |                            | —     |                  |       | 215,476 |   | 173,103 |   |
| Leasehold  improvements             |       |                            | *          |                  |       | 150,097 |   | 132,907 |   |
|                                |       |                            |       |                  |       | 3,127,839 |   | 2,507,299 |   |
| Less—accumulated  depreciation |       |                            |       |                  |       | (2,012,403 | ) | (1,631,748 | ) |
|                                |       |                            |       |                  |       | $ | 1,115,436 |   | $ | 875,551 |   |

----

*—Lesser of life of lease or estimated useful life

Depreciationexpense was $380,655, $278,932 and $205,023 for the years ended December 31,2006, 2005 and 2004, respectively.

**7.   AccruedExpenses**

Accruedexpenses consist of the following for the fiscal years ended December 31,2006 and 2005:

| ** **             | ** ** | **December 31,** | ** ** |
|------------------------|------------|-----------------------|------------|
| ** **             | ** ** | **2006**              | ** ** | **2005** | ** ** |
| ** **             | ** ** | ** **            | ** ** | **(as restated)** | ** ** |
| Professional  services |       | $                     | 401,186    |   | $ | 438,519 |   |
| Sales taxes            |       | 2,851,307             |       | 1,589,091 |   |
| Other                  |       | 1,023,490             |       | 601,318 |   |
|                   |       | $                     | 4,275,983  |   | $ | 2,628,928 |   |

 

F-23

----

 

**8.   Long-TermDebt**

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 through December 31, 2003. All borrowings under the lineof credit were collateralized by substantially all the assets of the Company.Borrowings bore interest at nominal rate of 11% per annum. Upon the finalmaturity date or the earlier prepayment of each advance, the Company wasrequired to pay, in addition to the principal and interest, an additionalamount equal to 11% of the original principal, or $330,000. This additionalamount was being accreted over the applicable borrowing period as additionalinterest 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.

Inconnection with the Line of Credit, the Company issued Lighthouse warrants topurchase up to 400,000 shares of Series E-1 redeemable convertiblepreferred stock at an exercise price of $1.50 per share, for a term of sevenyears. The fair value of the warrants calculated using the Black-Scholes optionpricing model was estimated to be $450,100, and was recorded as a debtdiscount. This discount was being accreted over the repayment term of36 months as additional interest expense. Upon completion of the Company’sIPO, this warrant converted into a warrant to purchase 100,000 shares of commonstock. This warrant was exercised in full on a net basis on June 13, 2005,resulting in the issuance of 63,707 shares of common stock.

**9.   RedeemableConvertible Preferred Stock**

The Company’s redeemable convertible preferred stockwas mandatorily redeemable by the holders. The carrying value of this preferredstock was being accreted to redemption value over the term to the redemptiondate. These adjustments were affected through charges, first against retainedearnings, then against additional paid-in capital, until it was reduced to zeroand then to accumulated deficit. Accretion for the year ended December 31,2004 was $1,386,301.

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 Eredeemable convertible preferred stock and 2,333,333 shares of Series E-1redeemable convertible preferred stock automatically converted into 7,488,758shares of common stock upon the completion of the Company’s IPO in July 2004.

In March 2004, the Company sold 7,050,771 sharesof Series E-1 redeemable convertible preferred stock at a price of$1.50 per share, resulting in gross proceeds of $10,576,157. The conversionrate associated with Series E-1 redeemable convertible preferredstock resulted in a 1-for-4 exchange or a conversion price of $6.00per share. The Series E-1 redeemable convertible preferred stockcontained a beneficial conversion feature as the estimated fair value of theCompany’s common stock was in excess of the $1.50 per share conversion price.Accordingly, the Company recorded a charge of $7,050,771 as a beneficialconversion 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 theSeries D redeemable convertible preferred stock.

F-24

----

**10.   IncomeTaxes**

Theincome tax provision consists of the following for the years ended December 31,2006, 2005 and 2004:

| ** **          | ** ** | **Years Ended December 31,** | ** ** |
|---------------------|------------|---------------------------------------------|------------|
| ** **          | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Federal tax expense |       | $                                           | 193,000    |   | $ | 35,000 |   | $ | — |   |
| State tax expense   |       | —                                      |       | — |   | — |   |
| Total               |       | $                                           | 193,000    |   | $ | 35,000 |   | $ | — |   |

 

TheCompany’s effective income tax rate differs from the statutory federal incometax rate as follows for the years ended December 31, 2006, 2005 and 2004.

