##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
 Washington, D.C. 20549
 
 FORM 10-Q
 (Mark One)
 þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the quarterly period ended September 29, 2007
 o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
 For the transition period from  to
 Commission file number: 0-24663
 
 ASPECT MEDICAL SYSTEMS, INC.
  Delaware
    
    04-2985553(State or Other Jurisdiction of
    
    (I.R.S. Employer Identification No.)Incorporation or Organization)One Upland Road, Norwood, Massachusetts
    
    02062(Address of Principal Executive Offices)
    
    (Zip Code)
 (617) 559-7000
 
  þ o
  o þ o
  o þ




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##### 



PagePART I
    
    FINANCIAL INFORMATION
    
    
    1Item 1.
    
    Financial Statements (unaudited)
    
    
    1Condensed Consolidated Balance Sheets (unaudited)
as of September 29, 2007 and December 31, 2006
    
    
    1Condensed Consolidated Statements of Operations
(unaudited) for the Three and Nine months Ended
September 29, 2007 and September 30, 2006
    
    
    2Condensed Consolidated Statements of Cash Flows
(unaudited) for the Nine months Ended September 29,
2007 and September 30, 2006
    
    
    3Notes to Condensed Consolidated Financial Statements
    
    
    4Item 2.
    
    Managements Discussion and Analysis of Financial Condition and
Results of Operations
    
    
    18Item 3.
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    32Item 4.
    
    Controls and Procedures
    
    
    32PART II
    
    OTHER INFORMATION
    
    
    33Item 1A.
    
    Risk Factors
    
    
    33Item 2.
    
    Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    49Item 6.
    
    Exhibits
    
    
    49SIGNATURES
    
    
    50Ex-31.1 Section 302 Certification of the Chief Executive OfficerEx-31.2 Section 302 Certification of the Chief Financial OfficerEx-32.1 Section 906 Certification of the Chief Executive OfficerEx-32.2 Section 906 Certification of the Chief Financial Officer




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##### Table of Contents



PART I  FINANCIAL INFORMATION
 
 Item 1. FINANCIAL STATEMENTS.
 
 ASPECT MEDICAL SYSTEMS, INC.
 CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share data and per share amounts)
 September 29,
    
    
    December 31,2007
    
    
    2006(unaudited)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    18,113
    
    
    $
    9,724Short-term portion of restricted cash
    
    
    82
    
    
    
    140Short-term investments
    
    
    68,186
    
    
    
    45,253Accounts receivable, net of allowance of $284 at
September 29, 2007 and $218 at December 31, 2006
    
    
    11,157
    
    
    
    12,486Current portion of investment in sales-type leases
    
    
    1,506
    
    
    
    1,493Inventory
    
    
    7,543
    
    
    
    6,501Deferred tax assets
    
    
    1,844
    
    
    
    1,844Other current assets
    
    
    2,633
    
    
    
    2,157Total current assets
    
    
    111,064
    
    
    
    79,598Property and equipment, net
    
    
    8,524
    
    
    
    7,798Long-term portion of restricted cash
    
    
    929
    
    
    
    911Long-term investments
    
    
    19,646
    
    
    
    7,442Long-term investment in sales-type leases
    
    
    2,858
    
    
    
    2,817Deferred financing fees
    
    
    4,373
    
    
    
    Long-term deferred tax assets
    
    
    23,246
    
    
    
    26,398Total assets
    
    $
    170,640
    
    
    $
    124,964LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    1,607
    
    
    $
    1,925Accrued liabilities
    
    
    10,533
    
    
    
    8,428Deferred revenue
    
    
    101
    
    
    
    1,865Total current liabilities
    
    
    12,241
    
    
    
    12,218Long-term portion of deferred revenue
    
    
    47
    
    
    
    3,498Long-term debt
    
    
    125,000
    
    
    
    Commitments and contingenciesStockholders equity:Preferred Stock, $.01 par value; 5,000,000 shares
authorized, no shares issued or outstanding
    
    
    
    
    
    
    Common Stock, $.01 par value; 60,000,000 shares
authorized, 17,039,624 and 22,363,564 shares issued
and outstanding at September 29, 2007 and December 31,
2006, respectively
    
    
    173
    
    
    
    226Treasury stock, at cost; 276,493 shares
    
    
    (5,008
    )
    
    
    (5,008
    )Additional paid-in capital
    
    
    175,941
    
    
    
    168,440Accumulated other comprehensive income (loss)
    
    
    164
    
    
    
    (1
    )Accumulated deficit
    
    
    (137,918
    )
    
    
    (54,409
    )Total stockholders equity
    
    
    33,352
    
    
    
    109,248Total liabilities and stockholders equity
    
    $
    170,640
    
    
    $
    124,964
  1




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
(unaudited)
 Three Months Ended
    
    
    Nine Months EndedSeptember 29,
    
    
    September 30,
    
    
    September 29,
    
    
    September 30,2007
    
    
    2006
    
    
    2007
    
    
    2006Product revenue
    
    $
    22,632
    
    
    $
    21,145
    
    
    $
    68,146
    
    
    $
    62,767Strategic alliance revenue
    
    
    
    
    
    
    1,710
    
    
    
    5,246
    
    
    
    4,606Total revenue
    
    
    22,632
    
    
    
    22,855
    
    
    
    73,392
    
    
    
    67,373Costs of revenue (1)
    
    
    5,533
    
    
    
    5,317
    
    
    
    17,379
    
    
    
    16,074Gross profit
    
    
    17,099
    
    
    
    17,538
    
    
    
    56,013
    
    
    
    51,299Operating expenses: (1)Research and development
    
    
    3,820
    
    
    
    3,951
    
    
    
    12,234
    
    
    
    11,166Sales and marketing
    
    
    9,669
    
    
    
    8,794
    
    
    
    29,913
    
    
    
    26,598General and administrative
    
    
    3,656
    
    
    
    3,020
    
    
    
    11,336
    
    
    
    9,161Total operating
expenses
    
    
    17,145
    
    
    
    15,765
    
    
    
    53,483
    
    
    
    46,925(Loss) income from operations
    
    
    (46
    )
    
    
    1,773
    
    
    
    2,530
    
    
    
    4,374Other income (expense):Interest income
    
    
    1,517
    
    
    
    898
    
    
    
    3,519
    
    
    
    2,415Interest expense
    
    
    (944
    )
    
    
    
    
    
    
    (1,059
    )
    
    
    Income before income taxes
    
    
    527
    
    
    
    2,671
    
    
    
    4,990
    
    
    
    6,789Provision for income taxes
    
    
    683
    
    
    