| ** **                                                          | ** ** | **Years Ended December 31,** | ** ** |
|---------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                          | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                          | ** ** | ** **                                  | ** ** | **(as restated)** | ** ** | **(as restated)** | ** ** |
| Federal tax provision  (benefit) rate                               |       | 34.0                                        | %          |   | 34.0 | % |   |   | (34.0 | )% |   |
| State tax provision  (benefit), net of federal provision (benefits) |       | 7.6                                         |       |   |  9.9 |   |   |   |  (3.9 | ) |   |
| Permanent items                                                     |       | 11.1                                        |       |   | 56.3 |   |   |   | 3.6 |   |   |
| Federal research and  development credits                           |       | (4.2                                        | )          |   | (54.5 | ) |   |   | (1.5 | ) |   |
| Alternative minimum tax                                             |       | 4.3                                         |       |   | 12.3 |   |   |   | — |   |   |
| Alternative minimum tax  credit                                     |       | (2.7                                        | )          |   | — |   |   |   | — |   |   |
| Valuation allowance                                                 |       | (45.8                                       | )          |   | (45.7 | ) |   |   | 35.8 |   |   |
| Effective income tax rate                                           |       | 4.3                                         | %          |   | 12.3 | % |   |   | 0.0 | % |   |

 

The Company’sdeferred tax assets consist of the following:

| ** **                                     | ** ** | **December 31,** | ** ** |
|------------------------------------------------|------------|-----------------------|------------|
| ** **                                     | ** ** | **2006**              | ** ** | **2005** | ** ** |
| ** **                                     | ** ** | ** **            | ** ** | **(as restated)** | ** ** |
| Deferred tax assets:                           |       |                  |       |   |   |
| Net operating loss  carryforwards              |       | $                     | 9,373,722  |   | $ | 13,878,358 |   |
| Research and development  credit carryforwards |       | 978,653               |       | 645,809 |   |
| Alternative minimum tax  credit                |       | 120,195               |       | — |   |
| Accrued expenses                               |       | 2,808,024             |       | 1,553,778 |   |
| Other                                          |       | 522,822               |       | 3,594 |   |
| Total gross deferred tax  assets               |       | 13,803,416            |       | 16,081,539 |   |
| Valuation allowance                            |       | (13,803,416           | )          | (16,081,539 | ) |
| Net deferred tax assets                        |       | $                     | —     |   | $ | — |   |

 

At December 31, 2006, the Company has federal andstate net operating loss carryforwards (“NOL”) of approximately $29.5 millionand $16.1 million, respectively, as well as federal and state tax creditsof approximately $889,528 and $317,152, respectively, which may be available toreduce future taxable income and the related taxes thereon. This amountincludes tax benefits of $4.0 million and $71,238 attributable to NOL andtax credit carryforwards, respectively, that result from the exercise ofemployee stock options. The tax benefit of these items will be recorded as acredit to additional paid-in capital upon realization of the deferred tax assetor reduction in income taxes payable. The federal NOL’s begin to expire in 2011and the state NOL’s begin to expire in 2007.

As required by SFAS 109, the Company hasevaluated the positive and negative evidence bearing upon the realizability ofits deferred tax assets, which are comprised principally of net operating loss.Management has determined that it is more likely than not that the Company willnot recognize the 

F-25

----

benefits of federal andstate deferred tax assets and, as a result, a valuation allowance ofapproximately $13.8 million and $16.1 million has been established atDecember 31, 2006 and 2005, respectively.

Ownershipchanges, as defined in the Internal Revenue Code, have limited the amount ofnet operating loss carryforwards that can be utilized annually to offset futuretaxable income. The Company anticipates that these limitations will have nomaterial impact on their ability to utilize the affected loss carryforwards infuture years.  Subsequent ownershipchanges could further impact the limitation in future years.

**11.   Commitmentsand Contingencies**

**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 31,2006 are as follows:

| 2007                          |   | $       | 930,000   |   |
|-------------------------------|--------|---------|-----------|--------|
| 2008                          |   | 930,000 |      |
| 2009                          |   | 232,500 |      |
| Total minimum lease  payments |   | $       | 2,092,500 |   |

 

Total recorded rentexpense was $871,819 for each the years ended December 31, 2006, 2005 and2004. 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, 2006 and 2005 of $130,909 and$189,091, 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, 2006 and 2005, the Company has $1,458,598recorded as restricted cash associated with this lease on the accompanyingbalance sheet.