    253
    
    
    
    3,142
    
    
    
    310Net (loss) income
    
    $
    (156
    )
    
    $
    2,418
    
    
    $
    1,848
    
    
    $
    6,479Net (loss) income per share:Basic
    
    $
    (0.01
    )
    
    $
    0.11
    
    
    $
    0.09
    
    
    $
    0.29Diluted
    
    $
    (0.01
    )
    
    $
    0.10
    
    
    $
    0.09
    
    
    $
    0.27Weighted average shares used in
computing net (loss) income per
share:Basic
    
    
    17,230
    
    
    
    22,440
    
    
    
    20,485
    
    
    
    22,406Diluted
    
    
    17,230
    
    
    
    23,211
    
    
    
    21,137
    
    
    
    23,524(1) Stock-based compensation
included in costs and expenses:Costs of revenue
    
    $
    145
    
    
    $
    107
    
    
    $
    430
    
    
    $
    318Research and development
    
    
    502
    
    
    
    366
    
    
    
    1,516
    
    
    
    1,110Sales and marketing
    
    
    805
    
    
    
    616
    
    
    
    2,402
    
    
    
    1,866General and administrative
    
    
    727
    
    
    
    549
    
    
    
    2,184
    
    
    
    1,636
  2




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
 Nine Months EndedSeptember 29,
    
    
    September 30,2007
    
    
    2006Cash flows from operating activities:Net income
    
    $
    1,848
    
    
    $
    6,479Adjustments to reconcile net income to net cash provided by
operating activities Depreciation and amortization
    
    
    1,856
    
    
    
    1,115Provision for doubtful accounts
    
    
    91
    
    
    
    97Stock-based compensation expense
    
    
    6,533
    
    
    
    4,985Deferred tax asset
    
    
    3,152
    
    
    
    Changes in assets and liabilities Decrease in accounts receivable
    
    
    1,238
    
    
    
    451Increase in inventory
    
    
    (1,042
    )
    
    
    (1,807
    )Increase in other current assets
    
    
    (476
    )
    
    
    (672
    )Increase in investment in sales-type leases
    
    
    (54
    )
    
    
    (490
    )Increase in other long-term assets
    
    
    (371
    )
    
    
    (Decrease) increase in accounts payable
    
    
    (318
    )
    
    
    302Increase (decrease) in accrued liabilities
    
    
    2,033
    
    
    
    (2,321
    )(Decrease) in deferred revenue
    
    
    (5,215
    )
    
    
    (47
    )Increase in income taxes payable
    
    
    
    
    
    
    257Net cash provided by operating activities
    
    
    9,275
    
    
    
    8,349Cash flows from investing activities:Decrease (increase) in restricted cash
    
    
    40
    
    
    
    (1,018
    )Acquisitions of property and equipment
    
    
    (2,400
    )
    
    
    (3,456
    )Purchases of marketable securities
    
    
    (115,102
    )
    
    
    (51,260
    )Proceeds from sales and maturities of marketable securities
    
    
    80,131
    
    
    
    43,714Net cash used for investing activities
    
    
    (37,331
    )
    
    
    (12,020
    )Cash flows from financing activities:Repurchases of common stock
    
    
    (85,041
    )
    
    
    Purchases of treasury stock
    
    
    
    
    
    
    (5,008
    )Deferred financing fees
    
    
    (4,556
    )
    
    
    Proceeds from issuance of common stock
    
    
    1,042
    
    
    
    2,121Proceeds from long-term debt
    
    
    125,000
    
    
    
    Net cash provided by (used for) financing activities
    
    
    36,445
    
    
    
    (2,887
    )Net increase (decrease) in cash and cash equivalents
    
    
    8,389
    
    
    
    (6,558
    )Cash and cash equivalents, beginning of period
    
    
    9,724
    
    
    
    20,437Cash and cash equivalents, end of period
    
    $
    18,113
    
    
    $
    13,879
  3




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
 (1) Basis of Presentation
   (2) Summary of Significant Accounting Policies
  Principles of Consolidation
  Foreign Currency
  Cash, Cash Equivalents and Marketable Securities
  Accounting for Certain Investments
in Debt and Equity Securities
 4




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
 Revenue Recognition
  Revenue Recognition, Revenue Arrangements with Multiple Deliverables
 Accounting For Leases
    5




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ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
 Accounting for
Contingencies
 Research and Development Costs
  Allowance for Doubtful Accounts
  Inventory
  Warranty
  Three Months Ended
    
    
    Nine Months EndedSeptember 29, 2007
    
    
    September 30, 2006
    
    
    September 29, 2007
    
    
    September 30, 2006Beginning balance
    
    $
    223
    
    
    $
    201
    
    
    $
    220
    
    
    $
    159Warranty expense
    
    
    14
    
    
    
    7
    
    
    
    33
    
    
    
    95Deductions and other
    
    
    (10
    )
    
    
    (11
    )
    
    
    (26
    )
    
    
    (57
    )Ending balance
    
    $
    227
    
    
    $
    197
    
    
    $
    227
    
    
    $
    197
 Shipping and Handling Costs
  6




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
 Advertising Costs
  Property and Equipment
 Accounting for the Costs of Computer Software Developed or Obtained
for Internal Use
 Income Taxes
 Accounting for Income
Taxes Accounting for Uncertainty in Income Taxes  an
Interpretation of FASB Statement No. 109
 Concentration of Credit Risk
  Single or Limited Source Suppliers
  7




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
 Net (Loss) Income Per Share
 Earnings Per Share
   Three Months Ended
    
    
    Nine Months EndedSeptember 29, 2007
    
    
    September 30, 2006
    
    
    September 29, 2007
    
    
    September 30, 2006Basic:Net (loss) income
    
    $
    (156
    )
    
    $
    2,418
    
    
    $
    1,848
    
    
    $
    6,479Weighted average shares outstanding
    
    
    17,230
    
    
    
    22,440
    
    
    
    20,485
    
    
    
    22,406Basic net (loss) income per share
    
    $
    (0.01
    )
    
    $
    0.11
    
    
    $
    0.09
    
    
    $
    0.29Diluted:Net (loss) income
    
    $
    (156
    )
    
    $
    2,418
    
    
    $
    1,848
    
    
    $
    6,479Weighted average shares outstanding
    
    
    17,230
    
    
    
    22,440
    
    
    
    20,485
    
    
    
    22,406Effect of dilutive stock options and
restricted stock
    
    
    
    
    
    
    771
    
    
    
    652
    
    
    
    1,118Weighted average shares assuming
dilution
    
    
    17,230
    
    
    
    23,211
    
    
    
    21,137
    
    
    
    23,524Diluted net (loss) income per share
    
    $
    (0.01
    )
    
    $
    0.10
    
    
    $
    0.09
    
    
    $
    0.27
 Comprehensive (Loss) Income
  Stock-Based Compensation
  8




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
    WeightedWeighted
    
    
    Average
    
    
    AggregateNumber of
    
    
    Average
    
    
    Remaining
    
    
    IntrinsicOptions
    
    
    Exercise Price
    
    
    Contractual Life
    
    
    ValueOutstanding at December 31, 2006
    
    
    4,160
    
    
    $
    17.00Granted
    
    
    453
    
    
    
    15.98Exercised
    
    
    (161
    )
    
    
    5.68Canceled
    
    
    (97
    )
    
    
    20.71Outstanding at September 29, 2007
    
    
    4,355
    
    
    $
    17.23
    
    
    
    6.01
    
    
    $
    7,212Vested or expected to vest at
September 29, 2007
    
    
    4,298
    
    
    $
    17.18
    
    
    
    5.98
    
    
    
    7,210Exercisable at September 29, 2007
    
    
    3,212
    
    
    $
    15.79
    
    
    
    5.19
    
    
    
    7,174
   WeightedAverageNumber of
    
    
    Grant DateShares
    
    
    Fair ValueUnvested at December 31, 2006
    
    
    47
    
    
    $
    23.95Granted
    
    
    324
    
    
    
    16.16Vested
    
    
    (77
    )
    
    
    17.44Unvested at September 29, 2007
    
    
    294
    
    
    $
    17.03
  9




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
 :
  Three Months Ended
    
    Nine Months EndedSeptember 29, 2007
    
    September 30, 2006
    
    September 29, 2007
    
    September 30, 2006Options granted
    
    
    153,387
    
    
    
    45,000
    
    
    
    3,393,949
    
    
    
    604,485Weighted average exercise price
    
    $
    13.29
    
    
    $
    14.38
    
    
    $
    15.98
    
    
    $
    27.81Weighted average grant date
fair value
    
    $
    5.93
    
    
    $
    6.99
    
    
    $
    7.51
    
    
    $
    12.08Assumptions:Risk-free interest rate
    
    
    4.69
    %
    
    
    4.97
    %
    
    
    4.55
    %
    
    
    4.72
    %Expected term
    
    5.2 years
    
    5 years
    
    5.2 years
    
    5 yearsExpected volatility
    
    
    42
    %
    
    
    49
    %
    
    
    46
    %
    
    
    42
    %Expected dividend yield
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
 :
    10




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
  Use of Estimates
  Fair Value of Financial Instruments
  Reclassifications
  Recent Accounting Pronouncements
 The Fair Value Option for Financial Assets
and Financial Liabilities
 11




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
 (3)    Comprehensive (Loss) Income
  Three Months Ended
    
    
    Nine Months EndedSeptember 29, 2007
    
    
    September 30, 2006
    
    
    September 29, 2007
    
    
    September 30, 2006Net (loss) income
    
    $
    (156
    )
    
    $
    2,418
    
    
    $
    1,848
    
    
    $
    6,479Other comprehensive income:Unrealized gain on
marketable securities
    
    
    127
    
    
    
    51
    
    
    
    164
    
    
    
    88Comprehensive (loss) income
    
    $
    (29
    )
    
    $
    2,469
    
    
    $
    2,012
    
    
    $
    6,567
 (4)    Investment in Sales-Type Leases
  September 29,
    
    
    December 31,2007
    
    
    2006Total minimum lease payments receivable
    
    $
    6,082
    
    
    $
    6,148Less:Unearned interest income
    
    
    950
    
    
    
    972Allowance for lease payments
    
    
    768
    
    
    
    866Net investment in sales-type leases
    
    
    4,364
    
    
    
    4,310Less  current portion
    
    
    1,506
    
    
    
    1,493$
    2,858
    
    
    $
    2,817
 (5) Inventory
  September 29,
    
    
    December 31,2007
    
    
    2006Raw materials
    
    $
    4,229
    
    
    $
    3,607Work-in-progress
    
    
    95
    
    
    
    156Finished goods
    
    
    3,219
    
    
    
    2,738$
    7,543
    
    
    $
    6,501
 12




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
 (6) Income Taxes
  Accounting For Income Taxes
   (7) Segment Information and Enterprise Reporting
  13




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ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
  Three Months Ended
    
    
    Nine Months EndedSeptember 29,
    
    
    September 30,
    
    
    September 29,
    
    
    September 30,2007
    
    
    2006
    
    
    2007
    
    
    2006Geographic Area by RegionDomestic
    
    $
    16,655
    
    
    $
    18,031
    
    
    $
    55,737
    
    
    $
    52,692International
    
    
    5,977
    
    
    
    4,824
    
    
    
    17,655
    
    
    
    14,681Total
    
    $
    22,632
    
    
    $
    22,855
    
    
    $
    73,392
    
    
    $
    67,373
 Three Months Ended
    
    Nine months EndedSeptember 29,
    
    September 30,
    
    September 29,
    
    September 30,2007
    
    2006
    
    2007
    
    2006Geographic Area by RegionDomestic
    
    
    74
    %
    
    
    79
    %
    
    
    76
    %
    
    
    78
    %International
    
    
    26
    
    
    
    21
    
    
    
    24
    
    
    
    22Total
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %
  (8) Commitments and Contingencies
 Leases
  (9) Loan Agreements
  14




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
  (10) Termination and Repurchase Agreement with Boston Scientific Corporation
  
    
    the OEM Product Development Agreement dated as of August 7, 2002 (as amended January
31, 2005 and February 5, 2007, the 2002 Agreement), pursuant to which the Company was to
develop certain products that Boston Scientific Corporation would then commercialize in
the area of monitoring patients under sedation in a range of less invasive medical
specialties, and pursuant to which the Company granted Boston Scientific Corporation an
exclusive option to become the distributor for a period of time of certain products;
    
    the Product Development and Distribution Agreement dated as of May 23, 2005 (the 2005
Agreement) pursuant to which the Company was to develop new applications of its
brain-monitoring technology in the area of the diagnosis and treatment of neurological,
psychiatric and pain disorders and Boston Scientific was appointed the exclusive
distributor of such products; and
    
    the Letter Agreement dated August 7, 2002, and Security Agreement dated August 7, 2002,
pursuant to which Boston Scientific Corporation agreed to make revolving interest-bearing
loans to Aspect from time to time at the request of Aspect, such revolving loans being
evidenced by a promissory note in the original principal amount of $5,000,000 dated August
7, 2002.
  15