**Legal Matters**

TheCompany is currently subject to an investigation by the Office of InspectorGeneral (“OIG”) within the Department of Health and Human Services based on asubpoena served to us in the second quarter of 2006. The Company is cooperatingwith the OIG with their informational request. Any such liabilities that mayarise out of this investigation in the future will be recorded as a charge inthe Company’s statements of operations in the period in which such liabilitiesbecome probable and estimable. The Company is aware of an investigation by theUnited States Department of Justice. The Company has not yet been informed ofthe subject matter of this investigation or received any formal requests forinformation relating to it.

**12.   RetirementPlan**

TheCompany established a 401(k) defined contribution savings plan for itsemployees who meet certain service period and age requirements. Contributionsare permitted up to the maximum allowed 

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under the Internal Revenue Code of each coveredemployee’s salary. The savings plan permits the Company to contribute at itsdiscretion. For the years ended December 31, 2006, 2005 and 2004 theCompany made no contributions to the plan.

**13.   SubsequentEvent**

On March 7, 2007, theCompany’s Board of Directors adopted a Shareholder Rights Plan and declared adividend distribution of one preferred stock purchase right for eachoutstanding share of the Company’s common stock to shareholders of record as ofthe close of business on March 8, 2007. Initially, these rights will notbe exercisable and will trade with the shares of the Company’s common stock. Underthe Shareholder Rights Plan, the rights generally will become exercisable if aperson becomes an “acquiring person” by acquiring 15% or more of the commonstock of the Company or if a person commences a tender offer that could resultin that person owning 15% or more of the common stock of the Company. If aperson becomes an acquiring person, each holder of a right (other than theacquiring person) would be entitled to purchase, at the then-current exerciseprice, such number of shares of preferred stock which are equivalent to sharesof the Company’s common stock having a value of twice the exercise price of theright. If the Company is acquired in a merger or other business combinationtransaction after any such event, each holder of a right would then be entitledto purchase, at the then-current exercise price, shares of the acquiringcompany’s common stock having a value of twice the exercise price of the right.

**14.**   Valuation andQualifying Accounts
|                                                          | ** ** | ** **                                     | ** ** | **Additions**                                 | ** ** | ** **                                              | ** ** | ** **                 | ** ** |
|----------------------------------------------------------|------------|------------------------------------------------|------------|-----------------------------------------------|------------|---------------------------------------------------------|------------|----------------------------|------------|
| **Description**                                          | ** ** | **Balance at  Beginning of  Period** | ** ** | **Charged to  costs and  expenses** | ** ** | **Charged to  other accounts  (Describe)(1)** | ** ** | **Deductions  (Describe)** | ** ** | **Balance at  End of  Period** | ** ** |
| **December 31, 2006**                               |       |                                           |       |                                          |       |                                                    |       |                       |       |   |   |   |   |
| Allowance for  Doubtful Accounts                         |       | $                                              | 400,000    |                                          | $          | 946,850                                                 |       |                       | $          | 74,539 |   |   | $ | (521,389 | )(2) | $ | 900,000 |   |
| Deferred Tax  Asset Valuation Allowance             |       | 16,081,539                                     |       | 2,226,513                                     |       |                                                    | —     |                       |       | (4,504,636 | )(3) | 13,803,416 |   |
| **December 31,  2005**                              |       |                                           |       |                                          |       |                                                    |       |                       |       |   |   |   |   |
| Allowance for  Doubtful Accounts                         |       | 300,000                                        |       | 281,684                                       |       |                                                    | 78,143     |                       |       | (259,827 | )(2) | 400,000 |   |
| Deferred Tax  Asset Valuation Allowance—as restated |       | 14,235,366                                     |       | 1,846,173                                     |       |                                                    | —     |                       |       | — |   | 16,081,539 |   |
| **December 31,  2004**                              |       |                                           |       |                                          |       |                                                    |       |                       |       |   |   |   |   |
| Allowance for Doubtful  Accounts                         |       | 300,000                                        |       | 221,796                                       |       |                                                    | 13,668     |                       |       | (235,464 | )(2) | 300,000 |   |
| Deferred Tax Asset  Valuation Allowance—as restated |       | 12,571,496                                     |       | 1,663,870                                     |       |                                                    | —     |                       |       | — |   | 14,235,366 |   |
|                                                          |            |                                                |            |                                               |            |                                                         |            |                            |            |  |  |  |  |  |  |  |  |  |

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(1)          Recoveries

(2)          Write-offs

(3)          Utilization andexpiration of Federal and State Net Operating Loss Carryforwards

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