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ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
  (11) Convertible Debt
   
    
    during the five business day period after any five consecutive trading day period
(the measurement period) in which the price per note for each trading day of that
measurement period was less than 97% of the product of the last reported sale price of
the Companys common stock and the conversion rate on each such day;
    
    during any calendar quarter (and only during such quarter) after the calendar
quarter ending September 30, 2007, if the last reported sale price of the Companys
common stock for 20 or more trading days in a period of 30 consecutive trading days
ending on the last trading day of the immediately preceding calendar quarter exceeds
120% of the applicable conversion price in effect on the last trading day of the
immediately preceding calendar quarter; or
    
    upon the occurrence of specified corporate events.
    16




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ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
    (12) Stock Repurchase Program
  (13) Subsequent event
  
    
    an Exempted Person shall mean any person that would be deemed an Acquiring Person
solely as a result of being the Beneficial Owner of shares of Common Stock issuable, but
not yet issued, upon conversion or exchange of the Companys 2.50% Convertible Senior
Notes due 2014 (the Notes), unless and until such time as such person, together with its
affiliates and associates, directly or indirectly, becomes the beneficial owner of 21.0%
or more of the shares of Common Stock then outstanding, in which event such person shall
immediately cease to be an Exempted Person; and
    
    the definition of Exempted Person has been amended to remove references to Boston
Scientific Corporation, such that the percentage of Beneficial Ownership of the Common
Stock held by Boston Scientific Corporation for purposes of determining whether it is an
Acquiring Person shall be 17.5% and not 28.5%, as was previously the case.
 17




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Item 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS.
 Overview
 ®
  Initial
    
    Date of ClearanceCommercial
    
    of 510 (k)Product
    
    Shipment
    
    Notification
    
    DescriptionEQUIPMENTBIS VIEW
    
    
    2007
    
    
    August 2007
    
    Basic-featured standalone monitor which has fewer optional
user configurations compared with the BIS VISTA monitor.BIS VISTA
    
    
    2006
    
    
    September 2005
    
    Monitor that offers an enhanced display and user interface
as well as greater processing capability compared to our
other monitors.BISx system
    
    
    2004
    
    
    February 2004
    
    BIS monitoring solution that provides the processing
technology required to obtain BIS information from a single
device the approximate size of a hockey puck. The BISx
system is designed to integrate with a wide range of
patient monitoring platforms sold by original equipment
manufacturers.BIS XP System
    
    
    2001
    
    
    June 2001
    
    BIS system offering enhanced performance capabilities and
expanded benefits as compared to the previous version of
the BIS system, designed to enable more precise measurement
of brain activity to assess the level of consciousness.BIS Module Kit 
4 Channel
Support
    
    
    2001
    
    
    October 2000
    
    Same as standard BIS Module Kit plus 4 channel EEG
monitoring capability.A-2000 BIS Monitor
    
    
    1998
    
    
    February 1998
    
    Compact, lightweight, portable third-generation BIS monitor.BIS Module Kit
    
    
    1998
    
    
    October 2000
    
    Components of BIS monitoring technology that are integrated
into equipment sold by original equipment manufacturers.SENSORSSemi-Reusable
(SRS) Sensor
    
    
    2005
    
    
    February 2005
    
    Semi-reusable version of a BIS Sensor that uses the same
algorithm and hardware as our other disposable sensors.
Currently available only in markets outside the United
States, excluding Japan.BIS Extend Sensor
    
    
    2002
    
    
    October 2000
    
    Disposable sensor with electronic memory device for use
with our BIS Monitors, BIS Module Kit and BISx System that
was designed for patients who are typically monitored for
extended periods.
 18




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##### Table of Contents



Initial
    
    Date of ClearanceCommercial
    
    of 510 (k)Product
    
    Shipment
    
    Notification
    
    DescriptionBIS Pediatric
Sensor
    
    
    2001
    
    
    October 2000
    
    Disposable sensor with
electronic memory
device for use with
our BIS Monitors, BIS
Module Kit and BISx
System that is smaller
and easier to apply to
children.BIS Quatro Sensor
    
    
    2001
    
    
    October 2000
    
    Disposable sensor with
electronic memory
device for use with
our BIS Monitors, BIS
Module Kit and BISx
System that is
designed to offer
enhanced performance
in deep anesthetic
states and enhanced
resistance to
interference from
noise sources.BIS Sensor Plus
    
    
    2001
    
    
    January 2000
    
    Second-generation
disposable sensor for
use with our BIS
Monitors and BIS
Module Kit.BIS Standard Sensor
    
    
    1997
    
    
    October 1996
    
    Disposable sensor for
use with our BIS
Monitors and BIS
Module Kit.
  Three Months Ended
    
    Nine Months EndedSeptember 29,
    
    September 30,
    
    September 29,
    
    September 30,2007
    
    2006
    
    2007
    
    2006(dollars in thousands)Domestic revenue
    
    $
    16,655
    
    
    $
    18,031
    
    
    $
    55,737
    
    
    $
    52,692Percent of total revenue
    
    
    74
    %
    
    
    79
    %
    
    
    76
    %
    
    
    78
    %International revenue
    
    $
    5,977
    
    
    $
    4,824
    
    
    $
    17,655
    
    
    $
    14,681Percent of total revenue
    
    
    26
    %
    
    
    21
    %
    
    
    24
    %
    
    
    22
    %Total revenue
    
    $
    22,632
    
    
    $
    22,855
    
    
    $
    73,392
    
    
    $
    67,373BIS Sensor revenue
    
    $
    19,031
    
    
    $
    16,126
    
    
    $
    55,148
    
    
    $
    47,578Percent of total revenue
    
    
    84
    %
    
    
    71
    %
    
    
    75
    %
    
    
    71
    %Equipment revenue
    
    $
    3,601
    
    
    $
    5,019
    
    
    $
    12,998
    
    
    $
    15,189Percent of total revenue
    
    
    16
    %
    
    
    22
    %
    
    
    18
    %
    
    
    22
    %Strategic alliance revenue
    
    $
    
    
    
    $
    1,710
    
    
    $
    5,246
    
    
    $
    4,606Percent of total revenue
    
    
    
    
    
    
    7
    %
    
    
    7
    %
    
    
    7
    %Total revenue
    
    $
    22,632
    
    
    $
    22,855
    
    
    $
    73,392
    
    
    $
    67,373
    19




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Share-Based Payment Accounting for Stock Issued to Employees
  20




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Critical Accounting Policies and Estimates
  Revenue Recognition
 Revenue
Recognition, Revenue Arrangements with
Multiple Deliverables
   Accounting For Leases
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Stock-Based Compensation
        22




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Allowance for Doubtful Accounts
  Inventories
  Warranty
  Income Taxes
 Accounting For Income Taxes,
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Results of Operations
  Three Months Ended
    
    Nine Months EndedSeptember 29,
    
    September 30,
    
    September 29,
    
    September 30,2007
    
    2006
    
    2007
    
    2006Revenue
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %Costs of revenue
    
    
    24
    
    
    
    23
    
    
    
    24
    
    
    
    24Gross profit margin
    
    
    76
    
    
    
    77
    
    
    
    76
    
    
    
    76Operating expenses:Research and development
    
    
    17
    
    
    
    17
    
    
    
    17
    
    
    
    16Sales and marketing
    
    
    43
    
    
    
    39
    
    
    
    41
    
    
    
    40General and administrative
    
    
    16
    
    
    
    13
    
    
    
    15
    
    
    
    14Total operating expenses
    
    
    76
    
    
    
    69
    
    
    
    73
    
    
    
    70(Loss) income from operations
    
    
    
    
    
    
    8
    
    
    
    3
    
    
    
    6Interest income, net
    
    
    2
    
    
    
    4
    
    
    
    3
    
    
    
    4Income before income taxes
    
    
    2
    
    
    
    12
    
    
    
    6
    
    
    
    10Provision for incomes taxes
    
    
    3
    
    
    
    1
    
    
    
    4
    
    
    
    Net (loss) income
    
    
    (1
    )%
    
    
    11
    %
    
    
    2
    %
    
    
    10
    %
 Three
and Nine Months Ended September 29, 2007 Compared with the Three and Nine Months Ended
September 30, 2006
 Three Months Ended
    
    
    Nine Months EndedPercentageSeptember 29,
    
    
    September 30,
    
    
    Increase
    
    
    September 29,
    
    
    September 30,
    
    
    Percentage2007
    
    
    2006
    
    
    (Decrease)
    
    
    2007
    
    
    2006
    
    
    Increase(in thousands, except
    
    
    
    
    
    
    (in thousands, exceptunit amounts)
    
    
    
    
    
    
    unit amounts)Revenue  WorldwideBIS Sensors
    
    $
    19,031
    
    
    $
    16,126
    
    
    
    18
    %
    
    $
    55,148
    
    
    $
    47,578
    
    
    
    16
    %BIS monitors
    
    
    2,090
    
    
    
    3,408
    
    
    
    (39
    %)
    
    
    7,969
    
    
    
    9,726
    
    
    
    (18
    %)Original equipment
manufacturer products
    
    
    833
    
    
    
    1,044
    
    
    
    (20
    %)
    
    
    2,806
    
    
    
    3,815
    
    
    
    (26
    %)Other equipment and accessories
    
    
    678
    
    
    
    567
    
    
    
    20
    %
    
    
    2,223
    
    
    
    1,648
    
    
    
    35
    %Total Equipment
    
    
    3,601
    
    
    
    5,019
    
    
    
    (28
    %)
    
    
    12,998
    
    
    
    15,189
    
    
    
    (14
    %)Total product revenue
    
    
    22,632
    
    
    
    21,145
    
    
    
    7
    %
    
    
    68,146
    
    
    
    62,767
    
    
    
    9
    %Strategic alliance
    
    
    
    
    
    
    1,710
    
    
    
    (100
    %)
    
    
    5,246
    
    
    
    4,606
    
    
    
    14
    %Total revenue
    
    $
    22,632
    
    
    $
    22,855
    
    
    
    (1
    %)
    
    $
    73,392
    
    
    $
    67,373
    
    
    
    9
    %Unit Analysis  WorldwideBIS Sensors
    
    
    1,377,000
    
    
    
    1,144,000
    
    
    
    20
    %
    
    
    3,945,000
    
    
    
    3,354,000
    
    
    
    18
    %BIS monitors
    
    
    741
    
    
    
    1,094
    
    
    
    (32
    %)
    
    
    2,548
    
    
    
    3,139
    
    
    
    (19
    %)Original equipment manufacturer
BIS products
    
    
    1,017
    
    
    
    1,198
    
    
    
    (15
    %)
    
    
    3,547
    
    
    
    3,992
    
    
    
    (11
    %)Installed base
    
    
    45,344
    
    
    
    37,911
    
    
    
    20
    %
    
    
    45,344
    
    
    
    37,911
    
    
    
    20
    %
 Revenue.
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Expense Overview
 Three Months Ended
    
    
    
    
    
    Nine Months EndedPercentage
    
    
    
    
    
    
    
    
    
    PercentageSeptember 29,
    
    September 30,
    
    Increase
    
    September 29,
    
    September 30,
    
    Increase2007
    
    2006
    
    (Decrease)
    
    2007
    
    2006
    
    (Decrease)(in thousands)
    
    
    
    
    
    (in thousands)ExpensesResearch and development
    
    $
    3,820
    
    
    $
    3,951
    
    
    
    (3
    %)
    
    $
    12,234
    
    
    $
    11,166
    
    
    
    10
    %Sales and marketing
    
    $
    9,669
    
    
    $
    8,794
    
    
    
    10
    %
    
    $
    29,913
    
    
    $
    26,598
    
    
    
    12
    %General and administrative
    
    $
    3,656
    
    
    $
    3,020
    
    
    
    21
    %
    
    $
    11,336
    
    
    $
    9,161
    
    
    
    24
    %
 Research and Development.
 .
 Sales and Marketing.
  27




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General and Administrative.
  Interest Income.
 Interest Expense.
 Income Taxes
 Liquidity and Capital Resources
  
    
    net proceeds of approximately $54.6 million from our initial public offering of an
aggregate of 4,025,000 shares of common stock in February 2000;
    
    approximately $3.4 million in equipment financing;
    
    approximately $5.1 million related to our investment in sales-type leases;
    
    proceeds of approximately $10.0 million related to our 2002 OEM product development
and distribution agreement with Boston Scientific Corporation;
    
    proceeds of approximately $8.1 million from the sale of our common stock to Boston
Scientific Corporation in 2004;
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
    
    $10.0 million in installment payments from Boston Scientific Corporation received in
May 2005 and May 2006 pursuant to the 2005 product development and distribution
agreement with Boston Scientific Corporation; and,
    
    net proceeds of $121.0 million received in connection with our 2.5% convertible
senior notes that we issued in June 2007.
       29




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Cash provided by operations.
 Cash used for investing activities.
 Cash provided by financing activities.
 Off-Balance Sheet Arrangements
  Income Taxes
  Accounting For Income Taxes,
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Accounting for Uncertainty in Income
Taxes  an Interpretation of FASB Statement No. 109,
 Effects of Inflation
  Recent Accounting Pronouncements
 The Fair Value Option for Financial Assets
and Financial Liabilities
 Forward-Looking Statements
 This Quarterly Report on Form 10-Q contains, in addition to historical information,
forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of
1934, including information relating to our ability to maintain profitability, information with
respect to market acceptance of our BIS system, continued growth in sales of our BIS monitors,
original equipment manufacturer products and BIS Sensors, our dependence on the BIS system,
regulatory approvals for our products, our ability to remain competitive and achieve future growth,
information with respect to other plans and strategies for our business and factors that may
influence our revenue and net income for the fiscal quarter ending December 31, 2007 and
thereafter. These forward-looking statements involve risks and uncertainties and are not
guarantees of future performance. Words such as expect, anticipate, intend, plan,
believe, seek, estimate and variations of these words and similar expressions are intended to
identify forward-looking statements. Our actual results could differ significantly from the results
discussed in these forward-looking statements. The important factors discussed under Part II 
Item 1A. Risk Factors below represent some of the current challenges to us that create risk and
uncertainty. In addition, subsequent events and developments may cause our expectations to change.
While we may elect to update these forward-looking statements we specifically disclaim any
obligation to do so, even if our expectations change.
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Item 3. Quantitative and Qualitative Disclosures About Market Risk.
 Interest Rate Exposure
   Foreign Currency Exposure
  
 Item 4. Controls and Procedures.
 (a)
    
    Evaluation of Disclosure Controls and Procedures.Our management, with the participation of our chief executive officer and chief financial
officer evaluated the effectiveness of our disclosure controls and procedures as of September
29, 2007. The term disclosure controls and procedures, as defined in Rules 13a-15(e) and
15d-15(e) under the Exchange Act, means controls and other procedures of a company that are
designed to ensure that information required to be disclosed by a company in the reports that
it files or submits under the Exchange Act is recorded, processed, summarized and reported,
within the time periods specified in the SECs rules and forms. Disclosure controls and
procedures include, without limitation, controls and procedures designed to ensure that
information required to be disclosed by a company in the reports that it files or submits
under the Exchange Act is accumulated and communicated to the companys management, including
its principal executive and principal financial officers, as appropriate to allow timely
decisions regarding required disclosure. Management recognizes that any controls and
procedures, no matter how well designed and operated, can provide only reasonable assurance
of achieving their objectives and management necessarily applies its judgment in evaluating
the cost-benefit relationship of possible controls and procedures. Based on the evaluation
of our disclosure controls and procedures as of September 29, 2007, our chief executive
officer and chief financial officer concluded that, as of such date, our disclosure controls
and procedures were effective at the reasonable assurance level.(b)
    
    Changes in Internal Controls.No change in our internal control over financial reporting (as defined in Rules 13a-15(f) and
15d-15(f) under the Exchange Act) occurred during the fiscal quarter ended September 29, 2007
that has materially affected, or is reasonably likely to materially affect, our internal
control over financial reporting.
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##### Table of Contents



PART II  OTHER INFORMATION
 
 Item 1A. Risk Factors
  Risks Relating to the Company
 We will not continue to be profitable if hospitals and anesthesia providers do not buy and use our
BIS system and purchase our BIS Sensors in sufficient quantities.
   We depend on our BIS system for substantially all of our revenue, and if the BIS system does not
gain widespread market acceptance, then our revenue will not grow.
  Various factors may adversely affect our quarterly operating results through the fourth fiscal
quarter of 2007.
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##### Table of Contents



Fluctuations in our quarterly operating results could cause our stock price to decrease.
  
    
    the timing and volume of customer orders for our BIS system;
    
    market acceptance of our BIS VISTA monitor;
    
    use of and demand for our BIS Sensors;
    
    transition of sales focus from expanding our customer base to developing our existing
customers and increasing their sensor utilization and procedure penetration;
    
    customer cancellations;
    
    introduction of competitive products;
    
    regulatory approvals;
    
    changes in management;
    
    turnover in our direct sales force;
    
    effectiveness of new marketing and sales programs;
    
    communications published by industry organizations or other professional entities in
the anesthesia community that are unfavorable to our business;
    
    sales of convertible debt instruments and repurchases of shares of our common stock;
    
    the amount of our outstanding indebtedness and interest payments under debt obligations;
    
    reductions in orders by our distributors and original equipment manufacturers; and
    
    the timing and amount of our expenses.
  If the estimates we make, and the assumptions on which we rely, in preparing our financial
statements prove inaccurate, our actual results may vary from those reflected in our financial
statements.
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##### Table of Contents



We may need additional financing for our future capital needs and may not be able to raise
additional funds on terms acceptable to us, or at all.
  
    
    the research and development costs of our products or technology currently under
development, including costs to fund our neuroscience program following
termination in June 2007 of our alliance with Boston Scientific Corporation,
increase beyond current estimates;
    
    we decide to expand faster than currently planned;
    
    we develop new or enhanced services or products ahead of schedule;
    
    we decide to undertake new sales and/or marketing initiatives;
    
    we are required to defend or enforce our intellectual property rights, or respond
to other legal challenges with respect to our products, including product
liability claims;
    
    sales of our products do not meet our expectations domestically or internationally;
    
    we are required or elect to pay the principal under our 2.5% convertible senior
notes due 2014 in cash at or prior to maturity;
    
    we need to respond to competitive pressures; or
    
    we decide to acquire complementary products, businesses or technologies.
  Cases of awareness with recall during monitoring with the BIS system could limit market acceptance
of the BIS system and could expose us to product liability claims.
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We may not be able to compete with new products or alternative techniques developed by others,
which could impair our ability to remain competitive and achieve future growth.
  
    
    other new monitoring products, based on new or improved technologies;
    
    new products or technologies used on patients or in the operating room during
surgery in lieu of monitoring devices;
    
    electrical or mechanical interference from new or existing products or technologies;
    
    alternative techniques for evaluating the effects of anesthesia;
    
    significant changes in the methods of delivering anesthesia; and
    
    the development of new anesthetic agents.
  If we do not maintain our relationships with the
anesthesia community and if anesthesiologists and
other healthcare providers do not recommend and endorse our products, our sales may decline or we
may be unable to increase our sales and profits.
   Negative publicity or unfavorable media coverage could damage our reputation and harm our
operations.
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If we do not successfully develop or acquire and introduce enhanced or new products we could lose
revenue opportunities and customers.
  
    
    identify and respond, in a timely manner, to new market trends or opportunities;
    
    assess customer needs;
    
    successfully develop or acquire competitive products;
    
    complete regulatory clearance in a timely manner;
    
    successfully develop cost effective manufacturing processes;
    
    introduce such products to our customers in a timely manner; and
    
    achieve market acceptance of the BIS system.
  
    
    we may not successfully adapt the BIS system to function properly for
procedural sedation, when used with anesthetics we have not tested or
with patient populations we have not studied, such as infants; and
    
    our technology is complex, and we may not be able to develop it
further for applications outside anesthesia monitoring, such as the
diagnosis and tracking of neurological diseases.
   If our clinical trials are delayed or unsuccessful, our business could be adversely affected.
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
    
    delays or the inability to obtain required approvals from institutional review boards or other governing
entities at clinical sites selected for participation in our clinical trials;
    
    delays in enrolling patients and volunteers into clinical trials;
    
    lower than anticipated retention rates of patients and volunteers in clinical trials;
    
    negative results from clinical trials for any of our potential products, including those involving the
management of depression and the early diagnosis and tracking of Alzheimers disease; and
    
    failure of our clinical trials to demonstrate the efficacy or clinical utility of our potential products.
  If we do not develop and implement a successful sales and marketing strategy, we will not expand
our business.
  
    
    provide or assure that distributors and original equipment manufacturers provide the
technical and educational support customers need to use the BIS system successfully,
    
    promote frequent use of the BIS system so that sales of our disposable BIS Sensors increase,
    
    establish and implement successful sales and marketing and education programs that
encourage our customers to purchase our products or the products that are made by original
equipment manufacturers incorporating our technology,
    
    manage geographically dispersed operations, and
    
    modify our products and marketing and sales programs for foreign markets.
 We encourage our direct sales force, distributors and original equipment manufacturers to maximize
the amount of our products they sell and they may engage in aggressive sales practices that may
harm our reputation.
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Our third-party distribution and original equipment manufacturer relationships could negatively
affect our profitability, cause sales of our products to decline and be difficult to terminate if
we are dissatisfied.
  We may not be able to generate enough additional revenue from our international expansion to offset
the costs associated with establishing and maintaining foreign operations.
  We may not be able to meet the unique operational, legal and financial challenges that we will
encounter in our international operations, which may limit the growth of our business.
  
    
    failure of local laws to provide adequate protection against infringement of our intellectual property,
    
    protectionist laws and business practices that favor local competitors, which could slow or prohibit our
growth in international markets,
    
    difficulties in terminating or modifying distributor arrangements because of restrictions in markets
outside the United States,
    
    less acceptance by foreign anesthesia providers of the use of disposable products, such as BIS Sensors,
    
    delays in regulatory approval of our products,
    
    currency conversion issues arising from sales denominated in currencies other than the United States dollar,
    
    foreign currency exchange rate fluctuations,
    
    longer sales cycles to sell products like the BIS system to hospitals and outpatient surgical centers,
which could slow our revenue growth from international sales, and
    
    longer accounts receivable payment cycles and difficulties in collecting accounts receivable.
  We may experience customer dissatisfaction and our reputation could suffer if we fail to
manufacture enough products to meet our customers demands.
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Our reliance on sole-source suppliers could adversely affect our ability to meet our customers
demands for our products in a timely manner or within budget.
  We may be required to bring litigation to enforce our intellectual property rights, which may
result in substantial expense and may divert our attention from the implementation of our business
strategy.
  We may be sued by third parties which claim that our products infringe on their intellectual
property rights, particularly because there is substantial uncertainty about the validity and
breadth of medical device patents.
  
    
    cease selling, incorporating or using any of our products that incorporate the
challenged intellectual property, which would adversely affect our revenue,
    
    obtain a license from the holder of the infringed intellectual property right, which
license may not be available on reasonable terms, if at all, and
    
    redesign our products, which may be costly, time-consuming and may not be successful.
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We could be exposed to significant product liability claims which could divert management attention
and adversely affect our cash balances, our ability to obtain and maintain insurance coverage at
satisfactory rates or in adequate amounts and our reputation.
  Several class action lawsuits have been filed against the underwriters of our initial public
offering which may result in negative publicity and potential litigation against us that would be
costly to defend and the outcome of which is uncertain and may harm our business.
   We and Boston Scientific recently jointly terminated our strategic alliance and other agreements
and, as a result, we may not have sufficient funding to finance our neuroscience programs.
  
    
    the original equipment manufacturer product development agreement dated as of August
7, 2002, pursuant to which we were seeking to develop certain products that Boston
Scientific Corporation would then commercialize in the area of monitoring patients
under sedation in a range of less invasive medical specialties, and pursuant to which
we granted Boston Scientific Corporation an exclusive option to become the distributor
for a period of time of certain of our products;
    
    the product development and distribution agreement dated as of May 23, 2005,
pursuant to which we were seeking to develop new applications of its brain-monitoring
technology in the area of the diagnosis and treatment of neurological, psychiatric and
pain disorders and Boston Scientific Corporation was appointed the exclusive
distributor of such products. Under this agreement, which we refer to as the
neuroscience alliance, Boston Scientific Corporation had agreed to provide $25.0
million of funding over a five year period. We received $10.0 million under this
agreement.
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
    
    the letter agreement dated August 7, 2002, and the security agreement dated August
7, 2002, pursuant to which Boston Scientific Corporation agreed to make revolving
interest-bearing loans to us from time to time at our request, such revolving loans
being evidenced by a promissory note in the original principal amount of $5,000,000
dated August 7, 2002 made by us in favor of Boston Scientific Corporation.
  We may not reserve amounts adequate to cover product obsolescence, claims and returns, which could
result in unanticipated expenses and fluctuations in operating results.
  We may not be able to compete effectively, which could result in price reductions and decreased
demand for our products.
  Our ability to market and sell our products and generate revenue depends upon receipt of domestic
and foreign regulatory approval of our products and manufacturing operations.
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Even if we obtain the necessary FDA clearances or approvals, if we or our suppliers fail to comply
with ongoing regulatory requirements our products could be subject to restrictions or withdrawal
from the market.
  
    
    untitled letters, warning letters, fines, injunctions and civil penalties,
    
    administrative detention, which is the detention by the FDA of medical devices believed to be
adulterated or misbranded,
    
    customer notification, or orders for repair, replacement or refund,
    
    voluntary or mandatory recall or seizure of our products,
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
    
    operating restrictions, partial suspension or total shutdown of production,
    
    refusal to review pre-market notification or pre-market approval submissions,
    
    rescission of a substantial equivalence order or suspension or withdrawal of a pre-market approval, and
    
    criminal prosecution.
  We may be subject, directly or indirectly, to federal and state healthcare fraud and abuse laws and
regulations and, if we are unable to fully comply with such laws, could face substantial penalties.
  If we do not retain our senior management and other key employees, we may not be able to
successfully implement our business strategy.
  If we do not attract and retain skilled personnel, or if we do not maintain good relationships with
our employees, we will not be able to expand our business.
   Our employees may engage in misconduct or other improper activities, including insider trading.
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Failure of users of the BIS system, or users of future products we may develop, to obtain adequate
reimbursement from third-party payors could limit market acceptance of the BIS system and other
products, which could prevent us from sustaining profitability.
   Transactions engaged in by our largest stockholders, our directors or executives involving our
common stock may have an adverse effect on the price of our stock.
   We have various mechanisms in place to discourage takeover attempts, which may reduce or eliminate
our stockholders ability to sell their shares for a premium in a change of control transaction.
  
    
    preferred stock that could be issued by our board of directors to make it more difficult for a third
party to acquire, or to discourage a third party from acquiring, a majority of our outstanding voting
stock,
    
    classification of our directors into three classes with respect to the time for which they hold office,
    
    non-cumulative voting for directors,
    
    control by our board of directors of the size of our board of directors,
    
    limitations on the ability of stockholders to call special meetings of stockholders,
    
    inability of our stockholders to take any action by written consent, and
    
    advance notice requirements for nominations of candidates for election to our board of directors or
for proposing matters that can be acted upon by our stockholders at stockholder meetings.
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Risks Related to our Issuance of $125 Million Principal Amount of 2.5% Convertible Senior Notes due
2014
 Our increased indebtedness as a result of the issuance of $125 million principal amount of 2.5%
convertible senior notes, or the notes, may harm our financial condition and results of operations.
  
    
    it could adversely affect our ability to satisfy our obligations under the notes;
    
    a substantial portion of our cash flows from operations will have to be dedicated to
interest payments, principal payments and, if we irrevocably elect to net share settle the
notes, conversion payments and may not be available for operations, working capital,
capital expenditures, expansion, acquisitions or general corporate or other purposes;
    
    it may impair our ability to obtain additional financing in the future;
    
    it may limit our flexibility in planning for, or reacting to, changes in our business
and industry; and
    
    it may make us more vulnerable to downturns in our business, our industry or the economy
in general.
  We may not have the cash necessary to pay interest on the notes, to settle conversions of the notes
(if we have obtained stockholder approval to elect net share settlement of the notes, and we
irrevocably elect such settlement method) or to repurchase the notes upon a fundamental change.
  The net share settlement feature of the notes, if available, may have adverse consequences.
  
    
    result in holders receiving no shares of our common stock upon conversion or fewer
shares of our common stock relative to the conversion value of the notes;
    
    reduce our liquidity because we will be required to pay the principal portion in cash;
    
    delay holders receipt of the proceeds upon conversion; and
    
    subject holders to market risk before receiving any shares upon conversion.
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Future sales of our common stock in the public market or the issuance of securities senior to our
common stock could adversely affect the trading price of our common stock and the value of the
notes and our ability to raise funds in new securities offerings.
   Conversion of the notes will dilute the ownership interest of existing stockholders, including
holders who had previously converted their notes.
  Provisions in the indenture for the notes may deter or prevent a business combination that may be
favorable to note holders.
  The notes may not be rated or may receive a lower rating than anticipated.
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The effective subordination of the notes to our secured indebtedness to the extent of the
collateral securing such indebtedness may limit our ability to satisfy our obligations under the
notes.
  The structural subordination of the notes to our secured liabilities and all liabilities and
preferred equity of our subsidiaries may limit our ability to satisfy our obligations under the
notes.
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Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
  ISSUER PURCHASES OF EQUITY SECURITIES (1)
 (c) Total Number of
    
    (d) Maximum NumberShares Purchased as
    
    of Shares that MayPart of Publicly
    
    Yet be Purchased(a) Total Number of
    
    (b) Average Price
    
    Announced Plans or
    
    Under the Plans orPeriod
    
    Shares Purchased
    
    Paid per Share
    
    Programs
    
    ProgramsJuly 1, 2007  July 28, 2007 (1)
    
    
    2,500,000
    
    
    $
    15.06
    
    
    
    2,500,000
    
    
    
    1,513,239Total
    
    
    2,500,000
    
    
    $
    15.06
    
    
    
    2,500,000
    
    
    
    1,513,239
  (1)
    
    On July 10, 2007, we repurchased 2,500,000 shares of common stock held by Boston
Scientific Corporation at a price of approximately $15.06 per share, or an aggregate of
$37,655,000. The repurchase was made in accordance with the Termination and Repurchase
Agreement by and between Boston Scientific Corporation and us, dated June 11, 2007. The
repurchased shares were cancelled and retired. 
 Item 6. Exhibits.
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SIGNATURE
  ASPECT MEDICAL SYSTEMS, INC.Date: November 8, 2007
    By:
    /s/ Michael FalveyMichael FalveyVice President and Chief Financial Officer
(Principal Financial and Accounting Officer) 50




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EXHIBIT INDEX
 EXHIBITNUMBER
    
    EXHIBIT10.1
    
    
    
    Amendment to Amended and Restated By-Laws is incorporated
herein by reference to Exhibit 3.1 to the Registrants Current Report on Form 8-K dated November 1, 2007.10.2
    
    
    
    Amendment No. 2 to Rights Agreement by and between
the Registrant and Computershare Trust Company, N.A. (formerly EquiServe Trust Company, N.A.) is incorporated herein by
reference to Exhibit 4.1 to the Registrants Current Report on Form 8-K dated November 1, 2007.10.3
    
    
    
    Letter dated November 7, 2007 by and between
the Registrant and Boston Scientific Corporation is incorporated herein by reference to Exhibit 10.1 to the Registrants Current Report
on Form 8-K dated November 7, 2007.31.1
    
    
    
    Certification by Chief Executive Officer Pursuant to Rule
13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934, as
amended.31.2
    
    
    
    Certification by Chief Financial Officer Pursuant to Rule
13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934, as
amended.32.1
    
    
    
    Certification by Chief Executive Officer Pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.32.2
    
    
    
    Certification by Chief Financial Officer Pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.